handbook of venture capital

HANDBOOK OF RESEARCH ON VENTURE CAPITAL

Handbook of Research on VentureCapital

Edited by

Hans Landström

Institute of Economic Research, Lund University, Sweden

Edward ElgarCheltenham, UK • Northampton, MA, USA

© Hans Landström 2007

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system ortransmitted in any form or by any means, electronic, mechanical or photocopying, recording, orotherwise without the prior permission of the publisher.

Published byEdward Elgar Publishing LimitedGlensanda HouseMontpellier ParadeCheltenhamGlos GL50 1UAUK

Edward Elgar Publishing, Inc.William Pratt House9 Dewey CourtNorthamptonMassachusetts 01060USA

A catalogue record for this bookis available from the British Library

Library of Congress Control Number: 2007921138

ISBN 978 1 84542 312 4 (cased)

Printed and bound in Great Britain by MPG Books Ltd, Bodmin, Cornwall

Contents

List of contributors viiForeword ixAcknowledgements x

PART I VENTURE CAPITAL AS A RESEARCH FIELD

1 Pioneers in venture capital research 3Hans Landström

2 Conceptual and theoretical reflections on venture capital research 66Harry J. Sapienza and Jaume Villanueva

3 Venture capital: A geographical perspective 86Colin Mason

4 Venture capital and government policy 113Gordon C. Murray

PART II INSTITUTIONAL VENTURE CAPITAL

5 The structure of venture capital funds 155Douglas Cumming, Grant Fleming and Armin Schwienbacher

6 The pre-investment process: Venture capitalists’ decision policies 177Andrew Zacharakis and Dean A. Shepherd

7 The venture capital post-investment phase: Opening theblack box of involvement 193Dirk De Clercq and Sophie Manigart

8 Innovation and performance implications of venture capital involvement in the ventures they fund 219Lowell W. Busenitz

9 The performance of venture capital investments 236Benoit F. Leleux

10 An overview of research on early stage venture capital: Current status and future directions 253Annaleena Parhankangas

11 Private equity and management buy-outs 281Mike Wright

PART III INFORMAL VENTURE CAPITAL

12 Business angel research: The road traveled and the journey ahead 315Peter Kelly

13 Investment decision making by business angels 332Allan L. Riding, Judith J. Madill and George H. Haines, Jr

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14 The organization of the informal venture capital market 347Jeffrey E. Sohl

PART IV CORPORATE VENTURE CAPITAL

15 Corporate venture capital as a strategic tool for corporations 371Markku V.J. Maula

16 Entrepreneurs’ perspective on corporate venture capital (CVC): A relational capital perspective 393Shaker A. Zahra and Stephen A. Allen

PART V IMPLICATIONS

17 Implications for practice, policy-making and research 415Hans Landström

Index 427

vi Handbook of research on venture capital

Contributors

Stephen A. Allen, Babson College, USA

Lowell W. Busenitz, Michael F. Price College of Business, University of Oklahoma, USA

Douglas Cumming, Schulich School of Business, York University, Canada

Dirk De Clercq, Faculty of Business, Brock University, Canada

Grant Fleming, Wilshire Private Markets Group and Australian National University,Australia

George H. Haines, Jr, Eric Sprott School of Business, Carleton University, Canada

Peter Kelly, Helsinki School of Creative Entrepreneurship and Helsinki University ofTechnology, Finland

Hans Landström, Institute of Economic Research, Lund University, Sweden

Benoit F. Leleux, IMD International, Lausanne, Switzerland

Judith J. Madill, Eric Sprott School of Business, Carleton University, Canada

Sophie Manigart, Vlerick Leuven Gent Management School and Department ofAccounting and Finance, Ghent University, Belgium

Colin Mason, Hunter Centre for Entrepreneurship, University of Strathclyde, UK

Markku V.J. Maula, Institute of Strategy and International Business, Helsinki Universityof Technology, Finland

Gordon C. Murray, School of Business & Economics, University of Exeter, UK

Annaleena Parhankangas, Institute of Strategy and International Business, HelsinkiUniversity of Technology, Finland

Allan L. Riding, University of Ottawa, Canada

Harry J. Sapienza, Center for Entrepreneurial Studies, Carlson School of Management,University of Minnesota, USA

Armin Schwienbacher, Finance Group, University of Amsterdam, the Netherlands andUniversité catholique de Louvain, Belgium

Dean A. Shepherd, Kelley School of Business, Indiana University, USA

Jeffrey E. Sohl, Center for Venture Research, Whittemore School of Business andEconomics, University of New Hampshire, USA

Jaume Villanueva, Center for Entrepreneurial Studies, Carlson School of Management,University of Minnesota, USA

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Mike Wright, Nottingham University Business School, UK

Andrew Zacharakis, Babson College, USA

Shaker A. Zahra, Center for Entrepreneurial Studies, Carlson School of Management,University of Minnesota, USA

viii Handbook of research on venture capital

Foreword

In today’s modern economy a country’s or region’s competitiveness lies in its capability toinnovate. Whilst earlier old and established companies were reliable producers of innov-ation as well as jobs, that is changing. The big corporations are outsourcing and down-sizing, and the new technologies are emerging from companies that did not exist 20 yearsago. Governments have come to realize that in order to sustain economic growth andcreate jobs they must have a policy that facilitates entrepreneurship. One of the importantcomponents in this policy is the supply of venture capital. Nowadays there are few fast-growing high technology companies that have not been financed by venture capital atsome stage. If they haven’t obtained venture capital, they probably tried to obtain it.Governments all around the world are creating schemes and policies that will facilitate thesupply of venture capital.

The increased attention given to venture capital from policy makers is also evidentwithin the research. The amount of research and literature on venture capital is enormous.There are several academic journals devoted solely to venture capital, and venture capitalresearch is occurring in a large number of journals; numerous books on venture capitalare published yearly. Though the venture capital phenomenon is not new, it generates anincreasingly large amount of research.

We are at a stage when it is suitable to synthesize the research findings and see what weknow and what we do not know about venture capital. This volume presents the state ofthe art in venture capital research. It includes writing from the elite of the venture capitalresearchers around the world and covers the most central aspects of venture capitalresearch. This volume gives the reader a unique opportunity to understand what venturecapital is and how it works.

The Swedish Institute for Growth Policy Studies (ITPS), Swedish Foundation of SmallBusiness Research (FSF), and Swedish Agency for Economic and Regional Growth(NUTEK) have as their mission to improve the entrepreneurial climate and the economicgrowth in Sweden. We see the supply of venture capital as one of the crucial factors tounleash the growth potential in the economy. We are proud to sponsor this handbook, andwe are convinced that it will be a frequently read resource for anyone interested in venturecapital and in fostering economic growth – as well as those who want to understand themodern economy.

Sture ÖbergSwedish Institute for Growth Policy Studies (ITPS)

Anders LundströmSwedish Foundation of Small Business Research (FSF)

Sune HalvarssonSwedish Agency for Economic and Regional Growth (NUTEK)

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Acknowledgements

I first became interested in venture capital in the mid-1980s when writing my thesis on thedevelopment and growth of new technology-based firms in Sweden. At that point in timethere was not much research available on the subject of venture capital – with the excep-tion of some seminal studies by researchers who are today regarded as pioneers within thefield. Venture capital has always fascinated me, and I have written a large number of art-icles and reports on different aspects of it. At the same time we have witnessed an enor-mous increase in academic research within the field internationally, thus we know a greatdeal more about venture capital today than we did a mere decade ago.

When I was asked by Edward Elgar Publishing to be the editor of a state-of-the-artbook on venture capital I was naturally very honoured, but I also found it timely in thesense that we have been researching venture capital for about 25 years, and in my view, itis important to reflect now and then on the knowledge acquired in order to establish abasis for further development of the field.

The first phase of the process involved in the production of the Handbook ofResearch on Venture Capital was to invite the most prominent international researcherswithin the field to participate in the project and write a chapter on a specific topic.I was encouraged to find that their reactions were very positive – the need to summar-ize and synthesize our knowledge after almost three decades of venture capitalresearch was obvious. The writing and reviewing process has been intensive, and thechapters have gone through three rounds of revision. At the end of the process (29–31May, 2006) the authors met in Lund, Sweden, in order to discuss and provide feed-back on each other’s chapters. I sincerely thank all the authors for their willingness togenerously share their knowledge on venture capital and for all the work they havedevoted to this project.

In connection with the meeting in Lund we also organized a ‘Workshop on VentureCapital Policy’ with more than 80 participants including a good mix of researchers andpolicy makers interested in venture capital, and during these days we achieved a veryintense and interesting dialogue between leading researchers and policy makers within thefield. As such events do not organize themselves I wish to thank Gertie Holmgren andElsbeth Andersson of Lund University School of Economics and Management as well asthe whole group of researchers and doctoral students within the research programme onEntrepreneurship and Venture Finance at the Institute of Economic Research andCIRCLE for their great efforts in organizing the workshop in Lund.

I am very grateful to the Swedish Agency for Economic and Regional Growth(NUTEK), the Swedish Institute for Growth Policy Studies (ITPS) and the SwedishFoundation for Small Business Research (FSF) for their financial support of the project.Sincere thanks to the project committee made up of Birgitta Österberg and Karin Östbergfrom NUTEK, Marcus Zachrisson of ITPS, and Anders Lundström and Helena Ericssonfrom FSF for their valuable help and comments throughout the project.

I have written the first and last chapter in this handbook, and I thank Doctor JonasGabrielsson, Doctor Diamanto Politis and Doctor Joakim Winborg for their valuable

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comments on my chapters. In addition, I am grateful to Professor Olle Persson at UmeåUniversity for helping me with the bibliographical analysis of the research field.

Finally, a special thanks to Francine O’Sullivan at Edward Elgar Publishing for invitingme to be the editor of the handbook, and for her excellent support throughout the process.

Hans LandströmInstitute of Economic Research School of Economics and Management

Lund University, Sweden

Acknowledgements xi

PART I

VENTURE CAPITAL AS ARESEARCH FIELD

1 Pioneers in venture capital researchHans Landström

Introduction

The importance of venture capitalWe need growth-oriented entrepreneurial ventures in society. These ventures represent animportant power in an economy – they create innovations and dynamics, new jobs, incomeand, not least, wealth. Although growth-oriented entrepreneurial ventures, or what Birch(1987) calls ‘gazelles’, can be found in all industry sectors and locations (urban as well asrural), there are some indications that the ventures with the highest growth potential areoften characterized as knowledge-based and technologically driven – primarily based onintangible assets, operating in rapidly developing fields and with no documented history.One of the main problems facing these growth-oriented entrepreneurial ventures is raisingcapital for the growth of the business and gaining access to the competence, experience andnetworks necessary for growth which most entrepreneurs lack (Brophy, 1997). It is in thisdomain of growth-oriented entrepreneurial activities that we need an efficient venturecapital market that can provide adequate capital and management skills. For example, it hasoften been argued that the scope and sophistication of the US venture capital industry isone reason for the exceptional ability of the US economy to turn innovative ideas from uni-versities and R&D laboratories into high growth companies such as the Intel Corporation,Cisco Systems, Microsoft, Oracle, Amazon.com, Yahoo!, etc. (Maula et al., 2005).

Thus, growth-oriented ventures are important in society, and venture capital is a sig-nificant vehicle for promoting their growth. The importance of venture capital makes itessential to understand the way the venture capital market operates, and how businessangels and venture capitalists manage their investments. In this book we will summarizeand synthesize the knowledge in the area of venture capital: what do we know? what dowe not know? And what can we learn from existing knowledge (or lack of knowledge)?

The aims of the bookThe scholarly interest in venture capital began in the 1970s and expanded substantially inthe following two decades. This interest was especially strong among researchers in theUS, which is also the home of the most dynamic venture capital market. Thus, systematicventure capital research is less than 25 years old, or a little more than half of an acade-mic career. But during those 25 years our knowledge has grown exponentially, and weknow a great deal more today about the venture capital market, business angels, venturecapitalists’ investment decision, and so on than we did 10 to 15 years ago. For example,an analysis of the Social Citation Index reveals an increase in the number of scientific arti-cles written on venture capital since the 1980s – from about 10 articles per year at the endof the 1980s to 25 articles in the mid-1990s, while today the annual number of articles onventure capital is between 60 and 70 (see Figure 1.1), and the last five years (2001–2005)account for 48 per cent of venture capital related research.

3

In this state-of-the-art book we will try to summarize and synthesize 25 years of venturecapital research. In addition, our aim is to communicate new and future directions of ourknowledge to scholars, venture capitalists, entrepreneurs and policy-makers, in order toincrease the understanding of the venture capital phenomenon.

Some comments regarding the content of the book will first be made to help the reader.If we look at our knowledge on venture capital, we can conclude that most venturecapital research concerns the supply side of the market (from the investor perspective)whereas little work can be found on the demand side – related to the decision-makingprocesses of ventures seeking venture capital. Obviously, this state-of-the-art book –which attempts to summarize and synthesize existing knowledge within the field – reflectsthis bias.

Second, in a citation analysis performed by Cornelius and Persson (2004; 2006) itwas revealed that the venture capital research community was divided into two sepa-rate clusters of researchers. With the exception of some very important core authorswithin the field who are generally cited (such as William Sahlman, Paul Gompers andWilliam Bygrave), there seems to be surprisingly little intellectual cross-fertilizationbetween the two clusters. One cluster of researchers has a background in finance andeconomics and mainly analyses venture capital on a macro level, using, for example,agency theory, capital market theory, and so on as theoretical frameworks in theirstudies, which are published in financial and economics journals. Another cluster ofresearchers has its roots in management and entrepreneurship research and thus has astronger managerial focus on venture capital with more heterogeneity in the researchparadigms employed. These researchers publish their works in entrepreneurship man-agement journals. The present book focuses on the managerial aspects of venturecapital – although several chapters in the book also cover more aggregated discussionsconcerning the development of the market, regional aspects of venture capital, andpolicy implications.

Finally, there is a geographical bias in our knowledge about venture capital. Since theemergence of the research field in the 1980s, venture capital has been regarded as a USphenomenon dominated by Anglo-Saxon (mainly US) researchers – and this has contin-ued, in spite of increased interest on the part of scholars all over the world since the 1990s.

4 Handbook of research on venture capital

Figure 1.1 Number of articles on venture capital

0

10

20

30

40

50

60

70

80

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

As a consequence, our knowledge is heavily influenced by the US context and model ofventure capital. However, not only is US research dominant; as venture capital has a ten-dency to concentrate in certain geographical regions such as metropolitan areas and high-technology clusters, our knowledge on venture capital does likewise and is mainly derivedfrom dynamic regions such as Silicon Valley and Boston. As this is a state-of-the-art book,these geographical biases will be reflected. However, we have tried to select authors fromdifferent parts of the world and have asked them to consider venture capital as a globalphenomenon.

Venture capital – what are we talking about?Venture capital is a specific form of industrial finance – part of a more broadly basedprivate equity market, that is investments (with private equity) made by institutions, firmsand wealthy individuals in ventures that are not quoted on a stock market, and which havethe potential to grow and become significant players on the international market (Masonand Harrison, 1999a; Isaksson, 2006). The private equity market can be divided into twodifferent parts (although the distinction is not always easy to make):

1. Venture capital, which is primarily devoted to equity or equity-linked investments inyoung growth-oriented ventures; and

2. Private equity, which is devoted to investments that go beyond venture capital –covering a range of other stages and established businesses including, for example,management buy-outs, replacement capital and turnarounds.

Venture capital will usually be regarded as an active and temporary (5 to 10 years)partner in the ventures in which they invest, and they are normally minority sharehold-ers. They achieve their rate of returns mainly in the form of capital gain through exitrather than by means of dividend income.

The venture capital market consists of different submarkets, and in this book we willfocus on three of them: institutional venture capital, corporate venture capital, andinformal venture capital.

Institutional venture capital It is not an easy task to provide a generally accepted defin-ition of institutional venture capital (also called ‘formal venture capital’) – the numberof definitions is almost as great as the number of authors writing articles on the subject.Institutional venture capital firms act as intermediaries between financial institutions(such as large companies, pension funds, wealthy families, and so on) and unquotedcompanies, raising finance from the former to invest in the latter (Lumme et al., 1998).Wright and Robbie (1998) defined institutional venture capital as professional invest-ments of long-term, unquoted, risk equity finance in new firms where the primaryreward is eventual capital gain supplemented by dividends. Elaborating on this defin-ition, Mason and Harrison (1999a, p. 16) stated that ‘the institutional VC industrycomprises full-time professionals who raise finance from pension funds, insurance com-panies, banks and other financial institutions to invest in entrepreneurial ventures.Institutional venture capital firms take various forms: publicly traded companies,“captive” subsidiaries of large banks and other financial institutions, and independentlimited partnerships.’

Pioneers in venture capital research 5

As indicated in the definition by Mason and Harrison, an institutional venture capitalfirm can take different organizational forms, depending on the ownership structure, butusually consists of:

● Independent limited partnerships, in which the venture capital firm serves as thegeneral partner, raising capital from limited partners such as institutional investors(for example, pension funds, insurance companies and banks).

● Captive venture capital firms, which are mainly funded by the internal resources ofa parent organization – often a financial institution, such as a bank or insurancecompany, but sometimes by a larger non-financial company (so-called ‘corporateventure capital’).

● Government venture capital organizations, which are financed and controlled bygovernment institutions.

Since the 1980s the limited partnership has emerged as the dominant organizationalform in venture capital. In a limited partnership, the venture capitalists are general part-ners and control the fund’s activities, whereas the investors act as limited partners who arenot involved in the everyday management of the fund (see Figure 1.2).

A fact that makes the definition of institutional venture capital even more complicatedis that the understanding of institutional venture capital differs from country to country.In addition, the characteristics of the venture capital industries in Europe and the US arenot the same, indicating that the view and definition of venture capital differ substantiallybetween them. Bygrave and Timmons (1992) distinction between two types of venturecapital may be helpful to illustrate the differences:

● Classical venture capital funds – where the capital is raised from patient investors,for example, wealthy individuals and families. The funds are managed by investorswith entrepreneurial experience and industrial knowledge, who invest in early stageventures and who actively operate in the companies in which they invest.

● Merchant venture capital funds, which raise capital from institutional sources withshort-term investment horizons, where the funds are managed by individuals witha background in investment banking or other financial organizations, who invest at


Figure 1.2 The venture capital process

INVESTOR

Returns Fundraising

VENTURECAPITALIST

Equity Cash

VENTURE

a later stage or undertake management buy-outs (MBOs) and who focus stronglyon analytical and financial engineering, deal-making and transaction crafting.

Bygrave and Timmons argue that, due to the growing dominance of institutional invest-ments in venture capital funds in the US, and not least in Europe, merchant venturecapital funds have taken over at the expense of classic venture capital. Accordingly, thedefinitions of institutional venture capital in Europe are somewhat different and venturecapital is usually considered synonymous with ‘private equity’ in a more general sense andincludes investments in terms of early and expansion stage financing as well as thosecovering a range of other stages such as funding of management buy-outs, consolidations,turnarounds, and so on. On the other hand, in the US, the term ‘venture capital’ is nar-rower and refers to early stage investments in growth-oriented companies, or whatBygrave and Timmons term ‘classic’ venture capital.

Corporate venture capital One distinguishable part of the institutional venture capitalmarkets is ‘corporate venture capital’ as a ‘captive’ venture capital organization. Maula(2001) defines corporate venture capital as ‘equity or equity-linked investments in young,privately held companies, where the investor is a financial intermediary of a non-financialcorporation’ (p. 9). Thus, the main difference between institutional venture capital andcorporate venture capital is the fund sponsor – in corporate venture capital the onlylimited partner is a corporation, or a subsidiary of a corporation.

Corporate venture capital should be seen as a specific strategic tool in the corporateventure toolbox. There are many other tools that can be used in order to develop new busi-ness, and Maula (2001) distinguishes between (i) internal corporate venture, in whichinnovations and new businesses are developed at various levels within the boundaries ofthe firm, and (ii) external corporate venture, which results in the creation of semi-autonomous or autonomous organizational entities that reside outside the existing firm.It is within the frame of external corporate venture that corporate venture capital is usedas a tool for strategic considerations and business development, together with other toolssuch as venture alliances and acquisitions.

Following this reasoning and using a rather broad definition, McNally (1994) statesthat corporate venture capital can take two main forms: externally managed investments,


Table 1.1 Corporate venture capital

Corporate Venture Capital

Type of investment Externally managed Internally managed

Investment via independently Direct subscription for minority managed venture capital fund. equity stake.

Investment vehicle Independently Independently In-house corporate Ad hoc/one-off

managed fund managed captive managed fund investments, e.g.fund strategic alliances/

‘spin-offs’ fromcompany

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

in which large corporations finance new firms alongside independently managed venturecapital funds, and internally managed investment, that is making investments throughtheir own internal organization (see Table 1.1).

Informal venture capital This book will also discuss the informal venture capital market,which for many years has been associated with and regarded as equivalent to ‘businessangels’. Originally, the term ‘angel’ was used to describe individuals who helped to financetheatre productions on Broadway (‘theatre angels’). The ‘angels’ invested in these pro-ductions mainly for the pleasure of rubbing shoulders with their favourite actors. It wasa question of high-risk investment – the individuals lost their money if the productionwas a flop but shared the profits if it was successful (Benjamin and Margulis, 2001;Mason, 2007). Later on, William Wetzel (1983) was one of the first to coin the term ‘busi-ness angels’ for people providing the same kind of risk investments in young entrepre-neurial ventures. Following this line of thought, Lerner (2000) defines a business angel as‘a wealthy individual who invests in entrepreneurial firms. Although angels perform manyof the same functions as venture capitalists, they invest their own capital rather than thatof institutional or other individual investors’ (p. 515).

In empirical studies we have successively seen a broadening of the study of object, fromfocusing entirely on ‘business angels’ to include a broader range of private investorsmaking equity investments in entrepreneurial ventures (Landström, 1992; Avdeitchikova,2005), with more and more emphasis on ‘informal investors’ (see Figure 1.3). A commondefinition in this respect is based on Mason and Harrison (2000a) ‘private individualswho make investments directly in unlisted companies in which they have no family


Figure 1.3 Definitions of ‘business angels’ and ‘informal investors’

Narrowdefinition

Business angels High net worth individuals who invest a proportionof their assets in high-risk, high-returnentrepreneurial ventures (Freear et al., 1994).Apart from investing money, business angelscontribute their commercial skills, experience,business know-how and contacts taking a hands-onrole in the company (Mason and Harrison, 1995).

Informalinvestors

Comprised of private individuals who invest riskcapital directly in unquoted companies in which theyhave no family connection (Mason and Harrison,2000a). Thus, informal investors include businessangels as well as private investors who contributerelatively small amounts of money and do not takean active part in the object of investment.

Informalinvestors,includingfamily andfriends

Defined as any investments made in start-ups otherthan the investors’ own businesses, i.e. includingfamily investments, investments by friends, colleagues, etc., but excluding investments in stocksand mutual funds (Reynolds et al., 2003).

Broaddefinition

connections’ (p. 137). This definition of informal investors includes not only investmentsby business angels but also those made by private investors who are less active in the ven-tures in which they invest as well as private investors who invest smaller amounts ofcapital in unlisted companies. On the other hand, the definition excludes investmentsmade by ‘family and friends’, and this perspective is not uncontroversial. For example, inthe large international research project Global Entrepreneurship Monitor, investmentsmade by ‘family and friends’ are included in the study of informal investments in differentcountries (Reynolds et al., 2003). However, a central argument in the definition by Masonand Harrison (2000a) is that investments made by close relatives and friends are based onother considerations and investment criteria than those of external investors and, there-fore, family-related investments should be excluded from the definition.

Without taking a definite position, we can conclude that there are many different defini-tions of informal venture capital: from (i) ‘business angels’ in a narrow sense, to (ii) thebroader definition of ‘informal investors’, and (iii) also including investments made byfamily and friends. In empirical studies, the terms ‘business angels’ and ‘informal investors’are sometimes used to distinguish one from the other, but more often are interchangeable.Needless to say, this lack of rigour makes empirical studies on informal venture capitaldifficult to interpret and compare. Business angels and other types of informal investorsdiffer significantly – in the way they make decisions, their ability to add value, and so on,and there is a need to divide the informal venture capital market into relevant segments.

A comparison between three sources of venture capital An overview of the similarities anddifferences between institutional venture capital, business angels and corporate venturecapital is an appropriate way in which to conclude this discussion about the definition anddifferent sources of venture capital. The overview (Table 1.2) shows that different sourcesof venture capital seem to represent partially complementary and partially overlappingsources of finance: complementary in the sense of investment in different venture devel-opment phases and the amount of capital provided; overlapping in that each category ofinvestors makes investments in a broad range of ventures.

As can be seen in Table 1.2, institutional venture capital, business angels and corporateventure capital seem to have some distinctive characteristics. Obviously, the source offunds and legal status differ, as do the investment motives – all venture capitalists havesome form of financial motive (and even if intrinsic rewards are evident among businessangels, there are also financial reasons for the investment), although corporate venturecapitalists place greater emphasis on strategic considerations. Investment and monitoringdiffer, and especially it is the business angels that distinguish themselves in that theirinvestment capacity and time for due diligence are much more limited; also they have amuch more informal control process compared to institutional and corporate venturecapitalists.

A final comment needs to be made regarding the definitions of venture capital. The fieldof venture capital is characterized by vague definitions and a great deal of confusionregarding central concepts. Of course, unclear definitions make knowledge accumulationmore difficult, and many authors who contributed chapters to the handbook call forclearer and consistent definitions within the field. However, we do not consider it the aimof this book – which outlines past and present research on venture capital – to providesuch authoritative recommendations on definitional issues, although in order to develop


the field of venture capital research we should spare no effort to clarify the conceptsemployed.

Reality and researchThe social sciences are not developed in isolation from the rest of society and, as in manyother social sciences, we can find a strong linkage between the development of the venturecapital industry (the reality) and the interest among scholars in focusing on venturecapital (research), although with a certain time lag due to the ‘natural conservatism’ thatcharacterizes most research. In this section we will describe the development of venturecapital in the US as well as in Europe and the rest of the world. We will also show thatearly research contributions by a number of pioneering researchers, often geographicallylocated near dynamic venture capital markets, took place in the context of an emergingventure capital industry.

The birth of venture capitalVenture capital as a phenomenon is a very ancient activity. Private individuals have alwayshad a tendency to invest in high-risk projects. Examples of entrepreneurs raising capitalfrom private financiers can be found in the Babylonian era as well as in early medievalEurope. One extraordinary example is the decision by Queen Isabella of Spain to financethe voyage of Christopher Columbus, which can be regarded as a highly profitable (for theSpanish) venture capital investment. It could also be argued that in many countries theinvestments by private individuals were influential in the development of the industrialrevolution during the nineteenth and the early twentieth century. For example, in the US,


Table 1.2 Characteristics of institutional venture capital, business angels and corporateventure capital

Institutional venture Corporate venturecapital Business angels capital

Source of funds Primarily institutional Investing their own Investing corporateinvestors who act as money fundslimited partner

Legal form Limited partnership Private individuals Subsidiary of a large company

Motive for investment Equity growth Equity growth Strategic and Intrinsic rewards equity growth

Investment Experienced investors Experience varies Experience withinindustry/technology

Large investment Limited investment Large investmentcapacity capacity capacityExtensive due Limited time for due Extensive duediligence diligence diligence

Monitoring Formal control Informal control Corporate control

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

groups of domestic and European private investors were responsible for financing thedevelopment of several new industries, such as railroads, steel, petroleum and glass. Onesuch successful investment, made by a group of wealthy individuals, was the merger andfinancing of a few less successful companies into what became International BusinessMachines (IBM) in 1924. These kinds of investments are not unique to the US – we canfind similar success stories in many other countries (Rind, 1981; Benjamin and Margulis,2001; Gompers and Lerner, 2003).

In a more institutional sense, the venture capital industry can be regarded as an out-growth of the informal venture capital market – the industry originated in the manage-ment of the wealth of high net worth families in the US such as the Rockefeller (DouglasAircraft and Eastern Airlines), Phipps (Ingersoll Rand and International Papers), andWhitney (Vanderbilt) families during the early decades of the last century. Gradually,these operations became more and more professional, employing outsiders to select andmanage the investments, forming the nuclei for what ultimately became independentventure capital groups (Gompers and Lerner, 2003).

The Boston area was perhaps the first region to show some degree of organized venturecapital. By 1911, the Boston Chamber of Commerce was providing financial and tech-nical assistance to new ventures and, in 1940, the New England Industrial DevelopmentCorporation was launched to provide a similar kind of assistance (Florida and Kenney,1988). Boston was also the home of the first venture capital company in the US. The ideaof venture capital came from Ralph Flanders, president of the Federal Reserve Bank ofBoston, who was concerned about the lack of new company formation and the inabilityof institutional investors to finance new ventures. Flanders proposed fiduciary funds,which would enable institutional investors to invest up to 5 per cent of their assets inequity in new ventures (Bygrave and Timmons, 1992). The proposal was supported byGeneral Georges Doriot (professor at Harvard Business School) and together with CarlCompton (president of MIT) and some local business leaders, Doriot establishedAmerican Research and Development (ARD) in 1946. ARD made investments in youngfirms with a basis in technologies developed for World War II, often with close ties to theHarvard and MIT communities. Its first investment was in the High Voltage EngineeringCorporation, which was founded by engineers from MIT and which later became the firstventure capital-backed firm listed on the New York Stock Exchange. However, not allinvestments were successful – almost half of ARD’s profit during its 26-year existencecame from its $70 000 investment in the Digital Equipment Company in 1957, which hadincreased in value to $355 million by 1971 (Bygrave and Timmons, 1992; Gompers andLerner, 2003).

In Silicon Valley/San Francisco, another region with a dense cluster of technology-based enterprises, venture capital groups began to emerge during the late 1950s and early1960s. The first venture capital firm in California – Draper, Gaither and Andersen – wasfounded in 1958, and the late 1950s became a seminal period witnessing the establishmentof more than a dozen venture capital firms in the Silicon Valley and San Francisco area(Florida and Kenney, 1988).

The development of venture capital in the USAlthough the venture capital phenomenon can be regarded as a very ancient activity,the venture capital industry grew slowly. The market was fragmented and geographically


concentrated (Brophy, 1986). One key point in the development of the industry was thecreation of Small Business Investment Companies (SBIC) in 1958 – privately operatedinvestment companies that could receive tax benefits and borrowing rights from the SmallBusiness Administration (from 1992 it was also possible to obtain equity capital from theUS Treasury at attractive rates), which meant that private investors could benefit fromadvantageous federal loans as well as favourable tax rules. However, despite these mea-sures to improve the venture capital industry in the US, the amount of venture capital wasrather limited. The flow of money into venture capital funds between 1946 and 1977 neverexceeded a few hundred million dollars annually (often much less). At the beginning ofthe 1970s, the venture capital market stagnated even more, mainly due to a sharp rise incapital gains tax – from 25 to 49 per cent – which reduced the potential profit on invest-ments. At the same time, the industry experienced several failures and the venture capitalcompanies did not succeed in managing the situation that arose; thus general mistrust ofthe venture capital industry emerged. At the end of the 1970s, the venture capital indus-try was very small, homogeneous in strategy and practice, and competition for deals wasweak. Few investors and entrepreneurs considered the venture capital market particularlyimportant for new and growing ventures, and the interest from scholars in academiawas limited.

However, in the early 1980s, the venture capital industry grew dramatically, due to anincrease in investment opportunities and the introduction of tax-related incentives. Themarket increased from approximately 200 venture capital firms and a pool of venturecapital of $2.9 billion in 1979 to almost 700 firms and a pool of more than $30 billion in1989 (Timmons and Sapienza, 1992). There are several reasons behind this growth(Bygrave and Timmons, 1992; Gompers and Lerner, 1996; 2003):

● Before 1979 the possibility for pension funds to invest in venture capital was limited,but following clarification by the Department of Labor (the Employers’ RetirementInvestment Security Act, ERISA) the rules explicitly allowed pension funds toinvest in high-risk assets such as venture capital funds – known as ERISA’s ‘PrudentMan Rule’.

● An associated change was the increased role of investment advisors. As venturecapital represented a very small proportion of pension fund portfolios, almost allpension funds invested directly in venture funds, and the monitoring and evaluationof these investments were rather limited. In the mid-1980s, advisors (so-called ‘gate-keepers’) entered the market to advise institutional investors in the area of ventureinvestments and pooled the resources from their clients, monitored existing invest-ments and evaluated potential new funds.

● Capital gains tax was successively reduced from 49 to 28 per cent – a measure thatwas not only important for the supply of capital, but also had positive effects on theentrepreneurial activity which created more investment opportunities.

● The emergence of new technologies in the economy (microprocessor and recombi-nant DNA) provided a fertile ground for venture capital investments.

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


across firms, and greater specialization in investment stage, industry and region. Venturecapitalists changed their strategy – and moved towards later stage and larger investments(Bygrave and Timmons, 1992; Timmons and Sapienza, 1992).

After this period of growth in the US venture capital industry, the development duringthe 1980s and 1990s was characterized by ‘ups’ and ‘downs’. In the mid-1980s, the returnson venture capital funds started to decrease, basically due to over-investment in variousindustries and the entry of inexperienced venture capitalists, thus investors becamedisappointed with lower returns and fund raising as a consequence. The end of the1980s was characterized by a drop in venture capital and a ‘shake-out’ in the industry, andthe number of venture capital firms declined. Venture capitalists tended to invest in laterstages, and specialization and differentiation of investment strategies continued (Timmonsand Bygrave, 1997).

There was renewed interest at the beginning of the 1990s – due to new possibilities onthe initial public offerings (IPO) market and the exit of many experienced venture cap-italists (Gompers and Lerner, 2003). The industry ‘shake-out’ consolidated and stabilizedthe market. Returns had improved – mainly due to a robust IPO market. However, wemust bear in mind that the venture capital industry was still heavily concentrated in a fewgeographical areas in the US and could be regarded as fairly limited. Despite an overallimprovement in the US venture capital industry, the total investment made by venturecapitalists never exceeded $6 billion until 1996, and it was the end of the 1990s before themarket really showed exceptional growth. In the year 2000 the total investment spendingreached an astonishing $102 billion, and the average investment was about $18 million percompany. Since then, the venture capital market in the US has declined due to the dot.comcrash (Megginson and Smart, 2006), where the drop was more significant than in manyother countries.

The diffusion of venture capital to EuropeFor a long time, venture capital was more or less regarded as an American phenomenon.Even though an emerging venture capital industry in Europe could be found already inthe late 1970s – much earlier we could find individual companies that provided equitycapital to unquoted firms, for example, 3i in the UK, Investco in Belgium and SVETABin Sweden. But these companies were rather isolated initiatives, and in general venturecapital was virtually non-existing outside the US during the 1970s. The development of aEuropean venture capital market mainly took place in the UK, which had just over 20venture capital funds at the end of the 1970s with a total investment of £20 million. Alittle more than a decade later, in 1992, the venture capital industry in the UK had grownsignificantly, investing in a total of £1326 million in 1297 ventures (Murray, 1995).

However, it was not until the late 1980s that a more significant venture capital industryemerged in Europe, and at that point in time its growth outperformed that of the indus-try in the US – between 1986 and 1990 venture capital in Europe grew from about $9billion to $29 billion (Bygrave and Timmons, 1992). This growth was associated with theintroduction of secondary stock markets in many countries, which enabled rapidlygrowing ventures to make IPOs and venture capitalists to obtain returns on their invest-ments. A number of secondary stock markets were created, such as the AlternativeInvestment Market in the UK, Nouveau Marché in France, and the Neuer Markt inGermany, and later on a pan-European secondary stock market (EASDAQ). However,


most of these markets were unsuccessful due to low levels of trading and liquidity (Lummeet al., 1998).

When describing the venture capital markets in different countries, it is important toemphasize that venture capital can differ from one country to another, depending on thecharacteristics of the financial markets. For example, Black and Gilson (1998) distinguishbetween bank-centred markets such as in Japan and Germany, and stock-market-orientedmarkets as in the US. The authors argue that a well-developed stock market and initialpublic offerings as well as a high level of private pension fund investments (Jeng and Wells,2000) are of significant importance for venture capital financing. Differences in the char-acteristics of the financial market in various countries make venture capital more or lessimportant, and venture capital operates in different ways.

Following this line of reasoning, we can find several similarities between the venturecapital industries in the US and Europe (Manigart, 1994; Sapienza et al., 1996; Jeng andWells, 2000) but also many important differences. For example: (i) venture capitalists inEurope seem to rely more heavily on investment from financial institutions (banks andinsurance companies) compared to the US, where a great deal of capital comes frompension funds; (ii) venture capital firms are organized in different ways, for example, in theUS and the UK firms are usually limited partnerships whereas in other European coun-tries we can find different organizational structures; (iii) historically, European venturecapital has been less focused on early-stage investments compared to venture capitalists inthe US; (iv) active involvement differs across countries – venture capitalists in Europe arenot always as actively involved in managing their investment as their counterparts in theUS; and (v) due to the lack of liquid stock markets for entrepreneurial ventures in manyEuropean countries, the exit strategies have differed and the returns on investments werelower compared to the US (Jeng and Wells, 2000; Megginson and Smart, 2006).

Venture capital worldwideIt was not until the end of the 1990s, and the boom in the dot.com industry, that we couldreally talk about the growth of the venture capital industry worldwide. The total invest-ments in the US exceeded $100 billion in the year 2000, and the corresponding figure forEurope is €35 billion (Megginson and Smart, 2006). In addition, the venture capital indus-try in Asia grew significantly between 1995 and 2000, although less rapidly than in the USand Europe – mainly due to the moribund venture capital industry in Japan. The mostpromising venture capital market in Asia was in India, and to some extent China,although the latter seemed to lack the basic legal infrastructure needed to support aventure capital market, and Chinese stock markets have remained inefficient (ibid.).

The Asian market is highly heterogeneous – at one end of the spectrum there are coun-tries like Japan and Australia with long-established market economies as well as newlyindustrialized countries while, at the other, there are countries such as China, India,Malaysia and Vietnam with emerging market economies (Lockett and Wright, 2002).However, a general characteristic of the venture capital market in Asia is that the insti-tutional framework – regulatory and legal as well as the venture capital culture – is notyet established to support venture capital. In addition, several NASDAQ-type stockmarkets have been established, such as the ‘growth markets’ in Hong Kong, Singaporeand Taiwan, but so far they have shown only limited success in funding fast growth firms.The lack of an institutional framework on many Asian venture capital markets means


that venture capitalists have to place more emphasis on employing personal networks tocarry out venture capital operations – indicating that venture capital practice in emerg-ing markets in Asia diverges somewhat from the Anglo-Saxon model (Ahlstrom andBruton, 2006).

Since the 1990s venture capital markets have emerged all over the world. However, thegrowth has not been unproblematic – the bursting of the Internet and dot.com bubble atthe end of the 1990s marked a historical peak in terms of capital volume and valuations,but the market collapse that followed had a major effect on the venture capital market,not least in the US. As a consequence, the number of venture capital firms declined andthe amount of capital invested decreased dramatically. The dot.com bubble also affectedthe behaviour of venture capitalists, who became ‘entrapped in the psychic prison of theinternet bubble’ (Isaksson, 2006).

The market recovered gradually, and in 2006 the size and activities of the US venturecapital market returned to the pre-dot.com level of 1998. The European market is notmuch smaller than the US venture capital market, and there are growing venture capitalmarkets in many Asian countries. We can conclude that venture capital has emerged frombeing a source of finance for high growth ventures in the US to a worldwide phenome-non. At the same time, the markets in different parts of the world exhibit a great varia-tion in their degree of maturation, for example, US venture capital is regarded as asignificant source of finance for entrepreneurs in high growth ventures whereas othercountries have less well developed markets in which venture capital still has to prove theircontributions to entrepreneurial ventures.

The pioneers who created the research fieldIn all emerging fields of research there are always some researchers who appear to have agreater influence than others – researchers who make a new phenomenon visible, who askthe interesting questions, who encourage other researchers to explore new and promisingfields – pioneers who open up new areas of research. These pioneers seem to play a majorrole in giving direction to the emerging field of research (Crane, 1972).

Venture capital is an old phenomenon and, as shown earlier in this chapter, the insti-tutional venture capital market was established by the end of the 1940s. However, it wasnot until the growth of the venture capital industry in the 1980s that it aroused interestamong scholars. The reason behind this time lag may be the fact that for many yearsventure capital was a relatively small industry and, even at the end of the 1980s, theventure capital industry in the US never exceeded a couple of billion dollars. By all stand-ards, it was a very small market, and few researchers realized that it would be an import-ant phenomenon for the development of entrepreneurial ventures. However, during the1980s, pioneers within the field of venture capital research appeared, such as WilliamBygrave at Babson College, William Sahlman at Harvard Business School, IanMacMillan at New York University/Wharton School of Business, and Tyzoon Tyebjeeand Albert Bruno at University of Santa Clara, who took an interest in the institutionalventure capital market. There was also Kenneth Rind with experience as an active cor-porate venture capitalist in New York, and William Wetzel at the University of NewHampshire who researched the business angels market, and all these researchers were geo-graphically located near the dynamic venture capital markets around Silicon Valley/SanFrancisco, Boston and New York.


The subsequent emergence of the venture capital industry in Europe aroused interestamong scholars during the early 1990s, especially in countries with an early and dynamicventure capital industry. For example, early research contributions were made by MikeWright, Richard Harrison and Colin Mason in the UK, Sophie Manigart in Belgium, andChrister Olofsson in Sweden.

The exponential growth of venture capital worldwide at the end of the 1990s and begin-ning of the 2000s – measured in terms of the number of researchers, published articles,and so on – was underlined by the launch of Venture Capital – an International Journal ofEntrepreneurial Finance in 1999 – which was mainly dedicated to venture capital research.There was also an increased number of contributions on venture capital from Asia. Inmany cases, these studies were conducted by Anglo-Saxon researchers in collaborationwith domestic partners.

The remainder of the chapter will highlight the contributions of the pioneers within thefield of venture capital. My objective is not only to provide an insight into the key con-tributions of these pioneers, but also to familiarize the reader with them as researchers.There are many researchers, who can be regarded as pioneers of venture capital research,and I do not claim to provide a complete picture – the selection is, to a large extent, basedon my own subjective view. However, the scope of research on institutional, corporate andinformal venture capital differs, which is reflected in the space each part of the venturecapital market is given regarding the pioneers as well as in the book in general.

Research on institutional venture capital

Some early contributionsIn 1981 Jeffry Timmons wrote that research on venture capital by academics was practic-ally non-existent, which was true at that point in time for rather self-evident reasons – theventure capital industry was still small and rather insignificant for the majority of highgrowth firms as well as for economic development in a more general sense. However, wecan find some pioneering contributions to the research on venture capital as early as the1950s. The first PhD thesis on the topic of venture capital, entitled ‘Corporate profits andventure capital in the post-war period’, was written by Hussayni in 1959 and published atthe University of Michigan. However, it was during the 1960s and 1970s that new topicsemerged in venture capital research (Brophy, 1982; 1986; Timmons and Bygrave, 1986).

One of the earliest interests in venture capital in the 1960s came from scholars in thefield of management through works on entrepreneurship who became interested in thecharacteristics of new technology-based firms, and the problem of external financing inthese ventures (see for example early contributions by Shapero, 1965; Roberts, 1969;Cooper, 1971; von Hippel, 1973). In addition, these management scholars stimulated aseries of studies on the financing of growth-oriented companies seen from the entrepre-neur’s point of view – demand perspective (see for example Baty, 1963; Aguren, 1965;Briskman, 1966; Rogers, 1966; Hall, 1967). Several of the latter studies were published asMS theses at MIT in Boston and can in many cases be regarded as ‘one shot’ studies,whose authors did not develop a sustained body of work in the field.

Another research strand came from scholars in the field of finance who, especially inthe 1970s, became interested in venture capital. For many years, knowledge of equitymarkets in finance theory has been well developed. These theories were typically oriented


towards equity finance of large publicly traded companies. However, venture capital wasdifferent in several respects; venture capital invested in young firms with little performancehistory, the relationship between investor and investee was characterized by a higherdegree of involvement and the investments were often illiquid in the short term due to thelack of efficient exit markets. As a consequence, there was an open field for theory devel-opment – trying to apply financial models to venture capital, and researchers alsoaddressed the issue of market efficiency on the venture capital market with early contri-butions by, for example, Donahue (1972), Bean et al. (1975), Charles River Associates(1976), Leland and Pyle (1977), Cooper and Carleton (1979), and Chen (1983).

A third area of early interest was the venture capital process, from the investment decisionto the exit of the investment. Throughout the 1970s attention was devoted to examining theinvestment and screening process from the venture capitalist’s point of view – a supply per-spective (see for example Briskman, 1966; Aggarwal, 1973; Wells, 1974) – and most of thestudies confirmed the general belief that the quality of the entrepreneur/founding team andthe marketability of the idea are central for success. Another issue of interest in venturecapital research was the performance of venture capital investments, and in several studiesthe annual rate of returns on these investments was calculated (see for example Faucett,1971; Wells, 1974; Hoban, 1976; Poindexter, 1976; Dorsey, 1977; Huntsman and Hoban,1980; DeHudy et al., 1981). The conclusions that can be drawn from these studies were thatit was difficult to find reliable data and the results of the studies were highly varied.Methodologically, most of the research at this time was based on anecdotal data and/orsurvey studies using small samples, and venture capitalists were not always willing to provideinformation that could be made public – factors that made the research less reliable.

The emergence of research on institutional venture capitalAs the venture capital industry grew in scope and importance during the 1980s, interestamong scholars increased. A main point of departure was that venture capital concerned‘building businesses’ and no single discipline could claim to possess sufficient knowledge toprovide complete understanding of this process. Therefore, a number of scholars, fromdifferent disciplines – mainly management and entrepreneurship as well as from the field offinance and economics – ‘rushed’ into this emerging topic – providing different concepts andmethodological approaches in order to understand venture capital finance. Thus, one suchgroup had a background in management and entrepreneurship and focused their attentionon the venture capital process (from fund raising, pre-investment activities, to exit of theinvestment) from a managerial point of view – a micro-level focus – or what we will call‘managerial-oriented venture capital research’. Several pioneering studies were presented inthe 1980s, and some examples are given in Table 1.3. It should be emphasized that the selec-tion of studies is based on my own subjective view, not on any bibliographical analysis.

Another group of researchers with roots in finance and economics concentrated on theventure capital market – a macro-level focus – trying to analyse and understand the flowof venture capital, its role in the development of new industries, regional aspects ofventure capital, and so on – or what we will term ‘market-oriented venture capitalresearch’. Some of the pioneering studies of the 1980s are presented in Table 1.4.

As noted by Sapienza and Villanueva in Chapter 2 of this book, the early contributionsto venture capital research can be characterized as highly descriptive, where the researchersprimarily aimed to document a more or less unknown phenomenon. As such, early research


has been extremely useful in that it has not only contributed to a deep understanding of theindustry and the way in which venture capitalists operate, but also provided a sound basefor further theory building. The ‘descriptive’ period of venture capital research during the1980s was followed by a growing interest in more theory-driven venture capital research.

Before discussing the development of venture capital research during the 1990s, I willcomment on the importance of databases in this regard. A contributing factor in theemerging interest in venture capital among researchers was the fact that data on venturecapital became available not least from sources such as Venture Economics. VentureEconomics gathered data from venture capital firms regarding their investment activities,and the information was published monthly in the Venture Capital Journal. But there were


Table 1.3 Topics in managerial venture capital research

Topics of research Pioneering studies

Pre-investment activities Tyebjee and Bruno (1984), ‘A model of venture capitalist and investment decision investment activity’, Management Science, 30 (9), 1051–66.criteria MacMillan et al. (1985), ‘Criteria used by venture capitalists to

evaluate new venture proposals’, Journal of Business Venturing,1, 119–28.

MacMillan et al. (1987), ‘Criteria distinguishing successful from unsuccessful ventures in the venture screening process’, Journal ofBusiness Venturing, 2, 123–37.

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

Syndication/Co-investing Bygrave (1987), ‘Syndicated investments by venture capital firms:A networking perspective’, Journal of Business Venturing, 2, 139–54.

Bygrave (1988), ‘The structure of the investment networks ofventure capital firms’, Journal of Business Venturing, 3, 137–57.

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

Post-investment Gorman and Sahlman (1989), ‘What do venture capitalists do?’,activities/board of Journal of Business Venturing, 4, 231–48.directors/value added Rosenstein (1989), ‘The board and strategy: Venture capital and

high technology’, Journal of Business Venturing, 3, 159–70.

MacMillan et al. (1988), ‘Venture capitalists’ involvement in their investments: Extent and performance’, Journal of Business Venturing, 4, 27–47.

Sapienza and Timmons (1989), ‘Launching and buildingentrepreneurial companies: Do the venture capitalist add value?’,in Brockhaus et al. (eds), Frontiers of Entrepreneurship Research,Wellesley, MA: Babson College, 245–57.

Success factors, returns Bygrave et al. (1989), ‘Early rates of returns of 131 ventureand performance capital funds started 1978–1984’, Journal of Business Venturing,

4 (2), 93–105.

also other databases available such as the Investment Dealer’s Digest on initial publicofferings of securities, and the Center for Research in Securities Prices with daily returndata on IPOs. The increased availability of data made the research on venture capitalmore methodologically sophisticated, and it became possible to test theories, thus leadingto more reliable and valid research.

As indicated above, during the 1990s we could increasingly identify a theoretical devel-opment in venture capital research. An interesting observation in this respect by Sapienzaand Villanueva (Chapter 2) is that the emergence of venture capital research coincidedwith the development of the entire field of management science, and it was natural thatearly contributions in venture capital research followed the prevailing trends of theoret-ical development in management science in general, with a reliance on rational economicmodels and use of agency theory as a dominant theoretical framework.

The number of researchers and published articles on venture capital grew significantlyduring the 1990s (see Figure 1.1). At the same time the research became more theoret-ically oriented and, as shown by Cornelius and Persson (2004; 2006), the field becamepartly divided into two separate clusters of researchers – one with a background in financeand economics and the other rooted in management and entrepreneurship theory. For areview of earlier research on institutional venture capital, see for example Wright andRobbie (1998), Mason and Harrison (1999a) and the three-volume compilation of keyarticles on venture capital research by Wright, Sapienza and Busenitz (2003).


Table 1.4 Topics in market-oriented venture capital research

Topics of research Pioneering studies

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

Venture capital as a Cooper and Carleton (1979), ‘Dynamics of borrower–lenderfinancial intermediator interaction: Partitioning final pay off in venture capital finance’,

Journal of Finance, 34, 517–33.

Chen (1983), ‘On the positive role of financial intermediation inallocation of venture capital in a market with imperfect information’, Journal of Finance, 38 (5), 1543–61.

Venture capital and the Sahlman and Stevenson (1985), ‘Capital market myopia’,development of industries Journal of Business Venturing, 1 (1), 7–30.

Kenney (1986), ‘Schumpeterian innovation and entrepreneurs incapitalism: A case study of the US biotechnology industry’,Research Policy, 15, 21–31.

Regional aspects of Florida and Kenney (1988), ‘Venture capital and high technologyventure capital entrepreneurship’, Journal of Business Venturing, 3, 301–19.

Martin (1989), ‘The growth and geographical anatomy of venturecapitalism in the United Kingdom’, Regional Studies, 23, 389–403.

Policy-oriented venture Timmons and Bygrave (1986), ‘Venture capital’s role in financingcapital research innovation for economic growth’, Journal of Business Venturing,

1, 161–76.

Many important contributions to venture capital research were made during the 1990s,and it would be impossible to choose two or three that could be regarded as more impor-tant than the others. However, in Figure 1.4 I will present some of the leading scholarswithin the field during the 1990s – researchers who showed a growing interest in theoret-ical understanding of the venture capital phenomenon and used more sophisticatedmethodological approaches.

One conclusion that can be drawn from the study by Cornelius and Persson (2004; 2006)is that there are two different clusters that seldom meet or cite each other’s work. In orderto develop our knowledge of institutional venture capital, I believe it is necessary to encour-age cross-fertilization between these two clusters of researchers. The building of a socialstructure among researchers within the field goes hand in hand with the cognitive develop-ment of the research. For example, it is important to develop a ‘cognitive style’ that includesa professional language and clear definitions of central concepts within the field of venturecapital. In order to establish this cognitive style, it is essential to develop a ‘social culture’within the field, which requires regular and intensive forums for discussions, where infor-mal communication between researchers is of central importance. Informal networks are aprerequisite for the exchange of ‘tacit’ knowledge, consensus regarding definitions, discus-sions on methodological approaches, and so on. Such ‘research circles’ (Landström, 2005)can be achieved through the establishment of research centres and well-developed informalinternational networks – promoting cross-fertilization within venture capital research.

Pioneers of institutional venture capital researchIn this section I will present some of the pioneers of institutional venture capital research:Tyzoon Tyebjee, Ian MacMillan, William Bygrave and William Sahlman. I will provide ashort summary of the seminal articles of each pioneer, followed by an interview with each


Figure 1.4 Researchers on institutional venture capital

Theoretical backgroundManagement andEntrepreneurship

Finance andEconomics

Macro

Level ofanalysis

Micro

Examples:Jeffry Timmons, WilliamBygrave, Gordon Murray

Main focusExamples:Paul Gompers, Josh Lerner,Raphael Amit, ThomasHellman, Bernard Black,Ronald Gilson, Leslie Jeng,Philippe Wells

Main focusExamples:William Bygrave, HarrySapienza, Lowell Busenitz,Jeffry Timmons, Anil Gupta,Andrew Zacharakis, DeanShepherd, Sophie Manigart,Vance Fried, Robert Hisrich

Examples:Paul Gompers, Josh Lerner,Mike Wright, Raphael Amit,James Fiet, Anat Admati, PaulPfleiderer

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

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


Picture 1.1 Tyzoon Tyebjee, Professor of Marketing, University of Santa Clara, USA

BOX 1.1 TYZOON TYEBJEE

Born: 1945Career1977 – Leavey School of Business,

Santa Clara University, USAProfessor of Marketing

1975–1977 Wharton School, University of Pennsylvania

Education1976 PhD in Marketing

University of California, Berkeley1972 MBA in Marketing

University of California, Berkeley1969 MS in Chemical Engineering

Illinois Institute of Technology, Chicago1967 B Tech in Chemical Engineering

Indian Institute of Technology, Bombay

comprised a telephone survey of 46 venture capitalists in California, Massachusetts andTexas, while in the second, Tyebjee and Bruno used Pratt’s directory of venture capital(1981) to identify 156 venture capital firms, 41 of which participated in the study. Theventure capitalists were sent a questionnaire for the purpose of evaluating deals underconsideration by the firm, and 90 completed evaluations were returned. On the basis ofthe studies a venture capital process model was developed, in which the investmentprocess was described as consisting of five phases: (1) deal origination; (2) screening;(3) evaluation; (4) deal structuring; and (5) post-investment activities. The authors par-ticularly focused on the evaluation phase in which venture capitalists assess a new ventureproposal based on a multidimensional set of characteristics.

The venture capitalists who participated in the study were asked to rate deals that hadpassed their initial screening according to 23 decision criteria. Based upon a factor analy-sis Tyebjee and Bruno concluded that venture capitalists evaluate deals in terms of fivebasic characteristics: (i) market attractiveness; (ii) product differentiation; (iii) manage-ment capabilities; (iv) environmental threat resistance; and (v) cash-out potential.

The score of each deal estimated on the basis of the five dimensions was related tosubjective estimates of the level of expected return and perceived risk using a linear regres-sion model. The results indicated that two aspects seemed to have a significant impact onthe risk associated with the deal – a lack of managerial capabilities significantly increasesthe perceived risk followed by ‘environmental threat resistance’, whereas the attractive-ness of the market and the product’s differentiation are related to the expected return.

In the sample of 90 deals, 43 were regarded as acceptable investments while 25 wererejected. A discriminant analysis was used to examine whether the level of perceived riskand return could be used as a means of distinguishing between rejected and accepteddeals. According to the results of the study, the decision to invest is determined by the riskversus return expectations, and venture capitalists seem to be profit oriented and averseto risk, although they are willing to invest in risky deals if the risk involved is offset by theprofit potential.

As indicated above, this seminal work by Tyzoon Tyebjee and Albert Bruno is one ofthe most cited articles within venture capital research and forms the basis for many of thestudies that constituted a strong research stream within venture capital research duringthe 1990s on the criteria used by venture capitalists when assessing new deals.

Interview with Tyzoon Tyebjee

What attracted your interest in venture capital and venture capital decision-making?I studied engineering and came to the US from India in the late 1960s to take my gradu-ate degree. Following some work as an engineer, I decided to go to business school, andin pursuing a PhD I specialized in the area of marketing, in particular consumer choicebehaviour. After a brief stay in the faculty at Wharton Business School I joined SantaClara University. At Santa Clara University, in the heart of Silicon Valley, my interests inbusiness, and my former interest in engineering and technology really came together,because I was now in an environment where the commercialization of technology playeda very significant role. So, it was not a big issue for me to go into the area of venturecapital, but my interest was really sparked by some funding which was made available bythe National Science Foundation in order to carry out research on what was then a


relatively young industry. My co-author Albert Bruno and I received a fairly large amountof funding for the project.

The interest of the National Science Foundation was actually a little different from ourinterests. The government wanted to know what happened to ventures that received nofunding . . . in other words, was the venture capital market efficient in terms of recogniz-ing strong opportunities, or were some commercially viable opportunities ignored by theventure capital industry, and if so, did these ventures find alternative sources of funding?My personal interest was to try to introduce consumer choice behaviour and apply choicebehaviour models to how venture capitalists made choices.

Your study was published in Management Science and became one of the truly seminalarticles within the field of venture capital research . . .At that time there was very little published work on venture capital in mainstream acad-emic literature. Most of the venture capital research was very descriptive . . . size of deals,amount of equity investments, profile of venture capital firms and ventures, and so on.And those kinds of studies were not very often published in the academic literature. Ithink one of our significant contributions was the legitimization of both area and topicby modelling them in a way that gave them academic credibility and, in this regard, theaspect of the study that focused on venture capital decision-making and venture capitalchoice behaviour was a piece that really lent itself best to serious modelling.

You have followed the development of the venture capital industry for a long time. Whatchanges in venture capital have taken place since the 1980s?I think a couple of things have happened in the venture capital market in the US. One isthat there is a much greater number of venture capitalists today who were actually entre-preneurs themselves . . . people who have been through the start-up process themselvesand, as a result, they are not just financiers, they are people who bring operational exper-tise. Having said that, the venture capital industry has become more professional with lessreliance on pure instinct, far more analysis, far more financial models applied to valua-tion, resulting in a significant improvement in technical skills within the venture capitaldecision-making process.

In addition, the geographic scope of investments has widened considerably. The focus isno longer local. There was a saying 25 years ago that people invest so that they can visit theventure and sleep in their own bed that same night . . . that is not so any more . . . venturecapital has become a global industry and that represents a big change. Globalization is alsoapparent if you look at what the venture capital network is composed of . . . in the 1980s,the members of the venture capital associations were all basically American white males.Today, the membership is global . . . firms employ the skills of people who have either livedor were born outside of the US and who have very strong networks over there.

Another big change is that there is a distinction now between funding products andfunding businesses. I think there is a discussion which did not take place 25 years ago thatif an entrepreneur has an innovative product – that is no longer enough . . . the venturecapitalist asks: Is this product the foundation . . . has it got the potential to spin off a widerrange of portfolio products or opportunities? A good example is Google. Google whichbasically started out as a search engine, but its business today has far exceeded that . . .basically, a product has to be a platform for building a wider range of businesses.


Looking at the venture capital industry today, is there anything that can be learned from yourstudy in the early 1980s?One of the things that I think we contributed to, besides the decision-making criteriamodel, was to model a process that identified the stages of the venture capitalists’decision-making process. A good venture capitalist, today as well as in the past, is strongin each of these areas, they have good networking in order to be able to locate and iden-tify deals, they have strong evaluation methodologies to be able to focus on deals to whichthey can bring the highest level of added value as a venture capital firm as well as thosewhich are most likely to succeed. Third, they have strong skills in terms of structuringthese venture capital arrangements, and finally, they are very strong in terms of the post-investment contributions they make in the venture, especially in the area of board repre-sentation and in their networking ability.

If you were to conduct your study today, what changes would you make?I think that I would have included a wider range of criteria to reflect today’s environment,and certainly the globalization of business and the ability of the venture to respond to themarket would have been something that I would have focused on . . . at that time it wasnot much of an issue.

Let us look at venture capital research in a general sense . . . what development can you seein venture capital research?I think it has broadened the questions that have been asked. It has drawn on a wider rangeof disciplinary interests, which in my opinion has been very useful. For example, thefinance community has become a much stronger discipline for venture capital research,and they have brought a methodology and line of inquiry that was lacking 25 years ago.So, questions such as what affects valuation, what affects the value of the firm when it goespublic . . . these were not questions which were really pursued 25 years ago . . . focus wasmore on the venture capitalist and less on the venture, and I think that has changed.However, I still think that there is not enough cross-fertilization between the researchwhich emerges from traditional entrepreneurship surveys and interviews and the moresecondary financial database oriented research which has been carried out by the financecommunity.

The second thing that has changed is that there are much stronger quantitative data-bases today, and these have been made available to members of the academic community,facilitating a line of inquiry much broader than self reports.

So, as I see it, it is more that methodology and disciplinary perspectives have changed.In terms of the questions themselves . . . I think that the basic questions have remainedthe same. These questions are: how do you select a deal, what affects its success, and towhat extent does the value added by the venture capitalists influence that success . . . theseare the fundamental questions.

What advice would you give to new PhD students on venture capital?My advice to them would be to push the issue to another level in terms of trying to bringnew approaches by means of new questions rather than simply doing some incrementaladvances on previous studies . . . I think a great deal of the research is based on that. Forexample, referring to our own study . . . five criteria became six (or maybe seven), and the


labels changed . . . but there has really been no significant advance in terms of looking atit in a new way.

A second piece of advice is to recognize that this is an area in which obtaining gooddata is very difficult, particularly if you are relying on venture capitalists and surveys ofthem as the source of such data. So, I think that an advance should come from newresearch in the area of methodology concerning how to obtain insightful data on venturecapital.

A third area that I would emphasize, and this is a far narrower observation than theprevious two, is to try to understand the role that the portfolio of the venture capital firmplays in the success of an individual venture. We have looked a great deal at the relation-ship between the venture capitalist and the venture, while the relationship between a par-ticular venture and the others in the portfolio has not received as much attention in spiteof the fact that it would facilitate an understanding of how the network of relationshipswithin a venture capitalist’s portfolio leverages individual ventures.

Fourth, I think it would have been useful to ask: has the structure of the venture capitalindustry changed? For a long time we have talked about two legs: institutional and angel,and corporate venture capital has been added as a third. But are there other emergingforms of venture capital? I think it is very useful to look at the context . . . different kindsof venture capital emerge in different contexts. For example, if we look at the Asianmarkets where family business structures are very strong; how does the idea of venturecapital and family business overlap and intersect?

Finally, if we look more specifically at venture capitalists’ decision-making, one areathat requires some improvement is that when we study venture capital decision-makingwe pretend that there is a single decision-maker . . . which is rarely the case. In a venturecapital firm there are multi-parties who jointly make a decision, so I think that it is impor-tant to try to understand how multiple inputs in a multi-decision-maker environment endup in an investment decision as well as how these decisions flow over the multi rounds ofinvestment in the same firm. So, a longitudinal decision-making approach over a singleventure . . . that is something that I haven’t seen.

Policy aspects of venture capital are always a ‘hot topic’: what can we learn from the US inorder to improve the venture capital market in other countries, for example in Europe?About 15–20 years ago I wrote a paper called ‘Venture capital in Western Europe’ in anattempt to understand what aspects of the US environment differ from Europe. I thinkseveral things have changed. At that time tax policy in Europe was very restrictive, but Ithink it is much less restrictive today. There are no strong cultural heroes, and there wasless of a tendency to pursue something outside of the established business institutionalstructure by striking out on your own. I think that has also changed . . . not as stronglyas in the US but there has nevertheless been a change.

One of the areas in which US venture capital has been extremely successful is the flowof knowledge . . . historically, much of that has been due to the US immigration laws. Ifyou look at many of the venture capital successes you will find that there is an immigrantsomewhere in the venture, and I think Europe has been very restrictive in that regard – interms of allowing people to bring knowledge capital. So, an efficient venture capitalmarket requires not only the free flow of capital, but the free flow of knowledge . . . andI think that policy-makers will have to encourage that.


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

BOX 1.2 IAN MACMILLAN

Born: 1940Career1986– Wharton School, University of Pennsylvania

1986– Director, Sol C. Snider Entrepreneurial ResearchCenter

1986–1999 GeorgeW.Taylor Professor of Entrepreneurial Studies1999– Fred R. Sullivan Professor

1984–1986 New York UniversityProfessor and Director of the Center for Entrepreneurship Research

1976–1983 Associate Professor, Columbia University1975 Visiting Researcher, Northwestern University1965–1970 Chief Chemical Engineer, Consolidated Oil Products, South Africa1963–1964 Scientist, Atomic Energy Board, Government Metallurgical Labs,

South Africa

Education1975 DBA, University of South Africa1972 MBA, University of South Africa1963 BS, University of Witwatersrand, South Africa


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

Seminal articlesFollowing on Tyebjee and Bruno, Ian MacMillan together with colleagues wrote somevery important articles on decision-making in venture capital in the mid-1980s. The firstarticle was ‘Criteria used by venture capitalists to evaluate new venture proposals’ in 1985,and it was intended as a follow-up and a replication of an earlier study by Tyebjee andBruno presented at the Babson Conference in 1981. In the article, Ian MacMillan and hiscolleagues elaborated on the question: what criteria do venture capitalists use when evalu-ating venture proposals? Based on interviews with 14 venture capitalists in the New Yorkarea and a questionnaire sent to 150 venture capitalists, the results indicated that venturecapitalists evaluated ventures in terms of six risk categories (which correspond closelywith the findings of Tyebjee and Bruno, 1981):

1. Competitive risk, i.e. little threat of competition and an existing competitively insu-lated market.

2. Risk of being unable to bail out if necessary.3. Risk of losing the entire investment.4. Risk of management failure, i.e. whether the entrepreneur is capable of sustained

effort and knows the market thoroughly.5. Risk of failure to implement the venture idea, i.e. whether the entrepreneur has a clear

idea of what s/he is doing and whether the product has demonstrated market potential.6. Risk of leadership failure, i.e. whether the entrepreneur has leadership qualities.

The main conclusion in the study was that the most important criteria had to do withthe entrepreneur’s experience and personality, which MacMillan expressed in the follow-ing way: ‘There is no question that irrespective of the horse (product), horse race (market),or odds (financial criteria) it is the jockey (entrepreneur) who fundamentally determineswhether the venture capitalist will place a bet at all’ (p. 128).

However, the fact that venture capitalists use certain criteria does not mean that suchcriteria can distinguish between successful and unsuccessful ventures. In a later article, in1987, entitled ‘Criteria distinguishing successful from unsuccessful ventures in the venturescreening process’, MacMillan and his colleagues tried to determine the extent to whichcriteria are useful predictors of performance. A questionnaire was designed in which 220venture capitalists were asked to rate one of the most successful ventures and one of theleast successful ventures they had funded, based on 25 decision criteria. In addition, theventure capitalists were asked to rate the venture’s performance on seven performancevariables. In total, 150 evaluations were usable in the study.

The results indicated that the major difference between a winner and a loser seemed tobe some ‘difficult-to-define’ entrepreneurial team characteristics, and MacMillan con-cluded that ‘. . . it is not surprising that venture evaluation remains an art, a long way frombecoming a science’ (p. 129). Another interesting finding was the identification of twomajor criteria as predictors of venture success: (1) the extent to which the venture is ini-tially insulated from competition; and (2) the degree to which there is demonstratedmarket acceptance of the product.

It is interesting to note that these two criteria are market- rather than product- orentrepreneur-related and neither was considered essential in the 1985 study. The questionwas: why were criteria related to the entrepreneurial team and the entrepreneur, which


were emphasized in earlier studies, not regarded as predictors of success? In this respect,MacMillan made a distinction between necessary and sufficient conditions for success.Venture capitalists will not back ventures with a bad entrepreneurial team. Success orfailure has to do with those ventures that receive funding. The evaluation of the entre-preneurial team is essential in order to obtain financial backing from venture capitalistswhereas the two criteria – threat of competition and market acceptance of the product –are predictors of success for firms already financed by venture capitalists.

Another topic in MacMillan’s early contributions on venture capital was the interest inthe added value brought by the venture capitalists to the ventures in which they invest.The article ‘Venture capital involvement in their investments’ (1988) followed some earlierstudies on venture capitalists’ involvement and value-adding (see for example Gormanand Sahlman, 1989; Timmons and Bygrave, 1986) indicating that, in addition to provid-ing capital, venture capitalists also play many other roles in their portfolio firms. However,none of these studies correlated the venture capitalists’ involvement with the ventures’performance – which MacMillan and his colleagues attempted to do in this study.

The study is based on a questionnaire distributed to a sample of 350 venture capitalists(response rate 18 per cent or 62 usable responses), in which the venture capitalists were askedto indicate their involvement in each of 20 activities for a specific venture. The results showthat serving as a sounding board for the entrepreneurial team and different financially ori-ented activities had the highest rating, whereas the lowest degree of involvement occurredin activities related to ongoing operations. However, the most interesting results concern theidentification of three distinct levels of involvement adopted by venture capitalists:

● Laissez-faire involvement – the venture capitalists exhibited limited involvement.● Moderate involvement.● Close tracker involvement – the venture capitalists in this group exhibited more

involvement in virtually every activity than their peers.

Some interesting conclusions emerged from the study. For example, it appeared thatventure capitalists exhibit different involvement levels as a matter of choice, and not dueto different characteristics of the ventures. When the performance of the ventures wasexamined, it was evident that there were no significant performance differences amongventures in the three clusters – each involvement strategy is about equally effective, that is‘close tracker venture capitalists’ were no more or less successful than the other groups.

Interview with Ian MacMillan

Let’s start with the seminal studies on venture capital decision criteria that you conducted inthe mid-1980s, and which were published in the Journal of Business Venturing in 1985 and1987. Why did you become interested in this topic?In 1975 I came from South Africa to the Northwestern University in Boston, but after afew years I moved to Columbia University in New York. In the early 1980s a decision hadbeen taken by New York University to launch a Center for Entrepreneurship, and in 1984I was offered the position as professor and director of the Center for EntrepreneurshipResearch. I remained in that position until 1986, when I moved to Wharton School ofBusiness in Philadelphia.


In New York we had a fair amount of contact with venture capitalists in the area. Wefound out that there seemed to be some criteria that all venture capitalists looked for whenevaluating a new deal, but the thing that struck me was that there were also some idio-syncratic criteria that differentiated venture capitalists from each other – some venturecapitalists seemed to use a different set of decision criteria – but although most venturecapital investments are highly risky and have a high failure rate, the venture capitalistswere still able to deliver a significant rate of return to their investors – that attracted myinterest: what criteria do venture capitalists use when evaluating new investment propos-als? And, does it matter?

In the first study we found that the quality of the entrepreneur and the entrepreneurialteam was of great importance in the venture capitalists’ evaluation, but we didn’t knowanything about performance in relation to the criteria used by the venture capitalists – asthe criteria emphasized by the venture capitalists were not necessarily correlated with thesuccess of the ventures. The big surprise in the second study was that the emphasis theventure capitalists attached to the quality of the entrepreneur and the entrepreneurialteam didn’t correlate with performance. So, there was a huge emphasis on the entrepre-neur, but when we looked at the impact of these criteria on outcomes it turned out that itwas not the entrepreneur that mattered so much but rather the demand for the product inthe market place and protection against competitive attacks . . . and this was a puzzle.

We went back to the venture capitalists and said: ‘Here is an anomaly . . . you place atremendous amount of emphasis on the entrepreneur, but the reality is that when welooked at performance, it is the product characteristics in the market place that seem tomatter!?’ The explanation was that we were overlooking the fact that the characteristicsof the entrepreneur and the entrepreneurial team were used to screen out the certainlosers . . . people that the venture capitalist would not invest in . . . and what was leftover is a bunch of people who, despite their qualities, provide no indication of whetheror not they will be successful. And what may determine the success of a project is anestablished demand in the market and that the product is protected from competitiveattacks. Thus, while the entrepreneur is a necessary condition, s/he is not sufficient forsuccess. What basically happened was that we went beyond simply accepting the resultsand said: ‘Let’s try to find the reasons why these results do not line up with our obser-vations of the real world.’

You also looked at the venture capitalists’ involvement in the ventures in which they invest . . .a study that was published in the Journal of Business Venturing in 1988.Many venture capitalists that we met claimed that they did more than just invest in acompany . . . that they brought an added value beyond capital . . . but at that point in timewe had very little hard data on this added value. I became intrigued by the ways in whichventure capitalists could add value. To me it was obvious that venture capitalists couldadd value – they had experience and expertise from active involvement in many ventures.To bring one of the leading venture capitalists into the venture meant not only money,but access to the venture capitalist’s experts and legitimizing the venture, which has adomino effect.

What we found in the study was that venture capitalists seemed to work in various waysbased on their own decisions, but there was no significant difference in performancerelated to their involvement strategy. This was interesting, but you have to remember that,


as in many earlier studies, we had some problems measuring input as well as output vari-ables. So, when you have judgemental data as well as messy dependent and independentvariables, it should come as no surprise that the relationships are ‘messy’. This is probablya very complex relationship. It might be a good thing for the entrepreneur to involve aventure capitalist in the venture, but such involvement also means a host of issues thatcould be very harmful . . . it is the mix of good and bad that leads to inconsistencies inthe results of the study, and we were unable to sort that out . . . a problem that researchersstill have.

How would you describe the research on venture capital that followed from your and others’pioneering studies?I think what we needed back in the 1980s was to get some scope and terrain identifica-tion. Much of the early work that I did on entrepreneurship and venture capital wasmore in the nature of documentation of phenomena that had not been described before,and categorizations of phenomena, rather than the development of new theories . . .going into emergent fields or topics and seeing if we could identify the decisive key vari-ables, to pass them on to other researchers to explore in greater depth . . . it made furtherwork possible . . . in that respect I think our early work was important. Once you havedone your explorative work somebody must bring some theory into it, and that is whatI think happened in the 1990s. Researchers started to think about the phenomenon ofventure capital in the context of theory and in particular brought economic conceptsand theories, not least agency theory, into venture capital research . . . that is a naturalprogression.

The concern is of course if you let these theories totally dominate the research . . . thenyou increasingly have the kind of research that we find in a lot of management researchtoday. We are not there yet, but there is a danger that it will happen – an incredibly sophis-ticated analysis of basically trivial problems . . . and less emphasis on what we can learnthat provides us with insights for people operating in the ‘real world’ – we need to developmeaningful knowledge.

Looking to the future. What kind of research questions would you like to see in the yearsto come?I will give you two examples of venture capital research that I would very much like to seein the future: first, as you know, I have been involved, together with Rita McGrath, in thedevelopment of what we call ‘option reasoning’, and I would very much like to see venturecapital research based on option reasoning. Second, I would like to see more room forresearchers who study venture capital investments as a sociological phenomenon . . .more attention to understanding how networks of venture capitalists make decisions . . .maybe to see the venture capital community as a neural net – a bunch of nodes makingdecisions and being aware of the decisions that are made by others.

You are a very experienced mentor and supervisor of doctoral students. What advice wouldyou give to a new doctoral student who wants to start research on venture capital?This is perhaps one of the most difficult questions to answer. I have spent many yearstrying to tell my doctoral students to think in terms of relevance . . . the research must berelevant and important to society, and you need a great deal of confidence and intellec-


tual capabilities to produce ground-breaking work that is relevant to and important forsociety. This is a challenging task and you never know if you will make it and be able todevelop a number of papers that set you up for the tenure race . . . and, it is difficult toencourage young researchers to take this path.

As a doctoral student you need to get published . . . have enough articles published toobtain tenure. Therefore, most doctoral students will work on more incremental studies,extending knowledge with a few minor variations, with greater chances of getting pub-lished . . . because journals are more interested in statistical, robust results than in relevanceto society. This is a strategic decision for a doctoral student – it is a trade off between rele-vance, newness and big risks, compared to replication, incremental development of knowl-edge, and less risk of failure. My heart indicates the first path, but not many people makeit. The problem is that the research easily becomes trivial. So, all doctoral students who Iwork with today must go through my ‘six-people-test’. If you are going to do research youneed to do something that couldn’t be solved by six smart people in a two-hour discussion.If they come to the same conclusion as you do from research, then why do the research?Why not talk to six smart people? Research must go beyond what is self-evident.


Picture 1.3 William Bygrave, Professor of Entrepreneurship, Babson College, USA

BOX 1.3 WILLIAM BYGRAVE

Born: 1937Career1985– Babson College

1991– Frederic C. Hamilton Chair for Free Enterprise Studies1993–1999 Director, Arthur M.Blank Center for Entrepreneurship

1982–1985 Associate Professor, Bryant College1984 Associate Professor, Boston University1979–1982 Associate Professor, Southeastern Massachusetts University1970–1978 Deltaray Corporation1963–1978 High Voltage Engineering Corporation

Seminal articlesOne of the most influential pioneers of venture capital research, and a researcher who hasdedicated his life to our knowledge of venture capital, is William Bygrave. During the1980s Bygrave presented several pioneering contributions in venture capital research. Onestudy that deserves mention is ‘Venture capital’s role in financing innovation for economicgrowth’ together with Jeffry Timmons (1986). The aims of the study were to (i) determinethe characteristics of technology-oriented venture capitalists and entrepreneurs in thesehigh-tech firms, (ii) examine the factors that influence the supply of venture capital for thedevelopment of small high-tech companies, and (iii) elaborate on whether or not public-policy instruments could be used effectively in this process. In the study, the authors usedthe Venture Economics database and classified 464 venture capital firms according totheir investments in ‘highly innovative technological ventures’ (HITV) and ‘least innova-tive technological ventures’ (LITV).

The study shed new light on the flow of venture capital to highly innovative venturesat that point in time. The reduction of the capital gains tax at the end of the 1970shad led to an unprecedented growth in the venture capital industry, and not least inHITV investments. However, HITV investment requires less capital than initial invest-ments in LITV – what is required is quite specialized management, not capital, and therewas a core group of highly skilled and experienced venture capitalists that accounted fora disproportionate share of HITV investments. In terms of policy implications, thegeneral view in the article was that government should take a ‘hands-off ’ approach tothe venture capital market – active government involvement could well do more harmthan good.

A second study that received a great deal of attention was on the subject of theco-investment networks of venture capital firms, and Bygrave elaborated on this issue inseveral seminal articles. The first article that appeared in the Journal of BusinessVenturing (1987), ‘Syndicated investments by venture capital firms’, is an examinationof linkages of venture capital firms through syndication investments. In this articleBygrave posed the following questions: why do venture capitalists network? Do thereasons differ for various types of venture firms? Bygrave used a sample of 1501 port-folio firms for the period from 1966 to 1982 and analysed the joint investments of 464venture capital firms.

The results show that co-investments were more common among venture capitalists inhigh than low innovative technology ventures, and in early-stage compared to later-stageinvestments. Thus, the innovativeness and technology of the portfolio companies werecrucial in explaining networking among venture capital firms. Bygrave argues that moreco-investments are made where there is greater uncertainty and that the primary reason for


Education1989 DBA in Management (Policy), Boston University1979 MBA (Executive Program), Northeastern University1963 D.Phil. in Physics, Oxford University1963 MA (Physics), Oxford University1959 BA (Physics), Oxford University

co-investing is the sharing of knowledge rather than the spreading of financial risk –venture capital firms gain access to the network by having knowledge that other firms need.

The second article on venture capitalists’ co-investment networks, ‘The structure ofinvestment networks of venture capital firms’ (1988), builds on his previous work and useshis classification of ‘high innovative’ (HIVC) and ‘low innovative’ (LIVC) venture cap-italists, depending on their investment profile. He employed this categorization to analysethe differences between HIVC and LIVC, but also to identify regional differences innetwork patterns. The venture capital firms from the Venture Economics database wereclassified into three groups: (i) the top 61 firms – in terms of most investment in portfoliofirms; (ii) the top 21 HIVCs – subset of the 61 firms that mainly invested in high-tech com-panies; and (iii) the top 21 LIVCs – venture capital firms among the top 61 that mainlyinvested in low innovative firms.

The conclusion was that the venture capital industry in general could be regarded as arather ‘loosely coupled system’, but the coupling of HIVCs, and especially those inCalifornia, was quite tight. In this kind of tight system, external influence can affect theentire system, as information can flow through many channels and make the behaviour inthese systems more uniform – which may also explain why herds of HIVCs stampede intoor out of new industries.

Finally, in another seminal work by Bygrave, together with some collaborators atVenture Economics, ‘Early rates of return of 131 venture capital funds started1978–1984’, published in the Journal of Business Venturing (1989), the authors noted thelack of reliable data and systematic analysis of the rates of return on venture capitalinvestments. On the other hand, there was no shortage of anecdotal accounts and folk-lore about the rate of return in the venture capital industry – often indicating returns of30 per cent or more. Bygrave compiled a database of 131 venture capital funds reportingtheir rate of return on investments – covering about 50 per cent of the new capital com-mitted to private funds at the beginning of the 1980s.

The contribution of this study is mainly the compilation of the database – for the firsttime ever it was possible to analyse the rates of return in the venture capital industry ina systematic way – although the analysis reported in the article was rather prematureand it was too early to draw any clear conclusions (for example the oldest fund in thedatabase was 7 years old and the youngest not more than 15 months old). However, thepreliminary analysis of the annual compound rates of return in the period 1978 to 1985was disappointing compared to the myths that flourished about them in the industry,which, in general, declined at the beginning of the 1980s, although the oldest funds inthe database showed a great performance – far in excess of the oft-quoted expectationof 25–30 per cent.

Interview with William Bygrave

You have an interesting background with a PhD in physics and many years as a manager.Can you give a short summary of your career?Yes, I did my PhD in Physics at Oxford in 1963. But I always had an interest in the com-mercial world – I grew up in a micro-business context, most of my relatives were entre-preneurs. So, when I graduated from Oxford in Physics I was recruited by an Americanfirm, the High Voltage Engineering Company. I was employed as sales manager for three


years, and after which I moved to America in 1966 and took charge of the commercial-ization of new products.

Interestingly, the High Voltage Engineering Company was a public company on theNew York Stock Exchange, and it turned out to be the first ever venture capital backedcompany, funded by Georg Doriot and his venture capital company American Researchand Development back in the 1940s.

After a couple of years I became more and more frustrated by the fact that the companydidn’t put enough resources into products that I thought had huge potential, and I leftin a friendly fashion. In 1969, together with an MIT professor, I started the DeltarayCorporation, a high tech company that manufactured ultra-stable, high voltage power sup-plies. We raised money from venture capitalists – at that time the venture capital market wasvery small and the market almost unknown, but we succeeded. In 1974 we sold the companyto the High Voltage Engineering Company . . . my former employer . . . and I stayed withthem for a couple of years and became marketing manager – but I didn’t enjoy it.

I took an executive MBA at Northeastern University in 1979. Jeff Timmons was theleader of the programme. I met Jeff and it turned out that we had many things in common.At one meeting Jeff said to me ‘I think you are a pretty good teacher. Have you everthought about an academic career?’ I said ‘why not?’ . . . my family wasn’t keen on mestarting another business. So, I became a teacher and I enjoyed it. However, I soon real-ized that I couldn’t go further than teaching at a rather average university without doingresearch within the field. I went to Boston University and started on their doctoral pro-gramme on a part-time basis in 1981. I contacted Jeff Timmons and Jeff replied immedi-ately and told me that he had a project on venture capital for which he tried to get fundingfrom the National Science Foundation.

At that time, the beginning of the 1980s, there were many myths about the venturecapital industry, for example, that the rate of return was at least 40 per cent, the most crit-ical factor for the flow of capital was a reduction in the capital gains tax, and venturecapital was more than money – venture capitalist brought value-added. But very little wasreally known about the industry. Some work had been carried out in the 1960s, mainlyfrom a financial perspective, and there were some studies done at MIT . . . mostly asmaster theses . . . but that was all. Very few knew about the industry, about the flow ofcapital, and where the industry was going.

We obtained funding for the project, and the National Science Foundation wanted toknow a great deal, but primarily to understand the flow of venture capital to innovativecompanies. I started to look at this issue together with Venture Economics . . . which wasa company just a mile from Babson College, and they had a database with about 450venture capital firms and 4000 portfolio firms. At that time everything was stored in amini-computer with 20 Mbyte, and it was a real limitation in terms of the amount of datathat could be stored electronically as opposed to physically.

The first thing we did was to characterize the industry based upon technologicalinnovativeness, the flow of capital in the market and, most especially, capital forhigh-tech companies. We developed a scale for classifying the portfolio firms depend-ing on their degree of innovativeness. Some rather interesting results came out of thestudy, and it became my first paper for the Babson Conference in 1983, after whichsome of the results were presented in my Journal of Business Venturing article with JeffTimmons in 1986.


But did that study not produce even more results?Yes, we had a good database from Venture Economics, and we had developed a catego-rization in which we could distinguish between ‘highly innovative technological ventures’and ‘least innovative technological ventures’, which we could use to look at the networksamong venture capitalists through their syndication investments.

We divided the venture capitalists into 21 ‘top high-tech venture capital firms’, 21 ‘low-tech venture capital firms’, and 61 firms that didn’t have any preferences. We contrastedthe high-tech firms with the low-tech firms, and what we found was that there weredifferences between venture capitalist networks on the east coast and the west coast – theCalifornia network was much tighter than its counterpart on the east coast, which alsoinfluenced the flow of information. But, what we couldn’t disclose in the articles that werepublished in the Journal of Business Venturing in 1987 and 1988 were the names of themost central venture capital firms in the network – the most central one being KleinerPerkins.

You also performed a study on the rate of returns in the venture capital industry?Shortly after the first study, Venture Economics called me up and asked me to put a data-base together, which included the rates of return in the venture capital industry. That musthave been in 1985. The problem was that the venture capital funds wouldn’t let us havethe information, but we could obtain it from the limited partners. Most of the limitedpartners, such as pension funds, didn’t even know about their rate of return from theirventure capital investments because they didn’t have any software to measure it . . . butwe said that we could put together a data set if they only allowed us access to their records.In that way we put together a data set including the rate of return for more than 200 fundsin America.

I’ll never forget the first time that we printed out the results. It took about 20 minutesto run . . . we could see it printing, but after a couple of minutes it stopped. In order tomake the programme run efficiently, I designed the rate of return algorithm to have amaximum 84 per cent rate of return . . . I never dreamt that anyone could achieve that, sothat wouldn’t be a problem . . . but, the printer stopped, and finally, I had to double theupper limit in my algorithm, and the printer started to run again. So, guess what . . . itwas Kleiner Perkins once again, not only were they the most central in the venture capitalnetwork, their rate of return was so high that it broke my algorithm. That is wonderful . . .seeing something nobody else knows on your computer screen.

However, Kleiner Perkins was one of the few winners. Looking at the industry ingeneral, the average rate of return was only 15 per cent in 1985, not the 40 per cent thateveryone was talking about. Venture Economics wouldn’t publish the figures, but theresults leaked out to journalists. The reactions from industry were mixed – some venturecapitalists were furious, others more grateful that correct figures now had been madepublic. But I couldn’t use the results in my research because the information was boundto secrecy until 1988 when Venture Economics agreed that we could publish it, and itbecame a Babson Conference paper in 1988 and then an article in the Journal of BusinessVenturing in 1989.

I was also doing my dissertation, and all these studies were included in my doctoralthesis entitled ‘Venture capital investing: a resource exchange perspective’, which I pre-sented in 1989 at Boston University.


How would you characterize the development of the research field since your pioneeringstudies in the 1980s?In the 1980s the venture capital industry was shrouded in mystery . . . it was an industryfull of myths, but it is fair to say that, by the beginning of the 1990s, venture capital wasan ‘open book’ and the research very much from a practitioner’s point of view . . . suchas venture capitalists, policy-makers, and entrepreneurs. Today, a great deal of researchon venture capital is more rooted in the theory of sociology, psychology and economics.Nothing wrong with theory, but research doesn’t have much impact on practice anymore.

Frankly, I think there is too much research being done on venture capital. If venturecapital disappeared tomorrow in America, we wouldn’t see any effects on entrepreneur-ship . . . a few years down the road there would be consequences because the growth oftechnological innovations would be slower, but venture capital does not develop new ven-tures, it merely takes existing ventures and accelerates their growth. I have realized moreand more that venture capital is so rare in start-ups that it is negligible – only 1 in 10 000start-ups will have venture capital when they start their business – and in fact, when Ilecture my MBA students, I say; ‘forget about venture capital . . . try to get informalinvestors instead’.

So, that is your advice to your MBA students, but what would your advice be to a new PhDstudent interested in venture capital?Don’t research venture capital! Since I started my research in the 1980s the proportion ofmoney going to early stage ventures has just kept declining, but if we look at the informalinvestors market – it is enormous. When we did the GEM study, the biggest surprise forme was to see the amounts of money from informal investors, in a broader sense than‘business angels’. I estimated that about 100 billion dollars a year comes from informalinvestors in America, and a great deal goes into early stage ventures. And from the entre-preneurs’ perspective the action is in the informal investors’ market, and it is there that weas researchers should make an effort.

The risk is that we are doing ‘easy’ research . . . where we can obtain easy data, asopposed to research that is relevant to policy-makers and entrepreneurs. If we study theinformal investors’ market, it isn’t easy to obtain data, we have to work with messy dataand less elegant databases, and we have to give credit to young researchers who are willingto work with this kind of data. Such research will be far more influential in terms of adviceto entrepreneurs and policy-makers.

Finally, if we look at policy implications, what should government do to promote an activeventure capital market?Looking back, we can conclude that the changes in the pension fund rules at the end ofthe 1970s were most influential for the flow of venture capital in America. However, thechanges in capital gains tax only seem to have had minor effects. Capital gains tax onlyaffects individuals and over the years the proportion of individuals investing in theventure capital industry has dropped. A majority of the money for venture capital is sup-plied by non-taxable sources such as pension funds, endowments and foreign investors. Inaddition, I have also learned that there is only one thing that really affects the flow ofventure capital and that is the strengths of the public offering market – forget anythingelse – you need to have a strong second tier market.


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


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

BOX 1.4 WILLIAM SAHLMAN

Born: 1951Career1980 – Entrepreneurial Management, Harvard Business School

1999–2002 Co-chair Entrepreneurial Management Unit1991–1999,2006– Senior Associate Dean1990– Dimitri V. D’Arbeloff Professor of Business

Administration

EducationPhD in Business Economics, Harvard UniversityMBA, Harvard UniversityA.B. degree (Economics), Princeton University

The Winchester Disk Drive industry, that is high-speed data storage devices for com-puters, grew rapidly in the late 1970s and early 1980s. The technology was first introducedby IBM in 1973, and many new entrants followed, resulting in an inexorable increase inthe performance of computers as well as disk drives. The expectations of the industrywere high, and there were many spin-offs where executives in firms that were active in thedata storage industry decided to go after a share of the growing market and started theirown companies.

Finding venture capital for start-ups in the disk drive industry was easy. The industrywas perceived as attractive, there was a large group of high quality management, and theequity capital market was increasing. The late 1970s and early 1980s were characterizedby a rapid growth in the venture capital industry in the US as well as robust stock marketperformance. Many of the firms in the disk drive industry received money from venturecapitalists – from 1977 to 1983 just over $300 million was invested in the industry byventure capitalists – and a number of firms began to raise capital through the public stockmarket rather than continuing to rely on venture capital funding.

However, something began to happen in the industry and many companies ran intodifficulties; new technologies were introduced and competition increased, many compa-nies were unable to produce acceptable quality drives, and the market for computers (thecustomers of the disk drive companies) showed a significant downturn in the rate ofgrowth. Sahlman and Stevenson argued that the venture capitalists could have been awareof these changes if they had used available information on the market, the technology andcompetition – ‘the data necessary to anticipate the problem were readily available beforethe industry shakeout began and stock prices collapsed’ (p. 7).

In another seminal article, ‘The structure and governance of venture-capital organiza-tions’ (1990), William Sahlman was one of the first to describe and analyse the structureof venture capital organizations. In the article Sahlman provides an analysis of the rela-tionship between the venture capital firm and its fund providers as well as between theventure capitalist and their portfolio firms. The article provides an in-depth understand-ing of how venture capital organizations are governed and managed.

Regarding the relationship between venture capital firms and their fund providers,Sahlman devotes particular attention to the financial contract that governs the relation-ship and highlights the agency problems involved in the relationship. He argues thatventure capitalists have many opportunities to take advantage of the fund providers andthat agency problems are exacerbated by the legal structure of the limited partnerships inwhich limited partners are prevented from playing a role in the management of theventure capital firms. In order to protect the limited partners the contract needs to bedesigned in such a way that the venture capitalists will not make decisions against theinterests of the limited partners, for example, by the inclusion of a limitation on the lifeof the venture capital fund, a compensation system that gives the venture capitalistsappropriate incentives, and a contract that addresses obvious areas of conflict betweenthe venture capitalist and the limited partner.

The article also includes a discussion about the relationship between the venture cap-italist and his/her portfolio firms. Sahlman drew particular attention to the informationasymmetry between the venture capitalist and entrepreneur, which may cause monitoringproblems. In this respect, Sahlman provided a rationale for venture capitalists to stagetheir commitment of capital, devise compensation schemes that provide the entrepreneur


with appropriate incentives through active involvement in the portfolio firms, and pre-serve mechanisms to make investments liquid.

Finally, in the article ‘What do venture capitalists do?’ (1989) Michael Gorman andWilliam Sahlman shed some light on how venture capitalists spend their time. Based onthe results derived from 49 responses to a questionnaire distributed to venture capitalistsin 1984 they concluded that:

● Venture capitalists spend about 60 per cent of their time monitoring nine portfoliofirms, in five of which they are the lead-investor.

● As lead-investors they devote 80 hours of on-site time and 30 hours of phone timeper year to each portfolio firm.

● The most common services for the portfolio firms were to help build the investorgroup (raise additional funds), formulate their business strategy and fill the man-agement team (management recruitment).

Even though the article is very descriptive, it has been heavily cited and can be regardedas very influential in terms of understanding venture capitalists’ involvement in the firmsin which they invest – the venture capitalist–entrepreneur relationship, monitoring activ-ities and value-adding effects.

Interview with William Sahlman

In the 1980s you wrote several seminal articles on the venture capital industry. Whatawakened your interest in venture capital and the venture capital industry?My background was that I had a degree in economics from Princeton, and for a shortperiod I worked in the area of finance in New York. I came to Harvard Business School(HBS) in 1973. As I was graduating from the MBA programme I applied to the PhD pro-gramme in Business Economics at HBS . . . I was accepted for the programme, but spenta year in Europe writing cases for Harvard Business School. I wrote my thesis in eco-nomics on the interaction between investment and financial decisions in companies andjoined the faculty of the Department of Finance at HBS in 1980.

In 1982 we started to plan for a conference on entrepreneurship at HBS, for which Iwrote a paper ‘The financial perspective: what should entrepreneurs know’. In the paperI tried to understand entrepreneurship, what financial decisions were like for entrepre-neurs, who the players in the financial market were, and whether or not finance for entre-preneurial firms was different from what could be called ‘traditional finance’. We had avery interesting conference, which included a number of practitioners, including quite afew from the venture capital industry as well as some entrepreneurs. The purpose was toset an agenda for HBS – what should HBS do to understand these kinds of activities? Youhave to remember that ten years after graduation just under 50 per cent of all HBS grad-uates describe themselves as ‘entrepreneurs’, a large proportion of all venture capitalistshave their roots at the Harvard Business School, and the group of people who started theventure capital industry in the US . . . Doriot, Perkins, to mention a few . . . all came fromHBS. So, the school is deeply rooted in entrepreneurship and the venture capital industry.

I began to write cases about entrepreneurship and about people in the venture capitalindustry – in total I have written almost 160 cases for HBS. In the mid-1980s I decided to


launch a new course in ‘Entrepreneurial Finance’ which was introduced in the spring of1985. I also decided to write all my own material and cases for the course . . . as I developedcourse materials, I observed several interesting questions in the venture capital industry, likewhy did they use securities that seem inappropriate for risky ventures; why did they stagethe commitment of capital; what decision rights do they retain; what happens down theroad depending on the performance of the venture, etc.? So, there were many interestingquestions to be explored.

Based on this experience I wrote a note called ‘Note on financial contracting’ that resultedin an article entitled ‘Aspects of financial contracting in venture capital’ in the Journal ofApplied Corporate Finance, in 1988, which then evolved into the article ‘The structure andgovernance of venture-capital organizations’ in the Journal of Financial Economics, in 1990.

Yes, the article ‘The structure and governance of venture capital organisations’ is probablyyour most cited article in venture capital research. What do you see as its major findings?At that point in time, no-one had really laid out the main issues in the venture capital indus-try – there was not much written about the venture capital industry – and the article wasan attempt to take a financial economist’s lens and apply it to a field-based research project.

I think the most important part of the article was to show the interconnectednessbetween the governance of the funds and the investments in individual ventures – theinterconnectedness of those two systems. Researchers often study one system but not theother, but you cannot understand why venture capitalists make bets and how they struc-ture the deals with individual entrepreneurs, without understanding how the funds arestructured. Another important contribution in my opinion was to provide some rationalefor staged capital commitment, and I also tried to compare that with how capital is allo-cated in larger companies.

Does fund structure matter?Well . . . on the one hand, you can say that limited partnerships are no better or worsethan other fund structures but, on the other hand, I believe there are several aspects thatmake limited partnership an important way of governing the venture capital funds. I con-sider that the structure of staging the capital committed to venture capital funds isextremely important . . . making the venture capital funds pay all the money back beforegiving them more money is a remarkably powerful control mechanism . . . that kind ofstructure works much better than providing a permanent pool of capital.

Looking at performance it seems as if US funds always outperform European VC funds . . .?Yes, historically you are correct . . . due to a stronger ‘right hand tail’ of successful com-panies in the US as well as a more active exit market – most exits have been IPOs in theUS, as opposed to mergers, and IPOs yield higher returns. But as the economy becomesmore global, we will see more successful ventures all over the world and stronger exitmarkets – and the differences between countries or continents will level out.

This leads us to some policy issues. What do you think policy-makers can do in order to createan efficient venture capital market?Well, I think there is essentially very little that governments can do to encourageventure capital. My view is that venture capital follows people and ideas . . . venture


capital doesn’t lead them . . . in many cases policies are based on the notionthat money attracts entrepreneurs, but I think it has a tendency to attract the wrongentrepreneurs and the wrong ideas. So, what you have to do is to encourageentrepreneurship.

However, one thing has to do with failures and bankruptcies. In many countries, itis a dishonour to fail, and if you go bankrupt there are a host of personal legalimplications as well as high costs – that context is damaging to entrepreneurship andyou will have fewer people starting new ventures. But it is not only a question of thedownside of failures, the question is also: what is the upside of entrepreneurship – theright hand tail . . . to be successful – is far less attractive in many countries than it is inthe US.

In another early article that you wrote together with Howard Stevenson, ‘Capital marketmyopia’, you were very critical of the venture capital industry.Yes, I noticed that all venture capitalists seemed to rush into the same industry at the sametime. Why did that happen, and what can be learned?

Historically, it turns out that every industry ever created seems to have the same courseof development. In the beginning, you start with a large number of entrants and manyplayers – it is the same if you look at the railroad industry, the telephone industry, or what-ever – and all will be financed in the early days by informal capital, by business angels.There will be some early successes. But, we also know that as the industry matures, manyfirms will be over-valued and some will disappear from the market, and there will be manylosers. So, this is not a new phenomenon. What was new in the Winchester Disk Driveindustry in the 1970s and 1980s was the new class of professional investors and a new tech-nology that very few people understood. The entrepreneurs within the industry all hadthe same origin in companies like IBM, Memorex, etc. and they were all desperatelysearching for faster, cheaper, smaller products . . . in this case disk drives. Every singleventure capitalist who invested in the industry believed that his team and their technol-ogy were going to win. As expected, not everyone can obtain a 10 per cent market share –at least not 130 companies – so, inevitably there were a large number of failures. But therewere not only losers – in the venture capital industry you know that there is a high likeli-hood of losses – there are a small number of interesting firms that will generate remark-able profits. So, the question was ‘Did it all make sense?’ and ‘Why were people assumingthat their company would win?’

We see this over and over again, in e-commerce, in nanotechnology, etc. Don’t venturecapitalists learn anything?You have to remember that this is a difficult game. If we look back 15 years, 50 per centof all distributions in the venture capital industry came from 30 firms. So, venture capitalreturns are heavily concentrated . . . the nature of the game is that everybody has to tryto find the winners. In this respect, it is not necessarily stupid to invest in companies wherethere is a high likelihood of failure, as long as you place your bets so that you end up withsome companies in the ‘right hand tail’ of the distribution – the great winners. It is a ques-tion of understanding the industry. And if we look at the disk drive industry itself, it wasnot very structurally attractive . . . it had no network effects, low operating margins . . .so, the likelihood of a huge pay-off in the ‘right hand tail’ is much smaller than in many


other industries. And, I think, the venture capital community has learned a bit aboutwhich industries may create big winners.

A third article that has been influential in venture capital research is ‘What do venturecapitalists do?’ published in the Journal of Business Venturing in 1989.Yes, I must admit that I am surprised that the article has been cited so often. It was basedon a student project and contains very little analysis and interpretations, but to someextent the data speak for themselves and I think researchers had never looked into thework of venture capitalists in a systematic way.

Does venture capitalist involvement in the firms in which they invest really matter?I believe that . . . there is a tremendous amount of evidence to suggest that venture cap-italists are beneficial in many different ways – introducing people to a network that theyhave cultivated over a long period of time, making it easier to get access to future finance,and there is a certification process that helps to legitimize the venture in the market place.

Have you seen any changes in the way venture capitalists work today compared to your studyin the 1980s?Yes, there is a change in the sense that venture capitalists today have much more capitalto allocate per partner – they are involved in more ventures and spend less time with eachcompany, and accordingly, they are not as helpful as they were before.

I think of venture capital as an art in which judgement and wisdom play a critical role.So, therefore, it is not a single attribute that makes a successful venture capitalist. Forexample, we have seen venture capitalists with quite different backgrounds who have beensuccessful . . . venture capitalists with a financial background, in other cases former topmanagers, etc. . . . and they are not always experts in the industries in which they invest –in this respect the venture capitalist hasn’t changed.

Finally, if we look at venture capital research in the future, what are the questions that oughtto be asked?I would say that there are some important questions that have not yet been addressed.First, venture capitalists allocate a great deal of money to projects and new ventures, butso do large corporations . . . and, how do we compare the relative efficiency of these twomodels? Thus, I would very much like to see comparative studies of different models ofventure capital investments. Second, I don’t think researchers have done an adequate jobin understanding the dynamics of venture capitalists’ portfolios. Looking at the port-folio of investments as opposed to individual investment I would liked to ask a series ofquestions, for example; what was the proportion of failures, what was the proportion thatrecouped more than ten times the money invested, what was the likelihood of obtaininga second round of financing, what was the pay-off structure for the investments, etc.? Athird area of importance in which we haven’t seen a great deal of research is the boardof directors in venture capital-backed firms. What is an effective and ineffective boardstructure?

One problem with these kinds of questions is that they require information from insidethe firms, not from databases . . . this is not an industry you can study without insideknowledge that current databases do not provide. So, there is much hard work to be done.


Research on corporate venture capital

A history of corporate venture capital investments and research on corporate venturecapitalProbably the first corporate venture capital investor was DuPont back in 1919 when oneof its important customers ran out of funds, and DuPont purchased 38 per cent equityinterest in the company – General Motors. They brought in a new president, Alfred Sloan,and General Motors grew substantially over the years. After World War I, AmericanTelephone, General Electric and Westinghouse made several investments. Soon afterWorld War II a small company, Haloid Corporation, funded the commercialization of anew technology developed by Chester Carlson and the Battelle Memorial Institute – laterthe company changed its name to Xerox Corporation (Rind, 1986). In the late 1950sseveral larger corporations became interested in venture capital activities, and venturecapital firms funded by larger corporations or a subsidiary of a corporation, emerged inthe mid-1960s, pioneered by companies such as Xerox and AT&T. Since then corporateventure capital has gone through several cycles (Rind, 1981; Gompers and Lerner, 1999;Birkinshaw et al., 2002).

The initial wave of corporate venture capital occurred at the end of the 1960s. Moreand more companies established divisions that acted as venture capitalists and in the early1970s more than 25 per cent of the Fortune 500 firms implemented corporate venturecapital programmes. However, the market diminished dramatically in 1973, following theoil price crisis, the abrupt decline in the market for new public offerings, and the ensuingrecession.

The second wave, beginning in the late 1970s and early 1980s, was fuelled by the growthof the computer and electronic sector and reached a peak in 1986 when corporate venturecapital funds managed $2 billion, or almost 12 per cent of the total pool of venture capitalin the US. However, when the stock market crashed in 1987 and the market for new IPOsdropped, larger corporations scaled down their venture capital investment commitments.

Finally, the third wave emerged in the 1990s linked to the technology boom and thedot.com era, and in 1997 corporate investors accounted for about 30 per cent of the com-mitments to new funds compared to an average of 5 per cent in the period from 1990 to1992. As in the earlier waves of corporate venture capital, the interest was stimulated bythe success of the venture capital industry in general – rapid growth of funds and attrac-tive rates of return. The market peaked in 2000 before the great crash (the collapse ofhigh-technology stocks, the loss of faith in internet-based businesses, and a number ofhigh-profile corporate failures). The conclusion arrived at by Gompers and Lerner (1999)is that, over time, corporate involvement in venture capital has mirrored the cyclicalnature of the entire venture capital industry.

The emergence of the industry during the 1980s led to some pioneering scholarly workon corporate venture capital, and in Table 1.5 some of the early contributions will be pre-sented. All of these contributions can be regarded as highly descriptive (and normative)in their approach. It was a way of making the ‘new’ corporate venturing tool visible anddiscussing its advantages and limitations, that is corporate venture capital was consideredin the frame of strategic management and the corporate venture process.

However, after these pioneering works, the research on corporate venture capital was rel-atively scarce with a few exceptions (for example, Gompers and Lerner, 1996; McNally, 1994)


until the late 1990s and early 2000s (linked to the third wave of corporate venture capitalinvestments) when a large number of studies on corporate venture capital appeared. A state-of-the-art review of recent studies can be found in Chapters 15 and 16.

Pioneers of corporate venture capital researchAs can be seen in Table 1.5, there were several early research contributions on corporateventure capital in the 1980s. One of the pioneers in this respect was Kenneth Rind, whoin 1981 published an early article on corporate venture capital in the StrategicManagement Journal. Rind can be regarded as an active advocate of venture capital, notonly in the US but internationally, being a mentor for new venture capitalists, the authorof several articles and a notable speaker on venture capital. He is also regarded as oneof the pioneers in introducing venture capital to countries such as Japan, Singapore,Israel, and Russia. In this section I will summarize his SMJ article and present aninterview in which he looks back on four decades as an active international venturecapitalist.

Seminal articleKenneth Rind was one of the first to recognize corporate venture capital as a tool in thecorporate development toolbox. His observations were based on his experience of beingresponsible for acquisitions and venture capital investments at Xerox DevelopmentCorporation, but were also influenced by the second wave of corporate venture capitalthat emerged in the late 1970s as a result of the growth of the computer and electronicssector. In his article ‘The role of venture capital in corporate development’ (an extendedversion was later published in the Handbook of Strategic Planning in 1986 entitled‘Venture capital planning’), corporate venture capital is mainly seen as a strategic tool,and in the introduction to the article Rind states (p. 169):


Table 1.5 Early contributions on corporate venture capital

Pioneering studies

Fast (1978), The Rise and Fall of Corporate New Venture Divisions, PhD Thesis, Ann Arbor, MI:UMI Research Press.

Rind (1981), ‘The role of venture capital in corporate development’, Strategic ManagementJournal, 2 (2), 169–80.

Hardymon et al. (1983), ‘When corporate venture capital doesn’t work’, Harvard Business Review,61, 114–20.

Burgelman (1984), ‘Managing the internal corporate venturing process’, Sloan ManagementReview, Winter, 33–48.

Siegel et al. (1988), ‘Corporate venture capitalists: Autonomy, obstacles and performance’,Journal of Business Venturing, 3 (3), 233–47.

Winters and Murfin (1988), ‘Venture capital investing for corporate development objectives’,Journal of Business Venturing, 3 (3), 207–22.

Sykes (1990), ‘Corporate venture capital-strategies for success’, Journal of Business Venturing,5 (1), 37–47.

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

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


Picture 1.5 Kenneth Rind, Venture Capitalist, New York, USA

BOX 1.5 KENNETH RIND

Born: 1935Career1961–1962 Post-doctoral Argonne National Laboratory1963–1964 Assistant Professor of Physics, City University of New York1964 Founder, Quantum Science Manager, Samson Fund1968–1969 Associate, Rockefeller Family & Associates1970–1976 Vice President – Corporate Finance at Oppenheimer & Co., Inc.1973 Founding Director of the US National Venture Capital Association

(NVCA)1976–1981 Corporate Development Venture Capital Executive – Xerox

Development Corporation1981 Co-founder of Oxford Partners – venture capital company1993 Co-founder of the Nitzanim-AVX/Kyocera Venture Capital Fund in

Israel1998 Co-founder of the Israel Infinity Venture Capital Fund

Education1956 BA in Chemistry at Cornell University1961 PhD in Nuclear Chemistry at Columbia University

factors led to the resurgence of interest, for example, the excess corporate liquidity at thatpoint in time, a relentless toughening of anti-trust regulations regarding acquisition, andthe entry of foreign companies to the US market.

In the article, Rind compared corporate venture capital with conventional institutionalventure capital and he also put corporate venture capital in the context of other corpo-rate development strategies. He provided an overview of corporate venture capital activ-ities in the US at the time of the second wave of corporate venture capital, but the mainpart of the article contains a discussion about the benefits for corporations involved incorporate venture capital activities as well as the problems of and difficulties involved incorporate venture capital programmes in different companies.

Focusing on the benefits of introducing a corporate venture capital programme,Rind reports strategic advantages such as: engaging quickly with companies whoseproduct/technology could play an important role in the future, a better understanding ofthe management strengths and weaknesses of potential acquisitions, obtaining productsat a lower cost and more efficiently than could be done in-house, and an early window onnew technologies and new markets that show future potential.

However, not all corporate venture capital programmes succeeded – in fact only 7 percent of active corporate venture capital organizations regarded themselves as very suc-cessful, and over half did not even rate themselves as marginal successes. In the articleRind emphasizes that the difficulties experienced from these less successful cases usuallyarose from one of the following sources:

● Lack of people with appropriate skills;● contradictory rationales (investee company versus the parent organization);● legal problems; and● inadequate time horizon (success in early-stage venture capital can take seven to ten

years, and corporate venture capital funds are generally terminated before that).

As a consequence, many corporate investors changed their investment approach andstarted to make investments through venture partnerships. A venture capital partnershipprovides the opportunity to attract good people, problem investments become less visible,management time is saved, long-term commitment is assured and many legal liabilities areeliminated.

Rind formulated his conclusion in the following way (p. 179): ‘venture capital is a usefultool for corporate development. It is difficult but possible to do internally, and an outsidepartnership investment can be either an alternative first step or a beneficial supplement toa direct corporate venture capital programme.’

Interview with Kenneth Rind

You had a long career as a venture capitalist. Could you say something about yourbackground?I obtained my PhD in nuclear chemistry at Columbia University, and after a couple ofyears as a post-doc at Argonne National Laboratory I returned to New York in 1963 asan Assistant Professor at the City University of New York teaching nuclear physics.However, the promises made to me were not kept, and although I was offered tenure, I


stayed there for only two years. My room mate at the university, whose father was in thefinance business, encouraged me to start consulting on technology evaluations for thefinancial community. So, I first did part-time consulting and after a couple of years itbecame a full-time business, and I co-founded Quantum Science/Samson Fund. We wereretained by 8 out of the 10 largest mutual funds in the US, 5 out of 6 then operatingventure capital firms, and 3 out of 5 of the largest banks.

One of my clients was the Rockefeller family, and they recruited me to be their tech-nology analyst but I also became involved in their venture activities. You can say that Iserved my first apprenticeship there. While I was at Rockefeller we made a couple of veryinteresting investments, for example, we were an initial investor in Intel – in the then newintegrated circuit business.

After a few years with the Rockefeller family I was recruited by Oppenheimer, a verylarge money manager in those days. I was responsible for a venture capital fund in whichI became the senior partner – you could say that I continued my apprenticeship atOppenheimer.

In 1973 I also became active in forming the National Venture Capital Association, andI was one of the initial Directors. Our main concern was to lobby for making venturecapital investments more attractive, and we were successful in so far as many changes weremade in the US regulations and tax system in the late 1970s – of which the ‘Prudent ManRule’, allowing pension funds to invest in venture capital funds, was the most important.

In 1976 I joined the Xerox Corporation and became responsible for their venturecapital and acquisition programme. You could say that this was a bad decision for me, butmaybe a good decision for the world. One consequential thing that I did was to go backto my colleagues at Rockefeller and ask what they were investing in. They told me abouta personal computer manufacturer which sounded like an ideal supplier for Xerox. Weput a million dollars into Apple Computer, so that Apple would develop a computer thatXerox had exclusive rights to – but Xerox rejected the design, and Apple produced it morecheaply and called it MacIntosh. In general, I must admit that I was very sad aboutXerox – as the management made some rather peculiar decisions after I had left.

After Xerox I formed my own venture capital firm – Oxford Partners . . . after the streetwhere I lived, and not the university in the UK . . . I started to look for investors in 1980and the fund was ‘closed’ in 1981. As I had been active in corporate venture capital atXerox, I brought in a large number of corporations, and within several years we had com-panies like Xerox, IBM, ATT, Siemens and General Motors as investors.

You have been referring to my article in the Strategic Management Journal in 1981, andI think you should consider my arguments in the article in the context of my experienceat Xerox and my new operation as an independent venture capitalist. In Xerox I hadexperienced the difficulties associated with corporate venture capital, and I had seen a newwave of corporations made venture capital investment. Many of these programmes failed,and corporate venture capitalists were not always well regarded in the venture capitalcommunity due to suspicions regarding their motives and doubts about their longevity –and I wanted to teach how they could succeed. I was also on my own . . . launching myown independent venture capital firm, and I went out to search for corporations to investin my fund. I travelled around making speeches, and the article in the SMJ was more orless a way of selling my new fund – it was successful in encouraging over 25 corporationsto give us money instead of trying to invest in corporate venture capital by themselves.


But you have also been very active as an international venture capitalist and regarded as oneof the pioneering venture capitalists in Japan and Israel, and now you are actively workingto introduce venture capital in Russia . . .Yes, I first became involved in international venture capital when I was at Oppenheimer.My senior partner called me up and said that there was a Japanese company that wouldlike to learn about venture capital. I hosted them for a summer, and I introduced them toventure capital situations and showed them what was happening in US technology . . . buton condition that they invite me to Japan and allowed me to look at venture investmentsin Japan . . . that must have been 1973 or 1974 . . . I went over and lectured about venturecapital, but I was turned down by MITI for making investments in Japan. However, atOppenheimer I hosted a number of people from Japan who had come to learn aboutventure capital.

In 1986 I was asked by the Israeli government to come over and consider starting aventure capital fund in Israel. I went over, but realized rather quickly that it was impossi-ble to make money – the best engineers were working for the military, the government didnot like business, the inflation rate was 100 per cent per annum, etc. – and I concludedthat there was nothing for me to invest in. However, a few years later I received a phonecall from a friend of mine, who had a factory in Jerusalem, and he told me that the Israeligovernment wanted to increase a venture capital activity and asked if I would be willingto help set up a fund in Israel. Based on my earlier experience, I was doubtful, but he con-vinced me that things had changed a lot in Israel by the early 1990s. So, in 1993 I foundedmy first fund in Israel – Nitzanim-AVX/Kyocera Venture Fund – which was a part of thegovernment-supported Yozma programme.

In 1997 I was asked to join the board of an organization set up by the US Congress tofind useful work for Russian weapon scientists – the United States Civilian Research andDevelopment Foundation – and I became interested in technology developments inRussia. I started to visit Russia, I held speeches on why venture capital should be encour-aged, and tutored people to understand venture capital. However, progress has been veryslow . . . there is no tradition and no entrepreneurial spirit, and as I see it, it will take timeto foster venture capital in Russia.

You have been involved in introducing venture capital in many emerging venture capitalmarkets. What is your advice to policy-makers who want to encourage venture capital in acountry?Over the years, foreign governments have learned more about venture capital . . . theyrecognize that venture capital is a good thing . . . and when I make my presentations,which are based on my experience from several different countries, I always say thatventure capitalists want to have (1) partners with an entrepreneurial spirit – drives andvisions; (2) a financial and scientific infrastructure; (3) world-class products and experi-enced management teams; (4) large world markets with unfulfilled needs; (5) easy exits;and (6) a context characterized by low taxes, low capital gains taxes, and the ability torepatriate funds.

I usually advise governments on what has been done elsewhere to promote an activeventure capital market (see Table 1.6). I am not suggesting that all these initiatives workin every country, but government should know what possibilities exist, and what has beensuccessful in other countries.


As I see it, the most important way of encouraging venture capital is to promote anentrepreneurial spirit in the country – people must feel it is a good thing to be an entre-preneur, to build something that the world wants, and to become wealthy.

In addition, government should try to keep away from attempting to pick the winnersand losers by themselves – it is always a disaster – anything they do to encourage the


Table 1.6 Rind’s advice to governments on how to promote an active venture capitalmarket

Taxes Other financial programmes Non-financial programmes

1. Reduce capital gains rate 1. Encourage non-taxable entities 1. Encourage military/– more for long-term to invest (‘Prudent Man Rule’) government labs/universities

capital gains to spin-out projects– defer taxes if 2. Provide leverage through the pro- – help organize venture

re-invested in qualified vision of equity/loans/grants capital funds to financeentity spin-out ventures

3. Ensure that investors will not – foster co-operation with 2. Give tax credits to lose capital start-ups

individuals/corporations for 4. Pay for % of R&D/new 2. Improve liquidity/capital investments in qualified facilities costs/labour raisingsmall firms, qualified (training) – create exchangesventure capital funds, – lessen listing requirementsand R&D activities 5. Fund incubators/companies

in incubators 3. Allow investors to control3. Waive corporate income investees

taxes, sales taxes, and 6. Make grants for generic – no cap limit on ownershipproperty taxes for R&D programmesqualified start-ups 4. Require US-compatible

7. Establish Bird-F type of reporting (so firms can list 4. Allow investor losses to activity on NASDAQ)

offset ordinary income8. Finance training abroad for 5. Permit immigration of

5. Lower taxes on venture capitalists skilled talentmanagement fees/bonus

9. Establish agencies to provide 6. Allow LLCs6. Permit option grants/ consulting/support

exercise without taxes – 7. Encourage foreign tax only when 10. Relax bank lending criteria corporations to: open cash received development centres, invest,

11. Coax émigrés to return and acquire7. Tax exemption for (e.g. housing)

foreign investors 8. Make successful (irrespective of 12. Create industrial parks entrepreneurs into heroes;tax treaty) encourage networks

13. Allocate part of government-managed pension fund 9. Don’t ostracize failuresinvestments

industry should be alongside experienced venture capitalists . . . and/or if the venturecapitalists select the companies, the government could say that they will leverage andinvest alongside the venture capitalists, but the venture capitalists are responsible formaking the company a success.

You have been active as a venture capitalist for four decades, you have been a mentor fornew venture capitalists, writing articles, making speeches about venture capital . . . what isnecessary to be a successful venture capitalist?This is a very difficult question to answer . . . a venture capitalist succeeds by making goodinvestment, but you never know in advance which investments will be good – many com-panies fail and venture capitalists lose money on most of their investments. But at leastyou should, as a venture capitalist, have the skills to help the companies in which youinvest. The difference between venture capital and predicting stock market prices is thatventure capitalists can help to change the odds. In this respect, I strongly believe thatventure capital is a business that requires an apprenticeship . . . you can’t teach it, one hasto experience venture capital situations and learn from them . . . and we need a trainedcadre of people who know how to operate in the world of venture capital.

And I can see a problem . . . the people who founded the venture capital industry in theUS are now retiring, and new people who are coming in should apprentice . . . but a wholebunch of people came in during the dot.com boom who didn’t know what they were doing.

Thus, venture capitalists must have the experience to help the companies in which theyinvest. One of the most important decisions to make is replacing the founding entrepre-neur at the right time and bringing in someone who is capable of running a growingcompany. At the same time it is important to keep the founder on board, so that he/shecan continue to contribute from a technical point of view, as a spokesperson, etc. Unlessthey have done that several times . . . people can’t learn that – they have to experience itby themselves.

I also teach entrepreneurs how to make exits and always tell them not to make thecompany dependent on having an IPO, but to run the company at all times as if either anIPO or takeover is imminent and to make contact with corporate venture capitalists whocould be potential acquirers – even if they have no interest in investing in your companyat that point in time they should get to know you.

It is also important to emphasize that venture capital is a rather heterogeneous phe-nomenon. I would say that there is no single way in which venture capitalists operate.There are venture capitalists doing seed investments, others wait until there is a developedbusiness plan, some only invest in particular technologies, etc. And different venture cap-italists are successful in different ways.

In your view, what will the venture capital market look like in the future?I am sorry, but it is impossible to answer that . . . the only thing I know is that the marketgoes through cycles and will always go through cycles – for the same reasons as the stockmarket – people are greedy and will invest when the market goes up, and that is good forventure capital. However, when a lot of money goes into the venture capital market,venture capitalists invest in too many companies that are doing the same things, so manygo out of business. Thus, investors lose money, then there will be too little money, and wewill start all over again . . .


Historically I can also say that most of the returns have come from the top quartile ofventure capitalists – the most experienced venture capitalists – and I expect the future willbe no different.

Finally, some advice for the research community. What would you say will be the most impor-tant questions for researchers on venture capital to answer in the future?The one question that I have never been able to answer is how to keep a corporate venturecapital activity going. For example: how do you offer incentives to people in a way that itdoesn’t make corporate management and the internal people working with the corporateventure capital group jealous?

In addition, I have given advice to many governments about what is needed to encour-age venture capital in a country, and of course, I would be very happy to see research thatcould confirm and sort out the initiatives that are successful – probably certain initiativeswould be more or less successful in different cultures and contexts.

Research on informal venture capital

Some early contributionsThe interest in the informal venture capital market among policy-makers and researchersstarted in the 1950s and 1960s. In particular, the financial problems experienced by manyyoung technology-based firms provided a starting point for studies on informal venturecapital. For example, in the late 1950s the Federal Reserve performed a couple of investi-gations regarding the initial financing of new technology-based firms – studies that precededthe Small Business Investment Act of 1958, which led to the creation of the Small BusinessInvestment Company (SBIC) programme in the US. The interest in early financing of youngtechnology-based firms originated in an emerging interest in business angels as an impor-tant external source of finance for entrepreneurial ventures with a basis in new technologies.Some of these early contributions during the 1950s and 1960s are summarized in Table 1.7.

However, it was the pioneering work by Professor William Wetzel at the University ofNew Hampshire in the US that led to an increasing interest in the informal venture capital


Table 1.7 Early contributions on informal venture capital

Pioneering studies

Rubenstein (1958), Problems of Financing and Managing New Research-based Enterprises inNew England, Boston, MA: Federal Reserve Bank of Boston.

Baty (1964), The Initial Financing of New Research-based Enterprise in New England, Boston,MA: Federal Reserve Bank of Boston.

Hoffman (1972), The Venture Capital Investment Process: A Particular Aspect of RegionalEconomic Development, PhD Thesis, University of Texas at Austin.

Brophy (1974), Finance, Entrepreneurship and Economic Development, Institute of Science andTechnology, University of Michigan, Ann Arbor.

Charles River Associates Inc. (1976), ‘An analysis of capital market imperfections’, prepared for theExperimental Technology Incentive Program, National Bureau of Standards, Washington, DC.

market. Wetzel’s study was based on the widely held perception that new technology-based ventures encountered problems when raising small amounts of early-stage financ-ing. On the other hand, anecdotal evidence indicated that ‘business angels’ played a rolein solving this problem. Little was known about the characteristics of business angels andthe flow of informal venture capital and in his study Wetzel wanted to ‘put some bound-aries on our ignorance’.

Some central themes in informal venture capital researchFollowing Wetzel’s seminal study in the early 1980s, interest in the informal venturecapital market grew among researchers in the US and around the world. Researchers felta need to quantify and describe the informal venture capital market, thus the research hasbeen fairly descriptive and focused on three main questions:

● How large is the informal venture capital market? – The market scale.● What characterizes the informal investors/business angels – ABC of angels (their

attitudes, behaviour and characteristics).● How can a more efficient venture capital market be created? – Policies and infor-

mation networks.

The market scale Estimating the size of the informal venture capital market is a difficulttask. In one of his first research articles on informal venture capital, William Wetzel (1983)concluded that the informal venture capital market is ‘unknown and probably unknowable’(p. 26). Despite conceptual and methodological problems in researching the informalventure capital market, a large number of scholars have been trying to estimate its size –mainly defined as business angel investments. The result varies significantly between coun-tries – from about 2.75 per millage of the GDP in the US to about 0.78 per millage inSweden – partly due to the different methodological approaches used to measure the scopeof the informal venture capital market (Mason and Harrison, 2000a; Avdeitchikova, 2005).

The conclusion that can be drawn from earlier studies is that the estimations of theinformal venture capital market are problematic in various ways (Mason and Harrison,2000a) due to the private and unreported nature of the investment activity and the desireof most informal investors to preserve their privacy. In addition, as indicated earlier, thereare severe problems of definition, for example, in some estimations investments by ‘familyand friends’ are included, whereas they are excluded in others, while some estimationsconcentrate on the group of investors known as ‘business angels’. Most of the studiesrelied on convenience sampling, and it remains unclear whether these samples are repre-sentative of the underlying population of informal investors (Riding, 2005). Finally, manyearlier studies had very small samples and low response rates (Mason and Harrison,2000a). Thus, the estimates made in the various studies must be considered very crude cal-culations of the informal venture capital markets in different regions.

ABC of angels It was not only essential for researchers to estimate the size of the infor-mal venture capital market – another question of importance was to characterize the indi-viduals making informal investments, mainly the group of informal investors we call‘business angels’ and to describe the attitudes, behaviour and characteristics of these indi-viduals (ABC of angels). As far back as the 1980s, several studies were conducted in


different parts of the US in order to describe the ABC of angels in different regions.However, at the end of the 1980s and early 1990s, academic and public policy interest inthe informal venture capital markets started to grow internationally and continued to doso throughout the 1990s (for a review of the characteristics of angels, see Chapter 12 byPeter Kelly).

Although the conditions for an active business angel market differ from region toregion and country to country, it is worth emphasizing that there seem to be many sim-ilarities in business angels’ attitudes, behaviour and characteristics irrespective of context(Lumme et al., 1998) as well as over time (Månsson and Landström, 2005). For example,the ‘typical’ angel investor seems to be a middle-aged male with a reasonable net incomeand net worth and previous start-up experience, who makes about one investment a year,usually close to home. The primary method of finding new investment opportunities isthrough friends and business associates, and they prefer high-technology and manufac-turing ventures, with an expectation to sell out in three to five years (Mason andHarrison, 1992).

However, despite many common characteristics, early research has repeatedly indicatedthat the informal venture capital market is highly heterogeneous – almost individualisticin character – and in the research we can find various attempts to develop categories ofinvestors that describe the market in more nuanced ways (see for example Gaston, 1989;Coveney and Moore, 1998; Sørheim and Landström, 2001; Avdeitchikova, 2005). Oneconclusion that can be drawn from these attempts is that there does not appear to be muchagreement with respect to the categorization schema developed in the various studies, andthe usefulness of the categorizations can be questioned: (i) informal investments areunlikely to be mutually exclusive – informal investors may invest in a variety of differentventures, including both ‘love money’ and ‘business angel investments’, and (ii) theirinvestment profile may change over time (Riding, 2005).

Thus, the conclusion that can be drawn is that we know a great deal more today aboutinformal investors and business angels but, despite 25 years of research, much moreremains to be learned about the characteristics of the investors and the dynamics of theinformal venture capital market.

Policies and information networks Wetzel’s pioneering work in the early 1980s addressedthe fact that the informal venture capital market experienced severe inefficiency problems,making policy interventions necessary. In many countries there seem to be two majorproblems associated with the informal venture capital market: (i) there are too few infor-mal investors active on the market, and (ii) there are market inefficiencies that make itdifficult for investors and entrepreneurs to find each other (Mason and Harrison, 1997).

Tax incentives for private individuals who invest in unquoted companies have been themain strategy for increasing the pool of informal investors on the market. The UK hasbeen the leading exponent of this kind of measure. Since the early 1980s, several strategiesthat provide investors with different kinds of tax relief for informal investments have beenintroduced. A study by Mason and Harrison (1999b; see also Mason and Harrison, 2000b;2002) shows that the tax relief available to UK business angels has had a positive impacton informal venture capital investment activity. The availability of tax relief on informalinvestments – which reduces the risks involved – seems to be the most important encour-agement for informal investors to invest more, whereas reducing the rate of capital gains


tax – increasing the reward – seems to be less influential than front-end tax relief, althoughboth have an impact on promoting informal venture capital activity. However, Lerner(1998) argues that new ventures are inherently risky, and there is considerable uncertaintyregarding their survival and growth. Thus, there is always a risk that attempts by govern-ment to stimulate the informal venture capital market may ‘encourage amateur individualinvestors’ which will be counterproductive for society. Lerner concludes that encouraginginformal investments could be ill-advised – some investors may lack the skills necessary toprotect themselves and to accurately value the opportunity in which they invest.

A conclusion that can be drawn is that tax incentives need to be complemented bymicro-level initiatives – one such initiative is ‘business introduction services’. One initia-tive was the Venture Capital Network (VCN), introduced by William Wetzel in NewHampshire in 1984 as a business introduction service to provide an efficient channel ofcommunication between business angels and entrepreneurs. This idea of business angelnetworks or matching services was later introduced in several places in the US as well asin other countries. In this respect the UK has also been at the forefront in encouraging theestablishment of such communication channels. According to Mason and Harrison(1999b), the performance of business angel networks (BANs) has been varied but, ingeneral, evidence suggests that on an aggregate level their impact on informal venturecapital activities has been both positive and significant (different kinds of business angelnetworks are discussed by Jeffrey Sohl in Chapter 14).

Pioneers of informal venture capital researchIn this section I will present the real exponent of informal venture capital research –Professor William Wetzel – starting with a summary of his pioneering article in the SloanManagement Review – an article that opened up the research field and inspired manystudies on business angels. I will also include an interview in which he gives his view onthe research on informal investors and business angels.

Seminal articleUntil the end of the 1970s the number of studies on the informal venture capital marketwas rather limited. However, at the beginning of the 1980s, Professor William Wetzel atthe University of New Hampshire put informal venture capital on the ‘research map’. In1978 Wetzel conducted a pilot study, based on a questionnaire distributed to 100 individ-uals with a known interest in venture investment situations. A total of 48 completed ques-tionnaires were returned and the results showed, among other things, that the totalpotential pool of venture capital represented by the respondents exceeded $1 million peryear, the required rates of return were lower than those typically required by professionalventure capitalists, and so on. Wetzel came to the conclusion that ‘business angels’ prob-ably represent the largest pool of risk capital for entrepreneurial ventures and that theinformal venture capital market plays an essential role in the growth of the high-techsector.

Based upon the analysis presented in the pilot study, the Office of Economic Researchof the US Small Business Administration funded an expanded study of the availabilityof informal risk capital in New England, USA, in the autumn of 1979. Wetzel and hiscolleagues undertook a nine-month search for business angels, resulting in a sample of133 investors. The results of the study were presented in one of the most cited articles on


business angels: ‘Angels and informal risk capital’ published in the Sloan ManagementReview in 1983. Some of the findings presented in the article can be summarized asfollows:

● Business angels are accustomed to sharing investment opportunities with friendsand business associates, and make investments together with others.

● Informal risk capital is an important source of external seed capital. Forty-four percent of business angel investments were start-ups, and 80 per cent involved venturesless than five years old. In addition, one third of the respondents expressed a ‘stronginterest’ in financing technology-based ventures.


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

BOX 1.6 WILLIAM WETZEL

Born: 1928Career1993– Professor of Management Emeritus University of New Hampshire1967–1993 Whittemore School of Business and Economics, University of New

Hampshire1983 Founder of the Center for Venture Research1983–1993 Director of the Center for Venture Research1984 Founder of the Venture Capital Network Inc (VCN)1987–1993 Forbes Professor of Management Chair

1987–1988 Paul T. Babson Visiting Professor of Entrepreneurial Studies,Babson College

Education1967 MBA (Finance and Accounting), University of Chicago1950 BA (Mathematics), Wesleyan University

● Business angels are active investors, typically having an informal consulting rela-tionship or service on the board of directors.

● Business angels invest in close geographical proximity to their home – 58 per centof the firms financed were located within 50 miles of the business angel.

● Risk capital is ‘patient money’. The median expected holding period among therespondents was five to seven years.

● Business angels were highly influenced by non-financial rewards, including ‘psychicincome’ and social responsibility (for example creating jobs in areas of high unem-ployment, socially useful technologies, and so on). Between 35 and 45 per cent ofthe respondents reported that they would accept lower returns if ‘non-financialrewards’ were included.

The conclusions from the study by William Wetzel were that business angels seem torepresent a substantial pool of funds for entrepreneurial ventures and to have someunique characteristics as well as being highly influenced by non-financial incentives tomake investments, but that the market was relatively inefficient in bringing entrepreneursand investors together.

William Wetzel made the informal venture capital market visible and revealed itsimportance. The study awoke interest among policy-makers as well as scholars and hasbeen replicated in many different contexts (within the US as well as internationally).

Interview with William Wetzel

Your studies on ‘business angels’ in the late 1970s are truly regarded as a pioneering piece ofwork in the area of venture capital research. What aroused your interest in the informalventure capital market?I think . . . earlier in my career I worked as a commercial banker in Philadelphia, and inthat position I managed a large commercial office, and many of my clients were familybusinesses that needed capital. They often went outside of family and friends to searchfor money, and I started to recognize people out there making investments in ventureswith growth potential, which really sparked my interest: how many of these people werethere, what kind of ventures do they look for?, etc.

Later on, as professor at the University of New Hampshire in the mid-1970s, I wasinvolved in an organization called New England Industrial Resource Development(NEIRD). NEIRD was often approached by inventors who wanted to commercializetheir ideas, but had no one to back them. Over a number of years NEIRD had informallyassembled names of people with money and experience who could assist the inventors . . .So, I knew that these people existed.

In 1979 I approached Milton Stewart, the first Chief Counsel for the Office ofAdvocacy in the US Small Business Administration and a former venture capitalist, andapplied for a research grant to explore the role played by these invisible private investorsin entrepreneurial ventures. I was successful and received a grant of $55–60 000.

What were the most interesting results of the study?It goes without saying that there were many interesting results, but one thing thatintrigued me greatly was the list of non-financial rewards that the private investors


reported . . . they either expected a lower return or took a bigger risk if there was somesort of pay-off that made them feel that they were doing something worthwhile, forexample, developing environmental technology or helping minority entrepreneurs. I feltthat this non-financial dimension was an important determinant for how these privateindividuals made decisions.

The study was later published in the Sloan Management Review . . .I had many problems getting it published. The paper was rejected by the Harvard BusinessReview and California Management Review, but I gave it one more try . . . I had sabbati-cal leave, and I sat down and tried to respond to the criticism in the reviews. Most of ithad to do with the problem of convenience sampling and sample bias. In my response Iacknowledged that this was a descriptive study without hypotheses to be tested. In add-ition, my style of writing was rather conversational . . . I didn’t use ‘academic jargon’ inthe article . . . because I was not really writing for an academic audience, I wanted to getvisibility out there for the phenomenon . . . but, at last the paper was published.

The article in the Sloan Management Review is definitely the most influential articlethat I have published in my career. The study was recognized by scholars interested inentrepreneurship, saying that ‘the informal investors market is certainly somethingthat deserves a lot more attention’, but the study also caught the interest of publicpolicy-makers.

I remember that there was an article in Inc Magazine about the study . . . ‘Businessangels myths and reality’. The reporter came to my office with a bundle of dollar bills andspread them out on my desk. It made a great picture for the Magazine, but it was notexactly the message that I wanted to give . . . however, the popular press began to pick upon my work . . . and I preached the role of business angels in the first round of outsideequity finance – taking the venture beyond the family and friend stage.

The methodological problems experienced in informal venture capital research today seemto be the same as 25 years ago. Are you disappointed about the progress of the research?There are many obstacles, and I think many researchers felt that they were beating theirheads against the wall. First, it is difficult and requires a great deal of hard work to locatethese people, and if you find them, they are not always interested in participating in astudy. Second, the obstacle that I struggled with in my article – and researchers studyinginformal venture capital still do – is to identify the population from which we can draw arandom sample and claim that it is representative of business angels. Third, as a conse-quence, informal venture capital research has been rather descriptive, with less testing ofhypotheses and statistical rigour. As a result, the research on informal venture capitalhas always been seen as ‘second class’ research, and it didn’t appeal in an academicsense to those who have been traditionally oriented towards research methodologies andstatistical rigour.

But how can we encourage new researchers, not least doctoral students, into the field?I would tell them that they will meet some very fascinating and creative people, peoplewho are willing to take risks but are not gamblers in a Las Vegas sense. In addition, theirresearch can make a difference. Today it is much easier for entrepreneurs, who have some-thing promising and with potential, to find the first round of outside equity funding from


business angels than it was 20 years ago . . . and I think in some way our work has facili-tated this whole entrepreneurial phenomenon. In my opinion there is still a great dealmore work to be done in the area of informal venture capital research – questions thatwill end up with important outcomes and make ‘the world a better place to live in’.

It was also a pioneering achievement to introduce the first match-making service on the infor-mal venture capital market – a ‘dating bureau’ between entrepreneurs and business angels.The background of this initiative was twofold. It was felt that there was a need on thepart of investors to see a flow of new deals . . . to see a broader range of investmentopportunities, not only based on random situations, for example, that you mention some-thing at the golf course. The second reason was to ease the frustration of the entrepre-neurs who were desperately trying to find external money for the growth of theirventures. Even at that time, the venture capital industry was not really interested in smallamounts of money.

We founded the Venture Capital Network (VCN) in 1984 in order to create a moreeffective market for angel finance. In addition to matching entrepreneurs with potentialinvestors, VCN offered seminars in pricing, structuring, and exiting venture investments.VCN was initially sponsored by leading accounting firms, banks, and by DigitalEquipment.

However, I think we were mistaken in our belief that we could make this process workin a more orderly and less random fashion. After five years of no home-run performancewe were unable to obtain additional sponsorship. So, we decided to find another home forit, a home that would have a higher probability of success. We opened up a discussionwith MIT in Boston, and in 1990 VCN became the Technology Capital Network (TCN)at MIT.

The VCN was used as a model for more than 20 other networks around the US andeven in Canada. We designed the software for the matching services and sold it to the net-works. We installed the programme, and trained them how to use it. One of the obstaclesfaced by these networks, as with the VCN, was locating a critical mass of investors as wellas entrepreneurs . . . and it is not a question of a static critical mass, because these arepeople who come in and go out of their entrepreneurial activities.

In many countries it is important to stimulate an active informal venture capital market.What policy implication can be drawn from your research?I am very sorry, but I don’t really believe that there is much of a role for public policy inthis field, because the market is very individual and personal. Maybe there might bepotential for tax incentives. In these kinds of investment there is always a risk/rewardratio, and if you could reduce the risk and/or increase the reward, that would certainlyhave a positive impact . . . but as to how big the effect would be, I cannot say.

However, we know that business angels invest close to home, and unless they have astrong attraction to a specific technology or market, they will typically not invest muchmore than a few hours’ drive away from where they live. This indicates that policy instru-ments should be anchored locally or regionally. I also believe that there is a need for someform of learning . . . both for the actors involved as well as with regard to the instrumentsused . . . we have a great deal of experience of different measures, and new initiatives don’tneed to start from scratch all the time.


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

1. Business angels exist – there are private individuals with know-how and money whoare interested and enthusiastic about backing promising start-up ventures.

2. Business angel investments are very much a personal process and depend heavily oninterpersonal contacts between investors, and between the investor and entrepreneur –the angel market does not lend itself to institutionalization.

3. The business angel market has a great economic value at regional level – businessangels can be found everywhere, and they invest close to home. At the same time, Ithink there are regional differences in taste – for example, investors in Missouri havedifferent backgrounds than investors in California and will invest differently.

4. There is great potential in the market – not only do business angels have an appetitefor more deals, but there is also a latent market of potential angels – I think the latentangels out-number their active counterparts by ten to one. Thus, there is a greatopportunity to convert latent angels into active ones.

State-of-the-art venture capital researchIn the Handbook of Research on Venture Capital we will cover different aspects of ourknowledge on venture capital as the research field. The book is divided into five parts.Part I contains some general discussions about venture capital. In the present chapter(Chapter 1), we present a historical overview of our knowledge within the field and high-light some of the pioneers of venture capital research who made the phenomenon visiblein the 1980s and attracted other researchers into this new and promising field. InChapter 2, Harry Sapienza and Jaume Villanueva will continue the historical journey byconsidering the extent to which venture capital research has contributed to the under-standing of the venture capital phenomenon and to our knowledge of entrepreneurshipin a broader sense. The authors also question some of the underlying assumptions madein management research in general and venture capital research in particular and makesome suggestions about the future direction of the field as well as arguing for what theycall ‘engaged scholarship’ in which research enriches practice and vice versa. Next, inChapter 3, we will look at venture capital from a geographical point of view, where ColinMason focuses on the ‘regional gaps’ in the supply of venture capital, that is the under-representation of venture capital investment in particular regions relative to their share ofnational economic activity. Mason argues that there are strong geographical effects char-acterizing venture capital investment, thus contradicting the economist’s concept of a per-fectly mobile capital market. Given the positive impact of venture capitalists on firmcreation and growth, the influence of the geographical clustering of their investments con-tributes to uneven regional economic development. Finally, Part I ends with a chapter onventure capital policy (Chapter 4), written by Gordon Murray. Venture capital is usuallywidely associated with the free market and an entrepreneurial spirit unrestricted by publicinterference but, as Murray comments, the state may have an important role in both ini-tiating risk capital programmes and providing a conducive environment for venturecapital. Murray argues that academic support for a public role(s) in the venture capitalmarket is, at best, conditional and cautionary. Therefore, policy-makers will have to actwith a deft hand, and there is plentiful evidence that governments are at least as likely to


produce overall negative effects by their involvement in the venture capital market as theyare to engineer a lasting improvement in market conditions. In this chapter Murray willseek to summarize what consensus may be found in seeking an appropriate role and modeof action for government in the light of the evidence of both academic studies and policyexperience.

Part II of the book focuses on the institutional venture capital market. It is within insti-tutional venture capital that we find the longest tradition of scholarly work and the mostextensive research volume. As research on informal venture capital and corporate venturecapital in many cases takes the institutional venture capital market as a point of reference,it seems reasonable to start our ‘journey’ in this area. In this part of the book, we will followthe ‘venture capital cycle’ from fund raising to the exit of venture capitalists’ investments.We start in Chapter 5, in which Douglas Cumming, Grant Fleming and ArminSchwienbacher discuss how venture capital funds are structured and governed. They notonly look at the typical US market fund structure but show how it varies across geo-graphical markets. Their conclusion is that the way the venture capital fund is structuredwill have an important influence on the way venture capitalists manage their operations,the strategy and type of firms that receive finance, the willingness to add value, and so on.

After this focus on the structure of the venture capital fund, a couple of chapters serveto elaborate on our knowledge of the investment process used by institutional venturecapitalists, that is the process from the pre-investment phase to post-investment activitiesand exit as well as the financial performance of the ventures. In Chapter 6 we look at the‘pre-investment phase’, in which Andrew Zacharakis and Dean Shepherd elaborate on theevaluation process – and especially the decision criteria and process applied when venturecapitalists make investments in new venture proposals. Zacharakis and Shepherd take aninformation processing perspective to increase understanding of the process of selectingnew investments. In particular, they examine how biases and heuristics impact on theinvestment process. In the following chapter (Chapter 7), Dirk De Clercq and SophieManigart focus on the ‘post-investment phase’ and provide an overview of the knowledgeof venture capitalists’ involvement in monitoring activities vis-à-vis entrepreneurs andvalue-adding for their investees. De Clercq and Manigart open the ‘black box’ by dis-cussing the question of how value-added is created in the venture capitalist–entrepreneurrelationship. In Chapter 8, Lowell Busenitz follows up on this discussion by suggestingnew research directions for venture capitalists’ value-adding activities. Busenitz arguesthat research needs to go beyond the broad questions that have been studied so far – andthat in many cases have produced very mixed results – and press forward in looking atgovernance arrangements, compensation systems and obtaining follow-on rounds offunding as well as exploring the broader impact of venture capital investments on innov-ation and the development of new industries. The chapter ends with a discussion on whatmeasures to use when evaluating venture capitalists’ performance. In Chapter 9, BenoitLeleux elaborates further on the performance aspect of venture capital, and raises theissue of the drivers behind venture capital performance on different levels of analysis. Thekey message is that the nature of the industry makes it very difficult to measure value cre-ation and hence performance over time, and Leleux provides an in-depth discussion onhow to measure financial performance in the venture capital context. In this way thechapter provides the reader with a solid basis for his/her interpretation of the data pre-sented on and by the venture capital industry.


In the next two chapters on institutional venture capital, we ‘cut the cake’ in a differentway – instead of looking at venture capital as a process we focus on two extremes of insti-tutional venture capital investments: (1) early stage ventures, and (2) late stage ventures,known as equity capital and management buy-outs (MBOs). Based on our knowledge ofearly stage venture capital, Annaleena Parhankangas argues in Chapter 10 that early stageventure capitalists are faced with specific problems associated with the combination oflong-term commitment in a young venture and a considerable likelihood of failure. Sheelaborates on the differences between investments in early and late stage ventures andidentifies several management practices available for early stage venture capitalists whoexpose themselves to a high level of information asymmetries and risk. At the other endof the investment spectrum, there are investments in private equity capital and manage-ment buy-outs, and in Chapter 11 Mike Wright provides an overview of the developmentand trend in the private equity and MBO market. He demonstrates the heterogeneity ofthe buy-out concept as well as the application of the concept to different firm and countrycontexts. In addition, private equity and MBOs are analysed using a life-cycle perspective:deal generation; screening and negotiation; valuation; structuring; monitoring andadding value; and exit.

In Part III we turn our attention to informal venture capital (or business angels)research. As in the case of institutional venture capital, there is a fairly long tradition ofresearch on informal venture capital (although the volume of research is less extensive)and the institutional and informal venture capital markets have been regarded as partlycomplementary and partly overlapping (see discussion above). Peter Kelly opens inChapter 12 by acknowledging that it is 25 years since William Wetzel published hisseminal study on business angels and summarizes and synthesizes the knowledge withinthe field: what have we learned about the informal venture capital phenomenon over thepast quarter century? Kelly not only looks at ‘the road that has been travelled’ in businessangel research, but also ‘the journey ahead’ and highlights some of the key issues thatneed to be tackled in future research. We then focus our attention on a couple of researchthemes that are important not only for informal venture capital researchers but also forpolicy-makers and business angels themselves. In Chapter 13, Allan Riding, Judith Madilland George Haines review recent research literature with regard to how business angelsmake investment decisions. The authors employ a model of the investment process includ-ing: (1) sourcing of potential deals and first impression; (2) evaluations; (3) negotiationand consummation; (4) post-investment involvement; and (5) exit, as well as examiningrecent knowledge pertaining to these stages and elaborating on the way business angels’investment decision-making influences each stage of the process. In Chapter 14, JeffreySohl argues that the informal venture capital market is fraught with inefficiencies whichresult in two persistent funding gaps: a primary seed gap and a secondary post-seed gap.These market inefficiencies and funding gaps have led the market to adopt various organi-zational mechanisms to increase efficiency – angel portals – and in the chapter the authorreviews and discusses current experiences of different kinds of angel portal.

In Part IV we focus our attention on corporate venture capital, that is equity or equity-linked investments where the investor is a financial intermediary of a non-financial cor-poration. Corporate venture capital is regarded as a distinct part of the institutionalventure capital market, but research on corporate venture capital is still in its infancy andthe amount of research rather limited. Part IV consists of two chapters. In Chapter 15


Markku Maula argues that the research on corporate venture capital is still quite frag-mented and has not been systematically reviewed – a challenge that Maula attempts totake on, and he synthesizes the literature on corporate venture capital with particularemphasis on research examining corporate venture capital from the corporate investors’perspective. In Chapter 16 we change perspective, and Shaker Zahra and Stephen Allenlook at corporate venture capital from the entrepreneurs’ perspective. Zahra and Allen’spoint of departure is that many new ventures need to assemble and use resources fairlyquickly in order to develop capabilities that can create and protect a competitive advan-tage, and corporate venture capital enables them to obtain the financial resources andbusiness contacts necessary for development and growth. The authors discuss the poten-tial financial and non-financial benefits that new ventures can gain from corporate venturecapital investments.

Finally, in Part V (Chapter 17), Hans Landström presents a summary and synthesis ofthe discussions in the Handbook by elaborating on the question: what advice can be givenbased on the knowledge developed in the book? The chapter provides some implicationsfor venture capitalists, entrepreneurs and policy-makers as well as a discussion about thefuture direction of venture capital research.

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2 Conceptual and theoretical reflections on venturecapital researchHarry J. Sapienza and Jaume Villanueva

Introduction

Entrepreneurship and early venture capital literatureAs indicated in Chapter 1 the research on venture capital1 dates back at least to the late1960s (for example Briskman, 1966; Aggarwal, 1973; Wells, 1974; Poindexter, 1976) whenthe industry itself was in its infancy. Whereas these early studies in venture capital tendedto focus on the efficiency of venture capital as an investment vehicle or on the decisioncriteria used by venture capitalists to assess entrepreneurs and opportunities, other areasof the more general entrepreneurship literature focused on the nature of the entrepreneurand on conditions of founding. Thus, early on, venture capital research contributed pri-marily in the areas of economic implications of this ‘new’ organizational entity (venturecapital) as a financing tool. In truth, the entire field of management or business ‘science’itself was just forming. Whereas the field of economics was comparatively well-developed,the examination and study of business organizations as atomistic entities worthy of studyin their own right was just emerging.

Through the 1980s and into the early 1990s, interest in venture capital and its uniqueproblems and contributions expanded. For entrepreneurship research in general, thedecade began with a focus on the entrepreneur and ended with a focus on the entrepre-neurial process of new venture creation. Venture capital research complemented thisdevelopment by beginning to unravel the mysteries of the venture capitalist–entrepreneurdyad in this process of venture creation (Sapienza, 1989; Fried and Hisrich, 1995;Landström et al., 1998). Although venture capital research focused solely on high-potential ventures (rather than on the vast majority of new ventures), it nonetheless con-tributed to the broader development of entrepreneurship theory because the majority ofpeople working diligently in the area were attentive to theory development. Into thetwenty-first century, research on venture capital has remained a vibrant and critical partof the more general entrepreneurship literature.

Purpose and overview of this chapterIn this chapter we share our reflections on the past, present, and, especially, the possiblefuture of managerial venture capital research. What we mean by managerial is that weconsider work with a disciplinary focus on management, work produced by managementscholars and published in management journals, rather than on other perspectives suchas finance or economics. We reflect on (without reviewing in depth) the historical patternof this domain, considering especially the extent to which this research has contributedto the understanding of the venture capital phenomenon and to the broader entrepre-neurship literature. We then turn our attention to suggesting how we would like to see

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future study develop. In the spirit of this collection of works, we reflect to some extent onresearch including private, institutional venture capital firm (VCF), corporate venturecapital (CVC), and business angel venture capital (BA). However, our primary focus is onthe literature that developed around institutional venture capitalists.

Our thinking is influenced by two recent ‘critiques’ of the management literature pub-lished by some of its prominent scholars. One critique opines that research has becomeincreasingly remote from phenomena of interest and suggests an approach of ‘EngagedScholarship’ to redress the problem (Van de Ven and Johnson, 2006). The other critiquecharges that an exaggerated ‘pretense of knowledge’ in social science combined with thedominance of unrealistically pessimistic assumptions about the character of individualsand institutions has led to ‘bad theory’ resulting in bad practice (Ghoshal, 2005). Theformer article offers suggestions to guide the engaged scholar to conduct meaningfulresearch. The latter pleads for a ‘Positive Organizational Scholarship’ movement (forexample Cameron et al., 2003) that will seek answers to the ‘positive’ problems of man-agement. We tend to share the views expressed in these works. We use them as a frame-work for suggesting how venture capital research may meaningfully develop in the future.

Our overall conclusion in reviewing past work is that managerial venture capitalresearch has accomplished a great deal in the twenty or so years since it began to blossominto a persistent area of study within the developing arena of entrepreneurship research.The ‘glass half-full’ view is that such research has been at the forefront of growingattempts to build serious theoretical underpinnings to the study of entrepreneurshipgrounded in a variety of disciplines. Important work has been done to apply and extendeconomic views such as agency theory (for example Robbie et al., 1997), game theory (forexample Cable and Shane, 1997), resource-based and knowledge-based views (forexample Lockett and Wright, 1999). Further, macro-organizational perspectives such aspopulation ecology (for example Manigart, 1994), institutional theory (for exampleBruton et al., 2005), and network theory (for example Bygrave, 1988) have figured prom-inently. Finally, with an outlook and basis quite different from the economic roots ofventure capital research, micro-organizational perspectives have provided importantbehavioral insights via such perspectives as social exchange theory (for example De Clercqand Sapienza, 2001), social capital theory (for example Maula et al., 2003), learningtheory (for example De Clercq and Sapienza, 2005), cognition and cognitive bias theories(for example Shepherd and Zacharakis, 1999), psychological contract theory (for exampleParhankangas and Landström, 2004) and procedural justice theory (for exampleSapienza and Korsgaard, 1996; Busenitz et al., 1997).

The ‘glass half-empty’ view is that there is still much we have ignored and much we donot know. We believe that, upon occasion, adopting such a critical view of ourselves willlead to productive new directions. This chapter provides us with the opportunity to stop fora minute, take a deep breath, and take stock of where we are and where we want to go beforecontinuing on our research agendas. We hope to engage you in this exercise with us. We firstoffer two cautions: (1) our suggestions do reflect our own biases and preferences; and (2)some of our suggestions reflect an ‘ideal’ of scholarship that may be more or less feasiblefor a researcher to heed, depending upon his or her stage of career and the institutional anddepartmental norms faced. We believe that as entrepreneurial scholars (double meaningintended), however, we prefer to spend energy envisioning where we would like to go ratherthan to spend it focusing on the barriers that keep us from getting there.

Reflections on venture capital research 67

In short, the most important question we raise in this chapter is: where should we goas a field? At one extreme, we could become a clinical field, with proliferation of clin-ical analyses and consulting activities. At the other extreme, we could become theoret-ically remote from the practice of venture capital but achieve great theoretical elegance.We endorse the concept of ‘Engaged Scholarship’ (Van de Ven and Johnson, 2006) inwhich research enriches practice and vice versa. We believe that theory that is notinformed by practice is neither useful nor interesting; similarly, practice without theoryis particularized and uninformative. Rigorous research with a solid theoretical andmethodological base is essential to advance the field. For us, the best research will alsobe meaningful to practitioners. It will not be done ‘for’ practitioners; it will be done‘with’ them. Perhaps the term ‘practitioner’ is too narrow, for it invokes an incompleteimage of those affected by our research. We suggest that stakeholders (beyondresearchers and their students themselves) include investors, entrepreneurs, policymakers and broad societal elements such as local communities and regional andnational economies.

The chapter proceeds as follows: first, we analyze the focus of research in venturecapital over time. We identify and discuss the dimensions that have been studied exten-sively, and we note the ones that have been relatively neglected. We present a stylized figurethat depicts key dimensions of past managerial venture capital research: the stage in theventure capital cycle, the perspective of the key focal actor (for example venture capital-ist or entrepreneur), the type of venture capital (institutional, angel, corporate), the levelof analysis used, and the theoretical framework through which works are designed andinterpreted. We also discuss the causes and consequences of the chosen perspectives.Next, we introduce the concept of ‘engaged scholarship’ (Van de Ven and Johnson, 2006),examining its applicability to venture capital research. In the penultimate section, weintroduce Ghoshal’s (2005) ‘positive organizational scholarship’ argument and considerits implications for our field. Finally, we use our stylized model and these two perspectivesto consider avenues for future research.

Causes and consequences of dominant areas of venture capital researchIn this brief section we trace the development of managerial venture capital literaturefrom the rich, detailed descriptions of the phenomenon that dominated early work to thelater theory-driven analyses (see also Chapter 1). We employ a metaphor of the kaleido-scope to represent the varied perspectives, levels of analysis, phases of the venture capitalprocess, and actors that have become part of the rich tapestry of the field.2 This metaphorallows us to introduce a discussion of the dimensions of the field that have received rela-tively greater attention.

Early contributionsMuch early literature focused on what exactly venture capitalists do (Tyebjee and Bruno,1984; MacMillan et al., 1985; Gorman and Sahlman, 1989). These highly descriptiveworks have proven extremely useful for three reasons. First, they helped everyone under-stand the mechanics of the industry and illuminated the significant ways in which venturecapital differs from other sources of capital for entrepreneurial start-ups and from oneanother (for example Elango et al., 1995). This contribution is in line with the engagedscholar view discussed later.


Second, by opening the black box of practice, early descriptive studies allowed subse-quent researchers to build theory effectively. The venture capital process itself is highlycomplex, and, without a deep understanding of the mechanics of the industry, theoristswould be likely to create incorrect or incomplete theoretical frameworks. That is, a deepunderstanding of the issues and practices involved in the phenomenon improves the valid-ity, sophistication and power of theoretical models developed. Finance theory work suchas Sahlman’s (1990) on the structure of the venture capital industry served to highlight theagency issues and financial structure challenges faced by venture capital firms. This typeof study paved the way for managerial work such as Gifford’s (1997) that pointed to theserious issue of the venture capitalist as agent and for Cable and Shane’s (1997) work thatelucidated the powerful forces for collaboration in venture capitalist–entrepreneur pairs.

Third, empirical descriptions chronicle venture capital at various points in time and atvarious economic epochs in a manner that allows us to understand the phenomenon andto see how types of financing interact over time. For example, the chronicling of corpor-ate venture capital in the aftermath of the economic booms of the late 1980s (for exampleBlock and MacMillan, 1993) and around the turn of the twenty-first century (for exampleMaula, 2001) has added understanding not only of corporate venture capitalists but alsoof institutional venture capitalists and business angels. Thus, theory has been aidedbecause the chronicles allow us to derive the meaning of variation (or non-variation) inpractice in different times and places. As we move into the twenty-first century, we canbuild sophisticated portraits that look at the entire ecosystem of venture capital and thatwill provide more complete pictures than are currently available.

Expansion of venture capital research along several dimensionsAfter the early ‘descriptive’ period, managerial venture capital research grew more theory-driven and developed along several different paths. Figure 2.1 represents the dimensionsby which the most common examples of past venture capital research might be viewedand classified. The outer circle surrounding the central dimensions in Figure 2.1 repre-sents the lenses (or theories) that researchers bring to bear on the questions or dimensionsbeing studied. Think of this diagram as a metaphorical kaleidoscope, one whose internaldimensions and external circumference can be rotated, bringing various theoretical viewsand elements into different juxtapositions and focuses. Imagine each theoretical perspec-tive as existing at a specific location on the outer ring of the kaleidoscope; imagine further,then, that we rotate the outer ring. From this new location, the perspective on the dimen-sions within the internal circle of the kaleidoscope will have changed. Further, think ofthe inner circles as also being capable of being rotated; they represent levels of analysis,for example, individual, group, venture, community, region, country, and so on.3

In the interior of the kaleidoscope, we see three overlapping dimensions: type ofventure capital (for example institutional venture capital – VCF, business angels – BA, orcorporate venture capital – CVC), the interests or perspectives being investigated (forexample investor4 vs. entrepreneur), and the stage of the venture capital process (forexample fund raising, selection). Although each dimension is composed of several ele-ments, most studies center on one element within each dimension. For example, Shepherdand Ettenson (2000) examined how an investor type (the institutional venture capitalfirm) attempts to maximize returns (investor’s perspective) via decisions made during theselection stage of the venture capital cycle.


We have chosen the metaphor of the kaleidoscope to convey the idea that changinglevels of analysis and/or theoretical lens provides very different views of the phenomena.For the Shepherd and Ettenson article, the level of analysis is the venture capital firm andthe theoretical framework is the industrial organization perspective. Had they chosen theentrepreneur’s perspective, different theoretical questions may have arisen such as how toposition their venture to attract capital or how to select venture capitalists if givenoptions. Other choices of frameworks or levels of analysis would also have resulted inquite different questions, data and interpretations.

The choice of framework affects the likely questions asked, the levels viewed, and thedata examined. Conceiving of possibilities in this manner may lead researchers to avariety of questions, some previously studied and some not. Examples of questions sug-gested if we consider different levels of analysis include: at the individual level, why doentrepreneurs seek venture capital, and how are their outcomes affected? At the dyadiclevel, how do governance structures and mechanisms affect returns, and how do venturecapitalist–entrepreneur interactions moderate these? At the firm level, why do venturecapital firms exist, and why do some venture capital firms outperform others? At theregional/national levels, how may venture capital activity be fostered, and what is theappropriate role of government in the venture capital process? The appropriateness of


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

Figure 2.1 Kaleidoscope of research in managerial venture capital

Focal perspectiveEntrepreneurInvestor

VC typeBAVCCVCPFVC

Stage in VC cycleFund raisingScreening/selectionNegotiation/investingMonitoring/advisingExit

Theoretical frameworks Levels of analysis

theories also varies by level: cognitive and behavioral theories are most appropriate at theindividual level; social exchange and power theories at dyadic levels; network, socialcapital, resource-based and knowledge-based at the firm level; and population ecologyand institutional theory at the industry/region/nation levels.

Figure 2.1 indicates that the most common studies focus on institutional venturecapital firm type, from the investor’s perspective, in the selection and/or monitoringstages of the venture capital cycle (for example Tyebjee and Bruno, 1984; MacMillanet al., 1985; Bygrave, 1988; Gorman and Sahlman, 1989; Sapienza and Manigart, 1996;Shepherd and Zacharakis, 1999). Despite the well-known fact that institutional venturecapital firm financing is a much smaller phenomenon than is business angel investing(Mason and Harrison, 1996; Landström, 1998; Freear et al., 2002), both in terms ofnumber of deals and in terms of absolute capital invested, several factors explain whyinstitutional venture capitalists have been studied most vigorously. First, the history ofthe venture capital industry itself is traced back to such famous institutional venture cap-italists as ARD (American Research and Development), Kleiner-Perkins, and others.Second, many high profile ventures such as Apple, DEC, Genentech and the like havebeen linked in the popular press to institutional venture capitalists. Third, in comparisonto business angels, institutional venture capitalists are more visible; they are easier forresearchers to locate, and they have more resources to devote to helping in research; and,in comparison to corporate venture capitalists, the institutional venture capital industryhas been more stable both in terms of number of firms existing at one time and in termsof the longevity of the firms.

The focus on examining issues from the investor’s perspective is also understandable forseveral reasons: first, even though they would not exist without entrepreneurs, venturecapitalists, are, after all, the individuals who comprise the industry itself. Second, venturecapitalists are the most clear and immediate of stakeholders for venture capital research.Third, as a practical reason, venture capitalists (possibly with the exception of angels) aremore visible than entrepreneurs and are able to provide researchers with access to largenumbers of ventures. Thus, researchers are apt to use institutional venture capitalists andcorporate venture capitalists to locate samples; this allows the possibility, too, of estab-lishing long-term relationships to which researchers may return for future studies. Becausebusiness angels are often as invisible and as fragmented as the entrepreneurs themselves,less research is executed in this domain overall. Nevertheless, even work on business angelstends to take the perspective of the investor (for example Mason and Harrison, 1996;Sohl, 2003).

The focus on selection and monitoring stages may also have practical roots. First, col-lecting information on selection criteria is especially amenable to the questionnaire andinterview techniques preferred by early researchers (for example Tyebjee and Bruno, 1984;MacMillan et al., 1985). Furthermore, as innovations in methods for studying selectionthrough such techniques as conjoint analysis arose, the selection literature was revitalizedand new empirical and theoretical insights were achieved (for example Shepherd andZacharakis, 1999). This technique allows the generation of large sample sizes and highability to control contextual factors that may confound typical field work. Second, asresearchers became aware of the dominance of post-investment activities in time spentoverall by investors, the pressure to understand this stage of the venture capital cyclegained momentum. Thus, a good deal of work attempted to penetrate the issues of exactly


how venture capitalists added value beyond selecting and providing money to entrepre-neurs (for example Sapienza and Gupta, 1994; Fried and Hisrich, 1995). This researchcould draw on a rich tradition of theory in organizational behavior and decision makingto guide research design (for example Sapienza and Korsgaard, 1996; Busenitz et al.,1997). Third, because many aspects of other stages of the venture capital process involveindividuals outside the venture capitalist–entrepreneur dyad (for example fund raisinginvolves limited partners, and exit involves several external organizations), researchdesigns on these other phases are especially complicated.

Dominant focusesGiven the focus on the investor’s perspective, it is unsurprising that the rational economicframework has been the prominent theoretical lens used. In particular, although itsefficacy in this context has increasingly been called into question (for example Landström,1993; Cable and Shane, 1997), agency theory has been the dominant approach to exam-ining the topic. Specifically, the investor has been framed as principal and the entrepre-neur as agent. This choice of agency theory is in harmony with focusing on institutionalventure capital type and on the investor’s perspective. First of all, among venture capitaltypes, institutional venture capital is the one in which economic return is most unam-biguously the sole motivation for venture selection. Second, Jensen and Meckling’s (1976)seminal presentation assessed in detail the likely consequences of conflict between owner-managers of firms (entrepreneurs) and outside equity holders (investors); furthermore,the publication of this article coincided with the emergence of the institutional venturecapital industry and doubtless influenced the emerging research on venture capital. Froman agency perspective the key issue is how outside investors can minimize agency costsemanating from adverse selection and opportunism.

Seeking both practical solutions and tests of a dominant theory, researchers devotedspecial attention to applying agency theory to the selection (MacMillan et al., 1985;Harvey and Lusch, 1995; Muzyka and Birley, 1996; Smart, 1999) and monitoring phases(MacMillan et al., 1989; Sapienza and Gupta, 1994; Mitchell et al., 1997) of the venturecapital process. While not all of these studies relied fully on agency theory, they all sharedwith it the assumptions inherent in rational economic models. Most importantly, manyprominent researchers, especially within the domain of financial venture capital research,have demonstrated the potency of agency theory in predicting the structure of venturecapital firms, the development and employment of financial instruments for investing, theterms of formal agreement, and the nature of syndication among institutional venturecapitalists.5

We can speculate on two additional factors that may have played a role in the predom-inance of this theoretical framework: (1) as an emerging topic, venture capital researcherssought to rely on basic and popular theories within the mainstream disciplines; and (2)because most of the initial venture capital research was developed in the United States, itmay be that governance, conflict and control of agency problems were more relevant inthat context than in other contexts such as those of Western Europe or Japan.6

In short, the dominant elements studied within our metaphorical kaleidoscope (insti-tutional venture capital firm, investor perspective, selection/monitoring) are logicallycoherent, especially when viewed through the rational economic lens. Because the under-lying agency theoretical framework was a familiar and widely used one even within the


management literature, venture capital researchers have been able to span boundarieswithin management literature (for example strategy, and organization theory) and acrossbusiness research domains. For example, the issue of how agency concerns affectrisk–return relationships in organizational decision making interests both finance andorganization behavior researchers. On the positive side, then, the particular focus adoptedover the past decade and a half has placed venture capital research at the core not only ofdevelopments in entrepreneurship but more broadly in the mainstream of disciplinarywork outside of entrepreneurship.

At the same time, we must recognize the costs of having focused so strongly on this par-ticular configuration of elements (institutional venture capital firm, investor perspective,and selection/monitoring, all through the rational economic lens) in our studies.Importantly, the costs are ones of omission or lack of knowledge development in theother areas such as venture type, actor perspective, and stage of the process. Some havealready noted that the level of investment activity in institutional venture capital isdwarfed by the enormous (but hidden) activity in the realm of business angels (Sohl,2003). Yet the amount of research conducted on business angels is but a fraction of thatconducted in the institutional venture capital arena. As is evidenced in the other chaptersof this Handbook of Research on Venture Capital, a thriving literature on business angelsdoes exist (see Chapters 12 to 14). Our point, however, is only that more work in this areais needed. Although some of the barriers to conducting empirical research on businessangels are much higher than they are for institutional venture capitalists or corporateventure capitalists, we believe that hurdling such barriers is worthwhile.

As one example of how moving away from the dominant model may enrich our work,the field of venture capital research would be enhanced by further examinations of theentrepreneur’s perspective. The work that does exist shows the promise of deep investiga-tions of entrepreneurs’ perspectives. For example, Busenitz et al.’s (1997) study of theeffects of procedural justice on entrepreneurs’ receptivity to investors has illustrated thevalue of examining the process from the entrepreneur’s perspective: their work suggeststhat investors who ignore the rules of respect and fairness may be destined to have crit-ical information distorted or withheld from them. Sapienza et al. (2003) also showed thevalue of considering the entrepreneur’s motives. They argued that entrepreneurs’ choiceof financing type (and the particular investor within the chosen type) involves both con-siderations of economic rationality and of self-determination.

In summary, we have noted above that managerial venture capital research started assimple descriptions of the processes and practices in the industry and eventually evolvedinto more complex studies that focused on several dominant themes or configurations. Inorder to represent this complexity and to highlight the areas of emphasis, we used themetaphor of a kaleidoscope. This metaphor helped to illustrate that certain areas receivedmuch more emphasis than others. Implicitly, then, many areas have not received muchattention. At the end of this chapter we point out which of these areas we believe espe-cially merit additional study.

Contributions of venture capital research to entrepreneurship literatureVenture capital research directly addresses many of the fundamental issues of interest toentrepreneurship scholars. For example, much of the research has been devoted to howinvestors assess opportunity (MacMillan et al., 1985; Shepherd, 1999; Smart, 1999). The


most common approach has been to look at the criteria that venture capitalists use tomake investment decisions. Smart (1999) takes the central conclusion from this literature(that is the conclusion that venture capitalists focus most strongly on the quality of theentrepreneurs themselves) and delves into how venture capitalists assess the entrepreneursand whether some assessment methods are more effective than others. Some work, suchas Fiet’s (1995) comparison of institutional venture capitalists and business angels,assesses how investors attempt to deal with risk in entrepreneurial settings; Fiet arguesthat institutional venture capitalists possess potent remedies against agency risks and thusfocus on market risk whereas business angels, lacking such potent contractual leverage,focus on agency problems. Some have even looked at business angels as entrepreneursthemselves (Landström, 1998); such work draws an essential but little recognized parallelbetween the challenges and issues facing both entrepreneurs and their investors.

In some ways contributions of venture capital research to the field of entrepreneurshiphave been indirect. For example, venture capital portfolio companies are usually consid-ered ‘high potential’ ventures. As such, venture capital provides a convenient samplingspace for studying ‘entrepreneurial’ firms. The venture capital setting provides an easy-to-identify, comparable and convenient sampling of high-potential firms. Another benefit ofstudying in the venture capital setting is that it helps researchers address a commonproblem plaguing users of survey designs. Here, the issue of common source bias – thevalidity problem of deriving measures of independent variables from the same source asdependent variables – may be addressed more readily than in other settings. The presenceof two sets of individuals (investors and entrepreneurs) highly knowledgeable about oneanother and about the venture in question provides venture capital researchers with ameans to overcome some common source and common method problems that typicallyplague entrepreneurship research. For example, using venture capitalists’ rating ofventure outcomes along with entrepreneurs’ rating of venture activities creates validratings and avoids spuriously related measures.

The high profile nature of the institutional venture capital industry and the stream ofgood descriptive early studies have made the industry understandable and accessible tothe broader management field. This matters because it makes entrepreneurship itselfaccessible to other areas of business scholarship. We can also be proud of the fact that avery high percentage of the entrepreneurship studies published in the widely distributed,highly regarded management journals (for example Academy of Management Journal,Academy of Management Review and Journal of Management Studies) have been aboutventure capital. Clearly, venture capital researchers have been able to execute worthyempirical work and contribute to entrepreneurship and management theory. And,whereas entrepreneurship research in general has been plagued by lack of replication,incomparable samples, variations in measures and constructs, and the like, venture capitalresearchers have created several relatively coherent streams of inquiry such as venturevaluation, investment decision making, partner interaction and governance.

Yet, we can do more to advance entrepreneurship literature. Given that venture capitalis a multi-stage, multi-actor process, its study can help us understand whether, or in whatways, the ‘myth’ of the solo, heroic entrepreneur is indeed a myth (Aldrich, 1999; Van deVen et al., 1999). The venture capital setting offers a plethora of circumstances in whichteamwork and inter-organizational relations may be carefully studied. We have the oppor-tunity to view how teams of entrepreneurs work together over a long period of time with


customers, suppliers, government entities, as well as with various sources of informal andformal financing. Further, we have the opportunity to learn how and when venture cap-italists operate as lone wolves or as parts of investment syndicates and venture ecosystemsthat reach far beyond their own organizations (for example Lerner, 1994; Lockett andWright, 1999). As yet, however, we understand little about the interconnections across theecological landscape of the entrepreneurial process.

To date, we have but begun to mine the potential in this setting to study the value cre-ation and organization creation processes. We can come to understand more not onlyabout value appropriation (as would be a focus of rational economic perspectives) but alsoabout the elusive areas of value creation. For example, how do the roles of the investor andinvestee complement, aid, or thwart one another? Are our current approaches to studyingthe phenomenon the appropriate ones, or should we approach the field in new ways? Arethe lenses and attitudes we have adopted the most useful, or are we being blinded by ourown perspectives? We take up in the next two sections recent critiques of the larger field ofmanagement scholarship itself to consider their implications for future research in venturecapital.

Implications of the ‘engaged scholar’ view for future venture capital workRather than simply enumerate under-researched topics and gaps in the literature, wecenter our suggestions on adopting the ideas laid out by Van de Ven and Johnson (2006)in this section and by Ghoshal (2005) in the following section. Our view is that lack ofprior study in a given area, by itself, is woefully inadequate justification for its future study.To warrant study, the understanding of the topic must also be important either to the phe-nomenon itself or to theory, or to both. In this section, we focus on how future researchin venture capital should be conducted so as to ensure these aims.

What is appealing for venture capital researchers about Van de Ven and Johnson’s(2006) exhortation for engaged scholarship is that it draws on existing strengths in venturecapital research and promises ways to build where we most need work: enhancing ourscholarly rigor and legitimacy. At the same time, this approach asks not that we becomeremote arm-chair theorists but that we become fuller scholars by growing closer to thephenomenon itself. In short, Van de Ven and Johnson offer five guidelines for engagedscholarship: (1) design work to study big problems grounded in reality; (2) design researchprojects to draw on and create a collaborative learning community; (3) design studies toexamine an extended duration of time; (4) employ multiple models and methods; and (5)re-examine assumptions about scholarship and the roles of researchers. The implicationsof these suggestions for future research in venture capital are the following:7

1. Design the work to study big problems grounded in reality. Asking the big and rele-vant questions requires practitioner or stakeholder involvement. It is the interactionbetween scholars and practitioners, through what Van de Ven and Johnson refer toas a process of knowledge arbitrage, which produces the questions that are bothgrounded in reality and theoretically relevant. Such work is especially likely to fire theimaginations of scholars and practitioners alike. Big problems grounded in realitywill have appeal to politicians, planners, community groups and many others beyondinvestors and entrepreneurs (for example how may high growth opportunities be nur-tured in our town/city/region in such a way as to preserve culture, build community,


and foster innovation?). Of course, such issues are likely to be complex and thus aretypically not amenable to being studied using a single lens or perspective. Thus, inter-disciplinary research will be necessary to capture and/or disentangle the complexity.In short, this guideline suggests that compelling problems or issues of great import-ance should drive the research questions asked and the means taken to answer them.In the process of focusing deeply on such problems, many preconceived ideas aboutspecific theoretical approaches or even disciplines will be set aside. Research shouldnot be a hammer searching for a nail.

2. Design the research project to be a collaborative learning community. Engagingventure capitalists and entrepreneurs (as well as community leaders and the like) inreal world research settings requires time to develop trust and reciprocal knowledge.Such long-term cooperation is unlikely to occur unless all sides are truly participantsin the research process. The process of arbitrage between other stakeholders andscholars, which ensures that the questions asked are both of theoretical importanceand grounded in reality, requires collaboration. Collaboration between researchers ofdifferent disciplinary backgrounds or ‘research circles’ (Landström, 2005) would alsoincrease the plurality of perspectives from which important questions can be ana-lyzed. Some obvious risks and concerns in such collaborative research efforts includeissues of academic objectivity, scientific methodological requirements, and issues sur-rounding the proprietary use of research findings. Van de Ven and Johnson argue thatwith clear rules of engagement between research partners, these problems can bemanaged and the benefits will outweigh the risks. In the venture capital setting, suchrules might include ways to minimize effort required on the part of entrepreneurs andinvestors, ways to ensure that proprietary knowledge is protected, and ways toprovide broad access to researchers. Put simply, researchers must help their partnersdeal with their specific, idiosyncratic problems, and their partners must be willing tohelp researchers gain insights into broader issues that may not be of immediateconcern to them.

A practical issue worthy of explicit mention here is that access to the venture capitalcommunity is extremely limited. An engaged scholar would have to be aware that s/hemay face extraordinary challenges both in ‘getting inside’ or getting access toinvestors and their limited partners, but also in convincing them of the value of par-ticipating in the research process and of the trustworthiness of the researcher to fullyprotect all proprietary information.

3. Design the study for an extended duration of time. As mentioned above, time is a crit-ical element to build relationships and trust, not only with research partners in col-laborative research efforts, but also with research subjects on whose information wedepend to advance our research. Time is thus a necessary condition to achieve thepreviously stated objectives of arbitrage and cooperation. Fortunately, studies con-ducted over an extended period of time also offer the extremely important advantageof allowing researchers the possibility to make a deeper and more valid assessmentof causality than is possible with cross-sectional studies or snapshots taken atdifferent points in time. Day-to-day, immersed involvement over a long period of timeand across many ventures is necessary to understand, for example, whether theproblem is bad leadership leading to bad performance or bad performance leading tobad leadership.


Calls for more longitudinal research are not new in entrepreneurship nor in otherresearch settings. Virtually every one of the ‘Sexton series’ in entrepreneurshipresearch from the early 1980s to the present has called both for more longitudinalresearch and for higher quality, in-depth qualitative research.8 These calls continue.For example, Freear et al. (2002) point out the desperate need to examine the processof business angel investing over time in order to understand the dynamics ofangel–entrepreneur relationships and the role of business angel investing in the entireprocess from bootstrapping to angel investing to institutional venture capital and cor-porate venture capital. Having made the case for long-term research projects, weunderstand that structural characteristics inherent to our profession impede effortsto carry out such research. Still, creative solutions can overcome some of these obsta-cles. For instance, senior researchers may be able to design and carry out longer-termresearch projects with shorter-term subcomponents that can be tackled by morejunior faculty, whose time horizons are apt to be quite short.

4. Employ multiple models and methods. The complexity of the questions that are likelyto emerge from the engaged scholarship approach require multiple frames of refer-ence. Van de Ven and Johnson point out that triangulation of methods and modelsnot only increases reliability and validity but also promotes learning among interdis-ciplinary research partners and facilitates the arbitrage process. For example, somestakeholders may derive a great deal of benefit from participating in simulation exer-cises that test cognitive capabilities, whereas others may learn by articulating in con-versation (using for example a verbal protocol approach) how and why they makedecisions as they do. Of course, structural difficulties also exist for adopting a broadmulti-method approach. Not only do some journals have strong preferences forcertain types of methods over others, but conducting research via multiple methodsis time consuming and inevitably presents dilemmas of interpretation and reconcili-ation. It must also be mentioned that in many circles the use of multiple theoreticalperspectives in a single work is strongly discouraged.

We propose that venture capital researchers, especially those in senior positions,should be vigilant in trying as many various methods of inquiry as can be usefullyemployed. We also advocate the use of multiple theoretical perspectives, but this lattersuggestion must be accompanied with strong justification for its necessity, given thebias against such approaches. We firmly believe that such barriers to advancing ourknowledge are counter-productive. We do believe that much of the most innovativeand insightful research in entrepreneurship has indeed occurred in venture capitalresearch that stretches the boundaries of common practice. For example, venturecapital researchers have already been innovators in terms of methodology via eventstudies, experiments, policy capturing, direct observation and case studies, simula-tions, verbal protocol, conjoint analysis, and many other pertinent methods. And wehave made good use of the more standard secondary database, interview, case, andsurvey methods. We have successfully experimented with theoretical perspectivessuch as justice theories and social exchange, among other things.

5. Re-examine assumptions about scholarship and the roles of researchers. Engagedscholarship implies that the degree of researcher intervention is dictated by the natureof the research problem or question. Preconceived notions that researchers’ objectiv-ity must be preserved at all costs should perhaps be questioned. Yet the fear of altered


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

In sum, we believe that researchers adopting the engaged scholarship approach willproduce innovative insights unavailable through more detached approaches. For example,venture capital governance occurs largely through the mechanism of the board of direc-tors, yet little work has explored how these boards actually make decisions because of thedifficulty of gaining access to board meetings (Sapienza et al., 2000). A truly engagedscholar may be able to develop the level of trust with the entrepreneur and the investorsthat allows the kind of access and understanding not previously possible. In terms of themetaphorical kaleidoscope that we introduced in Figure 2.1, such an approach wouldplace the scholar amidst the entrepreneur–investor–process triangle in the center of thefigure. A social exchange theory approach would suggest focusing on variations in boardbehavior depending on the development of reciprocity (or lack thereof), whereas anagency perspective might suggest examining the role of the board as a supplement to orsubstitute for bonding costs. The vantage from within would result in more intimate viewsthan would the ordinary position of the scholar on the outer rim of the lens looking in,and, theoretically, would lead to more valid interpretation of observed behavior.

Besides the time, effort and cost hurdles that ultimately must be dealt with as an‘engaged scholar’ in any research setting, the venture capital context poses an additionalbarrier that must be noted. Venture capitalists have been literally besieged by researchersseeking their aid in conducting research. The presumption that they would want to‘engage’ with us is a strong one. We can only note that succeeding in gaining their trustand attention is a significant challenge.9

Implications of the ‘positive organizational scholarship’ view for future venture capital work10

A posthumous publication of the views of Sumantra Ghoshal (2005) regarding trends inthe theoretical content of management literature sheds another light upon the issues andchallenges facing business scholars in the twenty-first century. Ghoshal expresses dismayover several trends in research which he claims are traceable to two common sources: (1)Attempts by many to treat the social science of business as an exact science; and (2)Acceptance by the majority of the assumption of rational economic self-interest as thesole explainer of behavior. Ghoshal’s article expresses a view similar to that stated atvarious times over the years by William Bygrave, that is, that business researchers sufferfrom ‘physics envy’, a condition in which scholars seek to emulate the physical sciences intheir theorizing, testing and interpretation by assuming that variables interact with a sortof law-like consistency. Such assumptions have the attractiveness for those seeking ‘pure’science of making investigations mathematically tractable and parsimonious. Further, the


single motive explanation also simplifies analysis and interpretation. The problem is thatwe know that these assumptions are not accurate. As one of our colleagues is fond ofsaying, ‘Good theory cannot be generated from bad assumptions.’11

Ghoshal (2005) argues that treating the study of human behavior as an exact sciencewhich can be based on one underlying law leads researchers to (1) an exaggerated ‘pre-tense’ of knowledge; that is, a greater belief in the certainty of conclusions than is war-ranted; and (2) an ideology-based gloomy vision of organizational reality which assumesthat the pursuit of self-interest (with guile!) is the sole driver of behavior and ignores theexplanatory power of affect and emotion. Ghoshal argues that the pretense of knowledgecombined with an ideology-based gloomy vision has several very negative consequencesfor theory and practice, and his work holds several suggestions for combating these trends.We review five of them here:

1. Abandon the smug arrogance of certainty about the nature of organizational life.Ghoshal suggests that the exaggerated ‘pretense’ of knowledge leads to sloppiness intheorizing, research design and prescription. Consistent with the engaged scholarview, Ghoshal cautions us to develop deep, accurate understanding of the phenome-non as a prerequisite for interpretation and prescription. This suggestion runscounter to the growing emphasis on large samples built on secondary data, datawhich is assumed somehow to be more valid and generalizable than carefully col-lected primary data. In terms of Weick’s (1979) famous ‘dial’ of theory development(which emphasizes the tradeoffs among parsimony, generalizability and accuracy),the trend in entrepreneurship research has been to favor generalizability and parsi-mony over accuracy. This movement reflects attempts to overcome the weaknesses ofanecdotal reflections based on inadequate sample size and selection that plaguedearly research in the area. Ironically, entrepreneurship scholars (including thosefocused on venture capital) may have become too remote from the phenomenon.

2. Adopt a balanced view of human nature in shaping premises and assumptions.Ghoshal argues that an ideology-based, inaccurate ‘gloomy vision’ of organizationshas come to infect our theorizing. This negative view dismisses alternative plausiblemotivations beyond self-interest and beyond rational calculation of self-serving ends.Using self-interest as an unquestioned premise has serious consequences for inferringcauses of failings and for prescribing remedies. Ghoshal’s plea for toning down the‘negativism’ is actually a plea for greater realism. Humans have both self-serving andother-serving tendencies (Lawrence and Nohria, 2002). Further, both ‘negative’ and‘positive’ emotions (for example greed, fear, trust or liking) may be important ele-ments to understand, elements whose ramifications we have hardly tapped. Forexample, despite the vast and impressive literature that we have produced on invest-ment selection, monitoring, CEO replacement, and the like, we still fall short ofunderstanding exactly how these incredibly important, novel and uncertain decisionsare actually made. In their astute game theoretic analysis of investor–investee inter-actions, Cable and Shane (1997) portray all of the economic reasons that theexchange partners should find it in their best interest to ‘cooperate’. Yet, if we digbeneath the surface, this cold, calculating self-interest veils a deeper game more akinto coercion than to collaboration. In this world, exchange partners do not keep theirend of the bargain because it is the right thing to do, but only because it is to their


advantage to do so. In this world, promises and integrity are only as meaningful asthe conditions that mandate them – cooperation becomes synonymous with coercion.As Bhide and Stevenson (1990) astutely point out, in reality people act with integrityand goodwill a great deal more than can be explained by enlightened self-interest.Why is that so, and what should it mean for our theorizing and hypothesis testing?

3. Keep human choice and ethics within the equation of organizational decision-making. According to Ghoshal, the upshot of accepting economic self-interest as thesole driving force for human endeavor is that we remove individual responsibility andethical norms from theoretical consideration. The assumption of economic self-interest as the sole motivation for action trivializes human choice as a subject forstudy. Many venture capital researchers have already explicitly noted that the applic-ability of assumptions varies with settings and/or with the subjects considered. Forexample, Van Osnabrugge (1998) has found that business angels explicitly consider arange of motives in ‘developing’ or ‘mentoring’ entrepreneurs. Arthurs and Busenitz(2003) discuss the limitations of explaining investor/investee decisions using eitheronly agency theory (which assumes self-interest and opportunism on the part of man-agers) or only stewardship theory (which assumes good faith stewardship on the partof managers). In short, researchers must avoid succumbing to the temptation toadopt simple, mathematically tractable assumptions that make hypothesis testingneat but inaccurate. Expanding our conceptualization of the drivers of human behav-ior expands the power and accuracy of our theorizing.

4. Remember that our theorizing affects practice. Ghoshal points out that researchers’negative presumptions become self-fulfilling prophecies, with undesirable conse-quences not only for the quality of theorizing but also for practice. When theoriststeach students to expect opportunism and self-serving dishonesty, they give suchbehavior currency and unintended legitimacy as industry norms. We argue here thatalthough malfeasance and dishonesty do indeed occur, they are not necessarily thenormal or expected behavior in practice. This suggestion to keep in mind that stu-dents may come to practice what we preach has overtones that go beyond the ordin-ary scope of being a researcher. Like entrepreneurs, we as researchers do play a smallpart in creating the world we inhabit.

5. Take up the ‘positive challenges of management’. The antecedents of integrity, for-bearance, and justice might be as productively explored as are the mechanisms to dealwith their absence or betrayal. Although it is perhaps human nature to experience fearof the negative more strongly than joy in the positive, as researchers of venture capitalwe should, like our subjects, seek paths to create or realize the upside potential of ourwork. Critical elements of the venture capital process include such positive conceptsas inspiration and innovation, for example. Where do these come from? How maythey be stimulated and enhanced? The rational economic perspective is silent on suchissues, providing little guidance for understanding the sources of inspiration, let alonesuch responses as magnanimity. Even in commonly investigated phenomena, such asthe post-investment activities of venture capitalists, too little has been done to under-stand the creative rather than the fiduciary actions of investors. Most works in the lit-erature treat investors as concerned solely with avoiding risk or protecting value whenin fact realizing the upside of investments is paramount in many cases. Creating gainsis not the same as avoiding losses.


We can relate the above reflections to our ‘kaleidoscope’ of venture capital research byemploying yet another metaphor. Ghoshal’s portrayal of the modern, cynical researchercan be understood by comparing this researcher with the title character in NathanielHawthorne’s short story ‘The minister’s black veil’. In this story, the minister in a smallNew England town emerged one morning to face his parishioners wearing for the firsttime a black veil through which he now viewed the congregation, and through which theynow viewed him. He now saw everything a bit more darkly, and they too imagined that heharbored dark secrets and dark thoughts too unpleasant to reveal. Not only were thoseon both sides of the veil affected by its darkness, but the dark veil seemed to invest theminister with a certain power over others. By analogy, this story illustrates two problemsin contemporary management research in general and venture capital research in particu-lar. First, the assumption of self-interest with guile as the true nature of the human actoraffects both those adopting the view and those glimpsed through it. Further, the assump-tion of the negative view of human nature (the dark veil) invests its adopters with power.This power stems from the fear people have of being seen as too naïve, of being portrayedas seeing the world through ‘rose-colored glasses’. Ghoshal challenges us to do more thanview venture capital activity solely through the dark veil of unbridled opportunism andself-interest – to see other views of actual and possible realities. Consider, for example, themeaning of the ‘game’ in Cable and Shane’s (1997) analysis: if reputation and reciprocityare seen not just as self-serving mechanisms to be calculated about and gambled upon,but rather as desirable human status to aspire to and uphold, then, collaboration is indeedcollaboration, and coercion is recognized for what it is.

If we indeed let go of our arrogant air of certainty, adopt a balanced view of humannature, keep ethics and responsibility in the picture, remember that what we teach haseffects, and take up the challenge of unearthing antecedents of positive outcomes we willcomplete the circle of theorizing. We believe that the spirit of these two works is not torepudiate and abandon all that has come before but rather to dig in deeply, questioningly,and with renewed vigor. Like Ghoshal, our call is not for naïve denial of ill-will but forbalanced recognition of the multiplexity of human choice and action.

ConclusionThis chapter was devoted to giving a taste of how venture capital research in managementsciences has progressed over its brief history and how it might evolve in the future. It wasnot our intent (nor would it have been possible) to thoroughly review the works comprisingthe managerial view of the venture capital phenomenon, much less the entire literaturewhich also includes the contributions of finance and economics. We instead broadlyremarked on how the descriptive roots of the literature have provided a sound basis forfurther study, and we offered a means of classifying work by focus on venture capital type,stage in the venture capital process, and whose perspective was being studied. Our metaphorof the kaleidoscope revealed a few areas of neglect, most of which certainly merit add-itional study. However, we have suggested here that perhaps more important than merelynoting what has not been studied is to consider how we ought to approach future researchto ensure that it is meaningful, revealing, and valid.12 Echoing the exhortations of Van deVen and Johnson (2006) and Ghoshal (2005) we have encouraged management researchersto immerse themselves in their phenomena, broaden and deepen their theorizing andmethods, and address questions that enrich theory and practice in meaningful ways.


Based on what venture capital researchers have already accomplished, we are optimisticabout the future. Venture capital research (like entrepreneurship research in general) hasbenefited from its multidisciplinary roots and its connection to practice. Our exhortationto take the ‘engaged scholarship’ approach seriously, implies that these roots and this con-nection should be preserved and enhanced. If we go a step farther and foster the kind ofincreased stakeholder cooperation, immersion in the field, and long-term research designssuggested by the engaged scholar view, we will face significant obstacles in terms of time,money, access and effort. However, as a relatively unified subfield within the area of entre-preneurship we have the potential to jointly accomplish some ends that would not be pos-sible individually.

Our review has surfaced a series of suggestions that represent an ideal of scholarship.For the most part, these recommendations do not represent single, specific areas ofinquiry but rather approaches to the study of venture capital that might yield significantinsight. These general suggestions may be summarized as follows:

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

Our practical side recognizes the difficulty and burdens of adopting such approaches. Wehave suggested, therefore, that efforts to achieve what we have laid out may need to beaccomplished in teams and that these teams might best be led by senior scholars whosecareer ‘clocks’ are not ticking quite so loudly. We heartily recommend that junior schol-ars participate and engage, but we also are cognizant of the fact that they may also needto nurture parallel conventional studies that have shorter time frames to completion.

In terms of the current dominant rational thinking paradigm, we are suggesting thatfuture research should neither abandon these roots altogether nor ignore the rationalactor approach in future studies. We do suggest, however, that efforts to look beyond thenarrow confines of rational economic thinking will allow us to discover and conjure someimportant, new questions that may have been obscured by the current view. Furthermore,the broader set of stakeholders (such as local communities, individual entrepreneurs,institutional representatives and the like) have legitimate interests that have little to dowith profit taking. To provide insights for these interests, we will have to delve deeply intoissues of the processes and mechanisms of value creation unconstrained by assumptionsregarding rent appropriation. In short, we will have to consider societal outcomes beyondprofit generation.

Returning briefly to our kaleidoscope, we can identify several specific suggestions forfuture research. Research in the business angel domain would be especially suited toexploration of the processes of venture and value creation. Furthermore, the role ofemotion and affect is especially amenable to study in the business angel context becausebusiness angels, more so than institutional venture capitalists or corporate venture cap-italists, have ‘skin in the game’ but are unconstrained by having to justify their decisionsto outside third parties. The corporate venture capital context, on the other hand,


provides an interesting setting in which to contrast entrepreneurial processes and leader-ship in new versus established organizations. Any of these settings (or perhaps a compar-ison of the three) could be used to examine the path-dependent nature of investmentdecisions, including both the impact of early investment decisions on the development ofthe venture as well as on the nature of later decision making. Our positive organizationalscholarship and engaged scholar views suggests that such studies might be viewed fromalternative lenses, over time, via a multiplicity of instruments. We are reminded, too, thatthese issues can and should be viewed from the perspectives not only of the venture cap-italist but of the entrepreneur and upon occasion by that of outside stakeholders.

Finally, we cannot help but conclude that venture capital research is but beginning toreveal all that it might, not only about its own complex workings, but also about entre-preneurship itself.

AcknowledgementsThe authors are indebted to Hans Landström, Gordon Murray and Andy Van de Ven forcomments on early versions of this chapter.

Notes1. Broadly construed, ‘venture capital’ refers to provision of outside equity for a claim against increases in

value of an independent entity. We, however, use the term in this chapter not to refer to the broader set ofall private equity, but primarily to refer more closely to what Bygrave and Timmons (1992) call ‘classicventure capital’, the provision of equity into earlier stage, high potential ventures (see Chapter 1).

2. Gordon Murray pointed out to us that perhaps an astrolabe is a more apt metaphor, given the random-ness of the outcomes that result when using a kaleidoscope. Nevertheless, we choose the kaleidoscope,despite its imperfection, because we think it has the advantage of audience familiarity.

3. It should be noted that an additional limitation of this kaleidoscope metaphor is that it implies that theresearcher is on the outside looking in at the phenomenon. As we discuss later, the ‘engaged scholar’ viewplaces the researcher within the phenomenon as an observer/participant. We are indebted to Andy Van deVen for this observation.

4. In this chapter when we use the term ‘investor’ we are referring to the venture capitalist, even though inthe institutional venture capital context the limited partner may be the actual source of the funds invested.

5. In our focus on managerial venture capital literature we almost entirely ignore the vast and significant con-tributions of Josh Lerner and Paul Gompers to the study of venture capital. From the early 1990s to thepresent, these two have produced (singly and/or in combination with one another) the most significantstream of work on the financial processes and structures in the institutional venture capital industry.

6. This latter reflection on the possibility that agency theory is less appropriate in some contexts outside theUS is not necessarily shared by all venture capital researchers. We thank Gordon Murray for this comment.

7. Please take note that we draw heavily on the work of Van de Ven and Johnson (2006) for these suggestions;we offer this reminder to avoid filling these pages with repeated references to their work.

8. Donald Sexton (along with several colleagues over time) was a pioneer in publishing early serious scholarlywork in entrepreneurship beginning in 1982 with The Encyclopedia of Entrepreneurship and continuing withThe Art and Science of Entrepreneurship, The State of the Art of Entrepreneurship, Entrepreneurship 2000and Handbook of Entrepreneurship Research.

9. This observation was suggested by Gordon Murray. Indeed, Professor Murray sees access to venture cap-italists and their limited partners as perhaps the most daunting and important for the success of futureresearch on the industry. Gordon sees the presence of industry databases as a two-edged sword, one thatprovides significant quantitative information that may help researchers overcome the common methodissues that plague primary research but that also may tempt researchers to conduct studies without ade-quate depth of knowledge.

10. This section is largely based on Ghoshal (2005); for brevity’s sake, we forgo repeated references. For addi-tional examples on this topic, see Cameron et al. (2003).

11. Phil Bromiley, former Curtis L. Carlson Professor of Strategic Management, University of Minnesota;statement made often in conversation.

12. Although we have highlighted new approaches to conducting future research, an explicit mention of areasrequiring greater study is not unwarranted. Gordon Murray suggested the following to us in providing


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

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3 Venture capital: A geographical perspectiveColin Mason

IntroductionA major focus of applied research on venture capital concerns the ‘equity gap’ – in otherwords, the lack of availability of small amounts of finance. In the case of formal (or insti-tutional) venture capital funds, because of the fixed nature of most of the costs thatinvestors incur in making investments it is uneconomic for them to make small invest-ments. Informal venture capital investors – or business angels – are able to make smallinvestments because they do not have the overheads of fund managers and do not costtheir time in the same way. However, most business angels, even when investing in syndi-cates alongside other business angels, lack sufficiently ‘deep pockets’ to fully substitute forthe lack of venture capital fund investment. Hence, whereas the market for investmentsof under £250 000/$500 000 is served fairly effectively by business angels, and the over£5m/$10m market is satisfied by venture capital funds, there is a gap in the provision ofamounts in the £250 000/$500 000 to £5m/$10m range which are too large for businessangels but too small for professional investors. This gap is mostly experienced by new andrecently started growing businesses. Governments have responded in a variety of ways inan attempt to increase the supply of small scale, early stage venture capital (see Murrayin Chapter 4 and Sohl in Chapter 14).

However, much less attention has been given to ‘regional gaps’ in the supply of venturecapital – that is, the under-representation of venture capital investments in particularparts of a country relative to their share of national economic activity (for example theirshare of the national stock of business activity). If it is accepted that venture capital –both institutional and informal – makes a significant contribution to the creation of newbusinesses and new industries then regions which lack venture capital will be at a disad-vantage in generating new economic activity and technology clusters.

This chapter reviews the literature on the geography of venture capital. It looks sep-arately at informal venture capital and formal, or institutional, venture capital. The liter-ature on the geography of informal venture capital is very limited and fairly superficial.There are enormous difficulties in identifying business angels and developing a databaseof investments, hence most studies have been based on small samples with limited geo-graphical coverage or depth. Moreover, issues of geography, place and space have rarelybeen given attention in studies of the operation of the informal venture capital market.The literature on the geography of institutional venture capital is also limited. It hasmainly been contributed by economic geographers. Because of the tendency for scholarsto work in disciplinary ‘silos’ it means that this literature is largely unknown amongst‘mainstream’ scholars of venture capital who are typically in the management and eco-nomics disciplines. A further consequence is that when scholars from such disciplines dowrite about the geographical aspects of venture capital they generally ignore these geo-graphical contributions and treat such geographical concepts as place, space and distancein simplistic terms. Finally, in order to put boundaries on the scope of this chapter it is

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concerned exclusively with the geography of venture capital investing within individualcountries. There is a separate literature on the internationalization of venture capital (seeWright et al. (2005) for a review).

The next section reviews what can be gleaned from the literature on the role of geog-raphy of the informal venture capital market (section 2). The chapter then moves on toconsider the formal, or institutional, venture capital market, initially by considering out-comes, describing the uneven nature of venture capital investing, illustrated by the exam-ples of the USA, Canada, the UK and Germany (section 3) and then works backwardsto explanations, attributing this uneven geography of investing to the combination of thelocalized distribution of the venture capital industry and the localized nature of invest-ing. The role of long distance flows of venture capital in reinforcing the clustering ofventure capital investments is also discussed. Section 4 brings some of these earlier themestogether in the form of a short case study of Ottawa, Canada, a thriving technologycluster. The intention is to show how economic activity is initially funded in emerginghigh-tech clusters by a combination of ‘old economy’ business angels and the importingof institutional venture capital from elsewhere, but over time, as it develops successfultechnology companies so a technology angel community emerges and it also develops itsown indigenous supply of institutional venture capital funds. Section 5 draws the chapterto a conclusion with some thoughts on future research directions and a brief consider-ation of the implications for policy. A fuller discussion of policy issues can be found byMurray in Chapter 4 of this volume.

Geographical aspects of the informal venture capital marketBusiness angels are very difficult to identify. They are not listed in any directories and theirinvestments are not recorded. Consequently, research has generally been based onsamples which are too small to be spatially disaggregated. Moreover, the identification ofbusiness angels is often based either on ‘snowballing’ or samples of convenience whichhave an in-built geographical bias. This has severely restricted the ability of researchers toexplore either the geographical distribution of business angels and their investment activ-ity or to compare the characteristics of business angels and their investment activity indifferent regions and localities. Some studies do make comparisons with findings fromindependent studies conducted in other regions and countries but the lack of consistencyin methodologies, sampling frames and definitions renders such comparisons highlysuspect. However, since the majority of business angels are cashed-out entrepreneurs (upto 80 per cent according to some studies) and other high net worth individuals, the size ofthe market in different regions is likely to reflect the geography of entrepreneurial activ-ity and the geography of income and wealth, both of which have been shown to beunevenly distributed within countries (for example Davidsson et al., 1994; Keeble andWalker, 1994; Reynolds et al., 1995; Acs and Armington, 2004).

The location of business angelsThe only study which has looked at the geographical distribution of business angels is byAvdeitchikova and Landström (2005). Based on a ‘large’ (n = 277) sample of informalinvestors in Sweden (defined as anyone who has made a non-collateral investment in privatecompanies in which they did not have any family connections) they suggest that bothinvestments (52 per cent) and the amounts invested (77 per cent) are disproportionately

Venture capital: A geographical perspective 87

concentrated in metropolitan regions (which comprise 51 per cent of the total population).However, this is a less geographically concentrated distribution than is the case for institu-tional venture capital fund investments.

Regional comparative studies suggest that business angels also differ by region. Forexample, a study that was based on a large sample of Canadian business angels (n = 299)(Riding et al., 1993) noted that business angels in Canada’s Maritime Provinces (NovaScotia, Prince Edward Island and New Brunswick) are distinctive in terms of the typicalsize of their investments, sectoral preferences, rate of return expectations and expectedtime to achieve an exit (Feeney et al., 1998). Investors in Atlantic Canada and Quebec arealso the most parochial (63 per cent and 58 per cent of investments within 50 miles ofhome compared with a national average of 53 per cent) (Riding et al., 1993). Johnstone(2001) makes an important contribution, suggesting that remote and declining industrialregions are likely to suffer from a mismatch between the supply of angel finance and thedemand for this form of funding. He demonstrates that in the case of Cape Breton, in theprovince of Nova Scotia in Canada, the main source of demand for early stage venturecapital is from knowledge-based businesses started by well-educated entrepreneurs(mostly graduates) with formal technical education and training who are seeking value-added investors with industry- and technology-relevant marketing and management skillsand industrial contacts. However, the business angels in the region have typically madetheir money in the service economy (retail, transport, and so on), have little formal edu-cation or training, are reluctant to invest in early stage businesses and are not comfortablewith the IT sector. Moreover, their value-added contributions are confined to finance,planning and operations. This suggests that the informal venture capital market in‘depleted communities’ is characterized by stage, sector and knowledge mismatches.

There is rather more evidence on the role of geography – specifically the distancebetween the investor’s location and that of the investee company – in the business angel’sinvestment decision. This literature has looked at three issues: (1) the locational prefer-ences of business angels; (2) how location is handled in the investment decision; and(3) the locations of actual investments.

Locational preferencesVarious survey-based studies in several countries have asked business angels if they haveany geographical preferences concerning where they invest. These studies reveal that someangels have a strong preference to make their investments close to home while othersimpose no geographical limitations on where they will invest. In the USA Gaston (1989)reported that 72 per cent of business angels wished to invest within 50 miles of home andonly 7 per cent had no geographical preferences. However, other US studies – based onsmaller sample sizes and confined to specific regions – report that well under half of allbusiness angels will limit their investing to within 50 miles of home (Table 3.1). Studies inother countries are equally inconsistent in their findings. For example, in Canada, a studyof Ottawa angels reported that 36 per cent imposed no geographical limits on theirinvestments (Short and Riding, 1989). In the UK, Coveney and Moore (1997) reportedthat 44 per cent of angels would consider investing more than 200 miles or three hours’travelling time from home, compared with only 15 per cent whose maximum investmentthreshold was 50 miles or one hour. Scottish business angels are rather more parochial,but even here 22 per cent would consider investing more than 200 miles or three hours


from home, compared with 62 per cent wanting to invest within 100 miles of home (Paulet al., 2003).

The role of location in the investment decisionStudies of how business angels make their investment decisions suggest that the locationof potential investee companies is a relatively unimportant consideration, and much lesssignificant than the type of product or stage of business development (Haar et al., 1988;Freear et al., 1992; Coveney and Moore, 1997; van Osnabrugge and Robinson, 2000). Amore nuanced perspective is offered by Mason and Rogers (1996). Their evidence suggeststhat most angels do have a limit beyond which they prefer not to invest, but – to quoteseveral respondents to their survey who used virtually the same phrase – ‘it doesn’t alwayswork that way’. In other words, the location of an investment in relation to the investor’shome base appears to be a compensatory criterion (Riding et al., 1993), with angels pre-pared to invest in ‘good’ opportunities that are located beyond their preferred distancethreshold.

Locations of actual investmentsStudies which have focused on the actual location of investments made by business angelsreveals a much more parochial pattern of investing (Table 3.2). The proportion of invest-ments located within 50 miles of the investor’s home or office ranges from 85 per centamongst business angels in Ottawa to 37 per cent amongst business angels in Connecticutand Massachusetts. In the UK, Mason and Harrison (1994) found that two-thirds ofinvestments by UK business angels were made within 100 miles of home. In other words,the actual proportion of long distance investments that are made is much smaller thanmight be anticipated in the light of the proportion of investors who report a preferencefor or willingness to consider long distance investments.


Table 3.1 Locational preferences by business angels: selected studies

Connecticut andMassachusetts

New California(Freear et al., 1992; 1994)

England (Tymes and USA Active Virgin(Wetzel, 1981) Krasner, 1983) (Gaston, 1989) angels angels

(all figures in percentages)

Less than 50 miles 36 41 72 32 2550–300 miles 17 – 10* 20 25Over 300 miles – – – 19 12Outside USA – – – 5 0Other geographical 7 13 11 – –

restrictionNo geographical 40 33 7 24 38

preference100 87 100 100 100

Note: * 50–150 miles

Reasons for the dominance of short distance investments This dominance of localinvesting reflects several factors. First, it arises because of the effect of distance on aninvestor’s awareness of potential investment opportunities. Information flows aresubject to ‘distance decay’, hence, as Wetzel (1983, p. 27) observed, ‘the likelihood of aninvestment opportunity coming to an individual’s attention increases, probablyexponentially, the shorter the distance between the two parties.’ Indeed, in the absenceof an extensive proactive search for investment opportunities, combined with the lackof systematic channels of communication between investors and entrepreneurs, mostbusiness angels derive their information on investment opportunities from informal net-works of trusted friends and business associates (Wetzel, 1981; Haar et al., 1988; Aram,1989; Postma and Sullivan, 1990; Mason and Harrison, 1994), who tend to be local(Sørheim, 2003).

Second, business angels place high emphasis on the entrepreneur in their investmentappraisal – to a much greater extent than venture capital funds do (Fiet, 1995; Mason andStark, 2004). Their knowledge of the local business community means that by investinglocally they can limit their investments to entrepreneurs that they either know themselvesor who are known to their associates and so can be trusted. This point is illustrated by onePhiladelphia-based angel quoted by Shane (2005, p. 22): ‘we have more contacts in thePhiladelphia area. More of the people we trust are here in the Philadelphia area. So there-fore we are more likely to come to some level of comfort or trust with investments that arecloser.’

A third reason is the tendency for business angels to be hands-on investors in order tominimize agency risk (Landström, 1992). Maintaining close working relationshipswith their investee businesses is facilitated by geographical proximity (Wetzel, 1983).Landström’s (1992) research demonstrates that distance is the most influential factor indetermining contacts between investors and is more influential than the required level ofcontact. This, in turn, suggests that the level of involvement is driven by the feasibility ofcontact rather than need. Furthermore, active investors give greater emphasis to proxim-ity than passive investors (Sørheim and Landström, 2001). Proximity is particularlyimportant in crisis situations where the investor needs to get involved in problem-solving.As one of the investors in the study by Paul et al. (2003, p. 323) commented ‘if there’s aproblem I want to be able to get into my car and be there in the hour. I don’t want to begoing to the airport to catch a plane.’


Table 3.2 Location of actual investments made by business angels: selected studies

Connecticut andNew England Massachusetts Ottawa (Short Canada (Riding(Wetzel, 1981) (Freear et al., 1992) and Riding, 1989) et al., 1993)

(all figures in percentages)

Less than 50 miles 58 37 85 5350–300 miles 20 28 4 17Over 300 miles/ 22 36 (28+8) 11 29

different country

Total 100 100 100 100

Finally, angels need to monitor their investments. This is often done by serving on theboard of directors. It is desirable that the angel can travel to, attend and return in a dayin order to minimize their travel costs. Some angels prefer to monitor their investments bymaking frequent visits to the businesses in which they invest, described by one angel inShane’s study as ‘seeing them sweat’ (Shane, 2005, p. 22). This is much easier to do if theinvestment is local. Avdeitchikova and Landström (2005) provide statistical support forthese explanations. In their study of Swedish informal investors, they found that investorswho rely on personal social and business networks as their primary method for sourcingdeals, and active investors who provide hands-on support to their investee businesses, arethe most likely to invest close to their home/office.

Some studies have further observed that experienced angels have the greatest awarenessof the benefits of investing close to home. Freear et al. (1992; 1994) noted that whereas38 per cent of virgin angels had no geographical restrictions on where they would be pre-pared to invest, this fell to 24 per cent amongst active angels (see Table 3.1). In a study ofUK investors, Lengyel and Gulliford (1997, p. 10) noted that whereas the majority (67 percent) of investors gave preference to investee companies which were located within anhour’s drive, actual investors placed an even bigger emphasis on distance in their futureinvestments, with 83 per cent indicating that they would prefer their future investments tobe within 100 miles of where they lived.

The characteristics of long distance investments Nevertheless, long distance investmentsdo occur. In studies of New England (Wetzel, 1981; Freear et al., 1992) and Canada(Riding et al., 1993) between 22 per cent and 36 per cent of investments were over 300miles from the investor’s home or office (see Table 3.2). In the UK, Mason and Harrison(1994) found that one-third of investments were in businesses located more than 100 milesfrom the investor’s home. Even in studies that have reported very high levels of localinvesting, at least 1 in 10 investments were over a long distance. For example, 11 per centof investments made by Ottawa-based business angels were over 300 miles away (Shortand Riding, 1989), while in Finland, 14 per cent of investments were over 300 miles awayfrom the investor’s home (Lumme et al., 1998).

Long distance investing is distinctive in several respects. First, in terms of investors,those who have industry-specific investment preferences (including technology prefer-ences) are more willing to make long distance investments, and the pattern of their actualinvestments supports this preference (Lengyel and Gulliford, 1997). Paul et al. (2003)suggest that the willingness of angels to make non-local investments is related to the fundsthat they have available to invest and the number of investments that they have made.They note, for example, that distance is not an issue for ‘super-angels’ with more than£500 000 available to invest. Such investors are also more likely to be well-known and somore likely to be approached by entrepreneurs in distant locations. The ‘personal activityspace’ of angels is also relevant. Investors with other interests elsewhere in the countrywill look for additional investments in these locations in order to reduce the opportunitycosts of travelling. Second, certain deal characteristics are associated with long distanceinvesting. Size of investment is important, with angels willing to invest further afield whenmaking a £100 000 investment than a £10 000 investment (Innovation Partnership, 1993).The amount of involvement required is also relevant, with one angel observing that aninvestment requiring ‘a one day a week involvement is going to be closer than [one which


requires] a one day a month involvement’ (Innovation Partnership, 1993). Third, angelswill make long distance investments if someone from the location in which the businessis based that they know and trust is co-investing with them.

From this fragmentary literature it can be concluded that there is not a national infor-mal venture capital market. Rather, in view of the dominance of short distance investingit is best described as comprising a series of overlapping local/regional markets. Localitiesand regions differ in terms of both the numbers of business angels and their investmentcapabilities. There are also more subtle, but equally significant, differences in terms of thecharacteristics of investors, their investment preferences and the nature of the hands-onsupport which they can provide to investee companies. It follows from this that informalventure capital is not equally available in all locations. Nevertheless, some long distanceinvesting does occur. However, there is little support from the available evidence to suggestthat regions with a deficiency of informal venture capital can import their capital needsfrom elsewhere. Indeed, in their exploratory study of long distance investing by businessangels in the UK Harrison et al. (2003) suggest that investors in the South East ofEngland – the most economically dynamic and most entrepreneurial region in the UK –are the least likely to make long distance investments, and long distance investments intechnology businesses are most likely to flow from economically less dynamic regions andinto the South East region (which contains the major technology clusters).

Institutional venture capital: a geographical analysis

DefinitionsWhereas the informal venture capital market comprises high net worth individuals invest-ing their own money in unquoted companies, the formal, or institutional, venture capitalmarket consists of venture capital firms – in other words, professional fund managers whoare investing other people’s money. Most venture capital firms are ‘independents’ whoraise their finance from financial institutions (for example banks, insurance companies,pension funds) and other investors (for example wealthy families, endowment funds, uni-versities, companies). The investors in the funds managed by venture capital firms (termed‘limited partners’) are attracted by the potential for superior returns from this asset classbut lack the resources and expertise to invest directly in companies themselves. Moreover,as they are only allocating a small proportion of their investments to this asset class (typ-ically a maximum of 1–2 per cent) it is more convenient to invest in funds managed byventure capital firms (who are termed the ‘general partners’) who have specialist abilitiesin deal selection, deal structuring and monitoring. This enables venture capital firms todeal more efficiently with asymmetric information than other types of investor. Venturecapital firms also have skills in providing value-adding services to their investee businessesand securing an exit for the investment which maximizes returns. The other, much smallercategory of venture capital firm is ‘captives’. These are venture capital firms that are sub-sidiaries of financial institutions (especially banks) or non-financial corporations andwho raise their investment funds from their parent organization. (See Cumming, Flemingand Schwienbacher in Chapter 5 for a more detailed discussion).

Three smaller types of institutional investors are also of note. First, some non-financialcorporations make venture capital investments for strategic reasons associated with R&Dor market considerations, an activity which is termed corporate venturing. Second, some


countries have venture capital funds that are funded entirely by investments by private indi-viduals and who qualify for tax incentives. Examples include the UK’s Venture CapitalTrusts and Canada’s Labor-Sponsored Venture Capital Funds (Ayayi, 2004). Third, inmany countries there are government-funded venture capital funds which have been estab-lished for economic development reasons usually in regions which lack private sectorventure capital funds (Hood, 2000).

Location of investmentsThe availability of information on the geographical distribution of venture capital invest-ing is rather poor. The main source of information is in the form of highly aggregatedstatistics produced annually by national venture capital associations or by organizationsacting on their behalf. However, this simply records the location of investments by region,offers limited disaggregation by type of investment and provides no information oninvestment source. A further concern relates to the comprehensiveness of the coverage(Karaomerlioglu and Jacobsson, 2000). Members of national venture capital associationstend to be skewed towards larger investors, including those which might not be regardedas belonging to the venture capital industry,1 whereas many small-scale local investors arenot members and so are excluded. Investments by most corporate investors (that is non-financial companies making strategic minority investments in small firms) and businessangels, including business angel syndicates, are also not covered. There are some com-mercial sources of data which do provide deal-specific information (including locationsof investor and investee business). However, these suffer from a lack of comprehensivecoverage, being biased towards larger deals.

In the USA venture capital investments are highly concentrated at all spatial scales:regional, state and metropolitan area. The pattern at the regional scale is bi-coastal,with venture capital investing concentrated in California, New England and New York(Table 3.3). Within individual states venture capital is concentrated in cities. At the met-ropolitan area scale just 10 such areas attracted 68 per cent of all investments in 1997–98,with just two – San Francisco and Boston – accounting for 39 per cent (Zook, 2002).Equally, there are large swathes of the USA, including much of the south and mid-west,which have attracted relatively little venture capital investing. The geography of venturecapital investing closely relates to the locations of high-tech clusters (Florida and Kenney,1988a; 1988b; Florida and Smith, 1991; 1992).

In Canada venture capital investments are concentrated in Ontario and Quebec at theprovincial scale, with the Atlantic and Prairie provinces having the smallest amounts ofactivity (Table 3.4). At the metropolitan area scale venture capital is concentrated in TheGreater Toronto Area (24 per cent), Montreal (20 per cent) and Ottawa (16 per cent) (2004figures) which together account for just 28 per cent of total population. Indeed, underly-ing the metropolitan focus of venture capital investing, just nine cities2 accounted for82 per cent of all venture capital investments in Canada by value.

Turning to Europe, it should first be noted that the definition of venture capital is ratherbroader than is the case in North America, and includes private equity firms which investin corporate restructuring situations such as management buy-outs, institution-led buy-outs and public-to-private deals. These deals are typically very large, usually well in excessof £10m. The geographical distribution of venture capital investing in the UK favoursLondon and the South East (Table 3.5) (Mason and Harrison, 2002). These regions have


the largest location quotients – a simple statistical measure to show whether a region hasmore, or less, than its ‘expected’ share of venture capital investments by dividing thisfigure with some measure of the region’s share of national economic activity (in this casethe business stock). The only other regions with more than their expected shares ofventure capital investments by amount invested (indicated by a location quotient greaterthan unity) are the East Midlands and West Midlands. Regions with the lowest locationquotients are in the ‘north’, notably Wales, Northern Ireland, Yorkshire and The Humber,the North West and North East. Because of the dominance of MBO investments in theUK there is a much weaker relationship between venture capital investing and high-techclusters (Martin et al., 2002). However, early stage investments continue to be dispropor-tionately concentrated in London, the South East and Eastern regions and are moreclosely linked to high-tech clusters (such as Cambridge) and more generally to the loca-tional distribution of high-tech firms (Mason and Harrison, 2002).

A number of other West European countries, notably France, also exhibit high levelsof geographical concentration of venture capital investments in just one or two regions(Martin et al., 2002). In Germany, 65 per cent of total investment in 2003 and 2004 wasconcentrated in just three of the 15 federal states – Bavaria, Baden-Wurttembergand North Rhine-Westphalia (Fritsch and Schilder, 2006). Nevertheless, venture capitalinvestments are less geographically concentrated in Germany than in other countries, withfive states having location quotients greater than unity (Martin et al., 2005).


Table 3.3 The location of venture capital investments in the USA, 2005

$ % number %

Alaska/Hawaii/Puerto Rico 17 044 900 0.1 5 0.2Colorado 618 597 900 2.8 80 2.6Washington DC/Metroplex 966 841 500 4.3 194 6.4Los Angeles/Orange County 1 501 132 000 6.7 176 5.8Mid West 773 419 400 3.5 147 4.8New England 2 672 148 900 12.0 398 13.1North Central 319 268 200 1.4 60 2.0North West 964 114 500 4.3 156 5.1NY Metro 1 865 528 600 8.3 168 5.5Philadelphia Metro 580 389 900 2.6 90 3.0Sacramento/N. California 80 262 200 0.4 15 0.5San Diego 1 035 312 000 4.6 125 4.1Silicon Valley 7 901 433 500 35.4 939 30.9South Central 54 604 000 0.2 4 0.1South East 1 219 747 600 5.5 204 6.7South West 590 206 100 2.6 79 2.6Texas 1 103 720 900 4.9 167 5.5Upstate NY 59 391 300 0.3 30 1.0Other US 57 099 000 0.3 2 0.1

Grand Total 22 380 262 400 100 3039 100

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

Little attention has been given to the extent to which these patterns of investing exhibitstability over time. In the UK the regional distribution of venture capital investmentsbecame less unevenly distributed during the 1990s compared with a decade earlier. Thedominance of London and the South East was reduced (declining location quotients),while the older industrial regions, such as the East and West Midlands and Yorkshire andThe Humber, increased their shares of venture capital investments. However, this gain wasmainly in the form of management buy-outs; early stage investments continue to be con-centrated in London and the South East (Mason and Harrison, 2002). In the USA theinvestment ‘bubble’ of the late 1990s – caused by a large inflow of capital into the venturecapital sector, resulting in more, and larger, investments – did lead to a short-lived spatialdiffusion in investment activity as venture capital firms had to look further afield forinvestment opportunities. However, in the subsequent investment downturn post-2000venture capital firms quickly reversed this geographical expansion in investment activityto re-focus on investments closer to home (Green, 2004). Indeed, the share of investingby value in the top three states of California, Massachusetts and Texas has increased from54 per cent in the pre-‘bubble’ period (1995–98) to 55 per cent in the ‘bubble’ years(1999–2000) and to 61 per cent in the immediate ‘post-bubble’ period (2001–2002).

Explaining the geographical concentration of venture capital investmentsThis uneven geographical distribution of venture capital investments arises from the com-bination of the clustering of the venture capital industry in a relatively small number ofcities, and the localized nature of venture capital investing.


Table 3.4 Location of venture capital investments in Canada, by province, 2005

Companies TotalAmount invested financed Financings* investments

Province $m % No. % No. % No. %

British Columbia 225.7 12.3 58 9.8 69 10.8 198 12.9Alberta 64.3 3.5 22 3.7 23 3.6 41 2.7Saskatchewan 30.9 1.7 17 2.9 18 2.3 32 2.1Manitoba 10.9 0.6 18 3.0 18 2.3 39 2.5Ontario 751.0 41.1 156 2.6 170 26.6 510 33.3Quebec 709.8 38.8 297 49.7 313 49.0 675 42.9New Brunswick 15.6 0.9 13 2.2 16 2.5 30 2.0Nova Scotia 17.2 1.0 6 1.0 8 1.3 16 1.0Prince Edward 2.8 0.1 2 0.3 2 0.3 6 0.4

IslandNewfoundland 0.2 0.0 1 0.2 1 0.2 1 0.1Territories 0.3 0.0 1 0.2 1 0.2 1 0.1

Total 1828.9 591 639 1531

Note: * companies may receive more than one investment in a year, hence the number of financings exceedsthe number of companies raising finance

Source: Thomson Macdonald (www.canadavc.com)

The spatial clustering of venture capital firms Venture capital firms are clustered in justa small number of cities, typically major financial centres and cities in high-tech regions.Since most venture capital firms have only a single office, including branch offices has onlya minor effect in reducing this high level of spatial clustering. In the USA venture capitaloffices are concentrated in San Francisco, Boston and New York. In Canada the maincentre for venture capital firms is Toronto (59 per cent), with smaller concentrations inCalgary, Montreal (both 9 per cent) and Vancouver (8 per cent). In the UK 71 per cent ofventure capital firms have their head offices in Greater London. There is greater dispersalin Germany. Munich is the biggest single host to venture capital firms but accounts forless than 20 per cent of the total (Fritsch and Schilder, 2006). In total, six cities accountfor 65 per cent of venture capital firms: nevertheless, all of them are major banking andfinancial centres (Martin et al., 2005).

The concentration of venture capital firms in financial centres reflects the origins ofmany of them as offshoots of other financial institutions (notably banks). It also offersaccess to the pools of knowledge and expertise that venture capital firms require to finddeals, organize investments and support their portfolio companies. Hence a location in afinancial centre enables appropriately qualified staff to be recruited and provides proxim-ity to other financiers, entrepreneurs, legal, accounting and consultancy firms and head-hunters during the investment process. The USA is unusual in having such a large


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

Early stageAll investments – All investments – investments –

companies amount invested amount invested

Region Number % LQ* £m % LQ £m % LQ

South East 758 20.1 1.27 3.063 23.0 1.46 238 25.8 1.64London 830 22.0 1.38 4031 30.3 1.91 229 24.9 1.56South West 210 5.6 0.60 664 5.0 0.54 26 3.9 0.42Eastern 413 10.9 1.08 827 6.2 0.62 216 23.5 2.32West Midlands 262 6.9 0.84 1374 10.3 1.24 17 1.8 0.22East Midlands 147 3.9 0.47 1147 8.6 1.27 22 2.4 0.35Yorkshire and The Humber 191 5.1 0.72 319 2.4 0.34 10 1.1 0.16North West 304 8.0 0.84 641 4.8 0.50 54 5.9 0.61North East 117 3.1 1.24 194 1.5 0.58 6 0.7 0.26Scotland 301 8.0 1.14 820 6.2 0.88 64 6.9 0.99Wales 116 3.1 0.71 126 0.9 0.22 31 3.4 0.78N. Ireland 128 3.4 1.06 100 0.8 0.25 25 2.7 0.85

Total 3777 13306 921

Note: * Location quotient (LQ) divides a region’s share of total venture capital investment by its share ofthe total population of businesses registered for VAT. A value of greater than one indicates that venturecapital investments are over-represented in that region. A value of less than one indicates that venture capitalis under-represented in that region

Source: British Venture Capital Association, Report on Investment Activity

proportion of venture capital firms located in Silicon Valley, a high-tech region. Incontrast to the venture capital firms in financial centres, these firms have typically beenstarted by successful technology entrepreneurs and raised a lot of their funding from localhigh net worth individuals (particularly wealthy cashed-out entrepreneurs). Technologyregions in other countries – such as Cambridge in the UK and Ottawa in Canada –typically have only a handful of local venture capital firms, and ‘import’ much of theirfunding from venture capital firms based in the major financial centres (London, Toronto,and so on). However, these local venture capital firms have often been established by suc-cessful local technology entrepreneurs (for example Amadeus in Cambridge, started byHermann Hauser, and Celtic House in Ottawa, started and initially funded by TerryMatthews), and illustrates how technology clusters benefit from the institution-buildingactivities of such individuals.

The localized nature of venture capital investing The clustering of venture capital officesneed not necessarily lead to the uneven geographical distribution of venture capital invest-ments – the money could be invested in distant regions. But in practice venture capitalinvesting is characterized by spatial biases which favour businesses located close to wherethe venture capitalists themselves are located. Florida and Smith (1991; 1992) haveobserved that venture capital firms located in high-tech clusters tend to restrict theirinvesting to the cluster. Powell et al. (2002) report that just over half of all biotech firmsin the USA attracted venture capital investment from local sources. This proportion waseven higher amongst smaller, younger, more science-focused firms and amongst firms inthe main biotech clusters (Boston, San Francisco and San Diego). Moreover, the tendencyfor venture capital firms to invest locally increased during the 1990s. In the case ofInternet investing, Zook (2005) points to a strong statistically-significant correlationbetween the offices of venture capital firms and the number of investments at all spatialscales from five-digit zip code to metropolitan statistical area, with the strongest correl-ation for early stage investments. Martin et al. (2005) similarly report a strong tendencyfor German venture capital firms to invest locally, with most Länder dependent on localventure capital firms for investment. On average nearly half of all firms raising venturecapital have been funded by local investors, with this proportion rising to 68 per cent inthe case of the Bayern region which is centred on Munich.

This strong spatial proximity effect arises because of the absence of publicly availableinformation on new and young businesses. Their unproven business models, untestedmanagement teams, new technologies and inchoate markets all represent key sources ofrisk and uncertainty for investors (Sorenson and Stuart, 2001). Venture capitalists seek toovercome this uncertainty about the future prospects of potential investee businesses byinformation sharing with other investors, consultants, accountants and a wide range ofother actors. Information sharing of this type is built on mutual trust that has been earnedthrough repeated interaction, while the nature of this information flow tends to be per-sonal and informal and therefore hard to conduct over distance. As a consequence, lessinformation is available about businesses in distant locations. Making local investmentsis therefore one of the ways in which venture capital firms can reduce uncertainty, com-pensate for ambiguous information and thereby minimize risk (Florida and Kenney,1988a; Florida and Smith, 1991). This reliance on personal and professional contacts –what one venture capitalist terms ‘Rolodex power’ (Jurvetson, 2000, p. 124) – can be seen


at every stage in the venture capital investment process: deal flow generation, deal evalu-ation and post-investment relationships.

Deal flow. At the deal flow stage, venture capitalists rely on their connections and rela-tionships to find the best deals (Zook, 2005). Most venture capital firms are inundatedwith business plans and have to develop systems which allow them to quickly identifyand focus on those which have the best prospects for success. There are two sources ofdeal flow: deals which come in cold and those which are referred by the venture capital-ist firm’s network – for example, law firms, accountancy firms, other venture capitalistsand entrepreneurs. Venture capitalists are unable to rely on the information provided bythe entrepreneur in deals which come in without an introduction. Instead, they rely ontheir networks – which tend to be local – as a means of receiving deal flow which hasalready been screened for relevance and quality. As one venture capitalist quoted byZook (2005, p. 83) explained, ‘I depend on someone I know to alert me to good deals. IfI don’t know this person at all and if they’re coming in totally cold, they have to say some-thing really compelling to get me to look at it.’ Moreover, venture capitalists can place ahigh level of trust in the quality of these referrals because these organizations and indiv-iduals concerned are putting their reputation on the line when they refer deals to venturecapitalists.

Deal evaluation. The outcome of the initial screening is a much smaller number ofopportunities which the investor thinks have potential. These undergo a detailed evalu-ation. As Banatao and Fong (2000, p. 302) observe, ‘at this stage the venture capitalist’scontacts in his Palm Pilot are his best friend.’ Venture capitalists use their extensive con-tacts to research the background of the entrepreneurs, the viability of the market, likelycompetition already in place or on the horizon and protection of the intellectual property.At the start-up and early stages of investing, considerable emphasis is placed on thepeople. What have they done? Are they credible? Do they have the right integrity andethics? This is particularly the case in situations where the investor believes in the tech-nology but there is no industry and market (von Burg and Kenney, 2000). In such situ-ations – before a dominant design or standard has emerged – venture capitalists ‘have tobet on the entrepreneurs presenting the business plan’ (von Burg and Kenney, 2000,p. 1152). It is easier and quicker for a venture capitalist to check an entrepreneur’s résuméif he or she is local, by using their own knowledge and local connections. The quality ofinformation is also likely to be better (Zook, 2004). Several Ottawa-based venture cap-italists commented on how easily due diligence could be done on a local entrepreneur(Harrison et al., 2004, p. 1064):

This is a community where most of the people are spin-outs of spin-outs. Two phone calls andI can find out everything . . . For the most part, you are dealing with teams and at least some ofthe team members come from the Ottawa community . . . Because I have six or seven investmentsin semiconductors, there are not many people in the Ottawa area in the semiconductor industrythat I don’t already know or know someone who knows them, or who has worked with them inthe past and so on.

Ottawa is a small town, so typically the individual worked at Nortel at some stage in his careerand you can find someone who worked alongside him at one point.

I look at where they worked . . . If they’ve worked at half a dozen places there’s got to be one ofthose places where I know somebody.


So, as Zook (2005, p. 81) notes, ‘limiting investments to nearby firms produces easierand faster access to an entrepreneur’s references, which can often be double-checked by aventure capitalist’s own personal connections and knowledge.’

Post-investment relationships. The local focus becomes even more important once aninvestment is made. Venture capitalists not only provide finance; they also monitor theperformance of their investee companies to safeguard their investment, usually by takinga seat on the board of directors, setting goals and metrics for the companies to meet andsupporting their portfolio companies with advice and mentoring in an effort to enhancetheir performance. They may even play a role in managing the company in the case ofscientist-led young technology businesses. Supporting and monitoring their investments –which is an important part of managing the risk and accounts for a significant propor-tion of a venture capitalist’s time – also emphasizes the importance of proximity. Eventhough some forms of support do not require close contact there will nevertheless bemany occasions when face-to-face contact is required and the venture capital firm willincur high costs each time a non-local firm is visited. It is undoubtedly the case that geo-graphical proximity plays an important role in both the level and quality of support thatbusinesses are able to obtain from their venture capital investors (Zook, 2004; 2005). First,venture capitalists can work more closely with their investee companies in their supportand advisory roles when they are located nearby. Second, venture capitalists have abun-dant contacts and deep knowledge of particular industries: providing referrals to thesesources of expertise is an important value-added contribution that venture capitalistsmake. This social network is more readily tapped when investee businesses are geograph-ically proximate to the venture capitalist (Powell et al., 2002; Zook, 2005). Third, a furtherbenefit which accrues when the venture capitalists and investee businesses are geograph-ically proximate is that ‘unplanned encounters at restaurants or coffee shops, opportun-ities to confer in the grandstands during Little League baseball games or at soccermatches, or news about a seminar or presentation all happen routinely . . .’ (Powell et al.,2002, p. 294). In short, it is precisely because venture capital is more than just the provi-sion of capital that geographical proximity is important (Hellman, 2000, p. 292).

Summary. In their efforts to minimize risk and uncertainty venture capitalists place aheavy reliance on their network of contacts to source quality deals, evaluate these deals,provide timely assistance to their portfolio companies and monitor their performance.This favours local investing because all of these activities become increasingly difficult toundertake over long distances (Zook, 2005).

Venture capital as a location factorThis strong emphasis on local investing by venture capital firms can also attract businessesfrom other regions where venture capital is lacking and which are seeking to raise finance.This is well illustrated by Zook (2002; 2005) in his account of the geography of Internetbusinesses. He notes that the importance of obtaining venture capital, combined with itslimited mobility, was a significant factor in encouraging Internet entrepreneurs in otherparts of the USA to move to the San Francisco area during the emergent phase of theindustry in the 1990s, either prior to starting their business or soon after founding a busi-ness elsewhere. A mix of both push and pull factors lay behind this trend. First, theventure capitalists in San Francisco were very receptive to approaches for funding byInternet entrepreneurs in this period: those ‘venture capitalists who had been scanning for


the next promising breakthrough jumped on the opportunity of the internet and beganto fund and be approached by a wide variety of internet entrepreneurs’ (Zook, 2002,p. 162). However, venture capitalists in other locations often ‘didn’t get it’ – they did notknow, understand or believe in the Internet industry – and so were more likely to rejectfunding proposals from Internet entrepreneurs. Second, the lesson from the successes ofNetscape and Yahoo! was the importance of speed to market in order to secure first-mover advantages. Thus, the strategy of Internet entrepreneurs during the Internet frenzyof the late 1990s was to ‘get big fast’. This required raising venture capital so that theycould quickly scale-up, hiring the resources, developing routes to market and so on inorder to gain competitive advantage. Internet entrepreneurs also recognized the value thatventure capital investors could add through their networks and knowledge. However,‘smart money’ in particular invests close to home (Zook, 2005). Thus, location became astrategic choice for Internet entrepreneurs: ‘entrepreneurs had to go to Silicon Valleybecause that was where the money was’ (Zook, 2005, p. 61).

Demand-side factorsUntil now the discussion has been considering supply-side factors as a reason for thegeographical concentration of venture capital investing. However, the presence orabsence of venture capital also influences the demand side. A further consequence ofthe localization of venture capital firms and their investment activity is that knowledgeof venture capital investing varies from place to place (Thompson, 1989). This, in turn,has implications for the demand for venture capital (Martin et al., 2005). Knowledgeand learning about venture capital will spread through the local business community inareas where venture capitalists are concentrated. Thus, both entrepreneurs and inter-mediaries, including accountants, bankers, lawyers and advisers, will have a greaterunderstanding of the role and benefits of venture capital, what types of deals venturecapitalists will consider investing in and the mechanics of negotiating and structuringinvestments. And, as noted earlier, the connections that lawyers, accountants and othershave with venture capital firms means that the businesses that they refer for funding willbe given serious consideration. The overall effect is to raise the demand for venturecapital in locations where venture capital is already established. As Martin et al. (2002,p. 136) observe:

A strong mutually reinforcing process seems to be at work: venture capitalists emerge anddevelop where there is a high level of SME – and especially innovative SME – activity and thisin turn stimulates further expansion of the local venture capital market which in turn contributesyet further to the formation and development of local SMEs, and so on.

In areas which have few or no venture capital firms, in contrast, knowledge amongstentrepreneurs and the business support network will be weak and incomplete, intermedi-aries will lack connections with venture capital firms and, perhaps most significantly ofall, will be less competent in advising their clients on what it takes to be ‘investable’. Theeffect is to depress demand for venture capital.

Long distance investingThe discussion thus far has emphasized the localized nature of venture capital investing.However, it is important to recognize that long distance investing also occurs.


The effect of long distance investing is actually to reinforce the geographical clusteringof venture capital investments, rather than producing a more dispersed distribution ofinvestments, because it ‘flow[s] mainly to areas with established concentrations of hightech businesses’ (Florida and Smith, 1992, p. 192). The best evidence on venture capitalflows is by Florida and Smith (1991; 1992) for the USA. They note that venture capitalfirms that are based in financial centres such as New York and Chicago make most of theirinvestments in distant places, typically high-tech regions. This contrasts with the venturecapital firms in these high technology regions which make a high proportion of theirinvestments locally, although some long distance investing occurs. Powell et al. (2002) sim-ilarly note for the biotechnology industry that New York money invests in Boston, SanDiego and the rest of the country whereas both Boston and San Francisco investors tendto invest within-state. Likewise, in Germany venture capital firms in the major clusters ofventure capital make a significant minority of their investments in the Bayern region,centred on Munich which is a major technology cluster. Indeed, Bayern is the second mostimportant region, after their own local region, for investments by venture capital firms,accounting for 29 per cent of investments by Hamburg-based venture capitalists and by25 per cent of those based in Dusseldorf (Martin et al., 2005).

The key point is that long distance venture capital investments typically occur in thecontext of the syndication of investments between non-local and local investors (seeWright and Lockett, 2003 and Manigart et al., 2006 for discussions of syndication inventure capital). Sorenson and Stuart (2001, pp. 1582–3) have observed that ‘venturecapitalists expand . . . their active investment spaces over time . . . primarily throughjoining syndicates with lead venture capitalists in distant communities.’ Syndicationarises because young, growing businesses – particularly technology businesses –typically require several rounds of investment before they are successful, with eachround involving larger amounts. However, venture capital firms seek to mitigate riskthrough diversification, investing in a portfolio of businesses, some of which they hopewill be successful, offsetting the losses from unsuccessful investments. Clearly, the initialinvestor would cease to have a diversified portfolio if it continued to provide all of thefunding that a business needed. Investee businesses also benefit from having additionalinvestors co-funding later rounds because they are able to access a wider range of value-added skills. Indeed, their initial investor’s value-added skills may be more appropriateto businesses at their start-up or early growth, whereas businesses which have success-fully negotiated this stage will require a different set of value-added contributions whichtheir initial investor may not possess. Because of the presence of a local lead investordistance is not important to these later stage co-investors, who themselves can either belocal or non-local. They are willing to trust the local venture capital fund to undertakethe deal evaluation, monitoring and support functions, including taking a seat on theboard, leaving them to take a purely passive role. If the long distance investors do con-tribute value-added functions then they are of a type that does not require close con-tacts with the investee business. There is a strong reciprocal effect in syndication, withthe local investor likely to be invited by the other venture capitalists into deals that theylead, which serves to reinforce the trust factor. Thus, syndication is a particular featureof longer established venture capital firms. Florida and Kenney (1988a, p. 47) suggestthat ‘investment syndication is perhaps the crucial ingredient in the geography of theventure capital industry.’


Venture capital clusters and technology clusters: the case of OttawaIt is widely thought that the local availability venture capital is critical in incubating andsustaining entrepreneurially-based high-tech clusters. As DeVol (2000, p. 25, emphasisadded) comments: ‘by financing new ideas venture capitalists are catalysts instrumentalin building a cluster as they provide a means for new firms to be formed.’ In other words,it is suggested that a well functioning venture capital infrastructure is required for aregional technology cluster to develop. But this contradicts evidence from Silicon Valley(Saxenian, 1994) as well as other clusters such as Ottawa (Mason et al., 2002), WashingtonDC (Feldman, 2001) and Cambridge (Garnsey and Heffernan, 2005) that venture capitallags rather than leads the emergence of entrepreneurial activity. However, venture capitalis needed for the sustained growth and development of a cluster (Llobrera et al., 2000):without venture capital a cluster is likely to stagnate or decline (Feldman, 2001; Feldmanet al., 2005).

The Ottawa technology cluster: an overviewThis process is illustrated by Ottawa, Canada’s capital city, which is one of the mainregions for venture capital investing in Canada. (See Shavinina, 2004 for an overview ofOttawa’s technology cluster.) It currently has around 1500 technology companies whichemploy around 70 000 workers (down from a peak of 85 000 at the peak of the technologyboom in 2000). Over 75 per cent of Canada’s telecoms R&D is undertaken in Ottawa. Itis the location for several of the federal government’s R&D facilities and is also the homeof many leading private sector technology companies, including Nortel Networks,Newbridge Networks (acquired by Alcatel in 2000), Corel Corporation, JDS-Uniphaseand Mitel Corporation – although many of these companies underwent substantialretrenchment during the post-2000 technology downturn. Nortel undertakes a large shareof its worldwide research in Ottawa. Recognition of Ottawa as a centre for telecoms tech-nology has led to global companies such as Cisco Systems, Nokia, Cadence DesignSystems and Premisys Telecommunications seeking a presence in the region during the late1990s either through greenfield site development or the acquisition of local companies.

Ottawa’s emergence as a high technology cluster is largely attributable to the start-upand growth of entrepreneurial companies over the past 40–50 years. Its origins date backto the early post-war period with the founding of Computing Devices of Canada Ltd in1948 as a spin-out from the government’s National Research Council (NRC) Laboratoriesto produce military computer hardware. Both NRC and other Government research labshave been the origin of many other spin-outs since then. A further significant buildingblock was the decision of Northern Telecom (the forerunner of Bell Northern Researchand later Nortel Networks) to move its R&D facilities from Montreal to Ottawa in the1950s. This facility has gone on to become one of the largest and most innovative telecom-munications research centres in the world, although it has contracted since 2000. It hasalso been a significant source of spin-outs over the years. A further boost to the clusteroccurred in the mid-1970s with the closure of Microsystems International – a subsidiaryof Northern Telecom – one of the earliest developers of semiconductor technology fol-lowing a temporary downturn in the chip business. The company had attracted a largenumber of highly skilled IT engineers and scientists to Ottawa. Following the closuresome of the redundant workers started their own companies. More than 20 start-ups canbe attributed to former Microsystems employees.


Venture capital in the early stages of cluster developmentThe key point is that the initial emergence and early growth of Ottawa’s technologycluster occurred in the absence of local sources of venture capital. One observer notedin 1991 that compared to technology clusters in the USA, ‘Ottawa is conspicuous byits . . . low venture capital investment’ (Doyle, 1991). Indeed, prior to the 1990s the onlysources of venture capital in Ottawa were provided by Quebec lumber companies whichbegan to invest in local high-tech companies in the 1960s. One of these companies wasacquired by Noranda which went on to create Noranda Enterprises, Ottawa’s firstventure capital company, in the late 1970s. Noranda ‘participated in nearly every suc-cessful high technology company that was ever formed in the Ottawa-Carlton Region’(Doyle, 1993, p. 12). However, Noranda and the other investors provided expansioncapital. The only source of start-up finance was therefore from business angels.3 Asurvey of high-tech start-ups founded since 1965 (but primarily between 1978 and 1982)found that few had raised external finance, none had raised venture capital and the mostimportant source of funding was the personal savings of their founders (Steed andNichol, 1985).

As recently as 1996 the Canadian Venture Capital Association (CVCA) directorylisted just two venture capital companies in Ottawa: a branch office of the BusinessDevelopment Bank, a Crown Corporation which provides both debt and equity financeto Canadian SMEs via a network of branch offices, and Capital Alliances, a LaborSponsored Venture Capital Fund, started by the former managing partner of NorandaEnterprises which had closed in the early 1990s.4 Moreover, venture capital firms in otherparts of Canada and the USA showed no interest in investing in Ottawa. The 1997 OttawaVenture Capital Fair was the first to attract non-local investors. For much of the 1990sthe only significant supplier of venture capital in Ottawa was Newbridge Networks,founded in 1986 by the entrepreneur Terry Matthews (who had previously co-foundedMitel with Michael Cowpland who went on to found Corel). Newbridge was acquired byAlcatel in 2000. The Newbridge Affiliates Programme was essentially a form of corporateventure capital. The affiliates were companies developing products that were compatiblewith Newbridge equipment and so could leverage Newbridge’s sales force. The affiliatesprogramme provided these companies with direct investment by Newbridge and also byMatthews himself, as well as mentoring and ongoing support, including back office func-tions. The affiliates programme was wound down in the late 1990s. However, Matthewscontinued his involvement in venture capital by establishing Celtic House, initially withoffices in Ottawa and London, but it subsequently opened a further office in Toronto. Hewas the only investor in the first fund but Celtic House’s second and third funds haveraised funding from a variety of investors.

The recent boom in venture capital investingThe availability of venture capital in Ottawa has been transformed since the late 1990s.Indeed, $1.2 billion (Can) was invested in Ottawa-based businesses in 2000, equivalent to25 per cent of the Canadian total, four times larger than the 1999 figure and seven timesbigger than in 1997. The post-2000 tech-downturn has seen a drop in the scale of venturecapital investment (in part linked to declining valuations). Nevertheless, even in the down-turn Ottawa continued to attract a disproportionate share of Canadian venture capitalactivity.


This growth in venture capital investing has two sources. First, there has been anincrease in the number of Ottawa-based venture capital funds, including several localfunds (in many cases started by ex-Newbridge staff who had been involved in the affiliatesprogramme) and branch offices of Canadian venture capital funds. In addition, otherCanadian and US venture capital firms put people on the ground to act as their ‘eyes andears’. Second, a number of investors based elsewhere in Canada and the US – notably inToronto and Boston – started investing in Ottawa-based businesses. In most cases – andespecially in the case of US investors – these investors have been brought in by the ori-ginal investors to provide second or third round funding.

Accompanying this growth in venture capital investing has a significant expansionin the population of business angels. This has been a direct consequence of the manysuccessful, cashed-out entrepreneurs since the mid-1990s and the large number ofsenior executives from the large company sector (for example Nortel, Newbridge,JDS-Uniphase) who have made significant money from stock options, Moreover, theseangels – unlike those who funded earlier generations of technology start-ups such as Miteland Lumonics – are technologically savvy and are investing in areas that they understandso that they are able to bring commercial know-how to support the entrepreneurs thatthey are funding. One of the value-added contributions that business angels can provideis to make introductions to venture capital funds. Indeed, Madill et al. (2005) noted that57 per cent of technology-based firms which raised angel financing went on to raisefinance from venture capital funds; in comparison, only 10 per cent of firms that had notsecured angel funding obtained venture capital. This reflects the role of business angels inbuilding up start-up companies to the point where they become ‘investor ready’. The repu-tation of a business angel can also be a positive signal to venture capital funds. Indeed,one local venture capitalist observed that he has invested in firms ‘largely because of thequality of their angels’ (quoted in Mason et al., 2002, p. 267).

There are four interrelated factors which account for this recent interest amongst venturecapitalists in investing in Ottawa (Mason et al., 2002). First, several contextual factorsfavoured Ottawa. The venture capital industry experienced a boom in fund raising in thesecond half of the 1990s, fuelled by a ‘hot’ IPO market and an active takeover market foryoung technology companies. Thus, there was plenty of money looking for profitableopportunities. In particular, US venture capitalists were finding that the money they had toinvest was outstripping the investment opportunities available locally, so they began to lookfurther afield (cf. Green, 2004). One of the key sectors in which venture capitalists wereinterested in was communications – voice, data, telephony and infrastructure businesses.These were precisely the sectors in which Ottawa was strong. Venture capital firms whichspecialized in communications technology recognized that Ottawa has an international rep-utation for world class technology in this area and knew that they could not overlook theregion as a source of potential opportunities. Two of Ottawa’s own venture capital funds –Celtic House and Skypoint Capital – also specialize in communications technology.

Second, the sale of three young venture capital-backed companies in 1997 and 1998 forwhat at the time were extremely high valuations demonstrated to the venture capital com-munity that, in the words of one local investor, ‘Ottawa is a great place to make money.’A further important consequence was that the monetary rewards of the entrepreneurs andstaff in these companies (through stock options) had a dramatic effect on the attitude ofengineers in the large companies, making them much more positive about starting, or


working in, a young technology company. Hence, it became much easier for venturecapitalists to attract people from major local companies to build strong start-up teams.

Third, the success of global companies based in Ottawa, such as Nortel, JDS-Uniphaseand Newbridge Networks, gave the region high visibility for the quality of its technologyand engineers. This attracted the attention of US venture capitalists in particular, givingOttawa-based entrepreneurs the credibility to get a hearing from venture capitalists. Oneformer local economic development official responsible for Ottawa’s Venture Capital Fairnoted that ‘when [entrepreneurs] call and say, “we’re from Ottawa and we’re working inthis area”, they get attention . . . because Ottawa is now really on their map.’ He went onto quote from a US venture capitalist who told him that ‘if you see a deal involving ex-Nortel guys, I want to see it.’ Indeed, by the late 1990s US venture capitalists were visit-ing Ottawa ‘looking for ex-Nortel engineers or whatever engineers and funding theirideas.’ Interestingly, Boston-based venture capitalists have invested in Ottawa despitehaving no physical presence there. However, the flight time is only an hour and a half –and because of Ottawa’s small size could quickly get plugged into the local networks.

Finally, Toronto-based venture capitalists also invested in Ottawa from a distance.Ottawa is an hour’s flying time from Toronto, close enough for Toronto-based venturecapitalists to do a day’s business. However, by the late 1990s many Toronto-based venturecapitalists were finding this model of investing to be problematic. They were unable tomatch the valuations paid by US venture capitalists for young technology companies.Moreover, the large size of many US funds meant that they did not need to syndicate thedeal, thus excluding Canadian venture capital funds from the investment. This promptedthe recognition amongst Toronto venture capitalists that they needed to invest at anearlier stage, ahead of the US investors, and therefore to already be an investor in com-panies when they raised a subsequent round of finance. To do this required a local pres-ence in order to improve their deal referral sources.

The Ottawa example therefore suggests that a technology cluster requires a previouslyestablished technology base comprising R&D activities, out of which emerge the first gen-erations of technology companies which get funded by local, usually non-specialist,investors. However, it takes time to build a technology cluster capable of generatingleading edge ideas, with an entrepreneurial culture and which can support the emergenceand growth of world class companies that will generate high returns for investors. Butonce venture capitalists recognize this they will be attracted to invest.

Conclusion

SummaryThis chapter has drawn attention to the strong geographical effects that characterizeventure capital investing, contradicting the economist’s concept of perfectly mobilecapital markets (Florida and Smith, 1991). Although venture capital firms can, and do,raise their investment funds from anywhere, there are strong geographical constraints onwhere they make their investments. First, investing locally is a way of minimizing uncer-tainty and reducing risk in identifying and evaluating investment opportunities and sup-porting their investee companies. In particular, the hands-on involvement of venturecapitalists encourages local investing. These considerations may also encourage therelocation of new firms seeking finance from other regions which lack venture capital.


Second, a significant proportion of venture capital is invested over long distances.However, because this investment is typically made alongside other venture capital firms,and requires a local investor to coordinate the syndicate and undertake the distance sen-sitive functions, it is highly constrained in where it can flow. Indeed, most long distanceventure capital investments flow to major high-tech clusters which already contain sig-nificant clusters of venture capital firms and investment activity. The effect is therefore toreinforce the geographical concentration of venture capital investing. It is for these samereasons that regions which lack local venture capitalists will encounter difficulties inaccessing venture capital from afar. Third, the concentration of venture capital investingcreates a virtuous circle in which knowledge and learning about venture capital spreadsto local entrepreneurs and intermediaries, resulting in increased demand for venturecapital. The exact opposite occurs in venture capital deficient regions where knowledgeand understanding of this type of finance in the business community will be weak, soentrepreneurs will be less inclined to seek it and intermediaries will be less competent ingetting their client’s investment ready.

Given the positive effect that venture capitalists have on new firm formation andgrowth, as both capitalist and catalyst, the effect of the geographical clustering of theirinvestments, in turn, contributes to uneven regional economic development. In the caseof Silicon Valley, for example, proximity to abundant sources of venture capital enablesfirms to raise finance at a younger age, complete more funding rounds and raise moremoney at each round. This translates into better performance: faster growth, profitabil-ity, greater employment and a high likelihood of achieving an IPO.5 By having early accessto venture capital this gives start-ups substantial first-mover advantages, enabling pioneerfirms to transform ideas quickly into marketable products and become industry leaders(Zhang, 2006).

Future research directionsThe geographies of venture capital have been largely ignored by those scholars who haveapproached the topic from entrepreneurial and finance perspectives. The subject has alsoattracted surprisingly limited attention from economic geographers despite the growinginterest in the geography of money (Martin, 1999; Pollard, 2003). Hence, many significantresearch questions need to be addressed. It is inevitable that any research agenda is per-sonal and idiosyncratic. Based on the material that has been reviewed in this chapter, fivetopics are identified as priorities for further research.

First, considering business angels, there is a need for research which can ‘put bound-aries on our ignorance’ (Wetzel, 1986, p. 132): for example, better quality statistical infor-mation on the locational distribution of business angels, the characteristics of businessangels in different locations, the circumstances in which long-distance investments occur(assessing the roles of investor characteristics, investment characteristics and local envir-onment), and how angels who make long-distance investments mitigate the locationalchallenges. These are fairly straightforward questions but pose considerable challengessimply because of the difficulties in obtaining comprehensive statistical information onbusiness angels and their investment activity.

Second, most geographical analyses of venture capital investing have used highly aggre-gate data. Future studies need to make use of databases, such as Thomson Financial’sVenture Expert Database, which contains a range of information on companies which


have received venture capital, and their investors, thereby permitting a much greater rangeof geographical questions to be explored.

Third, moving from the macro scale, and quantitative data, to the micro-scale andqualitative data, there is a need for greater insights into the way in which both businessangels and venture capital firms factor location and distance into their investment deci-sions. Even though most investors – particularly those who specialize in early stage invest-ing – emphasize the importance of investing locally, ‘exceptions’ are not hard to find(Mason and Rogers, 1996). This might suggest that the location of the potential investeeis a compensatory factor, waived if other aspects of the investment are particularlyfavourable. This is likely to require ‘real time’ research methodologies. More generally,there is a need to explore the spatial biases of investors which influence their attitudes toinvestment opportunities in different locations.

Fourth, there is a need to tease out the connections between venture capital and tech-nology clusters. There are two particular issues. The first concerns the popular view thatventure capital is a pre-condition for the emergence of technology clusters. This chapterhas highlighted the case of Ottawa, and cited several other studies, which clearly demon-strate that venture capital lags cluster development, with the funding of the early genera-tions of spin-off companies being undertaken by various actors, including business angels,established companies and government, and subsequently may attract venture capitalistslocated in other regions who make and monitor their investments on a fly-in, fly-out basis.Local sources of venture capital only emerge when a critical mass of entrepreneurialactivity is reached, the cluster develops an identity of its own, entrepreneurial successstories begin to emerge and the quality of the region’s technology is recognized. Moreresearch is needed to explore these processes.

The second concerns the process of knowledge spillovers in clusters. Firms that arelocated in clusters derive competitive advantages by gaining rapid access to knowledge oninnovation, production techniques and competitive strategies of other firms. This know-ledge, which is tacit and therefore difficult to transfer, circulates mainly by inter-personalcontact. Research has tended to focus on three main processes: the mobility of technically-qualified workers within the local labour market, the spin-off process, involving individu-als or teams leaving their existing employers to start new businesses, and various forms ofcooperative behaviour between firms in the cluster (for example suppliers, sub-contractors,strategic alliances). It has not considered the role of venture capitalists as either a genera-tor or diffuser of information. However, as this chapter has emphasized, venture capital-ists sit at the centre of an extended network in which they share information with otherinvestors, entrepreneurs, corporate financiers, head-hunters, consultants and experts. Thisprovides them with deep knowledge about likely technological and market trends in par-ticular industries which they draw upon to make decisions on what to invest in and whatnot to invest in, and supporting their portfolio of investee companies. How this shapes thetrajectory of technology clusters is an important issue for research.

Finally, the venture capital industry is dynamic and as it has matured it has becomemore heterogeneous. Research therefore needs to avoid extrapolating from what happensin Silicon Valley, or even the USA and to examine venture capital investing practices indifferent regions. There is also a need to recognize that investment processes and practiceschange over the course of the investment cycle and that this produces different geogra-phies (as Green, 2004, demonstrated). Research must also distinguish between ‘venture


capital’ – which can be defined as investing in new and growing entrepreneurialbusinesses – and ‘private equity’ – which involves investing in established companies whichtypically require restructuring and often takes the form of management buy-outs (MBOs)in which the incumbent management along with the investors purchase their division orsubsidiary from the parent group to become co-owners. Venture capital and private equityhave different geographies (Mason and Harrison, 2002) and their local and regionalimpacts are also very different. Fundamentally venture capital is providing finance whichis used for investment in growth whereas private equity is providing finance to enable own-ership change to occur. Moreover, private equity deals are typically highly leveraged – inother words, they have a high long-term debt component which is secured against thefuture cash flows of the business to pay shareholders. Such businesses have to generatecash in order to service this debt. This might involve asset sales. If they are unable toservice the debt then they will have to cut back on investment which may lead to loss ofmarket share and, in turn, to a decline in operating efficiencies and ultimately to financialdistress. Wrigley (1999, p. 205) has shown in the case of the US retail sector that the trans-formation of the capital structures of firms can have

vital implications for the economic landscape, both directly, through the spatial reorganisationof the activities of the high-leveraged firm, and indirectly, through the restructuring of marketsby rival firms responding to the commitments implicit in those transformations. . . . Divestiture,market consolidation and avoidance . . . spatial predation, market entry, expansion and exit . . .and competitive price response by rival firms . . . are just some of the outcomes.

Researchers also need to be alert to the changing nature of the venture capital indus-try. Two trends are particularly significant. First, venture capital has been growing in pop-ularity as an asset class amongst financial institutions. One of the consequences is thatfunds have substantially larger amounts of money under management. This, in turn, hasdriven up both the minimum and average size of investments and led to an increasingemphasis on later stage investments in established businesses which have larger capitalneeds than start-ups. Second, there has been a shift from generalist to specialist investorswho focus on specific industry ‘spaces’ (either vertical or horizontal). Both trends can beexpected to have geographical consequences, notably a weakening in the significance oflocal investing (Mason et al., 2002).

Policy implicationsThe evidence concerning the catalytic effect which venture capital has on business start-up and growth has prompted governments to see venture capital as an essential ingredi-ent in their efforts to promote technology-led economic development in lagging regions.However, as Florida and Kenney (1988b, pp. 316–17) observed, ‘simply making venturecapital available will not magically generate the conditions under which high technologyentrepreneurship will flourish.’ In similar vein, Zook (2005) comments that ‘simplypumping additional capital into a region will not necessarily produce the dynamism ofestablished venture capital centres.’ First, as Venkataraman (2004) notes, venture capitalneeds to be combined with talented individuals – typically business executives who cangenerate and develop novel ideas, start companies, make the prototype, obtain the firstcustomer, develop products and markets and compete in the rough and tumble of com-petitive markets. This, in turn, will generate some successes which provide the role models


for others. Without such a flow of high risk–high return businesses, private sector venturecapitalists will not invest, and wealthy local investors will shun becoming business angelsand invest in other asset classes instead. Second, it has been repeatedly emphasized thatproviding money is only part of the role of venture capitalists. Hence, using public moneyto create ‘venture capital’ funds which are staffed by managers who lack the value-addedskills of venture capitalists will be ineffective. According to Venkataraman (2004, p. 154)the money will flow ‘straight to low-quality ventures’. However, as the example of Ottawahighlighted, regions which do offer good investment opportunities will attract venturecapital. The implication for venture capital-deficient regions is therefore clear. Trying arti-ficially to create a regional pool of venture capital is likely to be ineffective. Venture capitalwill only be attracted to places with novel ideas and talented individuals (Venkataraman,2004). Instead, policy-makers should concentrate on developing the region’s technologybase, encourage business start-up and growth, and enhance the business support infra-structure. Specifically this means investing in the region’s research institutions to developknowledge in which they have some comparative advantage – to attract talented indivi-duals from other regions and generate a steady flow of novel technical ideas – and initia-tives which enhance the entrepreneurial culture of the region and raise the entrepreneurialcompetences of the population (Venkataraman, 2004). As one long-term participant andlatterly an observer of Ottawa’s high-tech cluster observed, referring to venture capital-ists: ‘if you build it they will come’ (quoted in Mason et al., 2002, p. 277).

AcknowledgementsI am grateful to Hans Landström for his insightful comments on earlier drafts of thischapter. It was completed while in receipt of a Visiting Erskine Fellowship at theUniversity of Canterbury, New Zealand. I am most grateful to the University ofCanterbury for the award of this Fellowship.

Notes1. Notably private equity firms which invest in large companies to facilitate their restructuring.2. Vancouver, Victoria, Kitchener-Waterloo, Calgary, Edmonton, Ottawa, Greater Toronto Area, Montréal

and Québec City. These cities accounted for 45 per cent of Canada’s population at the 2001 Census ofPopulation.

3. For example, Mitel was started with seed money from local lawyers while Lumonics raised its money fromlocal businessmen (‘retailers, lawyers and car lot owners’: Mittelstaedt, 1980).

4. Noranda Enterprises – the only Ottawa-based venture capital company listed in the 1992 CVCA directory –was closed down in the early 1990s following acquisition of the parent company in the late 1980s. Its newowners saw it as a resources company and so in 1992 closed its investment activities (despite having achieveda 38 per cent compound rate of return to shareholders: Doyle, 1991; 1993).

5. However, venture capital-backed firms in Silicon Valley also have lower survival rates. Zhang (2006) sug-gests this may reflect the lack of prudent screening. A more plausible explanation may be the competitionbetween venture capital firms for investment opportunities leading to over-investment in specific markets.

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4 Venture capital and government policyGordon C. Murray

Introduction

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

The above quote is taken from a contemporary evaluation of public venture capital activ-ity in New Zealand. It is one of a number of formal reviews of early-stage venture capitalactivity that have recently been concluded by government policy makers with the assist-ance of academic researchers.1 The authors of the New Zealand evaluation suggest that,despite venture capital being a financing instrument most widely associated with the‘animal spirits’ of the free market and of entrepreneurial agents unrestricted by publicinterference, the state may well have an important role in both initiating risk capital pro-grams as well as providing a conducive environment for the seeding and commercialgrowth of such activity.

This view of the importance of government commitment to entrepreneurial action,particularly in nascent (usually new knowledge or new technology-derived2) industries,has support from several academic researchers (Bottazzi and Da Rin, 2002; Lerner, 2002;Gilbert et al., 2004; Page West III and Bamford, 2005) who see evidence of a significantincrease of public initiated and financed venture activity on an international scale.Venture capital and the role of public actors may be seen as one part of such a wider move-ment to support new enterprise. These authors suggest that the logic behind this growthof activity is a widening appreciation of entrepreneurship policies ‘as one of the mostessential instruments from economic growth . . . for a global and knowledge-basedeconomy’ (Gilbert et al., 2004, p. 321). More tangible roles for public intervention aregiven by, among others, Lerner, 1999; Jeng and Wells, 2000; Keuschnigg and Nielsen,2001; 2002; Keuschnigg, 2003. They emphasize the importance of government in settingthe supportive legal and economic framework conditions necessary for risk capital activ-ity to flourish. Similarly, Audretsch and Keilbach (2004) see the entrepreneurial catalystas the ‘missing link’ in endogenous economic growth theory. Entrepreneurs become thecritical conduit for knowledge spillovers and the subsequent creation of valuable newproducts and services.

However, academic support for a public role(s) in developing early-stage venture capitalmarkets is, at best, conditional and cautionary (Lerner, 1998). Successful policy makerswill have to act with a deft hand. There is plentiful evidence that governments are at leastas likely to produce overall negative effects by their involvement in markets as they areto engineer a lasting improvement in market conditions (Gilson, 2003; Armour andCummings, 2006). Economists are particularly circumspect regarding micro-policy inter-ventions at the ‘black box’ level of the firm or venture capital fund. Their preferred

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prescriptions are more anonymously concerned with removing market barriers thatimpede individual agents (for example business angels, venture capital firms or entrepre-neurs) from pursuing their own commercial interests. But the involvement of governmentin risk capital markets presumes some form of serious and persistent market failure.Determining the importance or even existence of market failures will, in turn, require aview of both demand and supply-side efficiencies. The difficulty of determining marketfailure, despite its widespread presumption in entrepreneurship finance policy initiatives,is noted below.

Academic and policy interests closely reflect the rapidly growing importance of venturecapital activity at both national and international levels over the last 25 years.Governments’ recent endorsement of venture capital’s status as an important instrumentof entrepreneurial and innovation policy has been particularly noteworthy in Europe(EC, 1998; 2001; 2003a; 2003b; 2005b; 2006a; 2006b; Murray, 1998; Martin et al., 2003).3

A profusion of contemporary public schemes is also indicative of governments’ contin-gent response to the rapid reduction in supply of early-stage risk capital after the year2000 collapse in technology markets (Sohl, 2003). High potential young firms were amongthe first casualties of the changing market conditions at the start of the present century.In several European markets, publicly supported funds were quickly to become one of themost important and continuing sources of risk capital for new enterprises in the hiatus

of privately-funded, institutional and informal venture finance following the dot.comcollapse (Auerswald and Branscomb, 2003; EC, 2004; NEFI, 2005; Small BusinessService/Almeida Capital, 2005).

It would be incorrect to assume that venture capital is exclusively Anglo-Saxon in itsnature or distribution although a strong association exists between countries in theformer British Empire and the international centers of venture capital activity. Nascentor growing venture capital industries now exist in virtually all developed economies inthe world. They are frequently encouraged by government action. Similarly, policymakers in the emerging economies of China, Russia, and Brazil are also now exploringthe development potential of risk capital.4 India already has an established venturecapital community.5

Despite the assumption that venture capital is a suitable subject for policy action,surveys of SME finance repeatedly show that entrepreneurs’ receipt of risk capital fromprofessional investors is an extremely rare event. Reynolds et al. (2003) ‘guesstimate’ thatless than half a per cent of all nascent entrepreneurs receive either venture capital or busi-ness angel finance at start-up. A 2004 survey of UK SMEs showed that less than 2 percent of respondents had ever raised institutional venture capital (Small Business Service,2005). A similar percentage has been recorded in Europe (see European Commission,2005a). Given that the UK has the largest and most advanced venture capital/privateequity industry in Europe, it is probable that other countries are unlikely to register sig-nificantly greater risk capital activity among their young firms. European studies confirmthis reality of the scarcity of venture capital receipt (European Venture CapitalAssociation, 2005).

Early-stage (‘classic’) venture capitalists primarily target technology-based young firmsbecause of their potential for very rapid growth in attractive and immature markets. Yet,in a 1997 survey of 600 high-tech start-ups in Germany and the UK (that is conducted atthe start of the technology bull market), Bürgel et al. (2004) found that only around 1 in


10 of UK firms had received venture capital. In Germany, this ratio went down to 1 in 14.Even in the US, Auerswald and Branscomb (2003) note that the supply of institutionalventure capital finance for technology development trails significantly behind businessangels, corporations and the Federal Government. It is salutary to note that in 2005, theUS and UK venture capital industries invested collectively in only 412 seed and start-updeals (BVCA, 2006;6 PricewaterhouseCoopers/National Venture Capital Association,2006). This is from two major world economies where, collectively, over one million newbusinesses are started every year. Thus, institutional venture capital still remains a spe-cialist financing instrument of relevance only to a tiny percentage of the population ofnew and growing enterprises in any economy. This continues to be the case even during abullish, new technology market.

This chapter will seek to summarize what consensus may be found in seeking an appro-priate role and mode of action for government in the light of the evidence of both acad-emic enquiry and policy experience. The question of why governments appear to be sointerested in venture capital will be addressed while also noting the considerable influenceof US experience. The circumstances under which government itself becomes involved ineither influencing or participating directly in risk capital investment will be explained. Thenature of policy instruments at governments’ disposal are subsequently cataloguedincluding the growing interest in ‘equity-enhancement’ programs that incentivize privateventure capital agents. The chapter will also seek to address why governments have alsobecome involved in the ‘alternative’ policy direction of supporting informal investors orbusiness angels. The chapter will conclude by suggesting future research questions of bothacademic and policy import.

Why are governments so interested in venture capital?The attraction of an established venture capital industry lies in its putative ability both tohelp finance the creation of new industries and, in so doing, to transform and reinvigo-rate mature and established economies (Apax Partners, 2006; European Commission,2006a; 2006b). The joint application of risk capital and high levels of managerial andentrepreneurial experience is seen as a particularly attractive resource combination(Sapienza, 1992) which possibly explains venture capitalists’ popularly perceived abilityto both identify and nurture exceptional new and innovative enterprises.

It is evident that the venture capital experience of the United States in the second halfof the twentieth century has exerted a huge influence on the entrepreneurship policyambitions of the majority of developed and emerging economies alike. Above all, itwas America’s unique ability to generate a stream of new companies of enormous vigorand global span from the nation’s advanced science and technology research centers.American venture capital clusters, pre-eminently Silicon Valley and Route 128, are per-ceived as the ‘gold standard’ of early-stage innovation finance systems (Bygrave andTimmons, 1992). Venture capital – both in its institutional and informal variants – is seenas part of the very fabric of the USA’s ability to remain at the forefront of knowledge pro-duction and commercialization (Edwards, 1999) through risk capital’s contribution to theentrepreneurship/economic growth link (Audretsch and Keilbach, 2004). Multi-countryfindings from the Global Entrepreneurship Monitor (GEM) further validate venturecapital ‘as playing a central role in facilitating high growth entrepreneurship’ (Reynoldset al., 2000).

Venture capital and government policy 115

Accordingly, policy goals are often crudely framed as ‘How does country X or region Ycreate the necessary conditions to replicate a Silicon Valley’ (Armour and Cumming,2006). As the emerging BIC economies7 grow their global share of the production ofmanufactured goods of increasing sophistication, high value, knowledge-based goodsand services are seen to be of growing importance for the continued prosperity of devel-oped economies. Thus, the question of how to emulate world-class examples of innova-tive and entrepreneurial excellence remains an urgent policy goal for mature Westerneconomies as traditional markets erode (Archibugi and Iammarino, 1999). In Europe,these concerns about regional competitiveness are exemplified by the Lisbon Agendawhich sought by 2010 to make Europe the most competitive world region in which toestablish and grow a new business (EC, 2004; Kok, 2004).

Despite the absence of a resolution of the question of how to create a new Palo Altoin Bavaria or a Route 128 around Helsinki, governments’ concerns for the continuedsupport of the domestic science base (including the commercialization of intellectualproperty from laboratory to successful enterprise) remain intertwined with a strong faithin the value of venture capital finance. Venture capital is as much an instrument of innov-ation policy as enterprise policy. That many governments recognize the importance ofventure capital finance is, of course, no argument that they should directly engage in suchcommercial actions. Most free-market oriented, public administrations have considerablereservations about direct state involvement in specialist financing activities. They wouldprefer to remove themselves completely from this commercial role. None the less, gov-ernments reserve the right to intervene if there is clear evidence that: 1) the supply ofappropriate finance is insufficient; 2) as a consequence, material economic and other bene-fits from entrepreneurial actions are being lost to the domestic economy; and 3) no privateinvestors will independently increase the supply of risk capital. Thus, public interventionis predicated on an ‘insufficient’ response from private capital markets.

Market failureWe have argued that, given the evolution of the venture capital industry, the competen-cies and dynamism of its professional managers and the weight of institutional moneynow at their disposal, there appears little direct role for the state. Yet, there exists a conun-drum. As the size and scale of venture capital activity has grown internationally, govern-ments have perversely become increasingly drawn into the investment process. The statehas become both a provider of public funds to private venture capital firms and, on occa-sions, an active investor directly selecting new enterprises. Governments have by defaultbeen obliged to assume responsibilities for early-stage enterprise financing activities thatmany academic and industry observers believe should better be left to efficient capitalmarkets. Their involvement in the investment process is recognition that the institutionalventure capital industry increasingly believes that early stage investments are notsufficiently attractive.

A market failure can be said to have occurred when the price mechanism fails to producea socially optimal outcome. In effect, rent-seeking investors8 being unable to capture thefull economic and social value of their investments provide less finance (venture capital)than could effectively and profitably be employed in existing opportunities. In these cir-cumstances, public intervention is one possible contingent response to private marketshortcomings (European Commission, 2001). At best, the public involvement is seen as


temporary and should be designed to be phased out as the venture capital market corrects(OECD, 2004). Yet, the term ‘market failure’ is ambiguous at best. It is frequently used,and mis-used, to argue the case for public intervention and state subsidy in areas where themarket appears to deliver less of a product or service than may be deemed desirable byinterested parties. Within the context of SME finance, there are repeated calls from entre-preneurs, small enterprise owners and their lobbyists for the state to intervene in order toencourage the providers of finance (typically banks or venture capital firms) to lend moredebt or invest more equity capital. These arguments frequently resort to some vague defin-ition of ‘public good’ and are often linked, in the case of venture capital, with argumentspromoting internationally competitive, innovation and technology policies. Rarely do suchsubmissions acknowledge that a reduction in supply of finance may be an efficient market’sreaction to an insufficient supply of attractive companies.

Thus, the term market failure is often used as a label rather than a serious argument.The specific market(s) in which the problem occurs needs to be carefully defined. Repeatedsurveys of finance for SMEs are ambiguous in their findings. For example, a large pro-portion of small business owners do not require external finance (Small Business Service,2005). A Eurobarometer survey found that over three-quarters of SMEs have sufficientfinancing and only 14 per cent of respondents put easier access to finance as their primaryconcern (EC, 2005a). However, it is the much smaller population of high potential andrapidly growing young firms that are most likely to seek external finance. These immaturefirms with, as yet, limited assets are also one group that is most likely to find finance isproblematic both in its supply and in the cost of access. This is particularly the case forknowledge-based young firms with intellectual and experiential assets that are largelyintangible and tacit. (See, for example Bank of England, 1996; Storey and Tether, 1996;OECD, 1997; Westhead and Storey, 1997; European Commission, 2003a; 2003b; Maulaand Murray, 2003; 2007.)

For policy makers, the quandary exists in determining when a constraint in the supplyof finance to a potential user is either: 1) an adverse outcome of an inefficient and/or ill-informed market; or 2) a rational and well informed judgment by an efficient market onan unattractively priced proposal. In the former case, often called ‘the equity gap’, theremay be an argument for publicly incentivizing either economic principles or agents toprovide a greater supply of debt or equity (Keuschnigg, 2003). In the latter case, the failureresides in the entrepreneur’s inability to demonstrate the attractiveness of the businessproposal. In contemporary policy vocabulary, this venture is not yet ‘investment ready’(Mason and Harrison, 2001). Here, the prescription is much more likely to be public inter-ventions to improve human capital. A ‘supply-side’ response that seeks to manipulateinvestors’ returns would not address the core ‘demand-side’ problem of poor qualityenterprises.

The longevity of the ‘equity gap’The term ‘equity gap’ has entered the policy vocabulary. It was first used in an official Britishgovernmental report in 1931 that looked at the availability and access of small and mediumsized businesses to sources of external finance. The Macmillan Report concluded that firmswere facing impediments in the search for capital that were not a function of their attrac-tiveness as individual investment opportunities. Rather, because of their size and designa-tion as small businesses, owners were facing discriminatory actions by the institutional


providers of business finance. Thus, the equity gap was conceived as a supply-side marketfailure. Successive official reports in the UK (Bolton, 1971; Wilson, 1980; NationalEconomic Development Office, 1986; Williams, 1998; Pickering, 2002; HM Treasury andSmall Business Service, 2003) over the three-quarters of a century since the MacmillanReport have broadly echoed its findings that the capital markets are frequently discrimina-tory against smaller firms.9 However, the phenomenon is not unique to one nation but uni-versal to market-based economies obliged to make judgments on partial information.

It is perhaps not the longevity of the gap that is surprising but, rather, its continuingnotoriety. That the gap remains an issue of substantive debate (HM Treasury and SmallBusiness Service, 2003) is in large part because of the changing nature of the enterprisesaffected by capital constraints. The financing problems experienced by firms which couldbe classified as ‘high-tech’ or ‘R&D intensive’ (Butchart, 1987; OECD, 1997) only gainedvisibility in the latter quarter of the twentieth century. The use of the term ‘knowledgeeconomy’ with its implication of intangible (and thus un-bankable) intellectual assets issimilarly recent (Sweeney, 1977).

Murray (1995) and latterly Sohl (1999) have both argued that the use of the term ‘equitygap’ in the singular is a misrepresentation of the harsher realities faced by the young andgrowing firm in its vulnerable years prior to the accumulation of sufficient collateral-based assets or reputation. They both suggest that there exists a second equity gap repre-sented at the stage where seed or start-up capital had been exhausted and no additionalproviders were prepared to ‘follow-on’ from the original external investor. For small early-stage venture capital funds or business angels with limited resources to fund follow-onrounds without the participation of new syndicate partners, the absence of external co-funding also severely prejudices investment performance.

This discussion implies the delineation of a range of funding which is considered to bewithin the equity gap problem. The UK government believes that the gap exists for smallfirms seeking investments broadly between £500 000 to £2 million (HM Treasury andSmall Business Service, 2003). Yet, its exact quantification remains vague and inconclu-sive. The term, and its estimation, is frequently anecdotal. More than one gap has beenidentified for more than one reason (Lawton, 2002; Sohl, 2003). The institutional venturecapital industry largely denies the import of the gap arguing that there are few supply-sideconstraints. Rather, they counter that the (demand-side) failure is in the quality of theentrepreneurs seeking risk capital (Queen, 2002).

Causes of market failure when investing in knowledge-based industriesThe term equity gap nicely describes a financing constraint affecting high potential but asyet immature and vulnerable businesses. The actual reasons causing investors to provideinsufficient finance are embedded in the investment process and the risks and reward thatsuch investment decisions will incur. Further, there is an operational question of mater-iality. The investment process has high sunk costs and often little advantages of scale. Thus,small investments may incur transactions costs out of all kilter with the probable benefitsof the investment. In these circumstances, a rational and informed decision not to investin an early stage venture cannot be seen as a market failure. On the contrary, it is the marketworking effectively. None the less, there are genuine sources of market failure affecting newknowledge-based firms. Two are particularly pernicious: information asymmetries andR&D spillovers.


Information asymmetriesIn extremis, a highly innovative but immature technology employed to produce novelproducts and services provided to new customers by a technically knowledgeable but com-mercially inexperienced entrepreneur (possibly coming from a university environment)and who is starting a new enterprise provides a full spectrum of the sources of potentialrisk that the venture capital investor has to manage (NEFI, 2005). At its earliest stages,the technology is not proven in its applications. Even if the technology works as it is envis-aged, it will be used to create products and services which are not yet widely available norin some cases even fully comprehended by either future suppliers or users. In such cir-cumstances, how does the firm or its investor(s) determine the attractiveness of productsor services that as yet do not exist? These information challenges will remain while thecompany grows (see Box 4.1) up until that extremely unlikely event that the technologyattains a dominant position and becomes comprehensively understood as an industrystandard.

Thus, we can have simultaneously technology risk, market risk, managerial risk andfinancial risk, each impacting on a new high-tech enterprise (Amit et al., 1990; Storey andTether, 1998). Multiple decisions have to be made, often very quickly, on highly imperfectknowledge. As Amit et al. (1990) contend, less able entrepreneurs will choose to involveventure capitalists, whereas the more profitable ventures will be developed without exter-nal participation because of the adverse selection problem associated with asymmetricinformation. Amit’s argument implausibly assumes that unknown entrepreneurs, regard-less of skills, have alternative and sufficient sources of finance available.

BOX 4.1 INVESTMENT RISKS IN NEW TECHNOLOGY-BASED FIRMS

● Exceptional technical entrepreneurs are rarely competent or experiencedbusiness managers.

● Project assessment and due diligence are highly problematic in areasconcerning ‘leading edge’ technologies.

● Uncertainty is compounded by the need to analyze both technologicalfeasibility and the existence of a sufficiently large and attractive market(often for a product which does not yet exist).

● The speed of the change and the threat of technological redundancy oftenrequire an extremely rapid rate of commercial exploitation.

● Competitive response and the availability of alternative products/servicesare likely to be rapid in dynamic and attractive new technology markets.

● Successful NTBFs need to grow, internationalize and develop second gen-eration products in a very short time horizon.These imperatives place excep-tional managerial, financial and technical demands on a new business.

● The scarcity of large, liquid and technologically informed capital marketsincreases the uncertainty of the future financing of the investee firm andthe profitable ‘exit’ of the venture capital investor.


Risk is a computable state based on estimated probabilities. Thus, seed, start-up andother early-stage investments in unique enterprises where no prior history exists areparticularly problematic. Without reference benchmarks, investors also face incom-putable uncertainty of a Knightian nature (Knight, 1921). Audretsch and Keilbach(2004), in referring to new technology environments, uses the term ‘hyper uncertainty’.The use of quantitative approaches is effectively nullified in such a speculative andvolatile environment. The main implication of this situation is that the presence of non-quantifiable uncertainty affects commercial decisions by amplifying their perceivedrisk components (Einhorn and Hogarth, 1985; Kahn and Sarin, 1988; Ghosh andRay, 1997). As a result, early-stage venture capital investments may offer investors theprospect of little confidence of higher returns but with a considerable likelihood ofproject failure. In such circumstances, the abandonment of seed investments in favor oflater stage deals by commercial investors can be viewed as highly rational (Dimov andMurray, 2006).

R&D spilloversAudretsch (2004) also observes that it cannot be assumed that desirable spillover effects,that is whereby society at large gains access to and benefits from the availability of a valu-able new innovation, are automatic. The entrepreneur is a critical agent in the dissemina-tion of innovative ideas. In early-stage classic venture capital activity, a majority ofinvestments in a portfolio will either fail or return (at best) a negligible net present valuewhen the time cost of money and an appropriate risk premium are computed (Fenn et al.,1995; Murray and Marriott, 1998; Rosa and Raade, 2006). Where attractive net returnsare made by the fund, it is likely to result from the realization of a small minority of excep-tional investments within the portfolio (Huntsman and Hoban, 1980; Bürgel, 2000).Given these uncertainties, the venture capital investors will seek to ensure contractuallythat when abnormal rents are generated they are owned by the investors (van Osnabrugge,1999). Hence, the attention given by technology investors to ensure that they have strongpatent protection (Salhman, 1990; Kortum and Lerner, 2000). Indeed, the investors’ability to appropriate the commercial benefits of their actions is likely to affect their ori-ginal investment decision. None the less, the full value of a novel technology and the con-sequent stream of new products and services are rarely harvested in their entirety by theinvestors. Competitors may emulate and copy key attributes, both legally and illegally.The bargaining power of suppliers or customers may also erode the innovator’s surplusrents (Griliches, 1992). In a study of 600 high-tech start-ups in Germany and the UK,Bürgel et al. (2004) found that the high-tech young firms experienced their first seriouscompetitive threat after a median period of 16 months of sales.

In these circumstances, both entrepreneurs and investors may well feel that the enter-prise risks and uncertainties are too high and their ability to secure both full and attrac-tive returns from successful technology enterprises are too doubtful. This is likely to resultin an undersupply of investment regardless of the fact that the existence of the innovationhas benefits to a wide range of parties. Griliches estimates that the gap between the privateand the social rate of return spans 50–100 per cent of the private rate of return. Smallfirms because of their lesser market power and inability to finance the aggressive defenseof intellectual ownership infringements are particularly likely to see an erosion of theirreturns (Mansfield et al., 1977).


Policy challenges in the venture capital arenaBased on a near universal admiration as to the vigor of the US innovation financingsystem, several governments have sought to emulate elements of the American venturecapital system. The assumption is made, often implicitly, that elements of a system maybe isolated and applied within other different contexts. This raises a set of issues of boththeoretical and operational complexity that policy makers ignore at their peril.

The influence of a US exemplarGiven the noted hegemony of the USA innovation finance system, it is legitimate to ques-tion what can be learned from the American experience of venture capital activity andreadily applied to other national economies both in the developed and developing world.Yet the simplicity of the question betrays an ignorance of both ‘path dependency’(Kenney and von Burg, 1998) or what it is that can actually be made transferable evenassuming that the environmental and institutional conditions (for example tax regimes,legal and corporate governance structures, and so on) exist for such a transfer to be pos-sible.10 Gilson (2003) is explicit in his assertion that others cannot follow USA experiencein order to reach ‘the holy grail’ of a flourishing venture capital market modeled onSilicon Valley. He notes that because of the US industry’s highly idiosyncratic history, ‘themanner in which the US venture capital market developed is not duplicable elsewhere’(p. 3). He goes on to argue that other countries might be obliged to use public policy mea-sures given the inability to copy another country’s history.11

State interest in entrepreneurial action has moved from exhortation to involvementas many commercial investors have abandoned early-stage equity finance (Sohl, 2003;Cumming et al., 2005; Coller Capital, 2006). General and limited partners’ actions are anarticulate judgment of the economic attractiveness of the early-stage market. Their deser-tion has left a financing (equity) gap that governments have felt obliged to try and fill. Thismove from early to later stage deals (‘style drift’) is most evident in European venturecapital markets. However, it is not an exclusively European phenomenon. Gompers (1998)shows that US investors also moved to later stage deals as the size of the finance undermanagement by venture capital general partnerships increased rapidly in the late 1990s.This same phenomenon was earlier described by Bygrave and Timmons (1992) and morerecently by Branscomb and Auerswald (2003).

The specific problem of minimum fund scale‘Ask an LP what he thinks of investing in European venture tech and he is likelyto respond “what is European venture tech”?’ (European Venture Capital Journal,November 2004).

The single biggest problem – facing both governments keen to encourage early-stageinvestment in new technology-based firms as well as for general and limited partnershipsprepared to consider early-stage risk capital investment activity – is simply put. With veryfew exceptions, the investment record of early-stage funds worldwide has been very poor(European Venture Capital Association, 2005). The general exceptions to this rule overthe long term have been from the upper quartile of US technology investors. The consist-ency of poor venture capital returns in Europe has been so uniform as to make a numberof institutions question whether Europe actually has a viable, early-stage technologyinvestment activity (Ernst and Young, 2004).


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

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

Collectively, these firm-level influences can be interpreted as the positive application of‘scale and scope economies’ to the risk capital investment process.

Murray and Marriott (1998), in a simulation of early-stage venture capital fund activ-ity, showed that fixed costs have a severe effect on the net performance of small funds.Excess costs particularly fell on the venture capital firm or general partner (Figure 4.1).This view is also corroborated by Dimov and Murray’s (2006) analysis of the supplydeterminants of seed capital in their investigation of seed capital fund activities from1962 to 2002. They showed that the most active seed investors over time were almostexclusively large and well established US funds. The top five venture capitalinvestors active in seed capital which were all US based12 had, on average, made 92 seedinvestments from total funds under management of nearly $4 billion per venturecapital firm.


Table 4.1 Long-run investment returns to venture capital and private equity in Europe

European private equity funds formed 1980–2005. Net returns to investors from inception to 31 December 2005

Pooled Upper Top QuarterStage IRR Quartile IRR*

Early stage 0.1 2.3 13.6Development 9.2 9.0 18.8Balanced 8.3 8.5 23.7All venture 6.3 6.2 17.1Buyouts 13.7 17.8 31.8Generalist 8.6 8.8 10.3All private equity 10.3 10.6 22.9

Note: * The top quarter IRR is the pooled return of funds above the upper quartile

Source: Thomson Financial (venturexpert database)

Small is not beautifulThe most conspicuous outcome of these studies is to challenge the apparent willingnessof policy makers to create and to support programs which encourage the formation ofsub-optimal, and ultimately non-viable, seed capital funds. Here, the state can be seen asboth part of the problem as well as a possible solution to financing constraints. In thestate’s absence, few private investors would have participated in such funds. Small, early-stage funds have a series of structural weaknesses that serve to undermine the probabil-ities that these funds will earn an acceptable risk adjusted return on the finance under theirmanagement (Box 4.2). One effect of this sub-optimal fund size is a particularly damag-ing inability to recruit experienced professional investment executives in a highly com-petitive market for talent (European Investment Fund, 2005).

Insufficient fund size similarly reduces its attraction to institutional investors. Theseinvestors including pension funds, insurance companies and other money managersbecome limited partners in venture capital funds in order to add some controlled expo-sure to high risk/high reward opportunities (Bürgel, 2000; BVCA, 2000). Because of themulti-billion dollar global reach of these institutional investors, asset allocation has to bematerial in order to have any effect on the performance of their investment portfolio. Inthese circumstances, a minority position for a limited partner demands involvement in afund of sufficient scale in order to influence the institution’s overall performance. For allbut the smallest institutional investors, a minority position in a closed venture capital fundof under US$100 million is likely to be irrelevant.

Thus, a small seed fund’s circumstances often describe the worst of all worlds. It hasmodest funds to invest and little income with which to execute a strategy of finding andevaluating potential investee firms. It is unlikely to be fully diversified. Investee firms, par-ticularly at start-up, are costly in their urgent need for advice, and the fund has littlemoney to provide follow-on finance for the most attractive prospects in its portfolio. Thelack of finance results in either impeding the portfolio firm’s growth plans and/or in therapid dilution of the fund’s ownership share as syndication finance is arranged. Theseconditions are very likely to lead to a sustained poor investment record which will severely


Figure 4.1 Simulation model of the effect of fund size on management’s and privatepartners’ returns (Murray and Marriott, 1998)

–20

–10

0

10

20

30

40

50

7.5 10 15 20 25 30 35 40 45 50

Fund size £ million

IRR

%

LimitedPartners’ IRR

ManagementIRR

reduce the fund’s ability to survive by attracting subsequent follow-on funds from privatesector investors. In these circumstances, policy makers outside the elite technology clus-ters of the USA are likely to see the earliest and most uncertain stages of equity invest-ment virtually abandoned by commercial venture capital firms. Governments are obligedto come to a view as to their own response to such a withdrawal of private, early-stagefunding sources to priority (new technology) young enterprises. Almost universally, theyhave considered the reduction (or absence) of support for such firms to be strategicallyand politically unacceptable.

Government instruments to promote institutional venture capital financeGovernment’s influences on the entrepreneurial vigor of a national economy are mani-fold. For example, the institutional legal and fiscal frameworks (Fenn et al., 1995; LaPorta et al., 1997; 1998), the incentive structure of personal and corporate tax systems,the regulatory regime’s impact on business, and the efficiency of the market for corporatecontrol will each have profound (albeit not easily predicted) effects on the incentives forentrepreneurial risk taking. As such, these influences also affect the demand for venturecapital as an important source of entrepreneurial finance.

The eclectic nature of popular policy recommendations (see Box 4.3) reflects the wide spec-trum of important influences on venture capital activity. Further, such conditions in order tobe effective will in turn have to be embedded in, and legitimized by, a culture of opportunityrecognition and entrepreneurial endeavor (Shane, 2003). However, given the dynamic andlinked nature of investment activities to both micro- and macro-economic variables, it is not


BOX 4.2 NEGATIVE CONSEQUENCES OF SMALL VENTURECAPITAL FUND SIZE

Small, early-stage venture capital funds bear disproportionately the followingdis-economies:

● The high costs of reducing information asymmetries in immature, complexand dynamic markets

● The high levels of management support & guidance required by early-stage investees

● The limited ability to attenuate project risks by fully diversifying the venturecapital fund

● The limited ability to invest large sums early in the life cycle of the investeefirm

● The skewed risk/return profile resulting in the need for an exceptionalsuccess by the venture capital fund

● The long NTBF cycle and its implications on fixed term, fundstructure/conduct/performance

● The limited ability to provide follow-on financing in a successful NTBF● The danger of excessive dilution of ownership for the original investors in

deal syndication


BOX 4.3 VENTURE CAPITAL POLICY RECOMMENDATIONS

Investment regulations:

● Ease quantitative restrictions on institutional investors to diversify sourcesof venture funds

● Support the development of a private equity culture among institutionalinvestment managers

● Facilitate creation of alternative investment pooling vehicles, such asfunds-of-funds

● Improve accounting standards and performance benchmarks to reduceopacity of venture capital funds and protect investors

● Remove barriers to inflows of foreign venture capital finance

Taxation

● Reduce complexity in tax treatment of capital from different sources andtypes of investments

● Decrease high capital gains tax rates and wealth taxes which can deterventure capital investments and entrepreneurs

● Evaluate targeted tax incentives for venture capital investment and con-sider phasing out those failing to meet a cost–benefit test

Equity programs

● Use public equity funds to leverage private financing● Target public schemes to financing gaps, e.g. for start-up and early stage

firms● Employ private managers for public and hybrid equity funds● Consolidate regional and local equity funds or use alternative support

schemes● Focus venture funding on knowledge-based clusters of enterprises, uni-

versities, support services, etc.● Evaluate public equity funds and phase-out when private venture market

matures

Business angel networks

● Link local and regional business angel networks to each other and tonational initiatives

● Ensure linkages between business angel networks and technology incu-bators, public research spin-offs, etc.

● Provide complementary support services to enhance investment-readiness of small firms and increase demand

Second-tier stock markets

● Encourage less fragmentation in secondary-stock markets throughmergers, e.g. at pan-European level

● Enhance alternative exit routes such as mergers and acquisitions (M&As)

necessarily easy to determine what factors are most important at any one time. Factors thatconstrain entrepreneurial activity (for example legal and regulatory compliance) may not bytheir removal necessarily act as an accelerator for greater entrepreneurial endeavor.

A full treatment of environmental conditions conducive to venture capital finance isinappropriate in this chapter. Accordingly, we will focus specifically on what measures thestate may employ directly to support the actions and effectiveness of both the institutionaland informal venture capital industries.

The growing status of entrepreneurial activityThe late twentieth century saw a coming together of two related trends of 1) an increas-ing awareness of the importance of small and young firms to the wider economy afterBirch’s seminal MIT study (1979), and 2) an appreciation of the changing nature of eco-nomic value as represented by the growing importance of innovation via knowledge-based goods and services in mature and developed economies (Nonaka, 1994;Grant, 1996; Spender, 1996). Young high-tech firms were increasingly seen as an impor-tant conduit for continuing innovation particularly in fostering disruptive and non-incremental, technology developments (Drucker, 1985; Storey and Tether, 1998;Audretsch and Acs, 1990; Audretsch, 2002; Branscomb and Auerswald, 2003). Incumbentlarge firms were all too often seen as reactionary and thus vulnerable to adept new com-petitors (Christensen, 1997). The confluence of these new understandings meant that itwas highly unlikely that governments could envisage not supporting entrepreneurialyoung firms. The ‘political stock’ of small firms increased throughout the 1980s and1990s. The technology and Internet-related bull markets of the latter part of the 1990s,with their focus on young knowledge-based firms, further fueled public and governmentinterest in entrepreneurial activity. Accordingly, the specific financial constraints faced byyoung firms in their attempts to grow, and particularly the appropriateness of risk capitalfinance to high potential, new enterprises, became an increasing focus of policy interest.

Despite setbacks, there is also evidence that governments can and do learn over time.The environmental preconditions to effective entrepreneurial action including its financ-ing are increasingly being recognized in policy circles (OECD, 2004; Small BusinessService, 2005; US Department of Commerce and European Commission DirectorateGeneral for Enterprise and Industry, 2005). Thurik (2003) summarizes Europe’s eclecticpolicy needs in order to stimulate greater entrepreneurial activity (Box 4.4).

Thurik’s span of policy prescriptions reflects closely both the EC’s 2003 documentGreen Paper: Entrepreneurship in Europe and similarly the UK government’s own 2004policy roadmap for a more entrepreneurial Britain (Figure 4.2). These enabling environ-mental conditions set a context in which venture capital programs can operate. The UKmodel is interesting for its belief in entrepreneurial activity and its comprehensive linkingto government departments with both a commercial (for example DTI, Treasury andInland Revenue) as well as a social mandate (Home Office). The encouragement of newenterprises in economically disadvantaged communities borrows from earlier experiencesof immigration into both the British and US economies.

The two above illustrations raise an important issue of policy priorities and focus.Venture capital is an important instrument for promoting enterprise.13 But as the USexperience has also shown us, risk capital has played a critical role in the emergence oftechnology hubs on the East and West coasts. Thus, venture capital is additionally seen


as a major instrument of innovation policy. The conflation of the two policy goals is likelyto result in some contradictions. Entrepreneurship is largely about mass activity includ-ing a wider interest in new enterprise at all levels of the citizenry. In contrast, innovationpolicy is frequently much more meritocratic in nature and seeks the promotion of tech-nologies and enterprises of world-class competitive status. However, as the ‘TrendChartInnovation Policy in Europe’ (European Commission, 2004) report notes, priorities oninnovation among EU states include ‘fostering an innovation culture’ and ‘buildinginnovative capacity in smaller enterprises’. These instruments and goals of both innova-tion and entrepreneurship policies often appear remarkably similar.


BOX 4.4 FIVE AVENUES TO STIMULATEENTREPRENEURSHIP

1. Demand side interventionR&D expenditure, stimulating competition

2. Supply side interventionLabor mobility, regional development

3. Influencing input factorsHigher education, venture capital market

4. Influencing preferencesAttitude/mindset, image of entrepreneurship

5. Individual decision making processTaxes, social security, level of benefits

Source: Small Business Service (2004a)

Figure 4.2 UK government’s model of building an enterprise economy

Drivers of Policy Government Vision 7 National Strategies

Enterprisefor all

Productivity

Many more peoplehave the desireskills andopportunity to starta businessEveryone with theambition to growtheir business ishelped andsupportedA supportivebusinessenvironment makes it easy for all smallbusinesses torespond togovernment andaccess to its services

Building an Enterprise CultureEncouraging a more dynamicstart-up marketBuilding the capability for smallbusiness growthImproving access to finance for small businessesEncouraging more enterprise indisadvantaged communitiesImproving small businesses’experience of governmentservicesDeveloping better regulation andpolicy

Venture capital intervention typologiesAs noted earlier in this chapter, governments have restricted their direct financial involve-ment in venture capital to the more problematic investment stages of seed, start-up andearly firm growth (OECD, 2004). Their interventions are premised on a belief of the keyrole that professional risk capital can make to the innovative capacity of an economy.Hence their near exclusive focus on supporting seed, start-up and early growth stages. Inthese earliest and most speculative stages, it is still not fully evident that specialist early-stage venture capital investment is an activity than can be effectively mediated through amarket mechanism as apposed to directed grants or subsidy alternatives. As noted, thisuncertainty is exacerbated by the historically poor returns to early-stage venture capitalactivities. Outside the special case of the United States ‘high-tech’ industries prior to theyear 2000, risk-return characteristics have consistently been unfavorable for investorswishing to engage in early-stage ventures (Murray and Lott, 1995; Murray and Marriott,1998; Lockett et al., 2002; Rosa and Raade, 2006).14 In direct contrast, the later stages ofventure capital and private equity have been consistently profitable with managementbuy-outs becoming the European industries’ dominant product (Wright et al., 1994;EVCA, 2005). Private equity does not exhibit comparable problems of insufficient scaleor information asymmetries. Thus, government involvement in such later-stage actionsis rare other than in the setting of the appropriate enabling legislation (Wright andRobbie, 1998).

Having made the decision to intervene in the market for early-stage venture capital, thestate has to decide what form of intervention will be most effective for what purpose.While there are a number of national studies of venture capital programs (Lerner, 1999;Dossani and Kenney, 2002; Maula and Murray, 2003; 2007; Ayayi, 2004; Lerner et al.,2005), the value of such precedents is in part obscured by the specificity of the programsto their national context (Jääskeläinen et al., 2006). None the less, the risk capital deci-sions of government can be pared down to two generic choices:

1. Direct intervention – government as venture capitalist. Government may elect tobecome its own venture capitalist and undertakes all the roles that would otherwise bethe responsibility of a rent-seeking, market intermediary. Here, the government run,venture capital firm has to undertake all the selection and due diligence, governanceand nurturing duties incumbent on an early-stage risk capital investor. Given that thegovernment is investing public finance in order to fulfill its role, the state assumessimultaneously both the roles of general and limited partner in the public fund.

2. Indirect intervention – private venture capital firms as agent of government.Alternatively, government can delegate executive responsibility to a private venturecapitalist fund manager. This is often done on the assumption that the state has neitherthe professional skills nor the experience to be a ‘direct’ risk capital investor. Onceoperational responsibility has been assumed by a private general partner agent, theposition of the state becomes analogous to that of a limited partner in a traditionallimited liability partnership (LLP) fund. Limited partners are not able to intervene inthe operations of the fund manager at the risk of losing tax status privileges. Similarly,the government’s operational involvement ceases once the focus and mode of opera-tion of the fund has been agreed and public monies committed. Indirect interventionvia equity enhancement schemes is becoming the dominant contemporary mode of


public involvement as the importance of highly skilled, and properly incentivized,investment managers is recognized (Gilson, 2003; OECD, 2004).

Government uses multiple incentives with which to encourage the involvement ofprivate venture capital agents. It will exploit the power of the state to provide additionaland cheaper finance to the fund thereby allowing a leverage affect to increase ‘up-sidereturns’. Government may further reduce the costs of the venture capital fund by con-tributing to a proportion of the operating costs of the fund. However, such operatingsubsidies are less common than alternative measures with a direct incentivizing effect onthe fund’s performance. Finally, the state may change the risk/reward profile of the fundby underwriting part or all of the risk of financial loss to the limited and generalpartners.

Direct public involvementThe state as a direct investor creates some challenging issues. First, there is the questionas to whether government has appropriate personnel capable of carrying out such com-mercially sophisticated activities as equity investment in early-stage firms. It is unlikelythat such persons are widely available as civil servants. Secondly, the state by its size andinfluence inevitably will create an impact – for good or ill. Thirdly, that the state has toassume the role of a direct investor may be seen as a consequence of its failure to incen-tivize a private market to take on this largely commercial role. A number of countriesdo have direct investment via public bodies. The Finnish Investment Industry programwith civil servants investing public money directly into young enterprises primarily tofulfill government policy goals would meet this definition (Maula and Murray, 2003).Similarly, the Danish government financed VaekstFonden (Business DevelopmentFinance) also has a direct venture capital investment activity.15 Yet these programsraise some very considerable issues regarding the conflict between policy and commer-cial goals.

As noted, direct involvement in new venture investment by government agencies carriesa material risk of market disruption through the potential misallocation of capital andthe possible ‘crowding out’ of private investors (Leleux and Surlemont, 2003). Theseundesired effects can be due to both the commercial involvement of inexperienced publicservice personnel, who may often control substantial levels of finance relative to the totalsupply of early-stage venture finance in a market. In addition, there may be differingreturn requirements of public investors (OECD, 1997; Manigart et al., 2002; Armour andCumming, 2006). Government funding can further distort private markets by offeringfinance which does not fully reflect the appropriate risk premium (Maula and Murray,2003; 2007). Venture capital is a ‘learned’ activity (Bergemann and Hege, 1998; Shepherd etal., 2000; De Clercq and Sapienza, 2005). General partnerships often need the experienceof managing and investing multiple funds before they have accumulated sufficient tech-nical and market knowledge to provide their investors with acceptable returns (Gompersand Lerner, 1998). Many public programs have recognized the possible adverse effects ofgovernment inexperience on market outcomes. None the less, government’s direct inter-vention in the supply of venture capital has frequently been defended on market failurearguments without reference to the efficacy of such actions. It is perhaps inevitable thatcriticisms of market distortion have been leveled at such public programs. For example,


the Canadian Labor-Sponsored Venture Capital Corporations – a program with bothcommercial and social goals and made attractive to individual investors via substantialfederal tax breaks – have been accused of crowding out private venture capital activities(Cumming and MacIntosh, 2003).

Indirect or ‘hybrid’ public/private venture capital modelsThe OECD has used the term ‘hybrid’ to describe the structures where government andprivate interests work in concert as co-investors, that is limited partners, in a fund. Suchstructures are seen as an element of ‘best practice’ (OECD, 1997; 2004; US Department ofCommerce and the European Commission, 2005). In effect, the venture capital firm orgeneral partner is acting as an ‘agent’16 for a group of principals (limited partners), one ofwhich is the state using public monies. Governments’ history as active investors selectingcommercially attractive projects is problematic at the very least with many illustrations ofadverse selection. ‘Spotting winners’ among young and growing companies is fraught withdanger (Hakim, 1989) and denies the stochastic nature of the firm formation process. Ageneral conclusion from the last half a century is that government would do well to avoidplacing itself in a position where it has to make nominally economic decisions that arebounded by other, usually political, conditions (OECD, 1997; Modena, 2002; Gilson,2003). There appears to be a growing consensus on the limited role of government as adirect investor. Contemporary venture capital programs in, for example, the USA, the UK,Australia, New Zealand and Germany have each used private venture capital firms to investon behalf of government in areas of new enterprise deemed important for policy reasons.The parallel involvement of both public and private investors can be seen in Figure 4.3.

That the state would wish the participation of private investors to support its policygoals is self-evident. But why commercial investors would be prepared to be involved aslimited partners in such a hybrid activity needs further explanation. Such an arrange-ment may do little to alter expected outcomes that led to the supply side, market failurein the first place. Thus, the involvement of the GP and any private sector LPs17 in thefund will frequently require the engineering of more attractive profit expectations inorder for them to participate (Gilson, 2003; Maula and Murray, 2003; Hirsch, 2005;Jääskeläinen et al., 2006).


Source: Small Business Service (2004b)

Figure 4.3 Generic ‘hybrid’ venture capital model

Loan orEquity

Start-up &growing SMEs

‘Capped’Profit share

‘Uncapped’Profit share

PrivateInvestment GovernmentPrivate investors

Early-stagefund

In discussing the evolution of different incentive structures in government’s support ofventure capital, it is important to acknowledge the contribution of the Small BusinessInvestment Company program created by the US Government’s Small BusinessAdministration.18 The basic model of an ‘equity enhancement’ program by which thestate’s involvement (either by direct investment or acting as a guarantor to other fundproviders) enables additional and cheaper funds to be raised – thereby creating a leverageadvantage to private investors – has been reflected in venture capital programs worldwide.

It should be stressed that the full value of the Small Business Investment Companyprogram in its various forms (that is bank owned, debenture and participating securitiesfunds) was not restricted to the net returns generated by the funds. Indeed, the investmentperformance of these funds has been highly variable over time (Small BusinessAdministration, 2002; 2004). Rather, the value of the program has been in the espousingof novel public–private experiments used to address the problem of the inadequate sup-plies of risk capital for young firms across a range of communities. Of critical importance,the Small Business Investment Company program also enabled a generation of US invest-ment managers to obtain their first commercial experience of venture capital activity viagovernment supported funds. There is an ‘infant industry’ argument for interceding inimmature markets (Baldwin, 1969; Irwin and Klenow, 1994). In the UK, the government-conceived venture capital firm, 3i plc and its predecessor ICFC, performed a similarindustry development role from 1946 until the late 1980s (Coopey and Clarke, 1995).

Public-funded incentives in hybrid fundsHybrid funds illustrate the imperative of government action in strategically importantinvestment categories where consistently poor returns have precipitated a major reductionin private finance for young enterprises. Such structures also acknowledge that goodinvestment managers will rarely tolerate the state having an executive role in their funds.This impasse is resolved by the use of government finance to incentivize private managersto engage in more risky, early-stage funds. It is the ‘hands-off’ provision of governmentleverage finance that has appealed to professional investment managers mindful of theneed to increase fund scale in the challenging early-stage markets and frequently facedwith private investor indifference.

The term ‘equity enhancement’ is accurate. The state needs to incentivize the generaland limited partners to be prepared to engage in a fund that includes public welfare goalsas part of its raison d’être. In the absence of explicit economic incentives, there is littlelogic for profit maximizing, private agents to become involved. Pari passu funding,whereby the state and private investors provide investment finance on equal terms, onlyworks where the returns to private investors are attractive enough without needing to skewthe return distributions to private limited partners’ advantage. The state is obliged toenhance the returns to the general partner and to the other commercially motivatedlimited partners in order to attract private investors’ commitment to the co-investmentmodel. Essentially, the public investor forgoes some of its rights to a pro rata share in theeconomic returns of the fund. Given that the state is often the largest single investor inthe fund, a reduction of its share of any net capital gain can leverage a material increaseto the other parties’ returns in the event of a moderately successful fund. In all cases, thestate as a ‘special’ limited partner does not influence the commercial and executive deci-sions of the fund managers once the investment criteria of the fund are determined.


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

1. Capped returns to the state: the public limited partner invests at a rate which is com-monly fixed at approximately the government’s cost of capital.19 Once this returnthreshold has been met from the proceeds of the sale of any portfolio companies, anyfurther positive cash flows are exclusively shared between the other commercial LPsand the GP via its ‘carried interest’.

2. Differential timing of limited partners’ cash flows (‘first in and last out’): for thegeneral partners of the venture capital firm, their performance will be largely mea-sured and communicated by one universal metric – the Internal Rate of Return of thefund.20 When the state is the first investor to have its committed finance fully drawndown and the last investor to have its monies returned with any associated surplus,the shorter investment period of the other private LPs directly benefits their returns.Again, the performance enhancement of the private or commercial partners is at thedirect cost of the public partner.

3. Guaranteed underwriting of investment losses incurred by the limited partners: gov-ernment may seek to influence the investment decision by removing all or a large partof the costs of portfolio failure. Usually, a percentage of committed investments isguaranteed which may often vary from 50–75 per cent of investors’ costs. The guar-antee may be on a fund or on individual portfolio investments. However, the guaran-tee schemes do not, in themselves, improve the returns to investors but rather caplosses. Thus, it is common for a guarantee to be put in place in addition to some otherincentive which leverages the upside of a successful investment.

4. Buy-back options: buy-back options give the private investors the opportunity topurchase the entirety of government’s interest in a program at a pre-determined timeduring the public/private program. The terms of the exchange are arranged ex anteand thus present the private investors with a clear incentive and opportunity for anearly exit of the state as co-investor. Essentially, the facility is a purchase ‘option’which may be exercised at some stipulated future date when economic future of theinvestment is possibly indicated but not fully known. One of the most admired ofsuch programs was the Israeli Yozma program (1993–98). Seven countries have sub-sequently modeled programs on this Israeli experience.21

A list of a number of existing government-supported venture capital structures thathave adopted one or more of the four described incentives programs is given in Table 4.2.

Despite the increasing popularity of government involvement in hybrid, venture capitalfunds, rigorous evaluation of their effects is limited. Evaluations have been undertaken onsuch schemes in the UK, New Zealand and Australia.22 However, unabridged evaluationsare rarely available in the public domain.23 Thus, while we may assume that subsequentprogram rounds have learned from policy experience, our overall knowledge of contem-porary venture capital policy actions and outcomes is limited. Agreed evaluation method-ologies and the ability to compare and contrast across program and country are eachurgently required in an area of government interest and action of increasing scale(Lundström and Stevenson, 2005).



Table 4.2 Publicly financed venture capital ‘equity enhancement’ schemes

Examples (presentFeature Description Incentive effects & past)

Public Government Helps in setting up a fund. Also �50% of the fund:investor matching the helps to build a sufficiently big Europe/EIFco-investing investments by fund to benefit from economies Finland/FIIwith private private investors of scale Israel/Yozmainvestors However, investing in pari passu �50% of the fund:

with private investors does not Australia/IIF andhave direct incentive effects i.e. it Pre-seed Funddoes not improve the expected USA/SBIC and returns for private investors in SSBIC UK/regionalmarket failure segments such venture capital fundsas early stage

Capped After all the Capped return for the UK/regional venturereturn for investors (including government increases the capital fundspublic the public investor) expected IRR for private Australia/IIF andinvestors have received certain investors. The incentive effect is Pre-seed fund

IRR (e.g. interest such that it increases therate � perhaps some compensation for good Chile/CORFUrisk premium) the performance. This in turn createsrest of the cash flows a strong incentive for the privateare distributed to investors to incentivize the private investors only general partners to make

successful investments and addvalue to portfolio companies

Buy–out Private investors are The effect of buy-out option on Israel/Yozmaoption for given the option to the IRR of private investors is New Zealand/Newprivate buy the share of the quite similar as the effect of Zealand Ventureinvestors government at (or ‘capped return’ of public Investment Fund

until) a specific point investor. However, there are twoof time at additional benefits:predetermined price 1) The buy-out option gives(typically nominal both the public investor and theprice � interest rate) private investors an opportunity

to demonstrate success earlierand more visibly than in thecapped return alternative2) In the case of success,government gets a quick exitfrom the fund and can put themoney to work again instead ofwaiting for the returns on fundtermination

Downside Downside protection Downside protection has a Germany/WFGprotection means the negative effect from the incentive Germany/tbg &

government perspective. While downside KfW France/

Government’s role in venture capital ‘funds of funds’The hybrid venture capital fund structure assumes that government is the co-partner andlimited partner to an individual fund. In the ‘fund of funds’ option, the government doesnot signal preference for any one fund but supports investments in a range of funds thatare sanctioned by the general partner management. The fund of funds manager, acting asan allocator of limited partners’ commitments, allocates finance to specific venture capitalfunds, not to individual investments. While several such fund of funds exist, governmentstend to invest only in such groupings that specifically target young and high potentialfirms of policy interest. In France, the Fund for the Promotion of Venture capital (Fondsde Promotion pour le Capital Risque – FPCR) was set up in 2001. With €150 million,including European Investment Bank support, at its disposal, the FPCR has invested in10 French venture capital funds. Investments are geared towards innovating companiesless than 7 years old in sectors where it is difficult to mobilize private funding, that is lifesciences, ICT, electronics, new materials and environment and sustainable development.The UK equivalent is the UK High Technology Fund. This fund of funds, set up by gov-ernment in 2000 and managed by a commercial investment company, has raised £126million, of which £20 million only came from government. It invests exclusively in spe-cialist technology venture capital funds located in the UK. This fund of funds also


Table 4.2 (continued)

Examples (presentFeature Description Incentive effects & past)

underwriting losses protection helps support the IRR, SOFARIS Denmark/ from the portfolio it decreases the difference in Vaekstfonden

returns for private investors and (Loan Guarantee the management company Scheme)between successful and unsuccessful investments. The effects of good selection and value-added efforts have a lowerimpact on the performance ofthe fund

Fund Government gives a The fund operating costs are Europe/European operating subsidy for the neutral from the perspective of Seed Capital Schemecosts management incentives to fund management

company to cover or LPs while increasing the IRRsome of the costs of the fundfrom running thefund

Timing of Ordering of the cash The IRR of the private investor UK/Regional cash flows flows so that public can be enhanced through timing Venture capital Funds

investor puts the of cash flows improving themoney in first and attractiveness of the fundgets the moneyout last

attracted EC assistance via the co-investment of the European Investment Fund. It is asyet too early to appraise the performance of either of these programs.

Government policy and informal investors (business angels)So far in this chapter, discussions have focused on policy actions in the institutional marketfor risk capital. Thus, the unit of analysis has been the established, and often very visible,venture capital firms or general partnerships. Yet, advocates of the importance of businessangels have repeatedly noted that the scale of the informal supply is likely to dwarf that ofthe institutional venture capital in all developed risk capital markets. There is clear evi-dence of this disparity in the US and the UK where both types of investor co-exist. Thisargument regarding the scale, and thus potential for economic transformation via businessangels, is strongly made and mutually re-enforced by authors Mason, Kelly, Riding,Madill, Haines and Sohl writing in this book. Accordingly, governments concerned at theeffective supply of financial and business-related support to young and growing companieshave increasingly become interested in informal investors or business angels.24 As Kellyrightly notes, government interest in these ‘publicly hidden’ investors was materially influ-enced by the work of pioneering academic researchers both in the USA and Europe.

Given that three chapters in this book are devoted to different aspects of business angelresearch and practice, this author will not repeat the analysis of acknowledged experts inthe field. Rather this section will remain exclusively within the policy focus of the chapterand will look at how governments have sought to promote a vigorous and successful busi-ness angel sector.

Investors of first resortVan Osnabrugge (1999) ‘guesstimates’ that business angels provide between 2–5 times theamount of finance to entrepreneurial firms in the US and possibly invest in up to 40 timesthe number of portfolio companies compared to institutional venture capital firms.Bygrave et al. (2003), using GEM data on 15 nations, subsequently offer more modestdifferences in business angels’ favor of 1:1.6 in respect of funds allocated. Sohl (1999)argues that the ratio of understanding of business angels compared to their impact on theeconomy is lower than just about any other major contributor. Bygrave et al. (2003)support this view noting that entrepreneurs – and policy makers – should pay far lessattention to institutional venture capital activities. They observe that new enterprises,including those involved in the commercialization of revolutionary research, are muchmore likely to be self-financed or gain support from business angels rather than fromclassic venture capital firms. In an international venture capital and private equity indus-try which is becoming increasingly dominated by scale, those parochial investors that areprepared to undertake local investments within the equity gap spectrum are an increas-ingly valued asset. The overall trend is for an increase in size, and thus concentration ofventure capital funds, that continues to militate strongly against small investments.25

A complement to institutional investorsIn an ideal policy maker’s world, one might envisage informed and highly experiencedbusiness angels being the predominant seed capital providers to nascent businesses.Through their own commercial experience in allied sectors or activity, they would be ableto offer the new enterprise valuable practical experience of running a young company. Of


equal value, they can provide a ‘certification effect’ allowing fledgling entrepreneurs accessto valuable commercial networks (Birley, 1985; Stuart et al., 1999; Steier and Greenwood,2000), as well as offering timely and pertinent advice on markets, production and so on.As the investee firm starts to grow and to demonstrate a major economic opportunity, thebusiness angel could be the conduit to institutional venture capital. With firm growthaccelerating, the influence of the business angel would give way to the more structuredand ‘enterprise nurturing’ skills of the venture capital firm (Harrison and Mason, 2000).

However, as with formal investing, practice is likely to fall short of idealized expect-ations. The business angel invests his/her own money and thus does not need to meetexternal regulatory standards. The venture capital firms are handling investors’ moniesand must therefore be registered with the appropriate financial regulators. The former canact as idiosyncratically as they wish. Hunch, gut feel and subjective stimuli are all foundto be important investment decision criteria. The institutional venture capital manager ismuch more likely to undertake industry-specific training and to have clear guidelines fromboth the general partners of the fund as well as industry guidance from the nationalventure capital industry association on due diligence, deal pricing, use of share structures,legal contracts and so on. Accordingly, unless well known and trusted by the venturecapital investor, the idiosyncratic and untrained business angel is likely to be viewed withmistrust as an investment syndicate partner. As Kelly wisely notes: ‘complementarity’does not presume ‘compatibility’.

Business angels as a policy focusThe three writers on business angels in this volume each make some brief observation onthe policy implications of business angel activity. Mason, looking at the spatial dimensionsof investment, argues that a supply of attractive investments will generate the supply-sideresponse of adequate investments funds. His argument strongly reflects the venture capitalcommunities’ argument that effective demand (that is quality of proposals) is the greatestconstraint to early-stage financing. Perhaps more interestingly Mason and Harrison (2003)have argued that the UK government, by promoting the Regional Venture Capital Fundsprogram to address both spatial and early-stage inequities, have misunderstood both thenature of the problem and its prescription. They make a telling argument that businessangel finance could be a much more appropriate response to such problems. Kelly men-tions the three related problems of an excess demand for business angels’ equity financefrom would-be entrepreneurs; the information asymmetry or search problem of investorsand firms not knowing that each other exists; and the incentives problem of getting ‘virgin’business angels to turn intention into tangible investment activity. Finally, Sohl addressesfour areas of policy including promoting better linkages, sponsoring research in the field,more education of business angels, and unambiguous incentives for business angels to takethe risks of equity finance. How government has actually sought to tackle the issue ofstimulating informal investment will be addressed in the following sections.

Targeting business angels as individualsGovernment has generally adopted a two-pronged strategy to facilitate the supply ofinformal investors in the national and local market. Firstly, they have had to address the‘indirect measures’ (OECD, 2004) of taxation in order to ensure that the incentives avail-able to private investors are commensurate with the level of (undiversified) risk that they


have to assume. The major suppliers of venture capital at the institutional level arefrequently tax exempt in the most developed venture capital economies, that is pensionfunds, insurance companies and university or family trusts.26 But for informal investors,the means by which successful investments are made and recouped are profoundly influ-enced by the detail of the prevailing personal taxation regimes. The OECD’s view is thatit is counter-productive for a private investor to incur such high taxation and other coststhat they reduce the underlying logic for making the original investment. It is difficult toargue with this orthodoxy.

A number of countries have ‘front end’ incentives that give significant income tax shel-ters for bearing the cost of entrepreneurial activity. In the event of a successful investmentrealization, Capital Gains Tax may be delayed or removed from investments held for spe-cific lengths of time. Such fiscal incentives exist in, for example, the US, the UK, France,Ireland, Belgium and Canada. Because business angels are usually relying on their ownpersonal income and wealth for investment activity, the system seeks to incentivize themto remain active investors by improving (and protecting) their returns compared to thoseparties not involved in the incentive schemes. However, as the OECD also acknowledges,while sophisticated changes to the tax system for high net worth individuals may promptthem to make more investments and/or retain their investments in growing companies fora longer period, it may also confuse other less sophisticated, informal investors.

The UK has been one of the developed economies most interested in using fiscal incen-tives to encourage ‘virgin’ angels. In 1981, the Business Start-Up Scheme was announced.This program, which was the first to offer entrepreneurial investor incentives, evolved overtime to become the Business Enterprise Scheme. This was established to enable investors toobtain tax relief when purchasing ordinary shares in unquoted firms seeking seed-cornfunds for development.27 It ran ten years from 1983 to 1993. In turn, the Business EnterpriseScheme metamorphosed into the Enterprise Investment Scheme in 199428 in order toprovide a revised program that would incentivize individual investors to provide more riskcapital funds for the UK’s SME sector.29 In a review of the efficacy of this latter and extantprogram (Boyns et al., 2003), its authors concluded that the schemes had created significant‘additionality’, thereby improving the resources available to young firms while increasinginvestors’ returns. The simplicity of the Enterprise Investment Scheme is particularly attrac-tive to business angels as it makes no attempt to determine investment eligibility other thanstipulating the qualifying and non-qualifying categories of investment (see Box 4.5).

BOX 4.5 ENTERPRISE INVESTMENT SCHEME (UK):INVESTOR TAX BENEFITS

● income tax relief – 20% of amount invested in terms of tax – period to holdshares of 3 years

● exemption from capital gains tax on shares held for the 3-year period● capital losses on shares treated as income losses● deferral of chargeable gain on any asset● maximum invested per tax year for income tax relief is now £400 000

(€589 000)


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

● Higher risk, young companies clearly targeted and specified by age, economic sizeand type of activity;

● total tax forgone is capped for both the recipient company and the individualinvestor;

● ex ante tax relief given on investors’ income when equity investment made in targetbusiness;

● investment losses can be used in further personal tax computations; and● ex post Capital Gains Taxes either avoided or reduced after a minimum holding

period.

Based on several countries’ experiences, a European-wide program, the YoungInnovative Company Scheme is currently evolving (EuropaBio, 2006). It is proposed that,for eligible investments, no tax is levied on capital gains realized or stocks that have beenheld for a minimum of three years. The French equivalent of the Young InnovativeCompany program (that is Jeune Entreprise Innovante) was adopted by the FrenchParliament in the 2004 Budget Bill. A similar bill, HR 5198, the Access to Capital forEntrepreneurs Act of 2006, was presented to the US Congress in April of this year.

Targeting business angels as co-investorsThese above schemes are directed at incentivizing the individual to invest directly or via atax efficient, trust fund structure. Government has also increasingly seen the businessangel community as an entity that may be incentivized collectively at the fund level in apotentially similar fashion to institutional venture capital businesses. To date, the taxtransparency attractions of the Limited Liability Partnership structure have largely beenirrelevant to the private investor. Yet, a syndicate of business angels investing co-operatively on projects where the due diligence and other investment costs has beenshared, as well as any eventual capital gains, is broadly equivalent to the established prac-tices of the established venture capital industry. In recognition of this reality, the UK gov-ernment has tried to find means by which it can invest alongside informal investors. Suchleverage initiatives have had to address and accommodate the legal issue that the businessangel is a personal investor rather than an institutional investor. However, as businessangel networks or bespoke syndicates start to manage external funds, these differencesbegin to blur.

A number of recent developments are noteworthy. Governments may invest as a publiclimited partner in a fund specifically made up of business angels investors. The UK’s 2004scheme, the Enterprise Capital Fund, is designed in such a manner as to accommodateboth institutional and informal investor groups. The bringing of business angel investorsinto a legal identity as a group or fund is relatively novel. It addresses the commonproblem of business angel investors being severely curtailed in the size of personal invest-ments. Historically more common, the state may be a co-investor at the level of individ-ual projects. Such a scheme has been in operation for several years in a primarilyinstitutional venture capital context in Germany via the BTU program. An informal


investor equivalent is seen in New Zealand’s Seed Co-investment Fund. This latterprogram that has been designed in the light of UK experience via the publicly co-fundedScottish Co-Investment Fund and the London Business Angel program.

These schemes each bear common criteria of informal investor/government interaction:

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

Networks, portals, match-makers and information asymmetriesThe institutional venture capital industry, like many professional services, may be seen asa dense network of complementary actors associated in the common delivery of special-ist financial products and sharing critical information. Overlapping venture capital net-works may, for example, be classified by stage of investment, types of opportunity, orlocation. Issues of access and preference determine a pecking order of venture capitalfirms and partners efficiently calibrated by industry reputations. The intensity of theventure capital locations or clusters in a relatively small number of major cities acrossEurope, America or Asia further increases the ability to communicate effectively andquickly between interested parties. To date, the venture capital industries have beenbroadly characterized as country-specific. However, as the venture capital industrymatures and leading players grow and expand their locus of operations at the expense ofless successful partnerships, the incidence of internationalization has increased markedly(Mäkelä and Maula, 2005; Deloitte and Touche, 2006).

Communications between informal investors or business angels compares poorly tothe small number of well organized venture capital firms located within the umbrella ofan efficient and highly representative industry association. Gilson’s (2003) ‘simultaneityproblem’ exists but is much more acute in an informal venture capital environment. Abusiness angel has to signal to would-be investee businesses that he or she is interested inreceiving business proposals. At the same time, the informal investor may wish to informother angels of his/her30 presence and willingness to participate in syndicated invest-ments. This lack of preceding contact, the diverse personal histories of the investors andthe absence of physical market places each serve to confound efficient communication.In the absence of such communication, it is similarly difficult to ensure that investmentproposals are fairly appraised and sensibly priced. It is not uncommon for an inexperi-enced investor to face an equally inexperienced entrepreneur with neither party able toassess the quality or the credibility of the business proposal or the financing offered. Suchcircumstances are very vulnerable to inefficient (or disastrous) outcomes either by chanceor design. It is for these reasons that many in the insitutional venture capital industryremain highly ambivalent as to the involvement of business angels in professionalventure capital investment deals. The cost of sorting out badly constructed or poorlypriced financial arrangements previously arranged between an inexperienced businessangel and entrepreneur may be sufficiently time consuming for the venture capitalist towalk away from providing follow-on finance. As Gifford (1997) has noted, the con-straining resource for many general partners is management time rather than the flow ofopportunities or finance.


In these circumstances, the involvement of government in activities which increase theinformation available to investors and/or investees is likely to be productive at modestcost. Similarly, the powerful national venture capital associations also have an interest inensuring that informal investors looking for early-stage deals that might lead on to insti-tutional venture capital activity are also sensibly advised, financed and structured. Thepolicy benefits of reducing information asymmetries and ensuring deals are properly com-municated to an active and deep market appear universally accepted. Accordingly, busi-ness angels networks on a local, national and (on occasions) international basis have beensupported by both government and institutional venture capital associations. Sohl usesthe generic term ‘portal’ to describe this interface between investors and entrepreneurs.Public transfers have also allowed the networks to be sufficiently well financed to ensurethe recruitment of appropriate management and training resources.

A dissenting voiceLerner (1998) turns a refreshingly skeptical eye on business angel activity. This is a usefulantidote as the business angel literature is often highly evangelical in its arguments. Lernerasks two questions that he contends are too often assumed rather than posed: 1) do privatecapital markets provide insufficient capital to new firms; and 2) can governments betteridentify future winning businesses in which to invest? In the absence of robust empiricalexamination31 of both the contribution of angels and the value-added role of govern-ment, Lerner remains a skeptic. Picking up a major theme of this chapter, he notes thatthe importance of scale is clear, but business angels, with very few exceptions, are com-monly characterized by their modest investment resources. Even when bandied togetherin investment syndicates, they are seldom likely to create an aggregate fund size of >$50million. In classic venture capital terms, such a small fund size would now widely be seenas uneconomic. Lerner’s concern is that new enterprises of insufficient potential to befinanced by institutional venture capital firms are then taken up by sub-optimally sizedbusiness angel networks where the range and level of investment skills and experience arehighly variable. In effect, the informal investor network is both ‘second best’ in itsresources and in the potential assistance that it can offer entrepreneurial firms. Businessangels are also far less regulated for minimum quality practices than their institutionalequivalents. In Lerner’s arguments, there is an implied ‘trickle down’ process with classicventure capitalists first reviewing prospects and the huge majority they reject becomingpart of the raw material of informal investors. Accordingly, he argues that we have atpresent little proof that fiscal incentive programs funded by the state are necessary toincrease business angel activity, nor do we have a clear understanding as to how such pro-grams may best be structured in order to realize policy goals (Lerner, 2002). WhileLerner’s argument remains cogent, the assumption that business angels are second best toinstitutional venture capitalists when appraised by early-stage investment performanceremains hotly debated.

Lerner is supporting those academics who argue that there exists a failure in qualitydemand (‘investment readiness’ argument) rather than a lack of available risk capital fornascent enterprises (the ‘equity gap’ argument). Yet, in practice, the minimum size thresh-olds for new investments imposed by the majority of professional venture capitalists arenow so high that it is highly unlikely that they would consider investing in a seed or start-up investment other than for the most interesting opportunity in a new technology. Such


speculative and exploratory investment could be viewed as placing a ‘put’ option onpotentially important future developments (McGrath and MacMillan, 2000; Miller andArikan, 2004). Yet, as Dimov and Murray (2006) demonstrate, such an integrated, marketintelligence strategy is rarely undertaken by professional venture capital investors outsidethe largest US firms.

Business angels – future policy interestBusiness angels by their very scale and ubiquity remain a focus of considerable interest togovernments. Ironically, it is their lack of activity that makes them so enticing. A modestincrease in informal investment activity is likely to have a much larger impact than anequivalent increase in institutional venture capital given the business angels’ predominantfocus on early-stage investment. Accordingly, it is likely that business angels will increas-ingly feature in the enterprise policy activities of developed economies. Countries thatfacilitate and incentivize personal investment activity via generous fiscal incentives arelikely to have an important head start. A number of trends will reinforce the growingpolicy interest in business angels. As the maturing, venture capital industry gets larger interms of funds managed (rather than the numbers of venture capital general partner-ships), a number of traditional venture capital funds will continue to withdraw from theearliest stage activities as partners experience the need to invest large amounts of fundmonies quickly. The relative performance advantages of later stage funds, includingprivate equity investments, will exacerbate this long term trend in Europe. In order tosupport this rational trend by their venture capital firm members, national venture capitalindustry associations will increasingly work with government to ensure that businessangels receive public support.

Such a cooperative industry stance supports the supply of potentially attractive busi-nesses to their venture capital firm members (at later rounds of finance) as well as deflect-ing government concern of the limited impact of institutional venture capital on nationalinnovation and entrepreneurship programs. Business Angel Networks will be able toexploit this opportunity to argue successfully for greater support (operating grants, co-investment schemes, and so on) for individual investors and (increasingly) legally definedangel groups. Programs supporting networks’ development, information exchange andinvestor training, are likely to continue to attract public support at regional, national andinternational levels. Yet, few public-supported programs are likely to invite independentacademic evaluation and scrutiny de novo. Hence the importance of Sohl’s call for moresupport for empirical research into a major financing activity that, in comparison to itsinstitutional venture capital equivalent, can still reasonably be viewed as terra nullis.

What have we learned from public involvement in private venture capital activity?One can argue with some authority that the evidence of government learning in the arenaof early-stage risk capital finance is rather poor. Detractors of government’s role couldrepeatedly point to unviable small fund sizes in public supported programs; the willing-ness of governments still to manage their own business angel programs outside the incen-tives and disciplines of the market; the imperfect integration between governments’entrepreneurial agendas, their fiscal programs and investors’ interests;32 the still under-developed role of informal investors; and the poor financial returns on public supportedfunds. The vigorous growth over the last quarter of a century when venture capital has


grown to become a major asset class is not reflected in equal successes for public involve-ment in new enterprise financing.

However, the choices which government faces are not often easy or unambiguous.Governments with responsibilities for departmental portfolios of often competing inter-ests have to determine if they wish to intervene in order to correct market imperfectionsor to realign incentives in a manner congruent with their policy goals. They have to decidehow attractive a flourishing venture capital industry would be to the domestic economy,and what can sensibly be done to promote its realization. Yet, while there is considerableand growing governmental activity in the arena of early-stage risk capital investment, thebody of knowledge on which this activity is based remains sparse. Lerner (1999) has com-mented on the absence of theory in guiding public venture capital activity. Similarly, Jengand Wells (2000) note that just as later and early-stage venture capital investment behav-iors are different and not necessarily influenced by the same factors, so likewise are publicand private venture capital activities different. These authors note that we are still rela-tively poorly informed as to the appropriate role of government in venture capital activ-ity. We lack both a canon of theoretical understanding (and guidance) as well as adiversity of exemplar programs from which we can benchmark progress.

Gilson (2003) takes a similar view that governments often undertake programs withouta clear understanding as to the full consequences of their actions. In addition, politicalcycles and investment cycles are rarely likely to be synchronized. There appears a growingacademic consensus that sanctioning government intervention is a decision that shouldonly be taken with considerable caution, and perhaps only when private venture capitalmarkets are patently failing. Circumstantial evidence of the large number of sub-optimal,publicly supported venture capital programs operating across the world including the USwould suggest that academics’ concerns with the logic of public intervention have fre-quently been ignored by policy makers (Bazerman, 2005; Rynes and Shapiro, 2005).

Yet, to suggest little has been learned and acted upon would be too pessimistic a diagno-sis. The ubiquity of entrepreneurial finance programs at local, regional, national and,increasingly, international levels of government are now so omnipresent that some learningis inevitable. There is a burgeoning corpus of research knowledge from scholars based in theentrepreneurship, innovation, management and economics subject areas.33 However, thecommunication and accommodation of research lessons into contemporary policy actionsat national level is still capable of considerable improvement (Söderblom and Murray, 2006).

Further, and of equal importance, government usually works in the least attractiveareas of a financial market. The public exchequer becomes involved because of theabsence of private investors. Accordingly, the situation of difficult investment choices andpoor returns is virtually guaranteed. Governments should not be criticized for poorreturns per se. Rather, a more apposite question is whether they should rationally hazardpublic monies by attempting to undertake investment activities in areas so commonlyabandoned by informed, experienced and profit-seeking commercial interests.

These comments should not be seen as an apologia for harassed policy makers. There isregrettably little evidence that robust research findings are acted upon in new policy for-mation and execution. It is inevitable that partially informed program designs will have real(and avoidable) costs. Sometimes, in the absence of institutional venture capital researchprograms, government may too readily accept the convenient results of managementconsultants or venture capital industry association.34


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

● Institutional or informal venture capital programs should harness private investors’interests and experience as agents of government program goals. Any deviationfrom this norm should be rigorously evaluated prior to agreement.

● There are trade-offs between venture capital or business angel program outcomes.Policy makers should be explicit as to the ‘value’ of different objectives, for examplereturn on capital, innovation, employment, regional investment and so on in bothlaunching and evaluating programs.

● There are major economies of scale and scope in venture capital fund activities.Program outcomes should be modeled and simulations tested prior to committingpublic funds to unviable fund structures.

● The levels of unmanageable uncertainty at the very earliest stages of venture capitalinvestment in novel technologies may be such that it may not be sensible to allocateresources by markets alone. Venture capital should be seen as only one of a rangeof financing options that may also include merit-based grants and other support.

● The premium for managerial and investor experience is high in informed, profes-sional labor markets. Program designers need to reflect on how such tacit know-ledge may be best harnessed to address the challenges of early-stage investment.

● The USA has provided venture capital communities worldwide with a huge stockof experience and expertise. Much of this learning may be valid and relevantoutside North America. Some of it will be usable in other and different nationalcontexts. It is implausible that a globalizing venture capital industry will, over time,be reliant on one absolute and exclusive model of success.

● All new venture capital programs involving public funds should have a formal (andindependently validated) evaluation model built into the program design stage.

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

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


● Measured by the criteria of venture capital fund survival and acceptable investmentreturns, are early-stage (seed and start-up) activities a long term viable propositionboth within and outside the USA? What policy and operational conditions need tobe in place to secure such desired commercial outcomes?

● Business angels are seen as an alternative to institutional venture capital providersat the earliest stages of investment. Is such an assumption empirically valid? Bywhat means can business angels succeed in early-stage market conditions that arepresently hostile to venture capital success?

● What actions under governments’ control (for example tax incentives, equityenhancement, investor training, network support, and so on) are most effective instimulating the investment activities of current and potential business angels?

● By what means can business angels and venture capital firms most effectively worktogether to support high potential young firms?

● By what means should public/private ‘hybrid’ venture capital programs be evalu-ated in order to both capture the economic and social objectives of all participat-ing investors and to allow meaningful cross-program comparisons?

● Venture capital has evolved to become one of a range of ‘alternative asset classes’by which financial institutions may seek to engineer the risk/reward profiles of theirinvestment portfolios. The actors involved and the decision processes by which suchinstitutional portfolios are designed remains a ‘black box’. How may researchersaddress the dearth of empirical studies focusing on the nature of institutionalinvestor decision making?

● As venture capital activity has internationalized so has the policy response. Howmay academics best respond collectively to international and comparative studiesof venture capital activity?

● We now have an international and multi-disciplinary body of research into venturecapital studies that has chronicled the introduction and growth of risk capital activ-ity across a large number of developed economies in Europe, North America andbeyond. Emerging economies in Asia, South America and Eastern Europe areshowing considerable interest in the putative role of venture capital in supportingthe genesis and growth of new enterprises and industries. How may academicsfeature in the processes by which emerging economies learn effectively from extantventure capital experience?

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


research ideas as the creators and funders of the new enterprises on which their disciplineis founded.

Notes1. Contemporary venture capital evaluations by government have included programs in Finland (2002; 2006),

UK (2003), and Ireland (2005) as well as New Zealand in 2005. Only the Finnish and New Zealand eval-uation is in the public domain (Maula and Murray, 2003; 2007; Lerner et al., 2005).

2. We have tended to use the terms ‘knowledge-based firms’ and ‘new technology-based firms’ interchange-ably. While this is a sensible shorthand in the context of this chapter, new technology-based firms shouldbe seen as a specialist category of knowledge-based firms. They both share a reliance on tacit and intan-gible assets for their competitive advantage.

3. As Lerner (2002) has noted, the US similarly has financed a considerable amount of public venture capitalactions both at federal and state levels. This involvement continues to be material.

4. Each of these economies has already experienced considerable inward investment by private venturecapital and private equity firms. However, these commercial interests are rarely at the level of newenterprises.

5. See www.indiavca.org.6. BVCA statistics only record start-up deals and not seed investments: 208 companies received start-up

investment in 2005.7. Brazil, India and China.8. In practice, early stage investors rarely seek interest payments but if successful are (ultimately) rewarded

by a significant capital gain multiple at exit.9. See Pickering (2002) for a valuable government policy maker/insider’s view of six UK reports on funding

tech-based Small and Medium Sized Enterprises.10. While senior policy makers are usually very aware of the limitations of transferring models to new con-

texts, this complexity does not stop politicians framing the question as noted.11. The statement is curious in that it implies a modest historic role for public policy in the US experience.12. If funds are ranked by the proportion of seed investments to total investments, a UK fund does not appear

until position 59.13. The Directory of Support Measures (EC, 2003c) lists seven measures by which the state can assist SMEs:

Reception, facilities and basic information, referral; Professional information services; Advice and directsupport; SME-specific training and education; Finance; Premises and environment; Strategic services.

14. There is some more encouraging evidence that early-stage investing in Europe after 2001 is showing morepositive returns and that performance is not affected by location once fund structural characteristics arecontrolled (Lindstrom, 2006).

15. Over the last 25 years, Northern European countries have arguably had a stronger tradition of directinvestment activity via public agencies than the more market-driven Anglo-Saxon models of the US andthe UK.

16. Despite Rocha and Ghoshal’s (2006) concern with the adversarial presumption of agency theory, it is apowerful concept that has considerable salience to venture capital studies.

17. The managers of a venture capital fund which is structured in the industry standard format of a LimitedLiability Partnership are called ‘general partners or GPs. Similarly, the investors into such a fund are calledthe ‘limited partners’ or LPs. Both parties have a range of specific rights and responsibilities which are thesubject of considerable, and complex, legal documentation.

18. Over the period 1959–2002, this program was responsible for raising $37.7 billion for some 90 000 busi-nesses (US Small Business Administration, 2003).

19. See the Small Business Services’ notes for the proposed Enterprise Capital Fund www.sbs.gov.uk/SBS_Gov_files/finance/waterfall.pdf.

20. European Venture Capital Association valuation guidelines exist to set a basis for objective performancecomparison between funds.

21. Communication with Yigal Erlich, the Government Chief Scientist of Israel at the time of the program’sinception and now CEO of the Yozma Group, Tel Aviv. The seven emulating countries cited by Mr Erlichare: Australia, Czechoslovakia, Denmark, Korea, New Zealand, South Africa and Taiwan.

22. Finnish 2003 and Irish 2005 evaluations were on venture capital programs that, while involving state invest-ment, could not easily be classified as hybrid funds using the term as understood by the OECD.

23. The public access of Finnish evaluations is an honorable exception to the rule.24. In this chapter no difference will be drawn between business angels and informal investors on the simplis-

tic assumption that they are both categories of private individual who provide risk capital (and loans) fornon-family enterprises.


25. In Europe in 2006, a private equity fund, Permira, launched an international fund of approximately €10billion. At least four venture capital funds of over $10 billion are scheduled for launch in 2007.

26. University endowment programs and investment trusts for high net worth family dynasties have played animportant early role in the development of the US venture capital industry (Bygrave and Timmons, 1992).

27. See http://www.lse.co.uk/financeglossary.asp?searchTerm�&iArticleID�1646&definition�business_expansion_scheme.

28. The Venture Capital Trust program which allowed retail investors to access venture capital funds and pro-vided another source of capital for young businesses was similarly launched in April 1995 (see http://www.hmrc.gov.uk/guidance/vct.htm).

29. The Netherlands had a broadly similar tax incentive program for private investors starting in 1996 andknown as the ‘Aunt Agatha scheme’.

30. Research suggests that male informal investors outnumber female investors by about 5:1.31. There is a dearth of large scale, quantitative ‘matched sample’ empirical studies whereby the outcomes of

BA investment on recipient firms can be compared to the outcomes of alternative investment channels oncomparable enterprises.

32. Government’s low interest policies have helped fuel a property boom that has arguably been a direct substi-tute for personal investors to informal investments in new enterprise. See, for example, the contemporary UKand Irish economies.

33. See the international Norface program on Venture Capital Policy Research Seminars (www.norface.org)instituted by Murray in 2005.

34. Most national venture capital associations have research departments producing analyses of the benefitsof venture capital activities albeit from a clearly articulated position of interest.

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PART II

INSTITUTIONAL VENTURECAPITAL

5 The structure of venture capital fundsDouglas Cumming, Grant Fleming andArmin Schwienbacher

IntroductionVenture capital funds perform a vital intermediary role in the financing of entrepreneur-ial firms and the spurning of new technology and knowledge in an economy. These fundscan take a variety of different organizational and legal forms, including limited partner-ships, investment trusts, corporate subsidiaries, financial institution subsidiaries and gov-ernment funds. The variety of forms is reflective of the way in which the venture capitalmarket has developed over the last forty years, becoming increasingly institutionalizedand internationally active. Academic research has followed these market developments ina quest to analyse and explain how institutional markets emerge, what structures charac-terize them, and how venture capitalists behave.

The research literature on the structure of venture capital funds is still relatively young.And yet the topic is important because the structure of venture capital funds lies at theheart of the way in which the institutional venture capital market works. The institutionalmarket involves professional venture capitalists investing on behalf of their investors inentrepreneurial firms. The structure of these relationships is a combination of explicit andimplicit contracts that regulate and guide how venture capital finance, skills and expertiseis delivered to entrepreneurs. In some cases, venture capitalists are loosely governed bycovenants through limited partnerships, and ‘live or die’ by their investment success. Inother cases, more formal bureaucratic structures impinge on the delivery of venturecapital. Our review of the research on the structure of venture capital funds bringstogether theoretical and empirical studies in analysing and explaining how these struc-tures are designed, and vary across geographical markets. As we shall describe, the earli-est literature in this area focused largely on explaining how and why venture capital fundswere structured as limited partnerships. The focus in this work was on the USA and wasdriven by empirical observations. Only later have we witnessed the literature deepenthrough empirical work on markets outside the USA, and through research on theeconomic–theoretic foundations of the structure of venture capital funds. The literatureon contract design as it pertains to venture capital fund structure now makes an impor-tant contribution to a range of disciplines including economics, finance and organiza-tional theory.

The structure of venture capital funds also impacts how venture capitalists go abouttheir craft. Important issues include: to what extent does structure influence a venture cap-italist’s strategy and the type of businesses receiving finance? And what if the structure ofventure capital funds leads to different behaviour by rational venture capitalists? Is theremore or less risk taking, willingness to add value to companies, or indeed, investmentsuccess? Important policy and economic lessons can be gleaned from studying howventure capital fund structures vary within a country and between countries, and theimplications for the delivery of finance to entrepreneurial firms.

155

This chapter reviews literature on the structure and governance of different types ofventure capital funds with a focus on the institutional structures designed to alleviateagency problems associated with financial intermediation in venture capital finance. Asventure capital limited partnerships (VCLPs) are the most common type of venturecapital fund in many developed economies, our analysis uses the VCLP structure as abenchmark upon which other types of venture capital funds are compared. It is import-ant to note here, however, that the VCLP structure is not necessarily the best type of struc-ture in all situations. Seminal papers on the VCLP structure describe the role of venturecapitalists as financial intermediaries between investors and entrepreneurial firms. Asinvestors do not have the time and skills to structure venture capital contracts, screenpotential investees, and add value to investees so that they are brought to fruition in aninitial public offering (IPO) or acquisition exit, investors contract with venture capitalistssuch that venture capitalists act on their behalf in carrying out the process of entrepre-neurial investment. We examine research on this process and contrast VCLPs with otherstructures. We then turn to review literature and evidence on why fund structure matters.As discussed above, fund structure may impact strategy, types of firms receiving finance,incentives for venture capitalists, the venture capitalist’s behaviour in the investment selec-tion and management process, and investment returns. The variation in structural formsobserved in the market are due, in our view, to the way in which contracting parties solveagency problems given differentiated objective functions. The relationship between thestructure of venture capital funds and behaviour of venture capitalists is fundamental toour understanding of the nature of the venture capital market.

This chapter is organized as follows. The next section provides a short history of thedevelopment of institutional venture capital markets, with particular attention to thechange in fund structures. Next, we will review research surrounding the structure andgovernance of venture capital funds, and then our attempt is to show evidence on whyventure capital fund structure matters, in terms of the types of investments made and thereturns to such investments. Finally, we will present our conclusions and offer some areasof future research.

The development of institutional venture capital marketsResearch on the structure of venture capital funds has always been motivated by theempirical observations that venture capital markets around the world were using variousorganizational forms to finance entrepreneurial firms. The growth in the body of litera-ture on the subject can best be understood in the context of how markets themselvesdeveloped. Research did not emerge due to a paradigmatic shift in economics and finance,the development of new research techniques, or cross-fertilization of ideas from relateddisciplines. Rather, it was impetus to understand the increasing importance of profes-sional venture capital firms in the economy, and the way in which parties contract betweeneach other to create new businesses that characterized the seminal articles.

The history of institutional venture capital markets has been well documented by Fennet al. (1997) and Gompers and Lerner (2001a). The literature focuses on the emergence ofventure financing in the post-second world war period in the USA through AmericanResearch and Development (ARD), listed closed-end funds spawned by the ARD, thefirst limited partnerships in the late 1950s, and federally supported Small BusinessInvestment Companies (SBICs). Even today, the historiography provides few insights into


the institutional developments in non-US markets, or of the experiments in corporateventuring that were to become important developments in the venture capital industry inlater years.

While the lineage of institutional markets is not well developed in the literature, allresearchers point to marked changes in the level of capital committed to the US venturecapital markets in the 1970s and early 1980s that form the basis of today’s industry. Theconsensus is that this change was motivated predominately by the changes to legislationin the US pension system in 1979 permitting pension fund managers to invest in riskierassets such as venture capital (Gompers and Lerner, 1998). For Europe, the entry of newventure capital firms from the 1970s (the founding rate of firms) has been positivelyrelated to density, suggesting that a critical mass is also needed to spurn industry growth(Manigart, 1994).

The growth and development of venture capital markets is illustrated best through dataon venture capital. The capital committed data in Figure 5.1a shows the total amount ofcapital committed to venture capital funds in the three major regions – USA, Europe andthe Asia-Pacific.

The US venture capital industry has always dominated global capital available frominstitutional venture capital funds. Figure 5.1a shows total capital committed each yearbetween 1968 and 2005 for the three major regions – USA, Europe and the Asia-Pacific.There were steady commitments to US funds in the 1980s, and a noticeable increase fromthe mid-1990s. International markets in Europe and the Asia-Pacific only increased inimportance in the late 1990s. Capital commitments peaked in 2001 in all three regions. Theinformation technology ‘bubble’ and associated venture capital overshooting (Gompersand Lerner, 2000) led to large falls in new capital flowing into the industry until 2004–2005.

Figure 5.1b measures the relative development of institutional venture capital marketsusing USA as the benchmark. The graphs express capital committed per year in Europe and

The structure of venture capital funds 157

0

10000

20000

30000

40000

50000

60000

70000

80000

90000

100000

110000

1968

1974

1980

1986

1992

1998

2004

US

$m

USA Europe Asia-Pacific

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

Asia-Pacific as a percentage of US capital raisings. The European market grew rapidly inthe 1980s to be almost 50 per cent of US raisings, although it has fallen recently to 30 percent. The Asia-Pacific has shown steady increase to 30 per cent of the US market per year.

The data in Figures 5.1a and 5.1b illustrate that institutional venture capital marketshave become larger in each of the three major world regions since the 1980s (note that thedata here is annual capital commitments, not cumulative assets under management).Another notable trend has been changes in the way in which venture capital funds arestructured. Contracting out investment management to third party venture capitalists (viaVCLPs) uniformly became the dominant form of venture capital fund structure. Table 5.1provides summary statistics on this trend, by showing the relative importance of, andchanges in, different types of venture capital funds in the US, Europe and Asia-Pacificcountries between 1980 and 2004.

The data illustrate several trends that are insightful in explaining how the researchhas developed. First, from the 1980s VCLPs raised by independent venture capital firmshave been the most common structure in the market. It is not surprising then that thisform has attracted substantial research attention. VCLPs were 75 per cent of the newfunds formed in the USA in the 1980s, with this increasing to 84 per cent by 2002 to 2004.Even today, we know much more about the operations of VCLPs operated by independ-ent venture capital firms than we do about any other structure, although we have onlyrecently seen research on non-US VCLPs. Second, the late 1990s witnessed corporationsand financial institutions establishing venture capital funds to a much greater extent thanpreviously. These ‘captives’ were part of the venture capital fund-raising ‘bubble’ of theperiod, and although their proportion of all funds raised did not change greatly, the


0.00

0.10

0.20

0.30

0.40

0.50

0.60

1980

1985

1990

1995

2000

2005

Europe Asia-Pacific

Source: Thomson Venture Economics; Authors’ calculations

Figure 5.1b Relative venture capital market development 1980–2005: Europe andAsia-Pacific vs USA

159

Tab

le 5

.1V

entu

re c

apit

al f

und

stru

ctur

es a

roun

d th

e w

orld

Vin

tage

Yea

rU

nite

d St

ates

All

Eur

opea

n C

ount

ries

All

Asi

a-P

acifi

c C

ount

ries

(Agg

rega

ted

All

IND

C

OR

P

FIN

A

ll IN

D

CO

RP

F

IN

All

IND

C

OR

P

FIN

in

Per

iods

)F

unds

Fun

dsF

unds

Fun

dsF

unds

Fun

dsF

unds

Fun

dsF

unds

Fun

dsF

unds

Fun

ds

Tot

al N

umbe

r of

New

VC

Fun

ds b

y P

erio

d:19

80–1

989

957

661

7691

236

135

343

112

85–

1219

90–1

996

718

543

3051

274

170

832

391

279

854

1997

–200

118

0413

4212

094

1152

703

8013

485

659

554

116

2002

–200

437

631

713

1222

515

08

2915

090

1227

Rel

ativ

e Im

port

ance

of

Diff

eren

t V

C F

und

Typ

es (

in P

er c

ent

ofal

l New

VC

Fun

ds)

by P

erio

d:19

80–1

989

1.00

00.

691

0.07

90.

095

1.00

00.

572

0.01

30.

182

1.00

00.

759

–0.

107

1990

–199

61.

000

0.75

60.

042

0.07

11.

000

0.62

00.

029

0.11

71.

000

0.71

40.

020

0.13

819

97–2

001

1.00

00.

744

0.06

70.

052

1.00

00.

610

0.06

90.

116

1.00

00.

695

0.06

30.

136

2002

–200

41.

000

0.84

30.

035

0.03

21.

000

0.66

70.

036

0.12

91.

000

0.60

00.

080

0.18

0

Ave

rage

Num

ber

ofN

ew V

C F

unds

per

yea

r by

Per

iod:

1980

–198

996

668

924

142

414

11–

219

90–1

996

103

784

939

242

556

402

819

97–2

001

361

268

2419

230

141

1627

171

119

1123

2002

–200

412

510

64

475

508

1050

304

9

Not

e:T

his

tabl

e de

scri

bes

the

rela

tive

impo

rtan

ce o

fdi

ffer

ent

type

s of

VC

fun

d st

ruct

ures

ove

r ti

me.

IND

:ind

epen

dent

fun

d (V

CL

P),

CO

RP

:cor

pora

te V

Cfu

nd,F

IN:fi

nanc

ial-

affilia

ted

VC

fun

d.‘A

ll V

C f

unds

’inc

lude

all

3 ty

pes

as w

ell a

s ot

hers

.Tim

e pe

riod

s ar

e ba

sed

on v

inta

ge y

ear;

i.e.,

year

fun

ds w

ere

esta

blis

hed.

Sou

rce:

Tho

mso

n V

entu

re E

cono

mic

s;A

utho

rs’c

alcu

lati

ons

number of venture capital funds in the category increased between 400–600 per cent. Nowresearchers were faced with a new structural form whereby venture capital was providedto firms through more bureaucratic structures. Thirdly, the internationalization ofventure capital has prompted research on the ways in which legal systems, culture andinstitutions impact structure. While the USA continued to be the home of the most newfunds raised each year, Europe and Asia has increased in importance. Indeed, there arenow more funds raised outside the USA than inside the USA, providing impetus to cross-country research and the arrival of new researchers from various nationalities contribut-ing to the literature.

There is no doubt that new developments in the venture capital market will, over time,have additional stimulatory impact on the growth of the literature. To date, the markettrends described above have meant that research covers three major types of venturecapital fund structure: VCLPs, captive funds (financial institutions and corporate venturecapital funds), and government funds (under the guise of government venture capitalsupport programmes). We will examine each of these structures in turn.

The structure of venture capital fundsThe development of institutional venture capital markets and the rise of venture capitalas an important form of finance provided researchers with a fertile topic of analysis. Ofparticular importance was the way in which parties contracted to solve agency problemsin the investment management process. In this section we review the work that pioneeredour understanding of fund structures. We first discuss research examining venture capitallimited partnerships. We then turn to more recent work on captive venture funds and gov-ernment sponsored funds. An overview of the research discussed in this section is pro-vided in Table 5.2.

Venture capital limited partnerships (VCLP)

The characteristics of VCLP Venture capital limited partnerships are the contractualoutcome of negotiations between the general partner (the venture capital firm run byinvestment professionals) and the limited partners (investors). Two features of the for-mation of a VCLP have been documented – fund raising and contract negotiation. Interms of fund raising, limited partners are institutional investors that invest in a range ofassets across the risk spectrum (depending upon their asset–liability structure). Venturecapital and private equity forms a relatively small part of institutional investors’ assetportfolio. Investors (typically) aim to have up to 10 per cent of their capital to the venturecapital (funds focused on early stage investments) and private equity (funds focused onlate stage, turnaround and buy-out investments) asset class, depending on economic andinstitutional conditions (Gompers and Lerner, 1998; Jeng and Wells, 2000; Mayer et al.,2005). Endowments and foundations (long term, intergenerational asset pools) have trad-itionally allocated much higher proportions of their assets (often above 25 per cent) toventure capital and private equity. Gompers and Lerner (1998) and Jeng and Wells (2000)show that pension funds are dominant investors, while other investors include life insur-ance companies, corporations, commercial and investment banks, universities, endow-ments, foundations, and wealthy individuals. In an international study, Mayer et al. (2005)focus on fund raising in Germany, Israel, Japan and the UK, and show that banks are the


161

Tab

le 5

.2K

ey fe

atur

es o

fth

e st

ruct

ure

ofve

ntur

e ca

pita

l fun

ds

Typ

e of

VC

fun

d &

T

ypic

al o

wne

rshi

p of

stru

ctur

eth

e fir

mSo

urce

of

fund

sO

bjec

tive

sC

ontr

act

feat

ures

Inde

pend

ent

VC

firm

In

divi

dual

par

tner

s

Thi

rd p

arty

inve

stor

sF

inan

cial

ret

urns

L

imit

ed li

fe;m

ulti

ple

fund

(V

CL

P)

thro

ugh

a pr

ivat

e co

mpa

nyin

clud

ing

pens

ion

fund

s,(r

etur

n on

inve

stm

ent,

rais

ings

;con

trac

t en

dow

men

ts,f

und-

of-

IRR

)co

vena

nts;

limit

ed li

abili

tyfu

nds,

life

insu

ranc

e co

mpa

nies

,ind

ivid

uals

Cap

tive

(di

visi

on/b

usin

ess

Pub

licly

ow

ned

Bal

ance

she

et f

unds

;St

rate

gic

goal

s in

clud

ing

Unl

imit

ed li

fe;f

orm

alun

it)

corp

orat

ion

busi

ness

dev

elop

men

t or

acce

ss t

o ne

w t

echn

olog

ies

adm

inis

trat

ive

cont

rol a

nd

R&

D b

udge

tsan

d/or

pro

duct

s;lim

itin

gin

form

al c

ontr

ol t

hrou

ghco

mpe

titi

ve t

hrea

ts;

corp

orat

e cu

ltur

efin

anci

al r

etur

ns

Gov

ernm

ent

spon

sore

d In

divi

dual

par

tner

s G

over

nmen

t fin

ance

s (a

nd

Pub

lic p

olic

y go

als

Lim

ited

life

;sin

gle

fund

fu

nd (

vari

ous

stru

ctur

es)

thro

ugh

a pr

ivat

e so

met

imes

mat

chin

g in

clud

ing

deve

lopm

ent

ofra

isin

g;co

ntra

ct

com

pany

,end

orse

d pr

ivat

e se

ctor

cap

ital

fro

m

the

loca

l ven

ture

cap

ital

co

vena

nts

ofte

n w

ith

by a

gov

ernm

ent

thir

d pa

rty

inve

stor

s)in

dust

ry;a

ccel

erat

ing

geog

raph

ic,c

ompa

ny t

ype

prog

ram

me

econ

omic

gro

wth

and

an

d in

vest

men

t st

age

empl

oym

ent;

rest

rict

ions

com

mer

cial

izat

ion

ofte

chno

logy

major source of funds in all considered countries, but particularly in Germany and Japan.Pension funds are more important in the UK than elsewhere.

The motivation for limited partners to invest in VCLPs derives from portfolio theory.Gompers and Lerner (2001a) and Lerner et al. (2005) found that investors can increaseoverall portfolio return through a justifiable increase in associated risks so long as theyselect venture capitalists that perform, over their life time, above the observable medianfund return. Obtaining the required allocation and exposure, however, is not a simplematter. While institutional investors desire a set exposure to venture capital, this exposureis not achieved immediately upon committing capital to a venture capital fund (Cumminget al., 2005). Capital commitments are drawn down over time through capital calls whenthe fund managers have selected entrepreneurial firms to invest in, and as such, it typicallytakes a number of years before an institutional investor has reached their targeted expo-sure to venture capital and private equity. Once exposure is achieved the investor mustcontinue to commit new capital to venture capital in order to maintain a ‘steady state’exposure position. Institutions with long term, steady state programmes have been shownto outperform other investors in achieving returns (Lerner et al., 2005).

The second feature of the formation of a VCLP is the negotiation of covenants in thepartnership agreement. This area was first studied by Sahlman (1990) and Gompers andLerner (1996; 1999). The structure of VCLPs is designed to mitigate information asym-metries and agency problems associated with fund managers investing money in entre-preneurial firms on behalf of institutional investors. The VCLP is structured as acontractual relationship between limited partners and the general partner under partner-ship law, although it should be noted that not all countries around the world have codi-fied partnership laws conducive to venture capital. The VCLP has a finite horizon of(typically) 10 years, with an option to continue for 1–3 years (if the remaining companiesneed to be exited). This contractual arrangement is efficient, as it facilitates the timerequired to select entrepreneurial firms in which the VCLP will invest and bring thatinvestment to fruition (either in the form of an IPO or an acquisition). The time of firstinvestment until exit in an entrepreneurial firm can take between 2–7 years. Venturecapital fund managers start fund raising for subsequent funds in the later part of the lifeof their existing fund(s), and may operate more than one VCLP simultaneously (subjectto covenants, as discussed below). In industry practice, the collection of funds that com-prise a venture capital organization is sometimes referred to as a ‘venture capital firm’(whereas a ‘venture capital fund’ is a single fund that is part of a venture capital firm).

The economics associated with VCLPs are designed to secure interest alignment underconditions of hidden information and hidden action. Venture capital fund managers arecompensated in a way that provides them with a fixed management fee (1–3 per cent ofcommitted capital per year) and a carried interest performance fee (20–30 per cent ofprofits over return of capital). The fixed management fee is designed to provide enoughcapital to run the fund and pay the fund manager prior to any exit. The performance feeis designed to align the incentives of the VCLP managers with their institutional investors.Gompers and Lerner (1999) show younger inexperienced fund managers typically negoti-ate higher fixed fees at the expense of lower performance fees, as their ability to earn per-formance fees is uncertain. Moreover, more recent studies have evidenced deviations fromthe ‘2 and 20 rule’ of venture capital manager compensation (that is 2 per cent manage-ment fees and performance fee of 20 per cent of the profits) in recent years (Litvak, 2004b).


VCLPs have three key legal advantages. First, they avoid (or at least mitigate) doubletaxation of profits as would take place if the structure were a corporation. Second, theyallow for unlimited liability of the fund managers (the general partner), while allowing forlimited liability of the institutional investors (the limited partners). The fund manager isinvolved in the day-to-day operation of the fund, and can make decisions without inter-ference from the institutional investors (or otherwise the institutional investors risk losingtheir limited liability status). This autonomy is a marked advantage over corporateventure capital funds, as discussed below. Third, unlike a corporation (where covenantsare imposed by statute), VCLPs are structured by contract, which is completely flexibleand negotiated to specifically suit the best interests of the parties.

Covenants governing the VCLPs The covenants contained in VCLP set out the ‘rules ofbehaviour’ for long term relationships. Theory on the design of these covenants is in itsinfancy. Lerner and Schoar (2004) examine the extent to which venture capital managersmay want to include specific covenants in the LP agreements in order to screen betterinvestors for their fund (that is more ‘liquid’ investors that are long term oriented, withsecure sources of capital). The central hypothesis is that the manager benefits from havingtheir investors participate in follow-up funds, since it provides a signal to other investorsthat LPs are happy with the manager. Therefore, the latter may prefer to keep out liquidity-constrained investors in early funds, since these investors may not participate in follow-uprounds for reasons other than how well the fund performed. Their study leads to empiricalpredictions with respect to the particular design of partnership agreements.

In terms of empirical studies on covenants, the seminal work was undertaken byGompers and Lerner (1996; 1999), who analyse the covenants used to govern VCLPs inthe US. Subsequent work (Schmidt and Wahrenburg, 2003; Cumming and Johan, 2005)considers similar evidence in an international context. One type of covenant amongVCLPs is the restriction on the fund manager regarding investment decisions. First, fundmanagers are restricted on the size of investment in any one portfolio company. Withoutsuch a restriction, a fund manager might lower his or her effort costs associated with diver-sifying the institutional investors’ capital across a number of different entrepreneurialfirms. It also limits excessive risk-taking by venture capital managers as it forces them todiversify. Second, fund managers are typically restricted from borrowing in the form ofbank debt, as it would increase the leverage of the fund and impose extra risks on insti-tutional investors. Third, there are restrictions on co-investment by another fundmanaged by the same fund manager, as well as restrictions on co-investment by the fundinvestors, which limit conflicts of interest managing the fund. Fourth, there are restric-tions on the re-investment of capital gains obtained from investments brought to fruitionto ensure realized capital gains are returned to institutional investors.

A second category of covenants relates to types of investment and ensures that the insti-tutional investors’ capital is invested in a way that is consistent with their desiredrisk/return profile. Restrictions include investments in other venture funds, follow-oninvestments in portfolio companies of other funds of the fund manager, public securities,leveraged buy-outs, foreign securities, and bridge financing. Without such restrictions, thefund manager could pursue investment strategies that better suit the interests of the fundmanagers regardless of the interests of the institutional investors. In practice, covenantstend to be defined in relatively broad language in order to give flexibility to venture capital


managers. However, private equity offering memoranda used by venture capital firms toraise funds typically include more detailed investment objectives in terms of stage ofdevelopment, industry focus and geographical scope. Any deviation from these invest-ment objectives is traditionally called ‘style drift’. Cumming et al. (2004) study such styledrifts in a sample of US data, and show drifts are related to fund age (first-time fund man-agers are less likely to drift due to potential reputation costs), and to changes in marketconditions between the time funds were raised and funds are invested. Other forms ofcovenants are discussed in Gompers and Lerner (1996; 1999), Litvak (2004b), Lerner andSchoar (2004) for US evidence, and Schmidt and Wahrenburg (2003) and Cumming andJohan (2005) for international evidence.

Overall, the flexible nature of contractual covenants used to govern VCLPs, and theautonomy of VCLP managers vis-à-vis their institutional investors, are viewed to be amajor reason behind the successful development of the US venture capital market(Gompers and Lerner, 1996; 1999). Lerner and Schoar (2004) show that an effective wayto punish venture capital managers is to not participate in follow-on funds of a venturecapital firm. This provides an adverse signal to other fund providers about the quality ofthe venture capital firm. The manager then faces a ‘lemons’ problem when he has to raisefunds for a subsequent fund from outside investors. New investors cannot determinewhether the manager is of poor quality. Where prior institutional investors no longer par-ticipate in follow-on funds of the venture capital firm, other potential institutionalinvestors of the fund may infer that the existing investors believe that the venture capitalfund managers are of low quality. Thus, VCLP covenants bind the behaviour of theventure capitalist but it is rare for the sanctions involved in VCLPs to be invoked byinvestors. Punishment is more likely to take place through the investor exiting the rela-tionship when the next fund is offered for investment.

Captive venture capital fundsCaptive venture capital funds are funds that are partly or wholly owned by parties otherthan the venture capital professionals. Captives may be affiliated to banks, securities firms,larger diversified financial institutions or a division/unit of a corporation. The ownershipstructure of the captive venture capital fund means that its legal and organizational struc-ture differ from VCLPs in several crucial ways. First, captive funds primarily derive capitalfrom their parent and invest on behalf of the parent. There is no limited life fund struc-ture in the agency relationship. Second, governance of venture capitalists within thecaptive fund is materially different from governance as contracted through the covenantsin the VCLP. Rather, the company acts as a large (and often sole) shareholder controllingthe fund. Third, venture capitalists invest in entrepreneurial firms in order to satisfy objec-tive functions that may contain financial and non-financial goals. Finally, the behaviourof venture capitalists is influenced by the structure of the fund in terms of risk investing,portfolio construction and effort (we examine this last difference later on in this chapter).

Research on bank venture capital funds is still in infancy. Banks supply their venturecapital divisions with capital from the balance sheet of the bank, allocating a notionalcommitment amount (for example capital per year to be invested). Thus, fund raising isdifferent in process to professional venture capital firms under the VCLP structure(Gompers and Lerner, 1999; Cumming et al., 2005; Dushnitsky and Lenox, 2005;Cumming and MacIntosh, 2006). Banks intermediate between depositors and private


companies requiring longer term debt and equity. The investment objective for banks is tomatch longer term liabilities in their capital structure with debt and equity investment inprivate equity. As the major, or only capital provider to an entrepreneurial firm, there is noconflict between debt and equity in the bank’s view. Also, banks aim to sell additional ser-vices into the portfolio company (for example advisory services, capital raising and arrang-ing fees) in order to ‘service’ their client and generate income from the investment. Thus,the investment objectives are measured through a range of key performance indicators thatmay include non-return variables. Again, this is in stark contrast to VCLPs where returnmaximization is the sole objective. Banks establish venture capital companies as separatedivisions providing development capital to clients/prospective clients. Governance takesplace through the internal administration process that is used by the corporation in all divi-sions (rather than having governance tailored to the venture capital fund and its particu-lar circumstances). Deviations from the venture capitalist’s role and responsibilities insidethe bank venture capital fund (for example conflicts of interest, hidden action) are dealtwith like any other cases in the bank, as venture capitalists are employees governed bylabour contracts. Given hierarchical internal labour markets it is less likely to see oppor-tunistic behaviour in the venture capital unit (the payoff to such behaviour is low), and itis less costly for the bank to sanction inappropriate behaviour (implying for the venturecapitalist that the probabilistic costs of detection and punishment are high).

Corporate venture capital companies are organized to provide corporations withbalance sheet investments for strategic advantages (see Gompers and Lerner, 1999;Hellmann, 2003; Riyanto and Schwienbacher, 2005). In the late 1960s and 1970s, morethan 25 per cent of Fortune 500 companies attempted to create corporate venture capitalprogrammes. Corporate venture capitalists comprised 12 per cent of all US venture capitalinvestment in 1986; 5 per cent of all US venture capital in 1992, 30 per cent of all USventure capital in 1997 (Gompers and Lerner, 1999), 15 per cent of all US venture capitalin 2000 (Dushnitsky and Lenox, 2005), and 6 per cent of all US venture capital in 2003(VC Experts, 2003). Similarly, corporate venture capital comprised approximately 5 percent of the Canadian venture capital market in 2003 (Cumming and MacIntosh, 2006).

Large corporations use separate entities such as corporate venture capital funds (as awholly-owned subsidiary) to structure such operations (see for example Chesbrough,2002). Like banks, corporations usually establish a division/unit to invest committedamounts into venture capital investments. The investment objective is to maximize awidely defined objective function that relates to broad corporate goals, the securing ofnew technologies for competitive advantages (real options), and controlling competitivethreats. Captive venture capitalists are paid less, and have less pay-per-performance sen-sitivity than limited partnership venture capitalists (Gompers and Lerner, 1999;Birkinshaw et al., 2002). Captive venture capitalists also have much less autonomy thanlimited partnership venture capitalists (Gompers and Lerner, 1999). As such, captiveventure capital managers that show signs of success are often recruited away from thecaptive venture capital organization to work for limited partnerships.

Government venture capital funds

Government venture capital programmes Government-backed venture capital companyprogrammes have been popular around the world as governments support the development


of national venture capital markets servicing all stages in the entrepreneurial investmentprocess (see for example programmes operating in the USA (SBIC), the UK, Israel(Yozma), Scandinavia, Belgium (SRIW and GIMV), Australia (Innovation InvestmentFund), and New Zealand (Venture Investment Fund)). Typically, these programmesprovide government funding alongside private sector funding (sometimes with an optionto ‘buy out’ the government at a lower rate of return, providing a leverage effect). Theinvestment objective is usually to alleviate perceived market failure in the supply ofseed/early stage venture capital, where information asymmetries are highest and sub-optimal capital is allocated by private sector investors (Jaaskelainen et al., 2004).Government venture capital funds are often driven by policy objectives associated withwelfare outcomes to enhance the market structure, improve financing options to youngerfirms, increase employment, foster innovation and support economic growth (Kortum andLerner, 2000; Jaaskelainen et al., 2004). From a theoretical perspective, government pro-grammes have been shown to be Pareto improvements, leading to net positive economicbenefits to an economy (Keuschnigg, 2003; Kanniainen and Keuschnigg, 2004). The struc-ture of government funds involves covenants on the sector/stage geographic conditions, oninvestment behaviour (for example regional, state or country limitations, technology focus,stage focus), a commitment to wider policy goals such as knowledge transfer, commercial-ization of technology from universities, encouraging international linkages with compa-nies, and development of local venture capital industry.

Public policies towards venture capital Broadly classified, public policies towards venturecapital come in one of two primary forms: (1) law, and (2) direct government investmentschemes. Capital gains taxes are widely recognized as being one of the most importantlegal instruments for stimulating venture capital markets (Poterba, 1989a; 1989b;Gompers and Lerner, 1998; Jeng and Wells, 2000) (but there are other legal instrumentsfor venture capital markets; see Armour and Cumming, 2005). Poterba (1989a; 1989b)shows US venture capital fund raising increased from $68.2 million in 1977 to $2.1 billionin 1982 as there was a reduction in the capital gains tax rate from 35 per cent in 1977 to20 per cent in 1982. Venture capitalists invest with a view to exit. As entrepreneurial firmstypically do not have cash flows to pay interest on debt and dividends on equity, venturecapitalists invariably invest with a view towards an exit and the ensuing capital gains. Themost profitable forms of exit for high quality entrepreneurial firms are typically IPO andacquisitions (Gompers and Lerner, 1999; Cumming and MacIntosh, 2003b; Cochrane,2005). Therefore, tax policy in the area of capital gains taxation is particularly importantfor venture capital finance (for theoretical work on tax policy, venture capital and entre-preneurship, see Keuschnigg and Nielsen, 2001; 2003a; 2003b; 2004a; 2004b; Kanniainenand Keuschnigg, 2004; Keuschnigg, 2003; 2004). Da Rin et al. (2005) and Armour andCumming (2005) examine the effectiveness of several public policy measures. As conjec-tured by Black and Gilson (1998), the creation of active IPO markets in Europe appearsto be an important measure for fostering an effective venture capital market. Other mea-sures that increase the extent to which venture capital flows to high-tech and early-stageinvestment opportunities are tax benefits and reduced labour and bankruptcy regulation.

A second form of government support is via direct government created venture capitalfunds. Lerner (1999; 2002) discusses the ways in which government funds can be success-fully implemented to work alongside private venture capitalists. One of the most important


items identified by Lerner (2002) is the need for government funds to partner with, andnot compete with, private venture capital funds. It is also important for government fundsto work towards areas in the market where there exists a clear and identifiable marketfailure in the financing of companies due to, for example, structural impediments in themarket that have given rise to a comparative dearth of capital. Further, Lerner (2002) sug-gests it is useful for government funds to be structured in ways that minimize agency costsassociated with the financing of small and high-tech firms. For example, it is useful forfund managers to have covenants controlling investment mandates and compensationincentives to add value to all of their investee companies; such covenants and compensa-tion mechanisms have worked extremely well in mitigating agency problems amongprivate limited partnership venture capital funds (Gompers and Lerner, 1996; 1999).

Government programmes around the world Countries around the world have adopteddifferent forms of direct government investment programmes in venture capital andprivate equity. For example, the US has adopted the Small Business Innovation Research(SBIR) Programme, administered by the US Small Business Administration (SBA). TheSBIR programme is the largest government support programme for venture capital in theworld. SBIRs have invested over $21 billion in nearly 120 000 financings to US small busi-nesses since the 1960s. Investee companies include such successes as Intel Corporation,Apple Computer, Federal Express and America Online. SBIRs are operated like privateventure capital funds and are operated by private investment managers. The differencebetween a private venture capital fund and an SBIR is that the SBIR is subject to statu-tory terms and conditions in respect of the types of investments and the manner in whichthe investments are carried out. For example, there is a minimum period of investment forone year, and a maximum period of seven years for which the SBIR can indirectly ordirectly control the investee company. The SBIR does not distinguish between types ofbusinesses, although investments in buy-outs, real estate, and oil exploration are prohib-ited. Investee companies are required to be small (as defined by the SBA) which generallyspeaking is smaller than those firms that would be considered for private venture capitalfinancing. SBIRs also face restrictions as to the types of investment in which they mayinvest. Capital is provided by the SBA to an SBIR at a lower required rate of return thantypical institutional investors in private venture capital funds. Excess returns to the SBIRflows to the private investors and fund managers, thereby increasing or leveraging theirreturns. Lerner (1999) shows early stage companies financed by the SBIR have substan-tially higher growth rates than non-SBIR financed companies. This programme has beenquite effective in spurring venture capital investment and creating sustainable companies(Lerner, 1999). A key feature of this programme is that it complements and partners with,and does not compete with, private sector venture capital investment.

Similarly, the Government of Australia adopted the Innovation Investment Fund (IIF)Programme in 1997. As in the US SBIR programme, a key feature of the Australian IIFprogramme is that it operates like a private venture capital fund. There have been nineIIFs created in Australia, for which the ratio of government to privately sourced capitalmust not exceed 2:1. Investments will generally be in the form of equity and must only bein small, new-technology companies. At least 60 per cent of each fund’s committed capitalmust be invested within five years. Unless specifically approved by the Industry Researchand Development Board of the Government of Australia, an investee company must not


receive funds in excess of $4 million or 10 per cent of the fund’s committed capital,whichever is the smaller. Prior to the introduction of the IIF programme in 1997, therewas scant start-up and early stage venture capital investment in Australia. Cumming(2006a) finds that IIFs are fostering the development of the Australian venture capital andprivate equity industry in a statistically and economically significant way. In short, the USSBIR and Australian IIF are indicative that there is tremendous potential for govern-ments to foster innovation and economic development through public subsidization ofventure capital.

Policy makers in Canada have adopted a unique form of government venture capitalfund known as the Labour Sponsored Venture Capital Corporation, or LSVCC(Cumming and MacIntosh, 2006). The UK has adopted a similar type of fund known asthe Venture Capital Trust (VCT) (Cumming, 2003). Both the Canadian LSVCC and theUK VCT are mutual funds listed on stock exchanges, and not operated like privateventure capital funds as in the case of US SBIRs and Australian IIFs. The LSVCC andVCT investors are individuals, and they receive substantial tax incentives to contributecapital to this class of funds (by contrast, a mix of government and private funds are usedin partnership to support Australian IIFs and US SBIRs). In exchange for the tax subsidy,LSVCC and VCT managers agree to adhere to a set of statutory covenants that constraintheir investment decisions and activities. The dominant presence of government subsi-dized LSVCC funds in Canada is in sharp contrast to the US venture capital market. Priorwork has shown that LSVCCs distort efficient venture capital investment duration(Cumming and MacIntosh, 2001) and efficient exit strategies (Cumming and MacIntosh,2003a; 2003b) in Canada relative to the US. Further, LSVCCs crowd out private venturecapital funds (Cumming and MacIntosh, 2006). LSVCCs have much larger portfolios ofinvestee companies per fund manager than private independent venture capitalists inCanada (Cumming, 2006b), and distort the selected security in Canada (Cumming,2005a; 2005b).

Overall, government support programmes for venture capital have had mixed success.In countries where the government venture capital fund competes with private venturecapital funds (as in Canada), the policy objectives of the government programme has notbeen met. Where the government programme complements the private market and fills agap in the private provision of capital (as in the US and Australia, for example), the pro-grammes have been quite successful.

SummaryResearch on the structure of venture capital funds is consistent with the view that VCLPsare the most appropriate structure for the financing of entrepreneurship and innovation inmost areas of venture capital (Gompers and Lerner, 1996; 1999; Schmidt and Wahrenburg,2003; Cumming and Johan, 2005). As we showed in Table 5.2, these venture capital fundsare owned by the individual investment professionals and make contracts (VCLPs) withthird party investors. The delineation of activities between the parties is well laid out, andthe goals are clear. Entrepreneurial firms receive finance from venture capitalists who aremotivated to help the company to grow in order to maximize shareholder value and invest-ment returns. Indeed, the continuation of the venture capitalist’s franchise depends uponsuccessful support of entrepreneurial companies. The structure of the VCLP facilitates longterm autonomous investment structures and appropriate compensation arrangements.


Captive venture capitalists, by contrast, are structured in a more bureaucratic way with spe-cific corporate objectives given that they are located within a different ownership structure(for example publicly traded corporations). The captive venture capital division providesventure capitalists with little autonomy and the organizations are much less stable. Goalsmay be unclear, conflict, and include the potential negative effects of limiting entrepre-neurial company growth to protect the competitive position of the corporation. Finally, theownership of the venture capital fund by a corporation means that while its structure isopen-ended (which is more suitable than a VCLP for long term risk capital), there may beless certainty over the life of the fund as the corporation changes strategy or faces financialpressures in other areas of the business. Government venture capital funds have had mixedsuccess depending on the design of the programme, which varies significantly across coun-tries. Successful government programmes take the best structural characteristics fromVCLPs and complement this with specific features to minimize market distortions.

Why venture capital fund structure mattersWe have seen that venture capital fund structures vary within a market, and across geo-graphies. In this section we review the theoretical literature on why venture capital fundstructure matters for the value-added provided by venture capitalists to investee firms, aswell as for generating returns. We then examine empirical evidence.

Theoretical research on venture capital fund structure and venture capital behaviourThe main strand of theoretical research focuses on micro-level analysis and uses agencytheories and mechanism design to produce insights into the functioning of venture capitalmarkets. Venture capital-specific theories are relatively new, and the first ones certainlywere written after empirical research on venture capital started. The functioning of theventure capital market has been used as motivation ground for many analyses in incom-plete contracting and control theories (for example Hellmann, 1998). The theoreticalresearch in venture capital has largely focused on the relationship between the venturecapital fund manager and the entrepreneur, taking a single investment perspective. Onlyrecently has there been attention directed to the relationship between limited partners(LPs) and the venture capital fund manager (general partner, GP). A small number of the-oretical works have contributed to a better understanding of tradeoffs that a venturecapital fund manager faces, and how these are resolved in order to align the manager’sincentives with LPs’ interests. This is particularly important for venture capital funds sinceLPs cannot easily liquidate their positions once they have invested (or only at very highcosts). This reason, and the fact that LPs by definition cannot interfere in the day-to-dayprocess of the fund, makes the contract design of partnership agreements a crucial aspectof a well-functioning fund.

When examining decisions made by venture capital managers, a number of papersutilize information economics theories such as the signalling and learning hypotheses.These are especially useful when examining the decisions made by venture capitalistswhen approaching the fund raising process for their next fund (for example Gompers,1996; Cumming et al., 2005). The signalling hypothesis refers to fund manager actionsthat seek to demonstrate to institutional investors that they are of high quality. A centralvariable along these lines is the degree to which the manager (or the firm she runs) isalready well-established or still young. In the latter case, it is assumed that fund providers


have little information about the true quality of the manager and try to infer her qualityfrom information signals. Two possible signals that have been investigated are exit deci-sions (‘grandstanding effect’ as examined in Gompers, 1996) and investment decisions(that is whether the manager style drifted while investing, as examined in Cumming et al.,2004). For the context of establishing fund compensation arrangements, Gompers andLerner (1999) find evidence in favour of learning. However, other evidence shows sig-nalling is important for both exits (Gompers, 1996) and investment decisions (Cumminget al., 2004).

Investment decisions are also closely tied to the structure of a venture capitalist’s port-folio. Recent papers have therefore moved from a single investor model to take a portfolioperspective of venture capital investments. Kanniainen and Keuschnigg (2003; 2004) andKeuschnigg (2004) examine the tradeoff between the number of portfolio companies (thatis portfolio size) and the amount of effort each investment receives. Clearly, a managerthat needs to monitor more companies has less time for each of them. Their resulting com-parative static analysis provides a clear departure from earlier papers (for exampleGompers and Lerner, 1999) that did not consider the number of portfolio companies.Similarly, examination of the interaction between portfolio companies within a venturecapital fund shows that venture capital managers do not choose each company individu-ally but may have incentives to take a portfolio perspective. Fulghieri and Sevilir (2004)argue that venture capital fund managers may let related projects compete in their earlystages, and stop the less promising one afterwards so that resources and human capitalcan be redeployed to the most promising one. Under certain conditions, this providesbetter incentives to entrepreneurs and venture capital fund managers. Their work hasempirical implications for size and focus on venture capital funds. Along similar lines,Kandel et al. (2004) study the inefficiency arising due to the limited duration of funds.This forces the venture capital fund manager to liquidate the fund’s asset at a given timein the future. Given that LPs cannot observe the quality of the venture capital manager’sinvestments, they may not reward the manager appropriately at liquidation time of thefund. This in turn provides incentives to the GP to favour short-term projects at theexpense of value maximization of the fund.

Other papers have expanded the standard principal–agent framework to two-sidemoral hazard. This strand of the literature recognizes the fact that both players, entre-preneur and venture capital manager, need to bring in effort (for example Casamatta,2003; Schmidt, 2003; Repullo and Suarez, 2004). Among other things, this extension hasled to a better understanding of the widespread use of convertible securities in venturecapital finance.

In sum, theoretical work is consistent with the view that venture capital fund structureis important for the screening of new potential investments and the governance providedby venture capitalists to the investee firms. The next subsection describes empirical evi-dence consistent with this view.

Empirical researchEmpirical research has found that the structure of venture capital funds and the contractsthat govern the relationship with suppliers of capital influence the behaviour of profes-sionals and their investment strategy and style. While the next chapters of this book focuson investment decisions by venture capital companies, we emphasize here some research


findings specific to differences in the structure of venture capital funds. Research on howstructure influences behaviour has been organized into a small number of themes, asdetailed below.

Fund structure, types of investment and value-added advice The first set of evidence onhow structure matters relates to the effect that the source of funds has on the use of fundsby the venture capital. The basic proposition derives from the fact that as agents, venturecapitalists are often contracted to invest to provide defined investment outcomes that mayyield both financial and non-financial benefits to the capital provider. The differences inventure capital behaviour driven by structure include types of entrepreneurial firms sup-ported, portfolio structure, governance and value-added by the venture capital. Aspointed out by Mayer et al. (2005), in principle the source of funds is irrelevant to theinvestment decision (similar to Modigliani and Miller’s irrelevance theorem) as long as allventure capital funds pursue a sole objective of maximizing profits of their own funds.

Mayer et al. (2005) provide evidence from a large cross-country data set (Germany, Israel,Japan and the UK) that the use of venture capital varies by source, attributable in large partto differentiated objective functions. Venture capitalists sourcing capital from banks andpension funds invest in ‘low technology’ entrepreneurial firms in later stages (that is moreestablished firms) than individual and corporate backed venture capitalists. Similarly,Cumming et al. (2007) show that Japanese bank venture capitalists act differently from inde-pendent VCLPs by investing in later stage companies. The structure of venture capital com-panies also impacts the governance structure of portfolio companies. Cumming et al.’sstudy shows that individual owner-manager structures (typically VCLPs) give rise to muchsmaller portfolios of entrepreneurial firms and more advice to entrepreneurs. In contrast,bank affiliated funds hold larger portfolios (measured by number of entrepreneurial firmsper manager) and provide investees with less value-added advice. This negative link betweenvalue-added per investee and number of firms in the portfolio is examined theoretically byKanniainen and Keuschnigg (2003) and empirically by Cumming (2006b). Because venturecapitalists invest time and effort in advising their portfolio firms, as opposed to just pro-viding funds, increasing the number of firms in the portfolio dilutes the quantity and qualityof the advice provided. The relation between portfolio size per manager and venture capitaladvice, however, is not linear. Complementarities among venture capital and entrepreneureffort, and complementarities among different entrepreneurial firms in the portfolio, amongother things, make the relation between portfolio size and advice rather complex (see alsoKanniainen and Keuschnigg, 2003; 2004; Fulghieri and Sevilir, 2004; Keuschnigg, 2004;Cumming, 2006b).

Our discussion so far has looked at the variation across types of venture capital fundstructure. But even within structures differences in behaviour are evident, most clearlyseen in VCLPs operated by venture capitalists of varying experience. Gompers (1996)shows that younger funds tend to exit through an IPO earlier as a way to signal theirquality to fund providers prior to raising a new fund. Moreover, Cumming et al. (2004)find that the VCLP structure and the need for independent venture capital funds to raisecapital every few years affect the investment decisions of managers, not only exit deci-sions. Their analysis shows that younger funds are less likely to deviate from their statedobjectives (that is style drift less) prior to raising a new fund in order to signal their man-agerial quality. Incomplete information from the arm’s length relationship between


capital suppliers and the venture capital means that both grandstanding and style driftact as a signalling device.

Fund structure and financial returns (direct and indirect) The financial returns to venturecapital investing have been most commonly linked with the state of finance markets andthe legal conditions underpinning the structure of VCLPs. The stronger public financemarkets and legal protection for investors are in the VCLP, the higher are financial returnsto investment. Black and Gilson (1998) argue that there is a strong link between activestock markets and active venture capital markets, as the former allow investors to divesttheir most successful deals. An international study of venture capital in the Asia-Pacificregion by Cumming et al. (2006) provides evidence that a more important factor thanactive stock markets is the quality of a country’s legal system, which is a central mech-anism to mitigate agency problems between outside shareholders and entrepreneurs.Legality affects exits because legality affects the new owners’ ability to resolve problemsresulting from information asymmetries in the sale of the firm (consistent with La Portaet al., 1997; 1998; Shleifer and Wolfenzon, 2002). The venture capitalist’s goal is to maxi-mize capital gains upon sale of the entrepreneurial firm. All else being equal, the newinvestor(s) will pay the most when information asymmetries are lowest. IPOs are lesscostly exit routes relative to private exits (acquisitions, secondary sales and buybacks)among countries with a higher legality index and stronger investor protections, and shouldtherefore be observed more frequently in countries with higher legality indices (Cumminget al., 2006). Hege et al. (2003) find a significant performance gap (measured by IRR ofindividual investments) between Europe and the United States. US venture capital fundsoutperform their European counterpart in the financing of entrepreneurial firms fundedat the early stage. Their analysis is consistent with the idea that either European venturesare of lower quality or US venture capitalists are better at screening business plans.

Indirect financial benefits to venture capital funds are more important in non-VCLPstructures. Studies have shown that, for instance, large corporations set up their own fundsfor strategic reasons (Siegel et al., 1988; Winters and Murfin, 1988; Yost and Devlin, 1993;Chesbrough, 2002; Santhanakrishnan, 2002) so that the companies financed by the cor-porate venture capital fund fit within the corporation’s objectives. Some studies documentthat the use of corporate venture funds is most likely when complementarity gains arehighest (Lemelin, 1982; Dushnitsky and Lenox, 2005; Dushnitsky, 2004). Gompers andLerner (1998) find that corporate venture capital fund investments in companies with‘strategic fit’ to the mother company perform at least as well as investments by indepen-dent venture capital funds. Moreover, Riyanto and Schwienbacher (2005) develop a the-oretical framework where they study the incentives of large corporations to set upcorporate venture capital funds in order to generate demand for their own products. Thearticle also mentions a number of real cases where this indeed took place. Given these posi-tive externalities for corporate investors, they need to be taken into account in investmentdecisions of corporate funds. Hellmann (2002) analyses the strategic role of ventureinvesting, that is either a corporate venture financing or an independent venture financ-ing. The use of corporate venture capital mitigates the potential hold-up problem at theR&D stage. In contrast, Riyanto and Schwienbacher (2005) take another perspective.They focus on the corporate investor’s active role in utilizing corporate venture financingstrategically as a commitment to compensate the entrepreneur for potential opportunistic


behaviour in the product market. It therefore helps to avoid a potential ex post hold-upproblem in the product market (instead of at R&D stage).

Future research directionsThis chapter has examined the structure and governance of different types of venturecapital organizations, including limited partnerships, captive venture capitalists and gov-ernment venture capital programmes. This chapter has also examined the relationbetween organization structure and governance provided by venture capitalists to investeefirms, and has shown that prior research is consistent with the view that returns areaffected by venture capital fund structures. Agency relationships between capital pro-viders and venture capitalists are solved efficiently through a range of organizational con-figurations. We have reviewed the state of research on these forms of venture capital. Weoffer here our views on future research directions.

1. Internationalization of venture capitalThe past ten years has witnessed the increased internationalization of the venture capitalindustry, especially given the presence of large institutional investors (see Megginson,2004, for a review of work on non-US markets). Work on Europe and the Asia-Pacific(Lockett and Wright, 2002) show the potential provided by analysis of the internationalaspects of venture capital. The internationalization phenomenon raises a number of newresearch questions, listed below:

● How have, and how will, venture capital markets evolve around the world? Willthere be a convergence towards a single venture capital model?

● How will increasing financial integration affect the structuring of transactions inventure capital-backed companies?

● How does internationalization impact venture capital firm structure and its man-agers’ investment decisions?

● Will the growth of new markets with different legal systems (such as China andIndia) lead to different styles of venture capital investing?

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

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

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


venture capital funds face a different set of information and liquidity factors. Researchcould examine:

● Are venture capital outcomes different when the vehicle is listed?● What is the impact of listed structures on the types of venture capital investments,

venture capital behaviour and investment returns?

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

● How does organizational culture impact venture capitalist behaviour?● Are non-Western venture capital firms different in their outcomes? Approach to

investing? Use of non-contractual aspects (for example trust) of transactions?● How does the Western style of venture capital become integrated into the new

global venture capital world?

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

IntroductionThe venture capital process can be thought of as a series of activities or stages that eachnew venture works through from the time the venture is first proposed up until the timewhen the venture capital firm successfully exits from the venture and takes its profit. Forexample, Tyebjee and Bruno (1984) proposed a model of the venture capital process withfive such stages: (1) deal origination – seeking potential investments; (2) deal screening –quick review of business plans and/or oral proposals, both solicited and unsolicited;(3) deal evaluation – for those deals that pass the screen, more in-depth due diligence tovalidate business model and prospects; (4) deal structuring – establishing and negotiatingthe terms of the investments; and (5) post-investment – value-added activities suchas serving on the board, assisting with follow-on investment and liquidity events. Pre-investment activities refer to all venture capital tasks up to and including the signing ofan investment contract: soliciting new venture proposals for submission to the venturecapital firm, determining whether these proposals meet the firm’s broad screening criteria,conducting due diligence (more extensive research to determine the likely success of theventure), and then negotiating and structuring a relationship with the entrepreneur. Inthis chapter we focus on the screening phase of the pre-investment process – specifically,what decision criteria are important to the investment decision and how this decisionprocess works – while post-investment activities will be discussed in detail in the nextchapter by De Clercq and Manigart (Chapter 7).

The venture capitalist’s most valuable asset is his time. Gorman and Sahlman (1989)find that venture capitalists spend 60 per cent of their time on post-investment activities.On average, a venture capitalist commits 110 hours per year to assisting and monitoringone venture investment (Gorman and Sahlman, 1989). While venture capitalists spendmost of their time and effort on post-investment activities, that time and effort is inefficientif the venture capitalists make investments in marginal ventures. In fact, Roure and Keeley(1990) assert that success can be predicted from information contained in the businessplan. Therefore, improving the investment decision can improve the venture capitalist’sperformance. Better understanding how venture capitalists make decisions and moreimportantly, how they can improve their decision process will lead to more efficient use oftheir time and higher overall returns (Zacharakis and Meyer, 2000). Thus, the vast major-ity of research on the pre-investment process has focused on how venture capitalists selectthose ventures that they back. Deal flow and due diligence are under-researched (seeSmart, 1999, for one of the few studies on due diligence) and while work on valuation (forexample Keeley and Punjabi, 1996; Kirilenko, 2001; Seppä and Laamanen, 2001) and con-tracts is common (for example Gompers and Lerner, 1996; Kaplan and Stromberg, 2004;Cumming, 2005), it views the topic from an economic rational perspective (that is what is

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the optimal valuation to motivate and align the entrepreneur’s efforts with the venture cap-italist’s objective of achieving high ROI and deriving an appropriate contract to minimizethe threat of opportunism). While we limit the scope of this chapter to the investment deci-sion, we do believe that the decision process during the selection phase impacts both duediligence and negotiation. As such, there is room to explore how venture capital decisionsinfluence these phases.

Venture capitalists differ in the screening criteria they use to select ventures includingtype of industry, company stage of development, geographic location, and size of invest-ment required. For example, venture capitalists often specialize by industry (Sorenson andStuart, 2001). A venture capitalist interested in biotechnology will look at criteriadifferently than venture capitalists interested in retail; proprietary protection may be ofmore importance for instance. Likewise, venture capitalists focused on early stage dealsmay place more emphasis on the team – can the entrepreneur execute on the opportunity –since there is little past history of the venture to evaluate. Later stage venture capitalistscan assess the team’s capabilities based upon what the venture has achieved in its earlierstages. While venture capitalists with different objectives emphasize different criteria, thebasic categories still hold (the entrepreneur, the market size and growth, the product, thecompetition, and so on), but how the criteria are used or weighted differs.

The primary goal of this chapter is to review the progression of venture capital researchon investment selection in the screening phase and primarily takes an information pro-cessing perspective to do so. It is our belief that the field is becoming more sophisticatedin both its methods and questions asked. We have moved beyond simple surveys and inter-views asking venture capitalists how they select which ventures to back, to tests of howventure capitalists actually make decisions and how contextual and process factors influ-ence that decision. As is true with all fields of inquiry, the more we learn, the more ques-tions that arise. Thus, this chapter not only looks backwards, but suggests ways forward.

The chapter progresses as follows: first, we review the early research on venture capitaldecision making followed by an overview of how verbal protocols and conjoint analysishave helped us answer basic questions, such as what criteria do venture capitalists use inthe decision and how do they use those criteria. The following section looks at context ofthe decision. Industrial organization economics, the resource based view and institutionaltheory suggest how context might influence the decision. Next, we examine how biasesand heuristics impact the venture capital process. The basic question underlying processis whether biases and heuristics are efficient means for boundedly rational decision makersto pick the best ventures, or whether they lead to sub-optimal decisions. Much of theresearch to date assumes that venture capital decision making is relatively homogeneous,but more recently researchers are looking at factors that lead to heterogeneity in the deci-sion process. At the end of each of the major sections of our review, we raise several newresearch questions and avenues to explore them.

The evolution of research on pre-investment venture capitalVenture capital research has progressed and become more sophisticated. This sectionhighlights the move from simple surveys and interviews which rely on accurate introspec-tion to verbal protocols and conjoint analysis. Verbal protocols are real-time ‘think aloud’observations of the venture capitalist screening a potential deal. As such, they allowresearchers to track what and when information is used in the decision. Conjoint analysis


moves beyond verbal protocols to a controlled experiment which allows researchers tocapture the relative importance of different decision criteria.

Venture capitalists’ espoused decisionsVenture capitalists are conspicuously successful at predicting new venture success (Halland Hofer, 1993; Sandberg, 1986) and numerous studies have investigated their decisionmaking. The majority of research on venture capitalists’ decision making has producedempirically derived lists of venture capitalists’ ‘espoused’ criteria which are the criteriaventure capitalists report they use when evaluating new venture proposals, including earlyseminal articles by Tyebjee and Bruno (1984) and MacMillan and colleagues (MacMillanet al., 1985; 1987). Tyebjee and Bruno (1984) articulated four categories – market poten-tial, management, competition and product feasibility – and MacMillan et al. (1985)grouped their 27 criteria into six categories – the entrepreneur’s personality, experience,characteristics of product/service, characteristics of market, financial considerations andventure team. This early research consistently finds that the entrepreneur and team are themost important decision criteria in distinguishing between successful and failed ventures.For example, MacMillan et al. (1985) find that 6 of the top 10 criteria relate to the entre-preneur and team. The findings of these early studies fit the mantra espoused by GeorgesDoriot, the father of venture capital and founder of the first modern venture capital firmARD, that he’d rather ‘invest in an “A” team with a “B” idea than a “B” team with an “A”idea’ (as noted in Timmons and Spinelli, 2003). This early research provided a context inwhich to understand and evaluate venture capitalists’ decision making, but it was proneto recall and post hoc rationalization biases (Zacharakis and Meyer, 1995). Zacharakisand Meyer (1998) find that venture capitalists aren’t accurate in self-introspection. Inother words, post hoc studies may not truly capture how venture capitalists use decisioncriteria.

Verbal protocol analysis of venture capitalists’ decisionsNext there were studies by Sandberg et al. (1988), Hall and Hofer (1993), and Zacharakisand Meyer (1995) that attempted to overcome prior post hoc study flaws by using verbalprotocols. Verbal protocols are real time experiments where venture capitalists ‘thinkaloud’ as they are screening a business plan (Ericsson and Crutcher, 1991). Thus, venturecapitalists aren’t required to introspect about their thought processes which removes recalland post hoc rationalization biases (Sandberg et al., 1988). Moreover, the verbal protocolapproach provides richer understanding of the decision process whereas post hocmethods focus on the decision outcome (Hall and Hofer, 1993). Verbal protocols, forinstance, not only allow the research to capture what criteria venture capitalists use, butin which order they consider different criteria and how much time they spend evaluatingeach criterion, which gives us a relative sense of the importance of different criteria.Results from verbal protocol studies suggest that venture capitalists’ insight into theirdecision processes may be less than perfect. For example, Hall and Hofer (1993) find thatthe venture capitalist pays relatively little attention to entrepreneur/team characteristicsand even less attention to strategic issues of the new venture proposal. Instead, the mostimportant factor centred on the market and product attributes, which is congruent withthe findings of Zacharakis and Meyer (1995). Such findings appear to contradict mostpost hoc studies which find that the entrepreneur is typically the most important factor.

The pre-investment process 179

Zacharakis and Meyer (1995) suggest that the discrepancy may be attributable to thescreening stage on which verbal protocol research has focused. Specifically, venture capi-talists may assess whether the entrepreneur meets minimum qualifications during thescreening stage, and reserve final judgment for later evaluation (see Smart’s, 1999 study onhow venture capitalists evaluate the entrepreneur during due diligence).

While verbal protocols are rich in the amount of data collected from each venture cap-italist, they are time consuming as the researcher needs to observe each venture capitalistas he actually reviews a plan. As such, these studies are limited by the small sample sizesthat can be easily accommodated. Nonetheless, the discrepancy between verbal protocolsand earlier post hoc studies spurred a new wave of real time experiments that can moreefficiently manage larger samples.

Conjoint analysis and policy capturing of venture capitalists’ decision policiesConjoint analysis and policy capturing move beyond survey methods used to identify deci-sion criteria and verbal protocols used to assess how and when criteria are used. Conjointanalysis is a ‘technique that requires respondents to make a series of judgments, assessmentsor preference choices, based on profiles from which their “captured” decision processes canbe decomposed into its underlying structure’ (Shepherd and Zacharakis, 1997, p. 207).Policy capturing is a type of conjoint analysis. The research supports the notion that venturecapitalists aren’t very good at introspecting about their decision process (Zacharakis andMeyer, 1998). Conjoint studies (Zacharakis and Meyer, 1998) support verbal protocolresearch (Hall and Hofer, 1993; Zacharakis and Meyer, 1995) indicating that market issuesmight be more important than entrepreneur characteristics. In general, real time studies findthat venture capitalists tend to overweight less important factors and underweight moreimportant factors when they ‘espouse’ lists of decision criteria they say they use in theirassessments (Zacharakis and Meyer, 1998; Shepherd, 1999). Furthermore, the accuracy ofintrospection decreases the more information that the decision maker faces (Zacharakis andMeyer, 1998). This leads venture capitalists to remember more salient information as beingmore important than it actually was. The finding is particularly pertinent to the venturecapital process as information inundates the venture capital decision context. For example,there is information about the entrepreneur (for example entrepreneur’s industry and start-up experience), market (for example size and growth), product/service (for example propri-etary protection), among other categories. Not only is there a lot of available information,but much of it is of a subjective nature. For example, venture capitalists often discuss the‘chemistry’ between themselves and the entrepreneur. The deal often falls through if thechemistry is not right. Such intuitive, or ‘gut feel’ (MacMillan et al., 1987; Khan, 1987),decision making is difficult to quantify or objectively analyse. The added complexity fromsubjective information further clouds the decision making process and invites decisionmakers toward more biases that impede their ability to introspect accurately. Due to thecomplexity of the decision and the venture capitalists’ intuitive approach, venture capital-ists have a difficult time introspecting about their decision process (Zacharakis and Meyer,1998). In other words, venture capitalists do not have a comprehensive understanding ofhow they make the decision. This lack of understanding may lead to sub-optimal decisionstrategies and subject venture capitalists to biases that may lead to sub-optimal decisions.

Conjoint analysis and policy capturing allows us to gain a deeper understanding of theventure capital decision process (Shepherd and Zacharakis, 1999). Not only can researchers


capture how important each decision criterion is to the decision relative to other decisioncriteria (Zacharakis and Meyer, 1998), but it also allows for examining contingent deci-sion processes (Zacharakis and Shepherd, 2005). Thus, the research in venture capitaldecision making has followed a natural progression from identifying decision criteriathrough post hoc surveys (for example Tyebjee and Bruno, 1984; MacMillan et al., 1985)to understanding how that information is utilized during the actual decision via verbal pro-tocols (Sandberg et al., 1988; Hall and Hofer, 1993; Zacharakis and Meyer, 1995) to con-trolled experiments which can pull out the similarity/differences between venture capitalists(Zacharakis et al., 2007), the relative importance of different decision criteria (for exampleMuzyka et al., 1996) and more complex, contingent decision policies (Shepherd et al., 2000;Zacharakis and Shepherd, 2005). The following sections will elaborate on how the venturecapital decision making research has used experiments to test theory on both the contentventure capitalists’ decision policies and the decision process.

Theory development and experiments for empirical testingIn this section we continue our review of conjoint analysis and focus on the theory devel-opment in increasing our understanding of both the content of venture capitalists’ deci-sion policies and the process by which they make those decisions.

Theory development and content tested using experimentsRiquelme and Rickards (1992) pioneered conjoint analysis in the study of venture capitaldecision making. They ran a series of pilot tests on 14 venture capitalists and concludedthat conjoint analysis is an effective means of studying the venture capital process. Shortlythereafter, Muzyka et al. (1996) used conjoint experiments to explore the importance ofa long list of criteria (35 investment criteria) that venture capitalists had identified as beingimportant when making their decisions. They used a conjoint experiment that required 73venture capitalists to each make 53 pair-wise trade-offs with multiple levels. The criteriafell into seven groupings: (1) financial; (2) product-market; (3) strategic-competitive; (4)fund; (5) management team; (6) management competence; and (7) deal. They found thatventure capitalists ranked in the top seven criteria all five management team attributes,product market criteria appeared to be only moderately important, and fund and deal cri-teria were at the bottom of the rankings. This study led Muzyka and his colleagues (1996,p. 274) to conclude that the venture capitalists interviewed would

prefer to select an opportunity that offers a good management team and reasonable financialand product-market characteristics, even if the opportunity does not meet the overall fund anddeal requirements. It appears, quite logically, that without the correct management team and areasonable idea, good financials are generally meaningless because they will never be achieved.

While pair-wise conjoint studies identify which criteria might be more important thanother criteria, it still suffers post hoc recall biases as the venture capitalists are not makingreal time investment decisions, but thinking about how they believe they used the criterialisted on past decisions.

More recently, experimental methods such as metric conjoint analysis and policy cap-turing have been used to test theoretically derived hypotheses on the content of venture cap-italists decisions in a real time investment decision. For example, Shepherd and colleaguesused an industrial organization economics (IO) perspective of strategy to investigate the


types of information venture capitalists utilize when evaluating new ventures (including itsstrategy and experience) and how venture capitalists use this information to assess newventure survival (Shepherd, 1999) and profitability (Shepherd et al., 2000). Specifically,Shepherd (1999) used the IO strategy and population ecology literatures to develop a modelof new venture survival that centred on the importance of uncertainty. This study foundthat in assessing the probability of survival venture capitalists consider the new venture’stiming, lead time, educational capability, industry related competence and the nature of theenvironment in terms of stability of the key success factors and competitive rivalry. Theseresults suggested considerable consistency between the proposed theoretical framework andthe decision policies of venture capitalists. In investigating venture capitalists’ assessmentsof profitability, the theory development work of Shepherd et al. (2000) suggested contin-gent relationships between the criteria that were previously used to explain the probabilityof survival. Specifically, they found that the relationship between timing of entry andventure capitalists’ assessment of profitability is moderated by key success factor stability(environmental stability), lead time and educational capability.

Zacharakis and Shepherd (2005) used theory from the resource-based view (RBV) ofstrategy to hypothesize that venture capitalists use non-additive decision policies whenmaking their investment decision – interactions between leadership experience and otherinternal resources, and between leadership experience and environmental munificence arereflected in venture capitalists’ decision policy. A policy capturing experiment found thatalthough venture capitalists always prefer greater general experience in leadership, theyvalue it more highly in large markets, when there are many competitors, and whenthe competitors are relatively weak. It also found that previous start-up experience of theventure’s management team may substitute for leadership experience in venture capital-ists’ decision policy.

The above research has used theory to hypothesize content that is then tested usingexperiments to understand whether venture capitalists’ decision policies are consistentwith theory, or if they deviate, what the nature of that deviation is. These studies are illus-trative of the increasing sophistication in venture capital decision making research.Specifically, these studies go beyond the simple main effects studies of the past and asknot only what criteria venture capitalists use, but how these criteria interact with other cri-teria in the venture capitalist’s decision. These investigations produce a decision policy forthe sample as a whole yet there are theoretical reasons that under certain circumstancesventure capitalists should differ in their decision policies. The next level of sophisticationmoves beyond building base models that describe the general venture capital decision, towhen venture capitalists might deviate from this base model. In other words, newerresearch needs to examine the heterogeneity of venture capital decision making.

Recent experimental research on the content of venture capitalists has focused onexplaining variance in the decision policies across venture capitalists. Based on institu-tional theory that various economic institutions structure the incentives of humanexchange differently, Zacharakis et al. (2007) proposed that venture capitalists fromdifferent countries (US – mature market economy, South Korea – emerging economy, andChina – transitional economy) would use different information when formulating theirdecisions. Using policy capturing experiments on 119 venture capitalists across these threecountries, they found that venture capitalists in rules-based market economies rely uponmarket information to a greater extent than venture capitalists in emerging economies,


and also found that Chinese venture capitalists more heavily weigh human capital factorsthan either US or Korean venture capitalists. We expect that more research will use theoryto explain variance in decision policies across venture capitalists.

Future research opportunities into venture capital decision making content Beginning withRiquelme and Rickards (1992) and Muzyka et al. (1996), there has been substantialprogress in theoretically based conjoint experiments that allow us to understand theextent to which our theories are reflected in the way that venture capitalists make deci-sions. The theoretical approaches to date have relied heavily on strategy research to derivecriteria. This makes sense because both are interested in assessing firm performance.However, we believe that there are opportunities to move beyond theories of strategy todrive theory-based conjoint studies intent on better understanding the content of venturecapitalists’ decision policies. For example, much has been made about the managementteam. There are likely opportunities to explore theories of psychology and team behav-iour to derive criteria which we believe that venture capitalists may use in assessing the‘quality of the management team’. How motivated are entrepreneurs? Will they maintaintheir motivation and effort when things get tough? How do they handle stress? Perhapstheories from economics will provide the opportunity for more fine-grained experimentalwork to understand how venture capitalists assess potential competition. Are venture cap-italists always equally concerned about competition? Do venture capitalists weigh the riskof new entrants less heavily in their investment decisions when the potential portfoliocompany is in a highly munificent and/or highly dynamic environment? Is competitionsometimes viewed positively, such as with new entrants legitimating an emerging market?There are ample opportunities to take one of the criteria that have been tested above anduse theory to explore it in finer detail and then test it using conjoint analysis.

To date, research has focused primarily on the screening stage and venture capitalistslooking at early stage deals. There is reason to expect that decision criteria, or at least therelative importance of decision criteria, might differ across both venture capital processstage and the venture’s development stage. For example, Smart (1999) finds during the duediligence stage that venture capitalists quiz entrepreneurs on a number of ‘what if ’ sce-narios to see how they might react to different situations new ventures are likely to face,especially for early stage ventures. For later stage ventures, Smart finds that venture cap-italists spend more time evaluating the entrepreneur’s achievements within the currentventure to that point in time. Research along these lines could be expanded and tied to thetype of entrepreneur content venture capitalists explore at different stages of the venturecapital process. Likewise, the relative emphasis on other content areas may change basedupon the venture capitalist’s process stage and the venture’s development stage. There isalso reason to expect that venture capitalists’ criteria differ based upon the venture’sindustry. These avenues of future research extend the base model of venture capital deci-sion making and are the next logical step in the development of this line of research.

Theory development in process and experimentsUsing information processing theory (Anderson, 1990; Lord and Maher, 1990) has helpedthe venture capital decision making stream to develop by allowing us to predict andunderstand how venture capitalists make decisions, and when those decisions may be sub-optimal, biased and contain errors. The following sections delineate why we need to


understand the ‘process’, how information processing theory helps us understand theprocess, especially as it pertains to mean for managing all the information, potential biasesto the process and so on.

Why understanding process is important While understanding the content of the venturecapitalist’s decision is crucial to improving those decisions, it is also critical to understandthe process by which venture capitalists make decisions. Decision makers are not perfectlyrational, but boundedly rational (Simon, 1955; Cyert and March, 1963). It is impossiblefor venture capitalists to evaluate all information fully as their decision environment is par-ticularly rich in information (Zacharakis and Meyer, 1998) and highly equivocal in nature(Moesel et al., 2001). Venture capitalists must interpret information at the environmentallevel (industry trends, economic conditions, and so forth), the business model level (canthe venture capital financing enable the company to grow to a point where the venturecapital can extract a return on investment), and the team level (can the entrepreneur teamexecute). Information richness, or as Zacharakis and Meyer (1998) call it, ‘informationnoise’, leads venture capitalists to economize on their decision process in order to managethe sheer volume of information. Thus, venture capitalists will use heuristics, both con-sciously and unconsciously, that filter out certain information and allow the venture cap-italists to focus on other information. However, what information venture capitalists payattention to impacts their decision process and may result in decision biases.

Information processing theory Cognitive science, the study of how people make deci-sions, has provided a fruitful source for theories that have been applied to the venturecapital decision process. Barr et al. (1992) delineate a simple information processingmodel that describes decisions as a function of what information attracts the manager’sattention, how that information is interpreted, and what actions follow from that inter-pretation. The expert decision making model (Lord and Maher, 1990) best fits the venturecapital environment (Shepherd et al., 2003). Expert models can be characterized as fittingbetween a truly rational decision model where all information and alternatives are con-sidered and evaluated to a limited capacity model which recognizes the cognitive limits ofdecision makers (Cyert and March, 1963). Experts learn which factors best distinguishbetween successful and unsuccessful ventures (Shepherd et al., 2003), although this isoften on an unconscious level (Zacharakis and Meyer, 1998).

Venture capitalists possess a multitude of mental models which can be called into actiondepending upon the situation (that is based on past experience with industry, or pastexperience with lead entrepreneur, and so on (Zacharakis and Shepherd, 2001)). Thus,when the venture capitalist perceives a somewhat familiar situation which requires action,an appropriate mental model is summoned from long term memory (Moesel et al., 2001).In unfamiliar situations, the venture capitalist uses an evaluation strategy (a mental modelof how to approach new situations) to formulate the information into a mental modelwhich is then manipulated to make a decision. However, the venture capitalist’s mentalmodel of the situation influences what and how the information surrounding the situationis perceived; the mental model acts as a filter which preserves limited cognitive processingcapacity (Moesel et al., 2001; Zacharakis and Shepherd, 2001). An example might betterillustrate the mental model concept. Imagine two venture capitalists examining the sameproposal. The first venture capitalist is very familiar with the industry and, in fact, also


has extensive knowledge of the team. As such, the venture capitalist is likely to base her/hisjudgment on these two chunks of information. Other important information that doesn’tfit neatly within this configuration receives limited consideration. The second venture cap-italist, on the other hand, is not familiar with the industry or the entrepreneurial team. Inthis case, the venture capitalist doesn’t possess a mental model based on the larger chunksof information. The venture capitalist assesses the entire array of information and usesvarious decision strategies to make her/his decision. For example, s/he may use a satisfic-ing strategy (Simon, 1955) and assess whether the proposal meets the minimum criteria oneach decision factor.

With information processing theory as a theoretical lens, a number of pertinent issueshave been studied in the venture capitalist decision process. Primarily, what heuristics doventure capitalists employ to make decisions in an information rich environment? And,what factors might bias venture capitalist decision making? It is our estimation that wehave only begun to scratch the surface on these issues.

Heuristics Heuristics, or ‘rules of thumb’, are sub-optimal decision strategies in that thedecision maker does not fully utilize all available information (Tversky and Khaneman,1974; Simon and Houghton, 2002). Since decision makers have limited cognitive capacity,they rely on heuristics to conserve cognitive resources (Simon, 1981). Whereas biasesimpact decision effectiveness by directing the decision maker’s attention to salient infor-mation, heuristics provide a ‘road map’ on how and which information is used to make adecision. Eisenhardt (1989) suggests that heuristics allow decision makers to derive deci-sions based upon fragments of information about various attributes and alternatives sur-rounding the decision. In other words, heuristics are mental models that make certaininformation factors more salient than others. Therefore, while heuristics ‘are alwaysefficient, and at times valid, these heuristics can lead to biases that are persistent, andserious in their implications’ (Slovic et al., 1977, p. 4). Hitt and Tyler (1991) add thatalthough heuristics ease cognitive strain, they often lead to systematic biases.

The new venture environment encourages heuristic use as entrepreneurs and venturecapitalists face information overload, high uncertainty regarding success, novel situations,and time pressure (Baron, 1998). Baron (1998) points out that under certain contextualfactors, such as time constraints, heuristic strategies may lead to better decisions thanwould occur under the rational model. Busenitz (1999) adds that speed may be critical inan entrepreneurial environment where a new venture needs to launch while the ‘windowof opportunity’ is open. Although heuristic research has focused mostly on entrepreneurdecision making, much of it is relevant to venture capitalists as they participate in asimilar environment (Moesel et al., 2001). The underlying principle is that heuristiceffectiveness is a question of cost versus benefit (Fiske and Taylor, 1991). Is the time spentreaching an optimal decision more valuable than the approximate decision reached byusing a time saving heuristic? Part of the answer depends on which heuristic the decisionmaker is using.

Based upon Payne et al.’s (1988) categories, it is likely that venture capitalists use non-compensatory strategies (that is they don’t evaluate all the information surrounding analternative when making a decision); they do not have the time, or the cognitive capacityto use all information surrounding a proposal (Moesel and Fiet, 2001). Venture capitalistsare also likely to use an alternative versus an attribute-based approach (Payne et al., 1988)


as they typically review ventures as they are presented to them. Under an alternativeapproach, the venture capitalist evaluates each proposal in isolation, typically looking toreject the venture idea because it fails on one or more of the attributes. Since each proposalis evaluated in isolation, the venture capitalist may be inclined to compare it to past ven-tures. Comparing the current venture to other transacted deals is a representative heuris-tic; the tendency to generalize from small, non-random samples (Busenitz, 1999). In theventure capitalists’ case, they tend to compare current ventures under consideration todeals that they have made (or passed on) in the past (Zacharakis and Meyer, 2000). Whileusing a representative heuristic saves time, it can lead to sub-optimal decisions in that thedecision maker generalizes from a small, non-random sample and thereby is likely tounderestimate the risk of failure (Busenitz, 1999; Keh et al., 2002). The underestimationrisk is heightened in conjunction with the recall bias in that people tend to recall past suc-cesses and forget past failures (Dawes et al., 1989).

Venture capitalists also tend to use satisficing heuristics (Zacharakis and Meyer, 2000)which means that as they evaluate a venture they are looking for reasons to quickly dis-patch it as a poor investment choice. The rationale for such a heuristic is quite simple asmost venture capitalists are inundated with entrepreneurs seeking funding. Quicklyscreening out deals allows venture capitalists to spend more time on other activities thatcan increase returns, such as post-investment work with portfolio companies. Thus, con-sidering the time constraints that venture capitalists face, satisficing is both efficient andeffective by enabling venture capitalists to focus their time on those ventures that have thegreatest perceived potential. The downside of satisficing and representative heuristics isthat they may lead to a ‘herding’ phenomenon (Gompers et al., 1998). Venture capitalistsmay chose to invest in those ventures which are most like the ventures that other venturecapitalists have funded, such as was the case in the dot.com boom and bust. This can leadto overcrowding in the market space with lots of ‘me-too’ competitors that damage theoverall sector dynamics and increase the failure rate within that space.

Biases Biases are those salient factors that cause the venture capitalist to evaluate situ-ations differently by affecting which mental models are used for any particular decision(Zacharakis and Shepherd, 2001). For example, a venture capitalist’s experience within anindustry may cause the venture capitalist to evaluate available industry information morerigorously because s/he knows the industry well (that is industry indicators and bench-marks); an availability bias. On the other hand, it may cause the venture capitalist toevaluate the other aspects of the proposal less rigorously such as product and entrepre-neur attributes. The point is that such knowledge biases the venture capitalist; the venturecapitalist evaluates or uses different mental models for this proposal than a venture capi-talist who is unfamiliar with the industry. In other words, the venture capitalist deviatesfrom his/her base decision model.

Just because mental models bias decisions does not mean that they result in errors (Barret al., 1992). However, these biases most likely prevent decision makers from reachingoptimal solutions (in the rational model sense) because they may reduce the amount of infor-mation and alternatives considered. The number of potential biases to any decision is enor-mous. Table 6.1 lists several biases that affect decision making effectiveness. Only a few ofthe listed biases have received attention in the venture capital literature. The others providean opportunity to research their impact, if any, on venture capitalist decision making.


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


Table 6.1 Biases to decision making

Bias Description

Availability Easy recall of well-publicized or chance events which means thatdecision maker focuses more on available events in the decisionprocess, and neglects unavailable information

Selective perception Problems structured by an individual’s prior experienceFrequency Absolute cue frequency is used versus the relative occurrenceConcrete information Concrete data dominates abstract dataIllusory correlation Belief that two variables covary when in fact they do not covaryData presentation Evaluation biased by sequence, presentation mode, qualitative

versus quantitative mixture, perceived display ‘logic’, and contextInconsistency Inability to apply judgments consistentlyConservatism Failure to revise decisions when presented with new evidenceNon-linear extrapolation Underestimation of joint probabilities and growth rateHabit Previously successful alternatives are applied to solve a problemAnchoring/adjustment Prediction results from upward or downward adjustment of a cue

valueRepresentativeness Evaluation based upon a similar class of eventsLaw of small numbers Small samples are believed representativeJustifiability A rule can be used if it can be ‘justified’Regression bias Predictions fail to recognize regression toward the meanBest guess strategy Simplification and ignoring dataComplex environment Information overload and time pressures reduce consistencyOverconfidence Belief that your decisions are correct more often than is actually

the caseEmotional stress Induces panic judgments or reduced attentionSocial pressures Conformity or distortion of judgmentsConsistent data sources Increase decision confidence but not accuracyQuestion format Judgment process requirements or choice affects outcomeScale effects Measurement scale affects response perceptionsWishful thinking Preferences affect the assessment of eventsIllusion of control Perceived control resulting from activity concerning the outcomeOutcome irrelevant Observed outcomes provide incomplete feedback for correction‘Gambler’s fallacy’ Higher probability of event following unexpected similar chance

outcomesSuccess/failure attributions Success is attributed to skill; failure to chanceRecall fallacies Failure to recall past details leads to logical reconstructionHindsight bias Plausible explanations can be found for past surprises

Source: Adapted from Hogarth and Makridakis, 1981.

the type of information reviewed. The study finds that more information leads toincreased overconfidence. What this means is that venture capitalists believe more infor-mation leads to better decisions, yet they don’t necessarily use all that information andtheir overall decision accuracy is lower. Likewise, venture capitalists’ confidence increaseswhen they view information criteria with which they are more familiar and comfortable.Finally venture capitalists are more overconfident in their failure predictions than successpredictions. As such, Zacharakis and Shepherd (2001) posit that overconfident venturecapitalists may limit their information search (although they believe that they are fullyconsidering all relevant information) and focus on salient factors (for example how similarthis deal is to a past successful deal) despite other information factors that would suggestthis deal might fail. Unlike Busenitz and Barney (1997) who suggest that overconfidencecan have positive ramifications for entrepreneurs – they will launch the venture in thefirst place and then work harder to make sure the venture succeeds – overconfidence inventure capitalists is likely to be mostly a negative in that it is overconfidence in decisionmaking ability and it may not lead to increased effort to help failing ventures succeed,especially when venture capitalists often attribute failure to outside, uncontrollable events(Zacharakis et al., 1999).

Future research opportunities on the venture capital decision process Beyond the abovestudies, there does not appear to be much other work on heuristics and biases that impactthe venture capital decision process. Research on heuristics in the entrepreneurship liter-ature, however, has focused on those used by entrepreneurs, and has relatively ignoredventure capitalists’ decision making. Although only a small number of heuristics havereceived the attention of entrepreneurship scholars, there are others that may be pertinent.We suggest these as a source of future research. Finally, heuristics can have both positiveand negative outcomes. Much more research, along the lines of Baron (1998) andBusenitz (1999), can shed light under which conditions heuristics are better or worse.

The topic of biases has received more attention when looking at entrepreneurs’ deci-sion making. As noted above, Baron (1998) asserts that the new venture context createsan environment ripe for decision biases. Baron (1998) suggests that entrepreneurs areprone to counterfactual thinking; the tendency to think about ‘what might have been’. Heproposes that entrepreneurs are more likely to regret actions not taken (for example amissed opportunity), rather than the mistakes they may have actually made. A counter-factual bias may also have a strong impact on venture capitalists. Anecdotally, we readabout venture capitalists who bemoan passing up investments in big winners, such asAmazon or Google. This regret may increase the tendency to take bigger risks withoutfully evaluating all the information around a venture decision because the venture cap-italist doesn’t want to miss out again. It may also lead to chasing bubbles, as venture cap-italists see others succeed in a particular space and feel that they need to get in there orlose out (for example the dot.com bubble). This counterfactual thinking and any numberof the biases listed in Table 6.1 provide fertile ground for extending our knowledge ofventure capital decision making.

Future research opportunities to examine heterogeneity in venture capital decision policiesNow that the field has a strong grasp of the core venture capital decision making process,it is time to dig into aspects that lead to variance from that core process, such as heuristics


and biases. For instance, we suspect that there are a number of demographic and psycho-graphic factors that might lead to difference susceptibility to use certain heuristics andbiases. For example, Shepherd et al. (2003) find that experience has a curvilinear impacton decision accuracy. After 14 years of venture capital experience, decision accuracydeclines. Shepherd et al. (2003) suggest this is likely to be due to a number of biases thatlead to venture capitalists economizing their decision process; relying more on gut feel(Khan, 1987).

Simon and Houghton (2002) find that smaller, younger entrepreneurial firms exhibitmore biases than larger more established firms. It is reasonable to assume that size andage factors might cause venture capital firms to act differently. For example, Gompers(1996) argues that younger venture capital firms push ventures to IPO or other liquidityevents prematurely – called grandstanding – in order to gain credibility in the eyes ofpotential limited partners when raising another follow-on fund. We propose that newresearch start digging into these biases and heuristics to paint a deeper picture of theventure capital decision process.

There is also room to examine how context affects venture capitalist biases. Einhorn(1980) highlights a number of factors that can hinder effective decision making:

1. Information from the environment which is not clean; environmental noise disguisesinformation relevance;

2. feedback on past decisions which is often incomplete or distorted;3. the relationship between decision rules and their outcomes which is frequently

non-linear;4. placing information into an appropriate category which can be difficult due to ‘fuzzy’

category definitions;5. the need to consider several decision rules at once;6. decision rules which often have counterintuitive or unexpected relationships with the

outcome;7. certain actions by that person, after the decision has been made, which influence the

outcome of his/her decision; and8. judgments which, at times, must be made under pressure.

All of these factors are prevalent in the venture capital decision domain and create anopportunity to assess how they impact the venture capitalist decision. For example, areventure capitalists differently susceptible to these conditions? Are these conditionsstronger in certain industries than others? Do they differ across countries?

ConclusionThis chapter focuses on venture capitalists’ pre-investment activities, namely, their assess-ment and investment decisions. The implications from the research to date are many. Forexample, we have learned that venture capitalists are poor at introspecting about their owndecision processes (Zacharakis and Meyer, 1998). This lack of insight makes it difficultfor venture capitalists to learn from past decisions and to improve future decisions.Moreover, it is difficult to articulate and train junior associates if the venture capitalistdoesn’t understand his own decision process. Shepherd and Zacharakis (2002) suggestthat modeling a venture capitalist’s decision process can help him gain this insight and can


also be used as a training tool. Zacharakis and Meyer (2000) find that models of theventure capital process, or actuarial aids, improve the venture capitalist’s decision accu-racy. They suggest that such actuarial aids can be used by junior associates to screen ven-tures, thereby freeing up the venture capitalist’s time for other activities.

We have also called for more research into decision heuristics. Heuristics can be efficientand effective especially for time constrained venture capitalists. Yet, venture capitalistsneed to understand which heuristics they use and when different heuristics are mosteffective. While a satisficing heuristic allows venture capitalists to screen proposalsquickly, strictly following the heuristic may mean that venture capitalists reject potentiallyattractive deals because they fail to pass a hurdle on a relatively minor attribute. Creatinga venture ‘scorecard’ where the venture capitalist rates and records each proposal on theattributes that they believe to be most pertinent helps ensure that venture capitalists don’toverweight the importance of a negative evaluation on a relatively minor attribute orunderweight a positive evaluation on a relatively more important attribute. The scorecardalso creates a history that minimizes post hoc recall and rationalization biases and therebyprovides a feedback source that can help venture capitalists learn and improve their deci-sion process (Zacharakis and Meyer, 1998).

While some research has investigated potential biases and their impact (Zacharakis andShepherd, 2001), more research into biases will further benefit venture capitalists. The keyimplication is that venture capitalists should be aware that they, as is true for all decisionmakers, are prone to biases that might lead to sub-optimal decisions. Venture capitalistscan take steps to minimize the potentially negative impact of biases. Some methods, suchas the weekly partners meeting, are built into the venture capital process (Shepherd et al.,2003). During such meetings, a venture capitalist should articulate why they like a particu-lar venture and the other partners should challenge some of the underlying assumptions.This will help all the venture capitalists identify areas where they might be biased, such asoverweighting a salient attribute like the entrepreneur. Unfortunately, this meeting onlyhelps venture capitalists avoid biases that might incline them to back a venture that isn’tas attractive as it seems. Venture capitalists should consider also presenting a deal thatthey didn’t like and to articulate why. While it is true that venture capitalists reject far toomany deals to present all of them to the partner’s meeting, picking an occasional rejec-tion will help them learn if they have any biases that are causing them to reject potentiallypromising ventures prematurely.

In conclusion, this chapter has presented a historical perspective of research in the areawith pioneering works interviewing and surveying venture capitalists to gain deeperinsights into their reported decision policies. With more sophisticated methods, morerecent research has focused on real time methods of data collection from which decisionpolicies can be composed (for example verbal protocol analysis) or decomposed (forexample conjoint analysis and policy capturing). Along with the use of experiments todecompose venture capitalists’ decisions into their underlying structure, research has beenmore theory driven. Theory has been used to hypothesize which attributes are used inventure capitalists’ decision policy and how they are used, to hypothesize differences indecision policies across venture capitalists; and to better explain the process of con-structing a decision policy. In a short period scholars of venture capitalists’ pre-invest-ment activities have made great strides, but there is much still to learn. We look forwardto reading future research on this important topic.


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

IntroductionIt is well documented that venture capital is a special form of financing for an entrepre-neurial venture, in that the venture capital firm is an active financial intermediary. This isin sharp contrast with most financial intermediaries such as banks, institutional or stockmarket investors that assume a passive role. Once the latter invest in a company, they maymonitor the performance of the company periodically but they seldom interfere with thedecision making. In order to overcome the huge business and financial risks and thepotential agency problems associated with investing in young, growth oriented ventures(often without valuable assets but with a lot of intangible investments), venture capitalfirms specialize in selecting the most promising ventures and in being involved in the ven-tures once they have made the investment. In this chapter we focus on the post-investment,but pre-exit phase of the venture capital cycle. More specifically the principal theme ofthis chapter is to provide an overview of relevant aspects and research findings pertainingto the period after the venture capital firm (or venture capitalist) has made the decisionto invest in a particular portfolio company (or entrepreneur). We hereby focus on theinteraction between a venture capitalist and the entrepreneur, rather than on financialevents as follow-on financing rounds or exit. In essence, this overarching theme involvestwo important issues that will be addressed.

A first objective of this chapter pertains to categorizing the existing literatureinto research that has focused on venture capitalists’ involvement in monitoring activitiesvis-à-vis entrepreneurs and research on the potential for venture capitalists to add valueto their investees. Once an investment is made, the venture capitalist monitors the entre-preneur in order to reduce the chance that the latter appropriates the funds to pursue herpersonal interests. Next to monitoring, the venture capitalist helps in the decision making,so as to enhance value creation in the venture. In the earlier studies on venture capitalistinvolvement in portfolio companies, no clear distinction was made between monitoringand value adding, however. Research focused on understanding what venture capitalistsdo (for example Tyebjee and Bruno, 1984; MacMillan et al., 1988; Rosenstein, 1988),defining their roles and extent of involvement. Early evidence showed that there was a lotof variation with respect both to what venture capitalists do (that is content-related) andthe extent of their involvement (that is process-related) (Gorman and Sahlman, 1989;MacMillan et al., 1988), without explaining the difference. Subsequent research examinedthe conditions under which venture capitalists become more involved in their portfoliocompanies, especially with respect to variations in the characteristics of the portfolio com-panies. For example, the impact of greater agency risk (Barney et al., 1989; Sapienza andGupta, 1994; Sapienza et al., 1996), business risk (Barney et al., 1989), and task uncer-tainty (Sapienza and Gupta, 1994) on venture capitalists’ interactions with the CEOs of

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their portfolio companies was acknowledged. More recently, research acknowledges thatthe extent and impact of venture capitalists’ monitoring and value adding is not onlydriven by portfolio company characteristics, but also by the venture capitalists’ charac-teristics. The resource dependence theory, and the resource endowments of both venturecapitalists and entrepreneurs, such as their human, social or intellectual capital (forexample Baum and Silverman, 2004; Dimov and Shepherd, 2005) have been used toexplain the nature, level and effectiveness of the interaction between venture capitalistsand entrepreneurs. Recently, attention has also been paid to the nature and intensity ofventure capitalists’ involvement in different parts of the world, showing that their behav-ior shows commonalities, but differences as well (for example Sapienza et al., 1996;Bruton et al., 2005). In this chapter, we summarize some of the major research findingswith regard to the monitoring and value-adding role played by venture capitalists.

A second objective of this chapter pertains to highlighting recent research that hasstarted to open the ‘black box’ of the venture capitalist – entrepreneur relationship. Morespecifically, while early research discussed how entrepreneurs can benefit from theirventure capital providers, and how venture capitalists attempt to maximize the returnsfrom their investments, the specific question of how value added is created between thetwo parties was somewhat under-studied, both with respect to what type of informationis exchanged (that is content-related issues), and how the parties interact with one another(that is process-related issues). In this chapter, we will therefore include the findings fromsome recent research on the type of interactions that take place between venture capital-ists and entrepreneurs. We emphasize that we will neither discuss how venture capitalistsdecide to invest in a venture (see Chapter 6 by Zacharakis and Shepherd), nor what theoutcome of their monitoring and value adding activities is in terms of venture capitalists’exit routes and investment performance, nor the return to the entrepreneur (see Chapter 8by Busenitz and Chapter 9 by Leleux).

The chapter is structured as follows. In a first section, we compare the literature thatdescribes the role of monitoring and value adding in venture capitalist–entrepreneur rela-tionships. More specifically, we discuss the research that focuses on the importance for theventure capitalists to monitor their investments, thereby relying on the agency framework.We also discuss the research on the importance of value added in the post-investmentprocess, and describe the various value-adding roles that can be played by investors. In thesubsequent section, we report the findings from research that attempts to open the ‘blackbox’ of how value is added, and we focus on several issues pertaining to the content andprocess of the interactions that take place between venture capitalist and entrepreneur.With respect to content, we report research findings pertaining to the role of venture cap-italists’ experience, the knowledge exchange between venture capitalists, and the know-ledge exchange between venture capitalist and entrepreneur. With respect to process, wediscuss research findings pertaining to the role of trust, social interaction, goal congru-ence, and commitment, and we show in particular how these components have beenapplied to the context of venture capitalist–entrepreneur relationships. Figure 7.1 pro-vides an overview of the different issues that are discussed in this chapter.

The role of monitoring and value added in venture capitalist–entrepreneur relationshipsThe early research on the post-investment relationship between venture capitalist andentrepreneur has pointed to the undertaking of monitoring and value adding activities by


venture capitalists. Whereas these two broad types of activities overlap with one another,and in fact may represent complementary roles, the assumption underlying these activi-ties is quite different. More specifically, the focus on monitoring relates to venture cap-italists’ attempt to correct potential harmful behavior by entrepreneurs, and the focus onvalue added relates to venture capitalists’ attempt to increase the upside potential of theirinvestments. In the following paragraphs, we provide an overview of the literature onmonitoring and value added.

Monitoring and information asymmetryPrior research has indicated that an important aspect of the venture capitalist–entrepre-neur relationship pertains to the former’s monitoring of the latter’s actions. Monitoringpertains to the procedures that are used by the venture capitalist to evaluate the entrepre-neur’s behavior and performance in order to keep track of her investment (Sahlman, 1990;Sapienza and Korsgaard, 1996; Wright and Robbie, 1998). Given their equity ownership,venture capitalists have strong incentives to monitor entrepreneurs’ actions, as entrepre-neurs’ and venture capitalists’ goals are not always perfectly aligned. Venture capitaliststherefore receive strong control levers, sometimes disproportionate to the size of theirequity investment (Lerner, 1995). For instance, venture capitalists often receive convert-ible debt or convertible preferred stock that carries the same voting rights as if it hadalready been converted into common stock (Gompers, 1997), or they receive a relativelygreat board representation in order to allow the replacement of the entrepreneur as chiefexecutive officer if performance lags (Lerner, 1995).

The venture capitalists’ involvement in monitoring activities stems from the presence ofgoal incongruencies coupled with information asymmetry between the two parties. First,

The venture capital post-investment phase 195

Figure 7.1 Conceptual framework

Venture capitalist Entrepreneur

Monitoring

Value added

Content:– VC experience– Knowledge

exchange betweenVCs

– Knowledgeexchange betweenVC and entrepreneur

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

venture capitalists and entrepreneurs may not always have the same goals. For example,firm survival or generating a personal income, rather than value creation, may be ofprimary importance for the entrepreneur, but not for the venture capitalist. Alternatively,venture capitalists aim for early exit, while entrepreneurs may have more long term aspi-rations. Moreover, information asymmetries mean that the venture capitalist and entre-preneur have access to private information that is not available to the other party. Forexample, entrepreneurs often have a better insight into their own capabilities and the levelof effort they want to put in the venture, compared to external investors. Also, entrepre-neurs often have a good insight into the nature of technological developments. Venturecapitalists, on the other hand, may have a better insight into the potential market accept-ance and competition, given that they invest in a portfolio of companies (Cable andShane, 1997).

Goal incongruencies, together with unequal distribution of information, may lead toagency problems of adverse selection or moral hazard (see hereafter). They are thusimportant when both parties negotiate about establishing an investment agreement (seeChapter 8), as well as after the investment decision has been made (Sapienza and Gupta,1994). The presence of information asymmetry may be particularly high in the case ofhigh-tech investment deals in which the entrepreneur has an in-depth knowledge aboutthe specifics of an innovative technology. Given the information opaqueness surroundingtechnological ventures and the intangibility of most of their investments, close monitor-ing by venture capitalists is, albeit not easy, essential in order to understand the actionsof the entrepreneur (Sapienza and De Clercq, 2000).

In order to explain the impact of information asymmetry on venture capital behavior,agency theory has been used by many early researchers as their central framework toexplain venture capitalist behavior (for example Sapienza and Gupta, 1994; Lerner, 1995;Sapienza et al., 1996). The center of agency theory is the agency relationship in which oneparty (the principal) delegates work to another party (the agent), who performs that jobas defined in a contract (Eisenhardt, 1989). Interestingly, recently researchers have arguedthat both the entrepreneur and venture capitalist can play the role of ‘agent’. In the fol-lowing paragraphs we provide an overview of this research.

Entrepreneur as agent Most early research on venture capitalist behavior has depicted theventure capitalist as the principal and the entrepreneur as the agent (Eisenhardt, 1989;Sapienza and Gupta, 1994). That is, from the venture capitalist’s perspective, an importantquestion may evolve from the question of how to ensure that entrepreneurs do not takeactions that jeopardize the venture capitalists’ chances to generate maximum financialreturns. According to agency theory, two types of agency problems may arise, that is‘adverse selection’ and ‘moral hazard’. First, the term ‘adverse selection’ pertains to theuncertainty the venture capitalist faces with respect to the entrepreneurs’ capabilities tomeet pre-set expectations (Eisenhardt, 1989), and therefore is an important issue in theventure capital selection process (see Chapter 6). For instance, an entrepreneur may endup not having the required competencies to grow her venture successfully (Wright andRobbie, 1998). Second, and more importantly in terms of the post-investment relationship,‘moral hazard’ problems pertain to a party’s potential shirking behavior and unwillingnessto make sufficient efforts, even if it has the capability to meet pre-set expectations(Eisenhardt, 1989). For instance, from the venture capitalist’s perspective, there is a danger


that the entrepreneur, once she has received the money, may alter her behavior in ways thatmislead the investor. The entrepreneur, being an inside member of the company as well asthe controlling officer, has access to company information that is not necessarily readilyavailable to the venture capitalist (Cable and Shane, 1997). Many aspects may be hiddenfrom the venture capitalist, such as the actual progress of product development or even theentrepreneur’s hidden motives for having created the company. Other examples of entre-preneurs’ defective behavior might be their purchasing of a larger than necessary computerfor their enjoyment, charging personal trips to the company, or even activities that mightbe business related (for example product decisions) but not consistent with the venture cap-italist’s wishes (Cable and Shane, 1997; De Clercq and Sapienza, 2001).

In other words, this stream of research explains that opportunities abound for the entre-preneur to act in a manner that increases her personal wealth or that is consistent withher personal goals, but jeopardizes the company’s well-being, whereby the venture cap-italist’s money is not utilized as desired. This behavior will lead then to higher costs forthe venture capitalist, since she needs to supervise and monitor the entrepreneur’s activi-ties. One possibility for the venture capitalist to reduce moral hazard problems is bywriting appropriate contracts at the time of investment, thereby aligning the interests ofthe entrepreneur and the venture capitalist (Kaplan and Strömberg, 2003). One exampleis to use convertible securities, such as convertible debt or convertible preferred equity(Gompers, 1997; Cumming, 2005). The use of staged investing, where venture capitalistshave the opportunity to withdraw from an investment and thus motivate the entrepreneurto behave ‘honestly’, is also a commonly used method (Sahlman, 1990; Wright andRobbie, 1998).

Given that contracts are inherently incomplete and cannot foresee all future states ofnature, venture capitalists closely monitor their portfolio companies formally by taking aseat on the Board of Directors of their portfolio companies (Rosenstein, 1988; Rosensteinet al., 1993), and informally through periodical check-ups of the day-to-day activities andthrough interim financial reports (Gompers, 1995; Mitchell et al., 1995). Interim financialreporting by the entrepreneur is indeed an important monitoring device, included in theinvestment agreement (Rosenstein, 1988). Informal control may also include the use ofcodified rules, procedures and contract specifications that specify desirable patterns of theentrepreneur’s behavior.

The Board of Directors is the formal governance mechanism utilized by venture cap-italists in most countries. Boards of Directors can vary widely in their size and operation,however. There is evidence that Asian boards are, on average, larger in size, and have alarger percentage of insiders compared to US boards, while Continental European boardsare smallest (Bruton et al., 2005). Furthermore, Kaplan and Strömberg (2003) showedthat US venture capitalists have on average a quarter of all board seats, but they controlthe board in 25 per cent of their portfolio companies. Control over the board is morecommon when the business risk is higher, that is when the company has no revenues yetor when the company operates in a volatile industry (Kaplan and Strömberg, 2003).Interestingly, it has also been found that venture capital board members are, on average,not of better quality than other external board members, except if the lead venture capitalinvestor is ‘top quality’ (Rosenstein et al., 1993).

Evidence on the nature, extent and impact of monitoring activities of venture capitalistsis surprisingly scarce, however. There is some evidence that venture capitalist monitoring is


an attempt to reduce agency problems, as monitoring intensity is highest for companies withhigh information asymmetries and potential agency problems. For example, companies thatjust entered the venture capital portfolio and poorly performing companies are followedmore closely by venture capitalists (Beuselinck et al., 2007). Furthermore, it appears thatthe agency framework may be more applicable in the context of Anglo-Saxon compared toContinental European venture capital investments, as recent research has indicated thatventure capitalists exert more monitoring efforts in the former case than in the latter case(Beuselinck et al., 2007). Finally, the importance of monitoring has also been discussed inthe context of venture capitalists’ syndication, that is the simultaneous investment by atleast two venture capitalists in the same entrepreneur (for example Lockett and Wright,2001). For instance, it has been shown that lead investors exert more monitoring effort in asyndicate than non-lead investors (Lockett and Wright, 2001). The last finding opens anavenue of further research, namely how non-lead syndicate investors monitor the leadventure capitalist.

Understanding the monitoring process is important not only from an academic per-spective. From the venture capitalist’s perspective, more monitoring not only reducesagency problems, but also entails larger costs with respect to time allocation (Barneyet al., 1989; Gorman and Sahlman, 1989; Gifford, 1997). Greater governance maytherefore not always be cost-efficient (Sapienza et al., 1996). MacMillan et al. (1988,p. 37) already observed that ‘a relevant issue in need of examination is the opportunitycost of [greater] involvement.’ We believe that the research to date has not yet fullyaddressed the trade-off between greater monitoring and cost efficiency. Furthermore, itis possible that post-investment monitoring by the venture capitalists may be substi-tuted by more rigid contractual arrangements or equity control as agreed upon priorto the investment decision (Beuselinck and Manigart, 2007). From the entrepreneur’sperspective, more monitoring by venture capitalists increases the information produc-tion of the portfolio firm, leading on the one hand to enhanced decision making buton the other hand also to increased information reporting costs. Research indicates thatventure capitalist monitoring has positive outcomes for portfolio companies and theirstakeholders. It leads to the establishment of more effective corporate governance rulesin portfolio companies and subsequently to a higher quality of reported accountingfigures both in the US (Hand, 2005) and in Europe (Mitchell et al., 1995; Beuselinckand Manigart, 2007). Venture capitalists’ monitoring effects are especially beneficial formore mature portfolio companies. From the perspective of external parties such asbanks, employees, suppliers and customers, enhanced monitoring leads to qualitativelyimproved and more extensive external reporting of portfolio companies (Beuselinckand Manigart, 2007).

Venture capitalist as agent Alternatively, some researchers have suggested that venturecapitalists can be the agents of entrepreneurs. For instance, Cable and Shane (1997) crit-icized the representation of the venture capitalist–entrepreneur dyad as an agencyproblem, in that this framework ‘does not incorporate the possibility of opportunisticbehavior by the principal’ (Cable and Shane, 1997, p. 147). Also, Sahlman (1990) reportedthat a venture capitalist is often responsible for almost nine investments and sits on fiveboards of directors. Therefore, post-investment activities – such as the search for furtherfinancing, or assistance in strategic decision making – that venture capitalists undertake


for one portfolio company, cannot necessarily be undertaken for all portfolio companies,such that venture capitalists are often not able to allocate an optimal amount of time toeach entrepreneur (Gifford, 1997).

It has furthermore been suggested that venture capitalists are sometimes inclined to‘under-invest’ in their portfolio companies. That is, venture capitalists often prefer to stagetheir investments because this reduces the amount of money invested at the earliest stagesof venture development when investment risk is highest. This practice may not necessar-ily be bad for entrepreneurs as it enables them to retain a higher fractional ownership. Itnevertheless poses the risk that if their venture does not develop as planned, entrepreneursmay run out of money and be in a poor negotiation position to raise additional money(De Clercq et al., 2006), thereby potentially facing high levels of dilution. Furthermore,it has been argued that venture capitalists may sometimes be inclined to distribute a firm’sprofits rather than to reinvest these profits in the company as limited partners have theright to get returns on their investments before venture capitalists can secure a profit(Sahlman, 1990). This venture capitalist behavior can prevent an entrepreneur from bring-ing her company to a next growth stage.

Finally, prior research has shown that some venture capitalists may seek a prematureIPO in their portfolio companies in order to gain reputation and report enhancedperformance when raising new funds. This ‘grandstanding’ behavior is more likely tohappen among young venture capitalists that want to establish a reputation in the venturecapital community (Gompers, 1996). Also, venture capitalists are inclined to take com-panies public near market peaks, even if this is not necessarily the optimal timing for theentrepreneurial company (Lerner, 1994).

In short, it has been argued that venture capitalists’ actions can be contradictoryto the best interests of an entrepreneur in terms of their allocation of time and effort,re-investment decisions, or the timing of a portfolio company going public.

Concluding note Some researchers have suggested that the literature on venture capitalmonitoring and its assumptions regarding information asymmetry and opportunism,should be complemented with research that views the venture capitalist–entrepreneurrelationship from a more positive angle (Sapienza and De Clercq, 2000; Arthursand Busenitz, 2003). For instance, it has been suggested that stewardship theory mayprovide a framework complementary with agency theory for examining the venture cap-italist–entrepreneur relationship (Davis et al., 1997; Arthurs and Busenitz, 2003). Thestarting point in this alternative approach is the identification of situations in which theinterests of the venture capitalist and the entrepreneur are aligned, and both partiescommit themselves to the development of a trustful relationship. In other words, theapplication of agency theory to the venture capitalist–entrepreneur relationship may beappropriate only when the two parties have diverging goals (Arthurs and Busenitz, 2003).

Furthermore, the fact that both venture capitalist and entrepreneur hold informationaladvantages over one another may be related to the very nature of, and difference in, theactivities these parties engage in. That is, venture capitalists and entrepreneurs essentiallyspecialize in the development and contribution of different types of knowledge (Cableand Shane, 1997). By virtue of their repeated experience with the monitoring of start-upsand growing companies, venture capitalists may often have a better idea of their portfo-lio companies’ value than the entrepreneurs themselves. Alternatively, entrepreneurs are


specialized in detecting new opportunities in the environment and combining resourcesto exploit these opportunities in an original fashion (Kirzner, 1973). For instance, high-tech entrepreneurs may possess specialized technical knowledge and skills that aredifficult if not impossible to be replicated.

Although entrepreneurs’ wish to hide negative information from their investors com-bined with their superior insight into the viability of new technology may make defectivebehavior appear to be a likely option, the wisdom of hiding information for opportunis-tic purposes is of questionable practical value, since doing so directly threatens the via-bility of the company itself as well as the venture capitalist’s trust and support (Sapienzaand Korsgaard, 1996; Cable and Shane, 1997). Furthermore, although information asym-metry may lead to defective behavior, it also includes the potential for benefits to bederived for both parties. This issue will be discussed later in this chapter.

Value addingWhereas venture capitalists’ monitoring activities mainly focus on how venture capital-ists can minimize potentially harmful behavior by entrepreneurs, venture capitalists maytry to increase the value of their portfolio company through value-adding activities afterthe investment decision has been made. The literature on the post-investment processstarts from the dominant assumption that venture capitalists do add value and highlightsthe question of how they increase the upside potential of their investments. An earlystream of research has emphasized the value-adding activities venture capitalists engagein with respect to their investment deals. More specifically, this research has discussed thebeneficial role of the value-adding beyond financial capital that is provided by venturecapitalists to their portfolio companies (Sapienza, 1992; Fried and Hisrich, 1995;Sapienza et al., 1996; Busenitz et al., 2004). From the entrepreneur’s point of view, thepresence of added value beyond pure financial support compensates for the high cost ofventure capitalist money (Manigart et al., 2002). Interestingly, Seppa (2002) and Hsu(2004) showed that entrepreneurs are willing to accept significantly lower valuations andthus face higher dilution when they expect that the venture capitalist will contribute moreto the development of their venture, more specifically when the venture capitalist has abetter reputation.

In early research on value added, all venture capitalists were treated homogeneously or,if differences between venture capitalists were acknowledged, they were not clearlyexplained (for example MacMillan et al., 1988). For example, a distinction was madebetween three categories of venture capitalists, the ‘inactive’ investors, the ‘active advicegivers’, and the ‘hands-on’ investors (MacMillan et al., 1988; Elango et al., 1995), with thelatter category attaching most importance to value-adding activities. In contrast,other research has emphasized that ‘not all venture capital is the same’, and has startedto explain the differences in venture capitalist value-adding behavior. It has been sug-gested that the roles venture capitalists play in their portfolio companies differ dependingon the characteristics of the venture capitalist or venture capital firm itself (for examplereputation – Gompers, 1996) or of the portfolio company (for example its stage ofdevelopment – Sapienza, 1992). In the following paragraphs we give a short overview ofwhat we believe are two important sub-streams in the value added literature, that isresearch on the ‘classic’ value-adding roles, and research on how venture capital reputa-tion may influence venture capitalist involvement.


Value-adding roles Providing non-financial assistance to portfolio companies andthereby improving the risk–return mix, is an essential task of a venture capitalist as afinancial intermediary (Gupta and Sapienza, 1992; Amit et al., 1998). Research consis-tently stresses three key roles played by venture capitalists in their relationship withentrepreneurs: (1) a strategic role as generators of and sounding boards for strategic ini-tiatives, (2) an operational role as providers of key external contacts for locating man-agerial recruits, professional service providers, key customers, or additional financing,and (3) a personal role as friends, mentors and confidants (Sapienza et al., 1994).Venture capitalists see their strategic roles as having the greatest importance (Fried et al.,1998), their interpersonal roles as next in importance, and their operational roles asbeing relatively less important to helping their portfolio companies realize their fullpotential.

Interestingly, some conflicting results have been found with regard to the value addedproposition. Whereas some researchers have found support for the non-financial valueadded by venture capitalists (for example MacMillan et al., 1989; Sapienza, 1992;Hellman and Puri, 2000; 2002), other research has suggested that venture capitalists maynot necessarily add value (for example Gomez-Mejia et al., 1990; Steier and Greenwood,1995; Manigart et al., 2002). One of the reasons for the inconsistency of findings may bethat many studies examining venture capitalist value added have a survival bias in that thesurveyed samples contain relatively more success stories (Manigart et al., 2002; Busenitzet al., 2004).

Furthermore, it has been suggested that the value-adding intensity varies across venturecapitalists, across portfolio companies or across regions of the world. For instance, as canbe expected, venture capitalists related to a financial institution or with a financial back-ground have been found to place more emphasis on their financial role (Bottazzi and DaRin, 2002). Furthermore, venture capital managers with business rather than financialexperience spend more time with their portfolio companies, and especially with com-panies with high business and agency risk (Sapienza et al., 1996). Also, a study examin-ing the level and nature of European venture capital involvement in their portfoliocompanies found that venture innovativeness and stage had a consistent impact such thatgreater value added involvement by the venture capitalist occurred for highly innovativeventures and for early stage ventures (Sapienza et al., 1994). Finally, venture capitalists’value adding behavior may differ depending on the part of the world and therefore theinstitutional context they operate in (Sapienza et al., 1994; Bruton et al., 2005). Forinstance, Sapienza et al. (1994) found that venture capitalists in the Netherlands were lessinvolved with experienced CEOs than anticipated, while venture capitalists in the UKwere more involved with experienced CEOs. In France, involvement varied less and didnot follow a consistent pattern. It has also been found that more value adding is providedby American venture capital managers than by their European or Asian counterparts(Bottazzi and Da Rin, 2002; Bruton et al., 2005).

In sum, while the literature generally suggests that venture capitalists do add value, andthat this value added is contingent upon factors related to the venture capitalist, entre-preneur or external conditions (for example geographical region), the majority ofresearch to date has to a great extent treated the value-adding role played by venturecapitalists as a black box, whereby it is not clear what factors influence the degree to whichvalue is (potentially) added, or even whether value is added. As will be explained later


in this chapter recent research has begun to open this black box by probing the roleof content and process-related issues in fostering the creation of value in venturecapitalist–entrepreneur relationships.

Venture capital and reputation A more indirect but nevertheless important aspect ofventure capitalists’ value-adding potential pertains to their reputation, in that for theentrepreneur the venture capitalist’s reputation may be a critical point in gaining legiti-macy in the market place (Gompers, 1996; Black and Gilson, 1998). That is, next tomoney, monitoring and value adding, venture capitalists may provide enhanced credibil-ity to their portfolio companies, especially when they are highly respected players in theventure capital industry. The venture capitalist’s reputation can have a positive effect onthe entrepreneur because a company backed by a venture capitalist with an outstandingreputation may be more capable of attracting customers, suppliers and highly-talentedmanagers (for example Davila et al., 2003) as venture capitalist performance and experi-ence are associated with a greater likelihood of success.

Furthermore, venture capitalists’ role as reputational intermediary may be comple-mentary with their role as financier, monitor and provider of value added in that reputa-tion enhances the credibility of the information that the venture capitalist provides andtherefore yields a positive signal, not only in the eyes of third parties but also of the entre-preneurs themselves. Prior research has indeed argued that entrepreneurs are more willingto accept the advice from highly esteemed investors (Busenitz et al., 1997; Hsu, 2004).Interestingly, it has also been argued that venture capitalist reputation may potentiallyhave a negative effect for entrepreneurs. More specifically, because of the time constraintsventure capitalists are confronted with (Gifford, 1997), some venture capitalists may beinclined to treat their own reputation as substitutes for their value-adding services. Thatis, all else being equal, some venture capitalists with high reputational capital may devoteless effort to their investments compared to their less well-known rivals because they –perhaps falsely – assume that their mere reputation will be sufficient to create value,regardless of their post-investment effort (De Clercq et al., 2003).

For the venture capitalists themselves, reputation may be important because it givesgreat market power in their ability to close attractive deals, as entrepreneurs of start-upcompanies are more likely to accept a financing offer made by a venture capitalist with ahigh reputation, even at lower valuations (Seppa, 2002; Hsu, 2004). Reputation also pro-vides the venture capitalist with the ability to raise new funds and certify ventures to thirdparties (Gompers, 1996). The consequences of losing a good reputation can therefore besignificant. For example, in the aftermath of the market crash in 2001, a number of well-established venture capitalists damaged their reputation by over-investing in marginalventures, and subsequently were unable to raise new funds and were forced out of busi-ness (Lerner and Gompers, 2001). Furthermore, because venture capitalist reputation ishighly valued by the market, venture capitalists attempt to gain reputations as soon aspossible. A primary vehicle for building reputation is going public with a portfoliocompany because an IPO may serve as a visible (if somewhat imperfect) signal of theventure capitalists’ prowess in selecting, developing, and cashing out of high potentialventures (Stuart et al., 1999). Another way to build reputation is to syndicate withrespected venture capitalists (Sorenson and Stuart, 2001), which venture capitalists mayseek out of their own interest, rather than in the venture’s best interest.


Concluding note Overall, prior empirical studies on venture capitalists’ value added haveshown that both venture capitalists and entrepreneurs perceive value in active venturecapitalist presence in entrepreneurial ventures. The importance of venture capitalists’value-adding potential has been illustrated by the fact that successful venture capitalistshave been found to use a ‘hands-on’ approach on a discriminating and exceptional basisrather than in a universal manner, in that successful venture capitalists intervene in areaswhere they believe they can make an important economic contribution to their portfoliocompanies (for example Murray, 1996). However, and as mentioned earlier, despite theempirical evidence that venture capitalist value added is an important aspect of the post-investment relationship, the literature to date has to a great extent considered the venturecapitalist–entrepreneur relationship as a ‘black box’. That is, the notion that value can beadded is expected as ‘a fact of venture capitalist practice’, and no clear explanation isgiven of how exactly value is created. In the next section, we highlight some recentresearch that has attempted to focus more closely on the type of interactions that takeplace between the venture capitalist and entrepreneur. In essence, two categories of issuesarise with respect to the dynamics that occur between the two parties: (1) the content ofthe interactions; and (2) the process through which these interactions take place.

The role of content and process in venture capitalist–entrepreneur relationship

Content-related issuesAs indicated above, venture capitalists’ active involvement in their portfolio companiesrepresents an important path through which entrepreneurs can benefit. In the followingsection, we focus on research that has looked particularly at the role of knowledge andlearning in venture capital investments. More specifically, we discuss the role of venturecapitalists’ experience and knowledge, the importance of knowledge sharing betweenventure capitalists (either within a given venture capital firm or within an investment syn-dicate), and the communication that takes place between the venture capitalist and entre-preneur (Figure 7.1).

Venture capitalist experience Whereas some venture capitalists may prefer to diversifytheir portfolio in order to decrease their financial risk, others prefer to specialize and focuson developing specific expertise within a given domain (for example in terms of industryand/or development stage) in order to reduce the uncertainty embedded in their invest-ments (for example Gupta and Sapienza, 1992; Norton and Tenenbaum, 1993; Lockettand Wright, 1999; De Clercq et al., 2001). More specifically, it has been argued that whilefinancial risk management may help reduce a venture capitalist portfolio’s downside,knowledge management may help increase its upside (Dimov and Shepherd, 2005). DeClercq and Dimov (2003) found that investors’ specialization in terms of industry anddevelopment stage has a positive effect on their overall portfolio performance. Venturecapitalists’ specialized knowledge may make it more difficult for entrepreneurs to hideissues of management incompetence, misbehavior or other crucial information regardingcompany performance due to the investor’s more in-depth understanding of thecompany’s business. Furthermore, a positive relationship between specialization and per-formance may also suggest that specialized venture capitalists may be more efficient indetecting and providing adequate resources (for example potential customers, employees


or other investors) to portfolio companies depending on their particular industry andstage of development.

Other research has suggested that the advantages stemming from investment special-ization may be particularly strong in the case of high-tech investments. As high-techinvestments are characterized by high levels of informational asymmetry and opacity,specialized venture capitalists may be in a better position to reduce the uncertaintystemming from this asymmetry (Henderson, 1989). It has even been argued that the highinformational asymmetries typical for high technology investing create a competitiveadvantage for venture capitalists if they decide to specialize in these firms (Sapienza andDe Clercq, 2000). Going one step further, Hurry et al. (1992) found that Japanese venturecapital investments often serve as a learning mechanism to carry the venture capitalist toa new technology, and the success of this learning transition may take precedence over thesuccess of the portfolio company or the goal to produce immediate financial returns tothe venture capitalist.

In short, prior research suggests that investment specialization may facilitate the acqui-sition of specific information by the venture capitalist, and this in turn may enable theinvestor to become more effectively involved in the key decision-making processes of herventures. Experienced venture capitalists may thus be better equipped to detect deficien-cies (to monitor) and to deliver sound advice (to add value) to the entrepreneur.Interestingly, one study found that a venture capitalist’s overall experience is negatively,rather than positively, related to how much the investor learns from a particular portfoliocompany (De Clercq and Sapienza, 2005). This counter-intuitive finding needs furtherinvestigation in terms of what some of the boundary conditions are for venture capital-ists to learn from their prior investment experience and how exactly to apply this experi-ence in a constructive manner toward future investments. For instance, it could be that,in some cases, experienced investors adopt dominant logics that filter out new informa-tion and are guilty of assuming that their experience obviates the need to communicatewith the entrepreneur or other investors (Prahalad and Bettis, 1986).

Knowledge exchange between venture capitalists In addition to the knowledge held by anindividual venture capitalist, the communication that takes place between venture capital-ists may also play an influential role in generating positive investment outcomes. First, thecommunication between investors working for one and the same venture capital firm maybe important. Venture capital firms indeed consist of several general partners and a staffof associates who function as apprentices to the general managers (Sahlman, 1990). As thepartners and associates have to some extent varying backgrounds and skills, and each mayhold different ‘chunks’ of knowledge, entrepreneurs may benefit from investors who fostereffective communication routines with their colleagues within the venture capital firm. Forinstance, intensive knowledge exchange among individual venture capitalists regarding aparticular portfolio company may give the venture capital firm as a whole broader accessto and deeper insight into knowledge that is important to assist a portfolio company suc-cessfully (De Clercq and Fried, 2005). As such, in order for a venture capital firm to exploitits knowledge base optimally, it benefits from combining and integrating knowledge fromamong various individuals (that is venture capitalists) within the firm.

Furthermore, there is an increasing body of research that addresses the importance ofknowledge exchange that takes place within venture capital investment syndicates, that is


the cooperation between individual venture capitalists working for different venture capitalfirms (Lockett and Wright, 2001; De Clercq and Dimov, 2004; Dimov and De Clercq, 2006;Manigart et al., 2006). At a conceptual level, an important aspect of the beneficial effectof syndication pertains to the productive interactions that may take place among syndi-cate partners (for example Bygrave, 1987; 1988; Lerner, 1994; Brander et al., 2002). Froma knowledge perspective, there may be two principal positive outcomes resulting fromventure capitalists’ syndication. First, syndication may help facilitate venture capitalists’selection process in that venture capital syndicates may find better investment targets thaneach individual venture capitalist would find on her own (Lerner, 1994). Second, syndica-tion may increase the venture capitalists’ value-added potential after the investment deci-sion has been made since syndicate partners can bring complementary knowledge to thetable (Brander et al., 2002) and are heterogeneous with respect to their resources (Lockettand Wright, 2001). That is, as different syndicate members may have different skills rele-vant to a particular portfolio company (for example detecting new customers, filling topmanagement team vacancies, or bringing the entrepreneur in contact with additionalinvestors), investment syndicates represent a rich variety of knowledge relevant to theentrepreneur. Interestingly, Dimov and De Clercq (2006) found a positive, rather than neg-ative, effect of syndication on the proportion of portfolio company defaults in a venturecapitalist’s portfolio. One explanation of this finding is that once a portfolio company losesits promise of high returns, venture capitalists involved in a syndicate may feel a lowerresponsibility vis-à-vis a prior investment decision when this responsibility is shared withother investors. This may not necessarily be a bad thing as this practice diminishes the like-lihood of ‘living dead’ investments in a venture capitalist’s portfolio (Ruhnka et al., 1992).In this regard, further investigation is necessary to examine how venture capitalists’ esca-lation of commitment, that is their continued involvement with a portfolio company witha disappointing performance, may be attenuated when venture capitalists are being part ofa group of investors (Birmingham et al., 2003).

Knowledge exchange between venture capitalist and entrepreneur Recent research has sug-gested that venture capitalists and entrepreneurs are involved in a learning relationship,and that both sides may play alternatively the role of ‘student’ and ‘teacher’ (De Clercqand Sapienza, 2001; Busenitz et al., 2004). More specifically, the potential outcomes fromthe relationship between venture capitalist and entrepreneur may be highest when the twoparties hold complementary knowledge that enforces the other party’s expertise and skills(Murray, 1996). A specific manifestation of the complementarity between the venture cap-italist and entrepreneur pertains to the parties’ undertaking of relation-specific invest-ments, that is investments that are specifically targeted at their mutual relationship (Dyerand Singh, 1998). Relation-specific investments by the venture capitalist for example maybe to devote considerable time and energy with an entrepreneur to learn the nuances andpotential of a specific technology. Likewise, the entrepreneur may develop and utilizereporting procedures specifically aimed at fitting the venture capitalist’s timing and report-ing requirements. De Clercq and Sapienza (2001) argued that both venture capitalist andentrepreneur can benefit from such relation-specific investments since these investmentsenable them to access information and capabilities not widely available in the market. Thatis, the complementary skills of venture capitalist and entrepreneur can result in anextremely potent combination that leads to enhanced learning for both parties.


In addition to the nature of the knowledge that is held by venture capitalist andentrepreneur, effective knowledge sharing routines have to be established between the twoparties. Communication between venture capitalist and entrepreneur may occur in avariety of formal and informal forms, such as through telephone, email, voice mail,formal meetings and board meetings (Gorman and Sahlman, 1989; Sahlman, 1990).When effective board knowledge-sharing routines are in place, the interaction betweenventure capitalist and entrepreneur may lead to an improved capacity for both parties toexchange and process knowledge, and this may then lead to optimal learning outcomes(De Clercq and Sapienza, 2005). Furthermore, personal contacts outside board meetingsmay allow for easier exchange of information, in that such contacts may allow the venturecapitalist and entrepreneur to learn more about the other’s idiosyncrasies and to developa mutual understanding of each other’s goals. Also, the employment of frequent interac-tion routines between venture capitalist and entrepreneur enhances access to each other’sknowledge base and increases the capability of processing complex knowledge (Sapienza,1992). More generally, effective communication between venture capitalist and entrepre-neur stimulates a greater understanding between the two parties, and ultimately enhancesthe potential for favorable investment outcomes.

Concluding note An important aspect of how venture capitalists add value to their port-folio companies, or how entrepreneurs benefit from their venture capital providers, per-tains to the content of the interactions that take place between the two parties. Asillustrated in the research cited above, the knowledge held by the individual venture cap-italist, the aggregated knowledge held by multiple venture capitalists belonging to thesame or different venture capital firms, as well as the combined knowledge of investor andentrepreneur all play an important role in the effectiveness of venture capital investments.Overall, the literature indicates that the knowledge-based view and learning theory areappropriate frameworks that help explain why certain venture capitalist–entrepreneurrelationships are more effective than others. However, although the literature mentionedabove suggests that venture capitalists and entrepreneurs should work together in a com-plementary fashion in order to more fully exploit their respective knowledge bases, the lit-erature falls short of describing how exactly these advantages could happen. Therefore,more research is needed on the actual activities and procedures that are maintained by thetwo parties, for example, what are the specific task descriptions outlined for the venturecapitalist during and outside board meetings, or what is the content and frequency of thefeedback that entrepreneurs provide to their investors?

Process-related issuesWhereas the previous section focused on the role of knowledge in venture capital finance,we now turn our attention to process-related aspects of the relationship between venturecapitalist and entrepreneur. We draw hereby on the increasing body of venture capitalresearch that recognizes the importance of establishing strong social relationshipsbetween the two parties rather than focusing solely on behavior based on self-interest andopportunism as advanced by the agency framework.

Various theoretical frameworks In essence, the assumptions underlying agency theorydeny the establishment of a trusting relationship between exchange partners, and the


theory is predicated on an extreme form of self-serving behavior (Eisenhardt, 1989).Given the shortcomings related to the agency framework, alternative theories such asgame theory (Cable and Shane, 1997) and procedural justice theory (Sapienza andKorsgaard, 1996), have been applied to the context of venture capitalist–entrepreneurrelationships. Cable and Shane (1997) argued that the relationship between venture cap-italist and entrepreneur can be described as two parties locked together in a game, whichif successfully and rationally played together, will yield rewards greater than if appreci-ated in a contested and untrusting fashion. The authors’ application of game theory toventure capitalist–entrepreneur dyads is interesting in that it explains why the two partiesmay be motivated towards cooperative behavior, despite their different goals. However,this emphasis on the play of games still assumes economic gain as the exchange partners’sole motivator, and does not take into account the principles underlying relationalexchange and trust development.

Other studies have included trust as an important construct for describing the governanceof venture capitalist–entrepreneur relationships (Sapienza and Korsgaard, 1996; Fiet et al.,1997). The core idea of procedural justice theory is that regardless of the outcome of certaindecisions, individuals react more favorably when they feel the procedure used to make thedecisions is fair. For instance, it has been suggested that a regular provision of informationby the entrepreneur to the venture capitalist may be perceived as a fair component of theinvestment agreement by the latter, which will subsequently increase the investor’s trust inthe entrepreneur. However, whereas procedural justice theory does take into account therole of non-economical aspects in the venture capitalist–entrepreneur relationship, theunderlying assumption is still one of protection against each other’s opportunistic behav-ior.

In the following sub-sections, we focus on recent venture capital research that hasapplied a social exchange perspective for describing venture capitalist–entrepreneur rela-tionships, and we also refer to the broader sociological and management literature fromwhich the application of this framework has been derived. More specifically, we willdiscuss the importance of the following four process-related components of venturecapitalist–entrepreneur relationships: trust, social interaction, goal congruence and com-mitment (Figure 7.1). The first three components represent key dimensions of the socialcapital that is potentially embedded in venture capitalist–entrepreneur relationships(Nahapiet and Ghoshal, 1998). More specifically, ‘trust’ pertains to expectations oneparty has vis-à-vis the other’s behavior (relational dimension), ‘social interaction’ pertainsto the overall pattern of connections and the tie strength (structural dimension), and ‘goalcongruence’ pertains to the presence of shared interpretations between the parties (cog-nitive dimension). The fourth dimension, commitment, reflects the relational intensity ofthe cooperation between two parties, and hence represents a dimension deeper than socialcapital (Morgan and Hunt, 1994). The importance of the hereafter described research onprocess-related issues lies in its close connection with the role played by learning andknowledge in venture capitalist–entrepreneur relationships (as pointed out earlier). Morespecifically, prior research on social capital suggests that knowledge is essentially embed-ded in a social context, and that knowledge is created through ongoing relationshipsamong economic actors (Nahapiet and Ghoshal, 1998). As such, the literature on process-related issues provides additional insights into how the outcomes of the venture capital-ist–entrepreneur relationship can be further enhanced.


The role of trust Given the high importance accorded to trust in the dynamics of inter-firm relationships (Ring and Van de Ven, 1992; Zaheer et al., 1998), we discuss the role oftrust as the first process-related aspect characterizing venture capitalist–entrepreneurrelationships. The presence of ‘trust’ has for long been considered an essential determin-ant of the performance of exchange relationships since the willingness to interact withothers is often contingent on the prevalence of trust (Ring and Van de Ven, 1992). Froma social exchange perspective, trust involves the presence of positive expectations aboutanother’s motives in situations entailing risk, that is, ‘to trust another party’ essentiallymeans to leave oneself vulnerable to the actions of ‘trusted others’ (Boon and Holmes,1991). Although the early research in the venture capital area did not explicitly focus onthe importance of trust in venture capitalist–entrepreneur relationships, trust has gener-ally been considered as being an important aspect of relationships between investor andinvestee. For instance, Sweeting (1991) noted that venture capitalists are often quite con-cerned with whether entrepreneurial team members can be trusted. Further, Sapienza(1989) showed that successful venture capitalists try to build social, trusting relationshipswith their entrepreneurs.

The potential value of trust in venture capitalist–entrepreneur relationships has beenargued to derive from the more effective knowledge exchange that takes place between thetwo parties. For instance, De Clercq and Sapienza (2006) found a positive relationshipbetween the venture capitalists’ trust in their portfolio companies and their perception ofthe companies’ performance. The authors reasoned that the presence of trust betweenventure capitalist and entrepreneur creates a context in which both parties are willing toopen themselves to the other since the likelihood that the other will act opportunisticallyis diminished.

Interestingly, there is also some evidence that, in some cases, too much trust in venturecapitalist–entrepreneur relationships may potentially have a negative side effect. Morespecifically, at extremely high levels of trust there may be less need felt by the two partiesto engage in penetrating discussions and information exchange. In other words, theremay be a danger that they scrutinize the other’s decisions less (De Clercq and Sapienza,2005). This suggests that venture capitalist and entrepreneur should be wary not todevelop a level of trust that actually reduces the intensity of processing information intheir relationship.

The role of social interaction The level of social interaction that takes place between theventure capitalist and entrepreneur (or exchange partners in general) pertains to the socialcontacts and personal relationships that exist among the parties. The notion of socialinteraction is not necessarily synonymous with that of trust in that the venture capitalistand entrepreneur may have confidence that the other will not engage in opportunisticbehavior, but that they will still interact with one another in a formal rather than infor-mal manner. Prior research has suggested that strong personal contacts between exchangepartners may be beneficial as these contacts increase their willingness to be involved withthe other for a long period of time (Morgan and Hunt, 1994). Similarly, recent researchin the venture capital area has found empirical evidence for a positive relationshipbetween the extent to which venture capitalist and entrepreneur interact with one anotherin social occasions and the performance of venture capitalist investments (De Clercq andSapienza, 2006). The rationale for this positive relationship is that thanks to strong social


contacts the investor may become more motivated in assisting the entrepreneur forreasons different from economical ones (Zaheer et al., 1998). Social interaction betweenventure capitalist and entrepreneur can also expand the nature of the knowledgeexchanged in the relationship, in that social interaction increases the transfer of complex,tacit knowledge (Nonaka, 1994). In the venture capital context, tacit knowledge maypertain to the venture capitalist’s ability to detect the knowledge needs of her portfoliocompanies, or to the entrepreneur’s ability to detect hidden value-adding skills held by theventure capitalist.

An implication from this stream of research for entrepreneurs is that their willingnessto develop close social relationships with their investors may affect their standing withinthe venture capital community. That is, an entrepreneur’s reputation with respect to theirwillingness to engage in open relationships with external partners may function as a signalto the venture capitalist that cooperation with the entrepreneur will be efficient andeffective. Put differently, entrepreneurs may increase their potential access to additionalneeded funding by building a track record of strong social relationships with investorsand other exchange partners.

The role of goal congruence Goal congruence refers to the degree to which two exchangepartners hold common beliefs regarding their relationship (Nahapiet and Ghoshal, 1998).The notion of goal congruence, or goal incongruence, is closely related to the presence ofinformation asymmetry as described in agency theory (Eisenhardt, 1989). Goal congru-ence extends the idea of economic actors’ self-interest in that it speaks to the compatibil-ity between two parties’ vision of how their relationship will evolve in the future (Daviset al., 1997). The broader literature on inter-firm relationships has argued for a positiverelationship between goal congruence and relationship outcomes in that higher goal con-gruence facilitates the ability of the partners to interact effectively with one another(Larsson et al., 1998). That is, if two parties share similar goals, they will be more moti-vated to give the other full access to the own knowledge base because such access willpotentially help the other in better achieving the common goals.

In the context of venture capital financing, the venture capitalist and entrepreneur mayeach have unique skills and capabilities, and therefore, differ in terms of their orientation,activities and goals (Cable and Shane, 1997). Several types of goal conflict may hamperthe extent of the information exchange between venture capitalist and entrepreneur, andthe resulting poor communication may ultimately reduce the potential of the entrepre-neur to benefit optimally from the venture capitalist’s input. For instance, a possible goalconflict between the venture capitalist and entrepreneur pertains to the venture capital-ist’s expectation that the entrepreneur is willing to give up her absolute independence inorder to maximize the expected shareholder wealth through corporate growth (Brophyand Shulman, 1992). However, when the entrepreneur’s main objective is not just futurewealth maximization, but also meeting other personal needs, such as approval and inde-pendence (Birley and Westhead, 1994), she may not be willing to provide the venture cap-italist with useful information that would facilitate high company growth. Furthermore,although both parties may believe to hold similar goals at the time of the investment deci-sion, they may fail to honor their commitment to these goals in the post-investment phasebecause of divergent interpretations, which may then lead to mutual disappointments andconflict (Parhankangas et al., 2005).


From a more positive angle, high levels of goal congruence between venture capitalistand entrepreneur should stimulate the parties’ ability to interact effectively with oneanother. There is indeed empirical evidence for the existence of a positive relationshipbetween the level of goal similarity between the venture capitalist and entrepreneur andthe performance of the venture capitalist’s investment (De Clercq and Sapienza, 2006).When the venture capitalist and entrepreneur share the same goals and expectations, it ismore likely that they engage in more effective communication because each party has abetter understanding of which information is important for each, and how this informa-tion may benefit the other’s objectives.

The role of commitment Prior research has also emphasized the importance of commit-ment for relational outcomes. For instance, research on inter-firm relationships has shownthat relationship commitment represents an important driver for success in that commit-ted partners exert extra effort to ensure the longevity of their relationship with others, andthey engage in closer cooperation (Morgan and Hunt, 1994). In the context of venturecapital financing, the commitment of venture capitalist and entrepreneur to their mutualrelationship may manifest itself in specific behaviors that reflect the partners’ willingnessto invest highly in the relationship, that is their commitment may be reflected in their will-ingness to undertake significant efforts (Gifford, 1997). For instance, venture capitalistsmay devote more or less time and energy in consulting their network of business rela-tionships aimed at getting specific advice for the entrepreneur. Alternatively, entrepre-neurs may show varying efforts in reporting performance data to their investor. Inaddition, the level of commitment in venture capitalist–entrepreneur relationships maynot only pertain to the actual efforts that are undertaken on behalf of the relationship,but also to one’s identification with and feelings vis-à-vis the other (De Clercq andSapienza, 2006). Commitment therefore also reflects the affective or emotional orienta-tion by the venture capitalist and entrepreneur to their mutual relationship.

Signals of commitment by the venture capitalist may increase the value that is createdin the venture capitalist–entrepreneur relationship for two reasons. First, a deep commit-ment held by the venture capitalist vis-à-vis a particular investment can reflect itself in theventure capitalist spending more time in executing various value-adding roles (Sapienzaet al., 1994), which may then increase the likelihood that the entrepreneur will benefit fromthe venture capitalist’s assistance. Second, prior research has indicated that entrepreneursmay be resistant to the advice provided by their venture capital providers. This resistancemay be explained by the entrepreneur’s unwillingness to give up control over her company(Sahlman, 1990). However, when the venture capitalist shows a deep concern about andinterest in the entrepreneur’s well-being, the latter may be more likely to believe in theloyalty and motives of the venture capitalist, and therefore be less resistant in acceptingthe offered advice. It has indeed been shown that entrepreneurs are more receptivefor the venture capitalist’s advice when the venture capitalist is a highly involved memberof the board of directors (Busenitz et al., 1997). Also, De Clercq and Sapienza (2006)found empirical support for the positive relationship between a venture capitalist’s com-mitment to a particular investment and her perception of success of that investment.Overall, this stream of research shows that venture capitalists benefit from convincingentrepreneurs that they are ‘in the game’ for the long run and are willing to function ascommitted insiders.


Interestingly, although there is an important advantage related to venture capitalists’commitment, the reality does not always allow a venture capitalist to maximize her com-mitment for each single investment. In this regard, Gifford (1997) explained that venturecapitalists face a serious time allocation dilemma with regard to the myriad of activitiesthey are involved in, that is devoting attention to their existing portfolio companies,locating and closing new investment deals, and raising new funds. This author arguedthat venture capitalists often economize on allocating their effort across these activitiesin ways that are optimal for the venture capitalist herself, but not necessarily optimal forthe portfolio companies. More specifically, given that venture capitalists have a tendencyto devote as much time as possible to those deals that generate the majority of theirreturns (Sahlman, 1990; Sapienza et al., 1994), entrepreneurs who are in the highest needfor venture capitalist advice may in fact be left in the cold. Ultimately, this consciouschoice of reduced involvement may have gruesome consequences for the individualentrepreneur.

Concluding note An important aspect of how venture capitalists add value to theirportfolio companies, in addition to the content of the knowledge that is exchangedbetween the venture capitalist and entrepreneur, pertains to the social dynamics thattake place in the interactions between the two parties. The literature suggests thatprocess-related issues, such as trust and commitment, may facilitate venture capitalists’ability to aid a particular entrepreneur through an improved understanding of the entre-preneurs’ operations and needs. That is, good relationships between venture capitalistand entrepreneur may lead to more specific insights into how an investment deal can beoptimized, and therefore enhance the potential that the venture capitalist adds value.Also, process-related issues may increase venture capitalists’ value-adding potentialbecause these issues increase the receptivity of the parties vis-à-vis the other’s input andadvice. Finally, whereas the literature cited above appeals to the intuitive notionthat venture capitalists and entrepreneurs will benefit from more trustful, socially ori-ented, congruent and committed relationships, further examination is needed withrespect to whether in some cases close relationships may actually hurt rather than help.For instance, it is possible that high-quality relationships may lead to groupthink inwhich the scrutiny with which the two parties judge each other’s actions is diminished.This may then potentially lead to poor decision making (Janis, 1972; De Clercq andSapienza, 2005).

Future researchIn this chapter we have provided an overview of prior research on the post-investmentphase of venture capital investing. We first discussed the literature on the monitoringand value-adding activities undertaken by venture capitalists vis-à-vis their portfoliocompanies. We then turned our attention to the literature that attempted to betterexplain the mechanisms underlying the question of how value is added in venture cap-italist–entrepreneur relationships. Two types of issues relevant to better understandingvalue-added were discussed, that is issues pertaining to the content and issues pertain-ing to the process of the exchange relationship. In the remaining paragraphs, we givesome indications of how future researchers can further extend the literature highlightedin this chapter.


Heterogeneity of monitoring and value-adding activitiesFirst, future research should further elaborate on how the heterogeneity of venture cap-italists’ monitoring and value-adding activities depends on the combination of venturecapitalist characteristics, characteristics of the entrepreneur and venture, and the institu-tional and social environment in which both parties are embedded. More specifically, acomprehensive framework could be developed and empirically tested in which the variousantecedents of venture capitalists’ monitoring and value-adding activities are examinedat the same time. For instance, the following venture capitalist characteristics should beincluded:

● The type of investors in the venture capital fund (for example independent venturecapitalists compared to venture capitalists related to a financial institution or acorporate),

● the structure of the venture capital fund (for example open ended versusclosed; quoted or not; the nature of the compensation of the venture capitalmanagers),

● the investment strategy of the venture capital fund (for example generalist versusspecialist; early stage versus later stage or mixed),

● the human capital of the (team of) venture capitalists, and● characteristics of other investors (that is syndicate members).

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

● The business or financial risk of the venture (for example level of innovation; per-formance level, stage of development),

● the agency risk (for example depending on information asymmetries),● the human capital of the entrepreneur (for example her general or specific human

capital),● the complementarity and completeness of the entrepreneurial team, and● the initial resource endowments of the entrepreneurial venture (for example intel-

lectual capital).

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

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


Content and process-related issuesFuture research should also further build on the literature pertaining to how value isadded in the venture capitalist–entrepreneur relationship. It could hereby be examined inmore detail how the exchanges of specific knowledge and the process of such exchangesaffect investment outcomes. For instance, the following topics could be examined in termsof content-related issues:

● A longitudinal examination of venture capital performance and organizational learn-ing across a variety of portfolio companies could answer the question of how venturecapitalists are able to transfer knowledge from one venture to another. Furthermore,a related question that needs further investigation is: at what point does extensivecommunication between the venture capitalist and entrepreneur become a burden forlearning given the costs associated with extensive information processing?

● It is well-established that venture capitalists stage their investment across subse-quent investment rounds (Sahlman, 1990). The time period in which the undertak-ing of an additional investment round takes place may be particularly important interms of the intensity of the interactions that take place between the venture cap-italist and entrepreneur. It could be examined how the nature of communicationbetween the two parties differs and evolves across subsequent investment rounds.

● Another topic pertains to how venture capitalists are better able than others tocreate conditions and mechanisms that encourage quality interactions with theirportfolio companies. For instance, what is the importance of establishing know-ledge-sharing routines before the initial investment is made? How can the venturecapitalist motivate the entrepreneur to provide useful inside information in a con-tinuous and spontaneous manner, especially when the entrepreneur has not beenable to achieve pre-set performance targets?

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

● What is the combined effect of various process-related factors (for example trust,commitment) and issues related to the knowledge exchange itself (for example thecost, intensity, frequency, openness, or variety of communication) on the learningoutcomes that are generated in the dyad. Also, what factors determine the timingfor the exchange of information. How does the quality of the venture capitalist–entrepreneur relationship (for example reflected in the level of trust) affect theparties’ willingness and capability to plan early on in the relationship which type ofinformation needs to be exchanged in the subsequent stages of the relationship?

● It could also be explored how venture capitalists commit their time across the myriadof ventures in their portfolio. Also, how do venture capitalists divide their emotionalinvolvement across multiple portfolio companies based on their perception of howwell the portfolio companies have performed? Are venture capitalists always betteroff by focusing their efforts on those companies with a high upside-potential ratherthan on companies which just need lots of hands-on attention and guidance. Whichcriteria do venture capitalists use to allocate their time optimally across multiple port-folio companies? Also, how do the venture capitalists’ background and experienceaffect how they allocate their time and resources?


Classic venture capitalists versus other investor typesFinally, whereas the primary focus in this chapter was on the classic (or institutional) venturecapitalist, as opposed to the business angel (see Chapters 12 to 14) or corporate venture cap-italist (see Chapters 15 and 16), we believe that the literature would also benefit from com-paring how the content and process-related issues discussed in this chapter may differ acrossdifferent investor types. In essence, classic (institutional) venture capitalists, business angelsand corporate venture capitalists represent complementary sources of finance for entrepre-neurs, and each type of investor may have specific characteristics that reflect on the natureof the relationship between investor and entrepreneur (De Clercq et al., 2006).

First, given that business angels tend to be more willing than institutional venturecapitalists to invest at the very earliest stages (Benjamin and Margulis, 2005), their invest-ments may be characterized by more uncertainty. Consequently, business angel invest-ments may provide a higher opportunity for entrepreneurs to benefit from the knowledgeprovided by the investor, yet the uncertainty involved in such investments may make theestablishment of stable, trustful relationships more challenging. Furthermore, since busi-ness angels, compared to institutional venture capitalists, may be more motivated by theintrinsic reward of their involvement in a portfolio company and often do not have a wideportfolio of companies, the time allocation dilemma as described above (Gifford, 1997)may be less relevant for business angels. Also, due to the informal nature of angel financ-ing, entrepreneurs who have angel financiers may not enjoy as many reputational benefitsas entrepreneurs who have institutional venture capitalists or corporate venture capitalinvestors on board.

Furthermore, the nature of possible goal incongruence between investor and entrepre-neur may depend on the investor type. For instance, classic (institutional) venture cap-italists (and to a lesser extent business angels) may be primarily concerned aboutincreasing the realizable trade value of their ventures since a substantial portion of theircompensation is based on capital gains. When harvesting is an important short-termobjective, the investor will want to collect as much information as possible that is usefulfor presentation to potential buyers of the venture. However, the entrepreneur may not bewilling to provide the institutional venture capitalist with such information if she hasdifferent goals for the company. In contrast, a relevant goal for a corporate venture cap-italist may be to utilize the portfolio company as an external research and developmentresource, or to direct the company’s research towards the mother company’s strategicgoals (Siegel, 1988). In that case, possible goal conflict between the corporate venture cap-italist and entrepreneur may pertain more to how autonomous the entrepreneur can be interms of the strategic direction in which her company is going. This type of goal incon-gruence is of a very different nature and calls for different action, which in turn presentsa further route for fruitful research.

AcknowledgementWe thank the editor (Hans Landström), Lowell Busenitz and participants of the State-of-the-Art workshop (Lund) for helpful comments on earlier drafts of this chapter.

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8 Innovation and performance implications ofventure capital involvement in the venturesthey fundLowell W. Busenitz

IntroductionWhen entrepreneurs choose to take on venture capital funding, the life and dynamics of aventure change substantially. One of the first structural changes to occur is the implemen-tation of a board of directors of which the founding team usually plays a minority role(Rosenstein et al., 1993). There tends to be a fair amount of interaction between venturecapitalists and entrepreneurs that may allow venture capitalists to intervene in variouscapacities to build and protect an entrepreneurial venture. Venture capitalists may help theventure make key links to customers and suppliers, monitor venture performance, act as asounding board as well as assist with strategic issues (Timmons and Bygrave, 1986;MacMillan et al., 1989; Fried and Hisrich, 1995; Manigart et al., 2006). Research has onlybegun to explore whether venture capital involvement beyond their financial involvementadds value to the ventures in which they invest as well as the broader economic development.

One impetus for the emergence of the venture capitalist–entrepreneur relationship isthat it may enable firms to create value by the sharing of knowledge, combining or gainingaccess to critical resources and decreasing the time required for a new venture to marketits products. Venture capitalists spend approximately one-half of their time monitoringan average of nine funded ventures (Gorman and Sahlman, 1989). A venture capitalist’songoing involvement with the entrepreneurial team and the venture will generally impacton the venture in a variety of ways. Some research has found support for a venture cap-italist’s non-financial input adding value (MacMillan et al., 1989; Sapienza, 1992) whereasother research suggests that venture capitalists do not tend to add value (Gomez-Mejiaet al., 1990; Steier and Greenwood, 1995; Manigart et al., 2002). This chapter pressesforward with the following question: does venture capital involvement impact on ventureinnovation and performance?

At least two fundamental issues are embedded in answering this question. First, inaddressing whether venture capitalists add value to the ventures in which they invest,earlier research suggests multiple areas of venture capital involvement. For example, doesfrequency of interaction between venture capitalists and the entrepreneurs that they fundadd value? Do venture capital-backed firms perform better during the IPO process? Whilethere are contributions that earlier research has made on this subject, I will argue thatfuture inquiry needs to move beyond these broad questions. More specifically, it is timefor research to press forward with governance arrangements, compensation systems, andobtaining follow-on rounds of funding. It is argued that these areas represent promisingareas for future research and can help resolve some of the mixed results from earlierresearch. It seems apparent that venture capitalists do not always add value as the researchfindings seem quite mixed.

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Second, this chapter examines the broader impact of venture capitalist investments.The presence of venture capitalist investing should enhance the overall level of innov-ation. Whole new industries have been reported to emerge because of venture capitalistinvestments. While past research has started to probe this area, there is much work thatneeds to be done here.

Finally, this chapter addresses performance issues that come with studying venturecapital funding. Given that these ventures are private firms, obtaining legitimate financialnumbers clearly represents unique challenges. Given that investors such as venture cap-italists look to exit a venture after a season of involvement and, hopefully, growth (venturecapital exits are generally projected at approximately 5–6 years), organizational outcomesor exit modes represent a viable metric for analyzing performance. Furthermore, venturecapital involvement often involves interactions and relationships with individuals insidethe venture, making the evaluations of both venture capitalists and entrepreneurs import-ant. The final section explores these various measurement alternatives and addresses thestrengths and limitations of these alternatives.

This chapter will proceed in the following manner. The next section addresses activitiesin which venture capitalists typically get involved with a venture and how they may helpor hinder the development of the venture. Second, we discuss the impact that venture cap-italists have on innovation and the development of new industries. Third, we will exploreperformance measurement issues as they relate to venture capital-backed ventures. In sodoing, we will address the types of phenomena being researched and the type of perform-ance that is likely to be most appropriate as the dependent variable.

Venture capital impact on venture developmentVenture capitalists are known for potentially adding value to ventures through theirknowledge and contacts to enhance supplier and customer relationships, through offeringstrategic and operational advice, and helping recruit key managers (MacMillan et al.,1989; Sapienza, 1992; Barney et al., 1996). Furthermore, venture capitalists have oftenestablished relationships with underwriters (Bygrave and Timmons, 1992) and certify thevalue of their ventures to those underwriters (Megginson and Weiss, 1991). Thus, venturecapital involvement in ventures may represent an important asset that allows for aresource advantage in subsequent phases such as acquisitons and IPOs. In sum, the con-tributions of venture capitalists to the ventures that they back has found positive support(Sapienza, 1992) as well as little or no support (Daily et al., 2002). Given the mixed find-ings from previous research, it is time to probe some new areas for future research. Wenow develop research opportunities for addressing the potential impact that venturecapital involvement can have in the form of the governance oversight that they bring tothe venture, the financial accountability, the certification of venture capital backing andmanaging positive exits. By addressing these issues, we seek to provide direction to futureresearch where venture capitalists may add value to the ventures in which they investthrough governance and reputation effects.

GovernanceSome venture capital research is addressing internal governance issues in venture capital-backed ventures (for example Amit et al., 1990; Sahlman, 1990; Bruton et al., 2000). Whenthe entrepreneur (for example the agent) contracts with the venture capitalist (for example


the principal) for funding, an agency problem can arise as a result of incongruent goalsand potentially different risk preferences (Eisenhardt, 1989; Bruton et al., 2000). Becauseof information asymmetry and the venture capitalist’s bounded rationality (Amit et al.,1990; 1993; 1998; Bohren, 1998), the entrepreneur may engage in opportunistic behaviorsthat would benefit the entrepreneur at the expense of equity investors such as venture cap-italists (Gompers and Lerner, 1996). Particularly in US studies, agency theory hasemerged as the central paradigm for understanding the venture capitalist–entrepreneurrelationship (De Clercq and Manigart address this paradigm more extensively in the pre-ceding chapter).

From an agency perspective, the venture capitalist–entrepreneur dynamic does notdirectly mirror the principal–agent relationship. Rather, it is more like a principal (venturecapitalist)/principal and agent (entrepreneur) relationship. In other words, while entre-preneurs are agents of the venture capitalists (principals) who invest, they are also holdersof equity and thus principals themselves. With the onset of venture capital investments,the entrepreneur moves from being the sole principal to a partially diluted ownership pos-ition. With their investments, venture capitalists are eager to monitor the progress of theventure and the performance of the entrepreneurial team, both from a moral hazard andadverse selection perspective (Barney et al., 1989; Sahlman, 1990). Given their substan-tial ownership stakes, venture capitalists tend to be heavily involved in governance activ-ities such as board involvement and face-to-face interaction. Research across manycountries seem to bear this out (Sapienza et al., 1996). Consequently, venture capitaliststend to have extensive experience in aligning the goals of managers with owners, and giventhat they spend a fair amount of time monitoring firms in their portfolio, they are likelyto be able to provide greater protection compared to those ventures without venturecapital backing. On the other hand, we suspect that ventures without venture capitalbacking will not be as closely monitored and will not have the same level of protectionagainst potential adverse selection and moral hazard type situations.

Only a few studies to this point have specifically addressed board of director and gover-nance issues associated with the onset of venture capital investments (for exampleRosenstein et al., 1993; Lerner, 1995; Filatochev and Bishop, 2002). This is an under-researched area that needs much more inquiry. The make-up of the board of directors inventure capital-backed versus non-venture capital-backed ventures is proposed as a poten-tially important area of further inquiry. For example, boards of non-venture capital-backedfirms are likely to be dominated by the founding team and perhaps associates or familymembers. In contrast, venture capital-backed firms are likely to have boards where thefounding team and insiders are likely to play a much smaller role. As a condition of invest-ing in the venture, venture capitalists typically want the right to replace members of theexisting entrepreneurial team. Should such action be necessary, this can be accomplishedby having a greater portion of outsiders on the board. Furthermore, CEO duality (the pos-itions of CEO and Chairman of the Board held by the same individual) are likely to be farless common in venture capital-backed firms than non-venture capital-backed firms. Boththe number of outsiders on the board and CEO duality serve as signals of power to correctmoral hazard and adverse selection issues in a venture should they arise. In sum, better gov-ernance and board of directors should lead to greater venture performance.

Regarding the composition of venture capital-backed boards, we also expect that therewill be more homogeneity in the boards of non-venture capital-backed firms than venture

Innovation and performance implications 221

capital-backed firms. More specifically, I suspect that there is more industry experienceand more diversity in venture capital-backed boards. Venture capitalists are adamantabout moving a firm towards commercialization as soon as possible and generally wantas much experience on the board as possible. Non-venture capital-backed ventures tendto attract ‘likes’ and more family members to their boards whereas venture capitalists inand of themselves typically represent significant deviations from founder norms and char-acteristics. Furthermore, an increase in the equity held by one or two members of thefounding team is likely to be associated with insider domination on the board, and theboard may be less diverse (Filatochev and Bishop, 2002). In sum, we believe that the gov-ernance mechanisms put in place by the boards of venture capital-backed ventures willsignificantly differ from those of non-venture capital-backed ventures. More importantly,stronger governance should lead to better venture performance. These arguments lead tothe following propositions:

Proposition 1: Venture capital-backed ventures will have substantially better governancemechanisms in place than will non-venture capital-backed ventures.

Proposition 2: Because of the repetition and skill that venture capitalists have in moni-toring entrepreneurial ventures, there will be significantly less variance inthe governance mechanisms in venture capital-backed ventures than inventures with non-venture capital-backed ventures.

Proposition 3: Stronger governance mechanisms in venture firms will lead to betterventure performance.

Venture team compensationWhen entrepreneurs start their ventures, compensation and pay-off issues are almostalways assumed to be at some distance into the future. Often little compensation is takenby the founders from the venture in the early months with the assumption that their‘sweat’ equity will be rewarded by the long-term success of the venture. Consequently,near-term compensation tends not to be much of an issue until venture capitalists invest.A reduction in the equity stake of the venture and the implications of needing to sharethe long-term rewards of the venture are projected to create substantial compensationissues. While it seems that this subject has received at best minimal research attention, itis an important issue.

I first turn to the research on executive compensation as a platform into this new areafor venture capital research. Research on managerial pay has shown how monitoring andreward mechanisms can help to align the interests of managers and shareholders (Jensenand Murphy, 1990; Barkema and Gomez-Mejia, 1998). Furthermore, contingent pay, suchas stock options, may motivate managers differently than non-contingent pay, such as salaryand other annual cash compensations (Daily et al., 1998). The use of contingent pay mech-anisms more closely aligns managerial incentives with those of investors because managershave a substantial position in the firm whose value is contingent on firm performance(Jensen and Murphy, 1990). In addition, as noted above, the presence of venture capital-ists tends to reduce managerial equity stakes in the company. This reduction in equity own-ership can lead to less incentive alignment for managers (Fama and Jensen, 1983).


Non-contingent pay is also a part of the compensation scheme and may be moresalient with the advent of venture capital investments. Venture capitalists can realign theentrepreneurial team through greater use of contingent pay mechanisms. Contrary tocontingent pay, non-contingent pay is normally expected to generate managerial inter-est in the shorter term, although the empirical evidence for the effectiveness of cashcompensation on increasing firm performance tends to be relatively weak (Jensen andMurphy, 1990; Balkin et al., 2000). Cash compensation provides a stable income streamand mitigates compensation-based risk or rewards (Daily et al., 1998). Thus the incen-tive effects of non-contingent pay may not help to reduce managerial opportunism.However, Balkin and colleagues (2000) found that non-contingent pay was positivelyrelated to firm performance in high technology industries. In reality, too much contin-gent pay may result in the transfer of too much risk to managers (Beatty and Zajac,1994) such that they reduce their level of risk-taking (Gray and Cannella, 1997). Thismay be a particular problem in entrepreneurial ventures. With the onset of venturecapital funding, non-contingent pay may represent a mechanism through which man-agers can be rewarded without transferring too much risk. Furthermore, at lower levelsof non-contingent compensation, managers may feel that their income is inequitableand not commensurate with the amount of effort and time that they expend. As a result,lower levels of this type of compensation may encourage undesirable behavior (Kidwelland Bennett, 1993), or the pursuit of excessive perquisites (Jensen and Meckling, 1976)or other utility-maximizing behavior to the detriment of the firm. On the other hand,higher levels of non-contingent pay can help soften the impact of having to give up asignificant equity stake in the venture in exchange for venture capital funding. Futureresearch should explore the use of compensation in venture capital versus non-venturecapital-backed ventures as well as the importance of each with the advent of venturecapital funding.

Proposition 4: Venture firms with venture capital backing will have greater protectionagainst managerial opportunism compared to those new ventureswithout venture capital involvement as evidenced by the greater use ofcontingent and non-contingent compensation.

Proposition 5: Entrepreneurs will view the giving up of partial venture equity morefavorably with higher levels of non-contingent pay.

It is also likely that compensation schemes will affect the performance of venturecapital-backed ventures. Greater contingent pay helps to soften the impact of decreasedequity that entrepreneurs are likely to feel with the advent of venture capital funding,leading them to work harder for the overall well-being of the venture. Contingent payin the form of stock options is also likely to increase long-term venture performance.While the equity portion of entrepreneur ownership contracts with venture capital invest-ments, the availability of stock options potentially increases their stake in ownership.

Proposition 6: Greater use of both non-contingent and contingent pay in venturecapital-backed ventures will increase the long term performance of theventure.


Reputation and certificationSince entrepreneurs usually start firms in turbulent environments with an unproven productmarket, a great deal of uncertainty typically surrounds these ventures. Furthermore, thereis usually little or no historical information giving a venture little or no ‘track record’ onwhich to base future projections. It is in this type of context that venture capitalists have thepotential to add to the stature and credibility of a venture. Megginson and Weiss (1991)examined venture capital backing in IPO firms and found that their presence lowered bothunderpricing and the gross spread paid to underwriters. Dolvin (2005) also found supportfor the certification hypothesis with IPO firms, as venture capital-backed firms had lowerissuance costs, increased upward price adjustments, and shorter lock-up periods. Dolvinalso found support for venture capital certification among penny stocks.

While this prior research on certification in the IPO process is helpful, venture capitalcertification may also have implications in the earlier days of a venture. Venture capitalinvolvement and certification may make it easier for the venture to establish a relationshipwith critical buyers and suppliers, obtain additional financing, and develop a betterreputation with external constituents. Given the importance of credible commitments(Williamson, 1983; 1991), we argue that the presence of venture capital investments andpositions on the venture board of directors will serve in this manner. For example, venturecapitalists will not want to harm their reputation in the industry of the new venture (Amitet al., 1998) and will take steps to improve any difficulties between transacting parties. Thisin turn will act to reduce the potential transaction costs (Williamson, 1985) for the partiesinvolved, and will provide additional benefits for the new venture. Thus, we should expectto see greater efficiency, especially as it relates to governance costs (Williamson, 1991) inventure capital-backed firms.

Proposition 7: Venture capital-backed ventures will have higher levels of credible com-mitments with transacting parties such as buyers and suppliers than non-venture capital-backed ventures.

We also suspect that venture capitalists will have a significant effect with follow-oninvestors. Given that venture capitalists typically invest in stages or rounds providingenough money for venture firms for roughly a year before additional financing is needed,follow-on investors are critical. The amount of financing needed in subsequent roundsusually increases and if credible investors have been involved in earlier rounds and theycontinue to support the venture in subsequent rounds, this sends a positive signal and par-tially certifies the venture as a credible investment for follow-on financing. On the otherhand, non-venture capital-backed ventures are likely to have to find a whole new set ofinvestors. This is almost always a very time consuming process.

Proposition 8: Once venture capitalists have invested in a venture, the entrepreneurs willspend less time obtaining subsequent rounds of financing than non-venture capital-backed ventures.

Reputation and certification characteristics are also likely to lead to performanceeffects. When quality venture capitalists invest in a venture, this will add to their reputa-tion in a positive way, thus enabling the venture to develop alliances and relationships with


higher quality firms. The enhanced reputation is also likely to allow the entrepreneurs tospend more time on their own ventures instead of making and further establishing con-tacts. These issues should have positive effects on venture performance.

Proposition 9: Venture capital-backed firms will have better reputations leading tohigher venture performance.

Concluding remarksOne of the longest standing assumptions in the research literature on venture capitalinvolvement is that they add value to the ventures that they invest in. Unfortunately,empirical findings have been quite mixed thus far. This does not mean that venture cap-italists do not add value and that researchers should stop examining this area. Rather, theessence of the above arguments is that we need to focus our research in the areas arguedabove. I have developed arguments for more specifically examining governance arrange-ments, the compensation of founders and the top management teams as well as the repu-tation and certification implications of venture capital funding. More focused researchshould enable us to better address this critical issue.

Venture capital impact on innovationWith venture capital backing as an alternative becoming more common across the globe,it is often assumed that the presence of venture capital investments is an important con-tributor to the advancement of innovation and even economic development. The major-ity of the employment growth of even the most developed economies is coming fromsmaller and start-up firms, and much of this growth involves technological innovations(Tyebjee and Bruno, 1984). Venture capital is a common source of funding for these ven-tures that have high-growth potential (Bygrave and Timmons, 1992). However, we stillknow very little about the impact that venture capitalists have on the ventures they backindividually as well as the more collective impact. This section examines exploration andexploitation at the firm level as well as the development of new industries and how venturecapitalists impact these issues.

Exploration and exploitationVenture capital funding is often closely linked with the pursuit of innovative technologies,with this probably being particularly true in the US. Of course innovation can occur inlarger corporations as well as in smaller firms without venture capital funding, but venturecapitalists are almost always associated with the funding of innovative ventures. Theinvolvement of venture capitalists in such ventures stems at least in part from the issuethat newer technology-based ventures have few funding sources since they do not have anestablished financial history nor fixed assets on which to anchor their funding. Venturecapitalists also invest with a relatively limited time frame. Successful exits (IPOs or acqui-sitions) have to be anticipated within about five years to be considered for venture capitalfunding because of the funding cycle of their own limited partners. So while they tend toprefer innovative ventures, they are also very much concerned about their own returns andthe quick commercialization or exploitation of the innovations that they are funding. Byexploitation, we have reference to implementation, efficiency, production and marketdevelopment (March, 1991; He and Wong, 2004).


The development of the exploration and exploitation literature has shown that these twoapproaches to learning and organizational growth can be quite different. The strategies,capabilities, organization structures, organizational cultures and the like tend to be quitedifferent for the pursuit of exploration versus exploitation. For example, exploration isassociated with organic and loosely coupled systems, emerging markets, flexibility and path-breaking strategies (Brown and Eisenhardt, 1998). Venture capital backing is virtually syn-onymous with high growth potential ventures, and consequently, with innovative technol-ogy seeking to be exploited in the market place. This raises an interesting question: does thepursuit of exploitation when the venture was founded on an innovative idea and has explor-ation competencies, really enhance the value of the venture or does it pressure a venture toseek capabilities in areas that they will never be able to sufficiently obtain? It might be thatmoving from exploration to exploitation may create a conundrum for the venture firm.

While venture capitalists mostly prefer to invest in technology-based ventures pursuingan innovation versus an imitator strategy, there is some variance in the stage1 of the ventureat which venture capitalists start to get involved (Hellmann and Puri, 2000). Venturecapital funding also tends to accelerate the time a venture takes in getting their product tomarket. In a similar study, Timmons and Bygrave (1986) found that venture capitalistsseem to be increasingly interested in funding highly innovative technology ventures versusless innovative technology ventures and that their returns on the highly innovative tech-nology ventures tended to be superior. By extension, venture capital funding may also leadto significantly higher patenting rates (Kortum and Lerner, 2000). Without patenting, theproduct may be threatened as it seeks to move quickly into the marketplace. These find-ings indicate that venture capitalists tend to favor innovative ventures as is widely perceivedbut there is variance on this. In a study of venture capitalists across Austria, Germany andSwitzerland, Jungwirth and Moog (2004) found that venture capitalists did vary in theirpreference for investing in technology-based firms. Venture capital firms that were pursu-ing a generalist strategy tended to invest in lower technology firms while those venture cap-italists pursuing a specialist strategy preferred to invest in high technology firms.

On average, the evidence seems to link venture capitalists with technology-based ven-tures. However, that does not mean that they prefer to back exploration. While venturespursuing such innovation often hold the most promise, it appears that most venture cap-italists tend only to get involved in the later stages where capital requirements are quitelarge and the distance to successful exits and pay-offs is quite narrow. However, if theopportunity is at too great a distance (roughly five years), they are unlikely to pursueit. Therefore, I argue that venture capitalists are much more likely to be interested intechnology-based ventures with exploitation and commercialization already starting orclose at hand. If the innovation still requires much work and substantial time beforeexploitation can be pursued, most venture capitalists will tend to pass on the investment.Most of the exploration will tend to have already been accomplished. This leads to thefollowing proposition:

Proposition 10: Venture capitalists tend to invest in technology-based ventures thateither have or are ready to develop an exploitation strategy.

Consistent with the above proposition, I argue that venture capitalists, on average, tendto be best at helping firms transition from exploration to exploitation. While ventures


often start with exploration, developing exploitation strategies is likely to be critical forlong-term success. In this sense, they may need to become ambidextrous or multi-facetedin their capabilities (He and Wong, 2004). Most organizations struggle with transitionsand change. Newer and smaller organizations tend to do it better than anyone else butthey can struggle as well. The infusion of venture capital funding along with more intenseboard involvement that is typically associated with outside funding comes with an infu-sion of added human capital assets in addition to other changes and dynamics. The neteffect is that venture capital funding may well bring with it a growing ability for venturesto pursue exploration issues more quickly.

Proposition 11: Ventures receiving venture capital funding will make the transition tothe exploitation stage more quickly than non-venture capital-backedventures.

In going a step further, we again suspect that there will be performance implications.Venture capital backing brings with it the urgent need to move ventures towards com-mercialization so that a successful exit can be obtained within 5–6 years. Furthermore,venture capital involvement can bring with it the ability and attention to the skills associ-ated with commercialization. These issues lead to the following proposition:

Proposition 12: Ventures receiving venture capital funding will become profitable fasterand move towards successful exits sooner than non-venture capital-backed ventures.

Development of new industriesGiven that venture capitalists often invest in the commercialization of technologicalinnovation, they are often credited with being central to the development of entirely newindustries. Bygrave and Timmons (1992) and others have discussed their involvement inthe development of the biotechnology, hard disk drives, relational databases, worksta-tions and minicomputers, to name a few. Von Burg and Kenney (2000) have explicitlystudied the role of venture capitalists in the development of the local area networking(LAN) industry. In sum, the default assumption seems to be that venture capitalists areintimately involved with the development of entirely new industries. Without venturecapital involvement, these industries would not have developed.

In their in-depth study of the development of LAN networks, von Burg and Kenney(2000) carefully chronicled venture capital involvement in the early stages of this indus-try. At one point very early in the development of this industry, a venture capitalist actu-ally became involved in helping to write a business plan (venture capital involvement atthis level is the exception and is probably even less likely today than it was 25 years ago).However, they had a very difficult time finding other venture capitalists to collaborate inthe investment, a requirement of most venture capitalists. Most venture capitalists ‘couldnot envision the economic space and could not believe that a startup could construct sucha market’ (p. 1142). It was noted that virtually every venture capitalist in the world wascontacted with little success. While the von Burg and Kenney article notes that severalventure capitalists ultimately did invest in the venture, it was rejected by the vast major-ity of venture capitalists.


On average it seems that the venture capitalists are extremely reluctant to get involvedin funding new ventures that are not a part of an industry that is perceived to be devel-oping. While venture capitalists are often characterized as investors who pursuerisky opportunities, such opportunities seem to be true to the extent that the risk can bemanaged and minimized. When there are no industry benchmarks, no establishedventures in a specific industry and there is no clear market, most venture capitalists seemto be very reluctant to pursue such opportunities. An exception has been the onlinegrocery business where venture capital invested hundreds of millions of dollars in the late1990s and very early 2000s. Here venture capitalists invested in an industry that wasclearly ahead of its time. Given the tight networks that venture capitalists are typicallyinvolved with, they will tend to be persuaded by fellow venture capitalist decisions and a‘who is investing where’ mentality. This herding influence and the syndicated investmentapproach is constructive for minimizing risk (Gompers and Lerner, 2000), but it does notcontribute to the pursuit of ‘new industry’ type investments. This conclusion leads to thefollowing propositions:

Proposition 13: Venture capitalists tend not to make investments in ventures that are inunproven industries.

The risk associated with new ventures is one of the critical factors that outside investorsconsider. A solid entrepreneurial team is one of the most important factors in obtainingventure capital funding because an experienced team is believed to be able to mitigate atleast some of the risk that a venture is likely to encounter (for example Komisar, 2000;Timmons and Spinelli, 2004). Drawing from the von Burg and Kenney study, it seems thatonly when a venture capitalist has had a unique experience with a linking technology orhas a special relationship with the entrepreneurs involved will they ever consider invest-ing in a start-up in a new industry.

Proposition 14: When venture capitalists do invest in new industries, it will likely bemediated by the strength of the entrepreneurial team and their experi-ence with previous start-ups in related technologies.

Counter to the assumption that venture capitalists regularly help develop new indus-tries is the possibility that venture capitalist investments are sometimes counterproduc-tive. The venture capital community is widely regarded as tightly knit with investmentscommonly occurring in syndicates (Lerner, 1994). Furthermore, venture capital invest-ments typically occur in cycles based on the financial markets (number of successful IPOsand capital inflow to venture capitalists) as well as by which industries are in an aggres-sive growth phase. Given venture capitalists’ interest in investing in ‘hot’ deals and theherding behavior (Gompers and Lerner, 2000) that can so easily occur given the tightercircles that venture capital tend to run in, I suspect that venture capitalists often over-invest in some industries and this over-investment comes after it has become evident thata given industry is indeed emerging. For example, there were multiple venture capitalinvestments in the computer disk drive industry prior to a shakeout in the market occur-ring, and many venture capital investments came up short. It seems that once an indus-try starts to emerge and it appears to be a major growth area, venture capitalists tend to


over-invest in a specific market with capital rather than pull off and look to fund the nextindustry in the nascent stage.

Proposition 15: Venture capitalists make investments in industries after it becomesevident that it is a growth area.

Proposition 16: Venture capitalists invest in new industries only after a top venture cap-italist has decided first to invest.

Proposition 17: Venture capital investments made in new industries will be negativelyrelated to venture capital firm performance.

Concluding remarksVenture capitalists have a widespread reputation of funding risky ventures generally stem-ming from technology. While venture capitalists are often credited with starting newindustries, this rarely seems to be the case. On average, it seems much more accurate tosay that venture capitalists help to finance newer industries that are on the rise andshowing promise but are rarely involved in funding ventures that actually give birth to anindustry. It tends to be only after it becomes evident that a given technology is viable andthat it holds great promise in the marketplace that venture capitalists tend to get involved.It appears that one of the greatest places that venture capitalists can add value to the ven-tures that they back and to the development of newer innovations, is by funding venturesthat are ready to exploit their innovations and helping to move the venture into these newterritories. It is not easy for any organization to transition from one phase into anotheror to become ambidextrous. Furthermore, economic development in today’s world fre-quently involves having a global awareness, if not presence. Most entrepreneurs andfounding teams in themselves are unlikely to have the vision and capabilities to appropri-ately expand firms beyond the exploration phase. Venture capitalists can provide theimpetus for such transitions.

Measuring venture performanceTo this point, this chapter has discussed venture capital involvement in the ventures thatthey fund along with the broader impact that venture capitalists have on venture devel-opment and innovation. Furthermore, arguments and propositions have been developedregarding the potential performance effects that these various dimensions are likely tohave on venture firms. The intent has been to constructively push forward an agenda forfuture research. However, one of the major challenges of research regarding venturecapital involvement is data collection, and particularly the measuring of firm perform-ance. Measuring firm performance in a way that accurately represents the developmentand life of the firm is a substantial challenge as reflected by various discussions in thestrategy literature (see Barney, 2001, for a review).

The measurement of performance in entrepreneurial firms is compounded by severaladditional issues. First, performance indicators vary substantially across the industries ofstart-up firms. For example, ventures in the bio-technology industry rarely show any salesuntil the firm is 5–10 years old, often after it has gone public or is acquired. Second, privatefirms are typically very reluctant to disclose objective financial information that publicly


traded firms are required to do. Unless private ventures are required by law (as is the casein Canada), it is highly unlikely that private entrepreneurial ventures will disclose accuratefinancial indicators of firm performance. Third, there is substantial variation in the wayaccounting data are recorded (while this is also true for publicly traded firms, it is even moreso for newer entrepreneurial ventures). Accounting for all these differences in the way thesedata are recorded and then used for empirical research represents a substantial challenge.Given these issues, collecting meaningful data for venture capital-backed firms represents asubstantial challenge for future research (Chandler and Hanks, 1993). The purpose of thissection is to address some of the alternatives and challenges of measuring the performanceof venture capital involvement and the investments that they make. Different types of per-formance indicators will be discussed along with their potential for future use. The variousperformance measures along with their advantages and challenges are summarized inTable 8.1. This section does not deal with IPOs and publicly traded firms where perform-ance data is much more widely available. Rather, addressing the strengths and limitationsof performance data of publicly traded firms reaches beyond the scope of this chapter.

Accounting measures of performanceIn thinking of performance, one typically first thinks of common financial measuresinvolving growth in sales and revenue. A variety of financial measures and ratios havebeen developed with return on sales, return on equity and return on income being of themost common. Given that there are biases that come with each accounting measure, morethan one indicator of performance is often encouraged so as to correct for firms thatoperate with relatively low levels of capital or whose sales are not likely to reflect the truegrowth and value of the firm for years to come. The typical limitations and shortcomingsof these accounting measures become particularly problematic in entrepreneurial ven-tures. For example, many innovative ventures do not experience their first sales until yearsof research and testing are completed. Similarly, some ventures tend to be very capital-intensive while others are not creating substantial disparity in measures reflecting finan-cial equity. Given these issues, it is not surprising that I was unable to locate any studiesof venture capital firms or the ventures that they back (pre-IPO) using accounting meas-ures of performance.

Subjective measures of performanceIt seems that the most common type of performance measure used in venture capitalstudies involves subjective measures where entrepreneurs or venture capitalists (or both)respond to questions with Likert-type scales to indicate their own evaluations of theventure and the venture capitalist–entrepreneur relationship. The advantage of thesetypes of measures is that they can at least start to capture some of the depth and richnessof the relationship. Furthermore, self-report measures of performance should allow forbetter comparison of ventures across industries. Of course, as noted in Table 8.1, prob-lems and biases exist with such measures and I suspect that it is very challenging to getresearch with such measures published in top-tier journals without at least some data col-laboration from additional sources.

In their study of subjective measures of performance, Chandler and Hanks (1993) foundthat (1) venture growth and (2) business volume measures have the best in terms of relevance,availability, reliability, and validity. Furthermore, they were found to be superior to measures


231

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232

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that captured respondents’ satisfaction with performance and performance relative to com-petitors’ scales. Measures of growth that have broad appeal and meaning include growth inmarket share, cash flow and sales. Measures often used to measure business volume includeearnings, sales, and net worth. A study addressing the determinants of venture performanceused these measures of performance (Wang and Ang, 2004). Others such as DeClercq andSapienza (2006) have adjusted and developed their own subjective measures of performance.In spite of the limitations of subjective measures, ongoing research using such measuresseems to provide a legitimate window into the performance of privately held ventures.

Venture outcomes as measures of performanceA unique opportunity that comes with the study of venture capital-backed ventures is thepending change in firm status. Venture capitalists virtually always invest with a successfulexit strategy clearly in mind and a 4–7-year time horizon (venture capitalists are typicallycommitted to returning to their limited partners their principal and earnings within 8–10years). With ventures that are successful, the exits typically take on the form of an IPO oran acquisition. Ventures that are not successful typically end up in bankruptcy andclosure or they squeeze out a meager existence from which the venture capitalists at somepoint divest themselves (typically referred to as ‘living dead’). By example, Busenitz et al.(2004) used IPO, acquisition, living dead, and out-of-business as four distinct categoriesas their performance variable. More recently, Dimov and Shepherd (2005) contrasted IPOfirms with those that went bankrupt as their dependent variable. This performancemeasure shows particular promise because venture capitalists invest with an exit in mindand a limited time horizon.

While these outcomes provide four relatively clear and observable changes in organ-izational status, they are not without some caveats. The IPO market is clearly cyclical, withsometimes only the best of the best going public like in the early to mid-2000s. At othertimes, as in the late 1990s, some relatively poor performing ventures were able to go public.The IPO cycles undoubtedly impact the variance of the value that is placed on the acqui-sitions. Furthermore, variance in the value of an acquisition can be quite mixed sinceoccasionally such an exit can be used to liquidate a venture. In an overall sense, ventureoutcomes hold much promise for future venture capital-based research. Furthermore,there are ways to potentially improve on acquisition outcomes being sharper and morerepresentative of positive or negative exits.

Concluding remarksIn sum, performance measures for venture capital-backed ventures are critical for futureresearch to make progress in advancing our understanding of this critical area. While per-formance measures are virtually always a challenge in business research, they representsome unique challenges in entrepreneurship and venture capital research. There is clearlyno one right answer to this dilemma, although venture outcomes, as discussed above, rep-resent a particularly encouraging approach. Furthermore, future research should seek touse multiple measures of performance wherever possible.

Note1. Venture capitalists invest in what is widely known as stages: seed, start-up, first round, second round,

mezzanine, and so on. While venture capitalists do invest in all the rounds with some even specializing in


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

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9 The performance of venture capital investmentsBenoit F. Leleux

Introduction

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

This tongue-in-cheek reference by a leading institutional investor (who preferred toremain anonymous) points not only to many venture capitalists’ tendency for self pro-motion but also to a more fundamental issue the industry has struggled with since itsinception, namely the best metrics to use to report its financial performance. The issue hasproven a very difficult one to tackle by the academic and the professional communitiesalike, due to a unique combination of factors such as: (1) the basic difficulties in valuingventure capital investments (mostly minority stakes in restricted stocks of early stage,technology-rich companies), which test the limits of standard valuation techniques;(2) IRR-boosting cash flow management techniques, such as the progressive drawdownof the fund commitments; and (3) the very private nature of the industry, where reportednumbers are often aggregations of self-reported rates of returns.

In this chapter, we offer to review the documented drivers of venture capital perform-ance and the issues related to financial metrics in the venture capital industry, offering acritical perspective on the limitations inherent in the system. The ultimate objective is todevelop a grounded understanding of the performance dilemmas in the venture capitalindustry, more than it is to ‘explain’ variations in performance. While no comprehensivestudy exists to ‘explain’ fund performance, a growing body of evidence points to keydrivers, both endogenous and exogenous.

Performance in venture capital: a four-level approachThe literature on the drivers of venture capital fund performance has been relativelyscarce, partly due to the difficulty to access the fund-level data, which is normally onlyprovided to limited partners in the funds and, partially, to national venture capital asso-ciations. On the other hand, a rich literature has developed to examine the performanceof venture capital-backed companies, as well as the determinants of successful venturecapital investing, including the structural conditions in which it would thrive and the ben-efits as seen from the entrepreneurial perspective.

We use four complementary approaches to address the performance issue. First, at amicro (deal) level, we review the literature on key drivers of venture capital performance.This literature focuses mostly on how venture capitalists add value to entrepreneurial ven-tures. Second, we take a fund-level perspective and investigate the evidence regarding per-formance there. Third, we take a macro perspective (industry level) and review theevidence as to actual aggregated industry performance. Finally, we review generic issueswith performance measurement in the venture capital context.

236

The key messages in the critical review fall into three categories. First of all, the natureof the industry, and in particular the types of deals done, puts severe constraints on thevery ability to measure value creation and hence performance over time. These factors areingrained in the mesh of the industry, and thus to be taken as invariable. Second, struc-tures have emerged to deal with the nature of the deals, themselves contributing to thevariability of the returns. Finally, while the limitations inherent in performance reportingin this context are material, they do not prevent an efficient functioning of the industry.An expected contribution of this chapter is to highlight the conditions precedent to indus-try practices and hopefully to provide a solid basis for the necessary interpretation of thenumbers provided by the industry. This re-balancing of expectations is a pre-requisite fora healthy, sustainable venture capital industry.

Value drivers in venture capital dealsThe largest part of the venture capital literature actually investigates key drivers of per-formance in venture capital-backed deals. We separate the presentation into three cate-gories: (1) venture capital-controlled investment factors; (2) environmental factors; and(3) decision making processes.

Venture capital-controlled investment factors

Deal flows, screening and syndication Rigorous company and investment selectionprocesses, including proprietary deal flows, deal flow quality and quantity, screening andsyndication abilities are said to impact the performance of funds positively.

Birkshaw and Hill (2003) support the view that syndication may allow investors to makedecisions regarding investments based on multiple judgements by other parties, thereby(potentially) enhancing the accuracy of screening through the incorporation of greaterexperience and impartiality into the process. Corporate venture units may be able to moregreatly diversify their risk by utilizing co-investment tactics for a defined amount of finan-cial investment. Active participation in a community of investors may allow corporateventure units to avoid problems of adverse selection and to attain access to an enhanceddeal flow. Involvement in a community of investors may provide a corporate venture unitwith the opportunity to search more distant knowledge domains with reduced transactioncosts, thereby accessing a greater volume of novel investment opportunities.

Hochberg et al. (2004) show that venture capitalists tend to syndicate their investmentswith other venture capitalists rather than investing alone. Once they have invested in acompany, venture capitalists draw on their networks of service providers – head hunters,patent lawyers, investment bankers and so on – to help the company succeed. The twomain drivers of venture capital performance are the ability to source high quality dealsand to nurture the investments. Syndications support both critical activities. Syndicationnetworks facilitate the sharing of information, contacts and resources amongst venturecapitalists. Strong relationships with other venture capitalists are likely to improve thechances of securing follow on venture capital funding for portfolio companies, and mayindirectly provide access to other venture capitalists’ relationships with service providerssuch as head hunters and prestigious investment banks.

Controlling for other known determinants of venture capital fund performance such asfund size as well as the competitive funding environment and the investment opportunities

The performance of venture capital investments 237

facing the venture capitalist, the authors find that venture capitalists that are better net-worked at the time a fund is raised subsequently enjoy significantly better fund perfor-mance, as measured by the rate of successful portfolio exits over the next ten years. Perhapsthe leading alternative explanation for the performance enhancing role of venture capital-ist networking is simply experience. It seems plausible that the better networked venturecapitalists are, also the older and more experienced venture capitalists. Venture capitalfunds whose parent firms enjoy more influential network positions have significantly betterperformance as well. Similarly, the portfolio companies of better networked venturecapital firms are significantly more likely to survive to subsequent rounds of financing andto eventual exit. Interestingly, once network effects are controlled for in the models of fundand portfolio company performance, the importance of venture capitalist prior experienceis reduced, and in some specifications, eliminated. Given the authors’ documented largereturns to being well networked, enhancing a network position should be an importantstrategic consideration for an incumbent venture capitalist, while presenting a barrier toentry for new venture capitalists.

Engel (2004) stresses the value of syndication as a successful strategy to overcome prob-lems of information asymmetries. A public promotion of syndication can be helpful forsupporting the learning process of venture capitalists, for increasing the quality of thevalue chain process and hence for pushing up the capital inflow by investors. Gompersand Lerner (2001), for their part, argue that by syndicating investments, venture capitalfirms can invest in more projects and largely diversify away firm-specific risk. Involvingother venture firms also provides a second or third opinion on the investment opportun-ity, which limits the danger that bad deals will get funded.

Control mechanisms Venture capitalists have developed over time a sophisticatedtoolbox of structural and contractual arrangements to help manage difficult features oftheir transactions, such as high levels of uncertainty about future outcomes and largeinformation asymmetries between the parties involved. Contingent control rights, whichinclude continuous monitoring processes (such as positions on the Board, reportingrequirements, and so on), the ability to replace the entrepreneur, powerful stock optioncompensations, investor liquidation rights, and the use of convertible securities have allbeen presented as critical drivers of performance in individual deals.

Hege et al. (2003) focus on the significant performance gap between US and Europeanventure capitalists, both in terms of types of exits and of rates of return realized. Theauthors partly attribute the gap to differences in the contractual terms of the relation-ship, like the frequency and effectiveness of the use of instruments asserting an activerole of venture capitalists in the value creation process. Venture capitalists in the USassert vigorously contingent control rights, through systematic use of financial instru-ments that convey residual control rights in case of poor performance, such as convert-ible securities, and they activate these controls more frequently, as measured by thereplacement of entrepreneurs. Also, US venture capitalists exhibit sharper screeningskills than their European counterparts. A better average quality of selected projects inthe US is said to be consistent with the finding that a larger fraction of the totalinvestments occur there in the initial round. Finally, there is some evidence for a moreeffective management of financing relationship and participation of different groups ofinvestors in the US. Interestingly, the results also suggest that relationship financing,


which is more pronounced for European companies, does not have any significantimpact on performance.

Kaplan and Strömberg (2003) focus on the agency problems inherent in contractdesign. The external risk results suggest that risk-sharing concerns are unimportant rela-tive to other concerns, such as monitoring. Venture capitalists expect to take actions withtheir investments and those actions are related to the contracts. Venture capital manage-ment intervention is related to venture capital board control while venture capital supportor advice is shown to be more related to venture capital equity ownership.

Gompers and Lerner (2001) investigate the tools used by venture firms to address theinformation issues. These are said to include intense scrutiny before and after the provi-sion of capital. The monitoring and information tools used include meting out financingin discrete stages over time, syndicating investments with other venture capital firms,taking seats on a firm’s board of directors, and compensation arrangements includingstock options. Lerner (1995) similarly found evidence that board service is driven by aneed to provide monitoring, showing that geographic proximity is an important determi-nant of venture board membership. Another mechanism utilized to influence managersand critical employees is to have them receive a substantial fraction of their compensa-tion in the form of equity or options.

General partner experience The industry knowledge and experience of the GeneralPartners (GP), including access to and degree of implicit and tacit knowledge as well asthe degree of specialization has been shown to impact the performance of funds.

Gompers (1994) shows that unseasoned venture capital firms (those that have been inexistence five years or less) are under tremendous pressure to perform during the initialstages of their first fund. These inexperienced venture capitalists have an incentive to‘grandstand’, or to bring firms from their first fund to the public market sooner thanwould otherwise be optimal. On average, young venture capitalists lose almost $1 millionon each initial public offering because they bring the companies to market too early.

Kaplan and Schoar (2005) show that venture capital returns persist strongly acrossfunds raised by individual private equity partnerships. Performance increases (in the crosssection) with fund size and with the GPs’ experience. The relation with fund size isconcave, suggesting decreasing returns to scale. Similarly, a GP’s track record is positivelyrelated to the GP’s ability to attract capital into new funds. This is also supported byGottschalg et al. (2004) who show that the main drivers of underperformance are fundsthat are small, European and run by inexperienced GPs. Engel (2004) similarly finds thatlarge, older venture capital companies with access to implicit, tacit knowledge have ahigher quality of the value chain process.

Persistence of performance, timing and investment durations Kaplan and Schoar (2005)document substantial persistence in leverage buy-out (LBO) and venture capital fundperformance. General partners whose funds outperform the industry in one fund arelikely to outperform the industry in the next, and vice versa. Persistence is found notonly between two consecutive funds, but also between the current fund and the secondprevious fund. These findings are markedly different from the results for mutual funds,where persistence has been difficult to detect, and when detected, tends to be driven bypersistent underperformance rather than over-performance. Fund flows are positively


related to past performance, however the relationship is concave in private equity.Similarly, new partnerships are more likely to be started in periods after the industry hasperformed especially well. But funds and partnerships that are raised in boom times areless likely to raise follow-on funds, suggesting that these funds perform poorly. A largerfraction of fund flows during these times, therefore, appears to go to funds that havelower performance, rather than top funds. Not only do more partnerships decide tostart up after a period in which the industry performed well, but also, first time fundstend to raise bigger amounts of capital when the private equity industry performed well.Funds raised in boom years are more likely to perform poorly and therefore areunable to raise a follow-on fund. In sum, it appears that the marginal dollar invested inboom times goes towards financing funds which are less likely to be able to raise a sub-sequent fund. In periods of increased entry of funds into the industry overall, theauthors observe a larger negative effect on the young funds, than on the older, moreestablished funds.

Reputation of fund and general partners Nahata (2004) shows that venture capitalistreputation has a positive impact on the profitability of harvesting venture investments –as venture capitalists are able to attract higher tier underwriters, and companies backedby reputable venture capitalists are able to time IPOs near stock market peaks. Highquality affiliation also has a strong and positive effect on young companies’ valuations atthe time of IPO.

Kaplan and Schoar (2005) base their analyses on the premise that the underlying het-erogeneity in general partners’ skills and competences should lead to heterogeneity in per-formance and to more persistence if new entrants cannot compete effectively with existingfunds. Several forces make it difficult to compete with incumbents. First, many practi-tioners assert that unlike mutual fund and hedge fund investors, private equity investorshave proprietary access to particular transactions, that is ‘proprietary deal flow’. In otherwords, better GPs may find better investments. Second, private equity investors typicallyprovide management or advisory inputs along with capital. If high quality general part-ners are scarce, differences in returns between funds could persist. Third, there is someevidence that better venture capitalists get better deal terms (for example lower valu-ations) when negotiating with start-ups.

Value added services Value added services provided to the investee companies, such asadvisory services (including position on the Board, assistance with recruiting and com-pensating management, development/revision of business plan/strategies) and the uti-lization of syndication networks may improve the returns on investments.

Kaplan and Strömberg (2000) point out that the venture capitalists expect to be activein areas such as developing the business plan, assisting with acquisitions, facilitatingstrategic relationships with other companies, or designing employee compensation.However, while venture capitalists play a monitoring and advisory role, they do notintend to become too involved in the company. Hege et al. (2003) find evidence support-ing the view that venture capital firms in Europe are more deal makers and less activemonitors, lagging in their capacity to select projects and add value to innovative firms.In Chapter 7, De Clercq and Manigart revisit the evidence on the value added of venturecapitalists.


Multistage investment The ability of venture capitalists to come back to fund successivestages of a venture is presented as another means used to leverage performance.

Gompers and Lerner (2001) show that staged capital infusions may be the most potentcontrol mechanism a venture capitalist can employ. Staged capital infusion keeps theowner/manager on a tight leash and reduces potential losses from bad decisions.

Kaplan and Strömberg (2000) show it is common for a venture capitalist to makea portion of its financing commitment contingent on subsequent portfolio companyactions or performance. This reduces the amount of funds that the venture capitalist hasput at risk for a given investment and gives greater ability to the venture capitalist to liq-uidate the venture by not providing funds if performance is unsatisfactory. Higher man-agement risk and market risk leads to greater use of state contingent contracting andstaged investment commitment.

Environmental factorsA number of structural and environmental factors have also been shown to impact thereported performance of venture capital firms’ performance (Wang and Ang, 2004).

Availability and status of public markets for IPOs The availability and status of publicmarkets for initial public offerings strongly influences the reported performance of theindustry.

Gilson and Black (1999) show that an active stock market is important for a strongventure capital industry because of the potential for venture capital exit through IPOs.Jeng and Wells (2000) examine the factors that influence venture capital fundraising inter-nationally. The strength of the IPO market is an important factor, however it does notseem to influence commitments to early stage funds as much as later stage ones. BothGilson and Black (1999) and Jeng and Wells (2000) see access to strong IPO markets asthe key source of US competitive advantage in venture capital, as well as Cochrane (2000)and Gompers and Lerner (1998).

Jeng and Wells (2000) also show that an increased volume of IPOs has a positive effecton both the demand and supply of venture capital funds. On the demand side, the exist-ence of an exit mechanism gives entrepreneurs an additional incentive to start a company.On the supply side, the effect is essentially the same. Large investors are more willing tosupply funds to venture capital firms if they feel that they can later recoup their investment.

Gompers and Lerner (2001) show that venture capitalists take firms public at marketpeaks, relying on private financings when valuations are lower. Seasoned venture capitalistsappear more proficient at timing IPOs. The superior timing ability of established venturecapitalists may be in part due to the fact that they have more flexibility as to when to takecompanies public. Less established groups may be influenced in this decision by other con-siderations – for instance young venture capital firms have the incentives to grandstand.

Nahata (2004) points out that successful exits are critical to ensuring attractive returnsfor investors and in turn to their raising additional capital. The choice of exit vehicle isgoverned by both firm-specific and VC-specific factors. Better performing portfolio com-panies not only lead to more successful exits (IPOs or acquisitions) but even among thosetwo exit scenarios, relatively better performers are more likely to be taken public than soldto an acquirer. This is in line with the finding by Gompers and Lerner (2001) that IPOstend to yield higher return.


Overall economic cycle The investment opportunities available in the context of the com-petitive environment significantly determine venture capital performance.

Gompers and Lerner (2001) suggest that the valuation of individual deals is affected byoverall macroeconomic conditions and the degree of competition in the venture capitalindustry. When a surge of money enters the venture capital industry, but there are only acertain number of worthy projects to finance, the result can be a substantial decline inthe returns on investment in the industry. This results in ‘too much money chasing toofew deals’.

Inflows of venture capital tend to raise valuations. In the past, overinvestment by venturecapitalists led to too many projects at too high valuations resulting in low returns. Increasesin demand can, in the short run, only be met by existing funds which accelerate their invest-ment flows and earn excess returns. Increases in supply lead to tougher competition for dealflow, and private equity fund managers respond by cutting their investment spending.Supply increases possibly indicate overheating accompanied by poorer performance.

Ljungqvist and Richardson (2003) show that the competitive environment facing fundmanagers plays an important role in how they manage their investments. During periodsin which investment opportunities are good, existing funds invest their capital and exittheir investments more quickly, taking advantage of the favourable business climate. Thistends to lead to better returns on their investments. In contrast, when facing greater com-petition from other private equity funds, fund managers draw down their capital moreslowly and hold their investments for longer periods of time. Returns on investmentundertaken when competition was tougher are ultimately significantly lower.

Gottschalg et al. (2004) support the view that there was a substantial amount of moneychasing too few deals in Europe and that part of the observed European underperform-ance is explained by this aspect. Fund performance is very sensitive to both business cyclesand stock market cycles.

Regulatory environment The regulatory environment faced by the venture capital indus-try, in particular capital gains tax rates, the evolution of interest rates (long and shortterm), labour market rigidities and information reporting requirements, can all impact onperformance.

Gompers and Lerner (1998) investigate aggregate performance and capital flows. Theauthors find that macroeconomic factors like past industry performance and overall eco-nomic performance as well as changes in the capital gains tax or ERISA provisions (seeChapter 1 for a review of the development of venture capital in the US) are related toincreased capital flows into private equity. Lower capital gains taxes seem to have a par-ticularly strong effect on the amount of venture capital supplied by these tax-exemptinvestors. The impact of the capital gains tax does not arise through its effect on thosesupplying venture capital, but rather by spurring corporate employees to become entre-preneurs, leading to more demand for venture capital.

Jeng and Wells (2000) also highlight the fact that if the market does not have good infor-mation on small start-up firms, then investors will demand a high risk premium, resultingin more expensive funding for these companies. This cost of asymmetric information canbe reduced if the country in which the company operates has strict accounting standards.With good accounting regulation, venture capitalists need to spend less time gatheringinformation to monitor their investments.


Gompers and Lerner (2001) show that government policy can have a dramatic impacton the current and long-term viability of the venture capital sector. In many countries ofcontinental Europe, entrepreneurs face numerous daunting regulatory restrictions, apaucity of venture funds focusing on investing in high growth firms, and illiquid marketswhere investors do not welcome IPOs by young firms without long histories of positiveearnings.

Despite wide recognition of venture funds as key players underlying a country’s entre-preneurial performances, there are huge differences across industrialized countries in therelative amounts invested in venture capital. Jeng and Wells (2000) show that labourmarket rigidities, the level of IPOs, government programmes for entrepreneurship andbankruptcy procedures explain a significant share of cross country variations in venturecapital intensity.

Leleux and Surlemont (2003) highlight the role played by direct state interventions inthe venture capital market across Europe. Their evidence is consistent with state inter-ventions coming in after the emergence of a venture capital industry and to a large extentvalidating the industry, leading to higher private capital flows into the venture capitalindustry. They could not support the traditional view that state interventions prime themarket, nor could they find evidence that public interventions crowded out private capital.

Romain and Van Pottelsberghe de la Potterie (2004) show that indicators of techno-logical opportunity, such as the stock of knowledge and the number of triadic patentsaffect positively and significantly the relative level of venture capital activity. Labourmarket rigidities reduce the impact of the GDP growth rate and of the stock of know-ledge, whereas a minimum level of entrepreneurship is required in order to have a positiveeffect of the available stock of knowledge on venture capital intensity.

Availability of investors Jeng and Wells (2000) find that the level of investment by privatepension funds in venture capital is a significant determinant of venture capital over timebut not across countries. Using mutual funds as a benchmark, studies by Sirri and Tufano(1998) and Chevalier and Ellison (1999) indicate that funds that outperform the marketexperience increased capital inflows. This relationship tends to be convex; mutual fundswith above-average performance increase their share of the overall mutual fund market,something shown for private equity by Kaplan and Schoar (2005). The latter show thatcapital flows into private equity funds are positively and significantly related to past per-formance. Fund size is positively and significantly related to the performance of the pre-vious fund.

Decision making processes by venture capitalistsHatton and Moorehead (1994) showed that the quality of the entrepreneur ultimatelydetermines the funding decision. Venture capitalists expect the product to be capable ofhigh profit margins and to provide exit strategies. Three criteria were shown as heavilyweighted by venture capitalists: (1) the degree of market acceptance for the product;(2) the return potential; and (3) the need for subsequent investments.

Leleux et al. (1996) use binary conjoint analysis to formally investigate for the first timethe decision tree of venture capitalists across Europe. Using a comprehensive list ofinvestment criteria, they point out four major ‘types’ of investor, the largest one focusingprimarily on human factors.


Venture capitalists have also been shown to be subject to a number of decision-makingbiases. Zacharakis and Shepherd (2001) prove experimental evidence of their possibleoverconfidence, dependent upon the amount of information, the type of information,and whether the venture capitalist strongly believes the venture will succeed or fail.Overconfidence describes the tendency to overestimate the likely occurrence of a set ofevents. Overconfident people make more extreme probability judgements than theyshould, and overconfident venture capitalists may overestimate the likelihood that afunded company will succeed. The authors show that venture capitalists are intuitive deci-sion makers, and when people are familiar with a decision and the structure of the infor-mation surrounding that decision, they resort to automatic information processing. Itseems that forcing them outside their comfort zone has a negative effect on their confi-dence and has an even greater effect (negative) on their accuracy. Venture capitalists relyon how well the current decision matches past successful or failed investments. The sup-ported high level of overconfidence in success or failure predictions may encourage theventure capitalist to limit information search and fund a lower potential investment (orprematurely reject a stronger potential investment). Overconfident venture capitalists maynot fully consider all relevant information, nor search for additional information toimprove their decision. Moreover, the natural tendency for people to recall past successesrather than failures may mean that venture capitalists will make the same mistakes again.Venture capitalists evaluate hundreds of data points during venture screening and duediligence which can lead to information overload (Zacharakis and Meyer, 2000) – asventure capitalists are drawn to more salient information factors and may ignore otherfactors that are more pertinent to the decision.

Shepherd and Zacharakis (2002) also document the fact that venture capitalists rarelyuse decision aids, where bootstrapping models have the potential to improve venture cap-italists’ decision accuracy, improving consistency, reducing the bias caused by a non-random sample, and by optimally weighting information factors and reducing thedecision maker’s cognitive load. Decision aids also allow venture capitalists to acquireexpertise faster than do current educational and training methods. Decision aids canprovide cognitive feedback, which is the return of some measure of the person’s cognitiveprocesses used in the decision. Cognitive feedback helps people come to terms with theirdecision environment and has been found to be markedly superior to outcome feedback.

Zacharakis and Shepherd revisit in Chapter 6 the latest evidence on venture capitaldecision making.

A fund level perspective on venture capital risk – return performanceResearch specifically concerning the returns to private equity has focused on describingthe basic risk/return profiles of investments in private equity partnerships and privateequity investments in companies, as documented by Hand (2004).

Stevenson et al. (1987), in a pioneering study, highlight the following conditions whichlead to high rates of return on venture capital funds: (1) a multistage investment or com-mitment of funds on an incremental basis with evaluation of venture performance beforecommitment of additional funds; (2) an objective evaluation of venture performance withthe clear distinguishing of winners from losers; (3) parlaying funds or having the confi-dence to commit further funds to ventures identified as winners; (4) a persistence ofreturns from one round to the next, which implies that valuable information is gained


from previous rounds of investment in the same venture; and (5) long term holding ofinvestment portfolios for a period sufficient for geometric averaging of compound returnsto cause winners to take over or raise portfolio returns.

Ljungqvist and Richardson (2003) report that the risk adjusted excess value of thetypical private equity fund is in the order of 24 per cent relative to the present value ofinvested capital, probably because of the highly illiquid nature of the fund. Cochrane(2000) characterizes venture capital returns based on the economics of individual invest-ments in portfolio companies. He finds that venture returns are very volatile, with laterstage deals showing much less volatility than early stage deals.

Gottschalg et al. (2004) support the opposite view on performance: PE funds in theirsample (raised between 1980 and 1995) seem to under-perform public stock markets. PEperformance is higher when investments are exited in periods of high valuation levels onpublic stock markets, as proxied by the overall earning to price ratio. The authors alsoshow that PE funds are exposed to substantial ‘left tail’ risk, that is they deliver signifi-cantly higher losses during large market downturns but are not as sensitive to economicconditions in good times.

Lerner et al. (2004) support the view that the returns realized from private equity invest-ments differ dramatically across investor groups. In particular, endowments’ annualreturns are nearly 14 per cent greater than average. Funds selected by investment advisorsand banks lag sharply. These results were robust to controlling for the type and year ofthe investment, as well as the use of different specifications.

Kaplan and Schoar (2005), on a sample of funds active over the period 1980–1997,show average fund returns net of fees roughly equal to those of the S&P 500. Weightedby committed capital, venture funds outperform the S&P 500 while buyout funds do not.The authors suggest that gross of fees, both types of private equity partnerships earnreturns exceeding the S&P 500. While LBO fund returns net of fees are slightly less thanthose of the S&P 500, VC fund returns are lower than the S&P 500 on an equal weightedbasis, but higher than the S&P 500 on a capital weighted basis. They also show that per-formance persists strongly across funds raised by individual partnerships and improveswith partnership experience.

The industry level evidence: is venture capital delivering?The European venture capital scene was seriously shaken on its foundations by thepublication in early 2005 of the benchmark returns for the industry, presented below inTable 9.1 and Figure 9.1. For the first time in its relatively short history, the average 10-yearinvestment horizon returns for early stage investments became negative on a per annumbasis. For all venture capital classes, including development and balanced funds, the per-formance was an equally unimpressive 5.3 per cent for the period. The pooled cumulativereturns since inception for funds created since 1980 showed practically a zero return.

The latest figures reported by the National Venture Capital Association (NVCA) forthe US showed an average 10-year investment horizon return of 45.8 per cent per annumand a 20-year investment horizon return of 19.8 per cent, as shown in Table 9.2. Thebroader venture capital class, including also vehicles focusing on development capital,showed respectively figures of 25.4 per cent and 15.6 per cent for the 10- and 20-yearinvestment horizons. The differentials between the European and US performance figuresin terms of early-stage deals were the largest reported in the last 20 years.


These comparative numbers are intriguing. First, they seem to support the view thatthe industries in the US and Europe are at very different stages of their development.European venture capital industry emerged in the early 1990s, and only faced its firstdownturn when the Internet bubble burst. In other words, it never really had a chance tolearn. The poor results indicate a painful ‘teething’ problem by an emerging industry.Second, it appears that the lessons from the natural selection process that led to a strongperforming US industry were either not transferable or not adopted by its Europeancounterpart.

Generic issues with industry performance measurementThese industry statistics clearly warrant further investigations. Both the absolute perfor-mance level of European venture capital and relative to the US industry is intriguing.In this section, we focus on issues related to the measurement of performance in venturecapital.


Table 9.1 European investment horizon returns as of 31 December 2005 (in per centper annum)

Net Horizon Returns as of 31 December 2005

1-year IRR 3-year IRR 5-year IRR 10-year IRRStage % % % %

Early-Stage 4.9 �2.3 �7.5 �0.1Development 12.2 0.9 �1.6 8.8Balanced 32.7 2.8 �2.7 7.6All Venture 25.4 0.6 �4.0 5.3Buyouts 20.9 7.9 5.0 12.6Generalist 51.2 1.2 �4.8 9.7All Private Equity 24.1 5.2 1.2 10.2

Figure 9.1 European 5-year rolling window IRRs as of 31 December 2005 (in per centper annum)

40 All VentureAll Buyouts

+12.6%+5.3%

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ear

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Issue #1: Valuing early stage companiesWe define venture capitalists as risk capital, that is equity-like, investors in young, rapidlygrowing companies that have the potential to develop into significant economic contrib-utors. Their willingness to take the risks associated with such investments is driven by theirbeliefs that they can generate superior returns, even after adjusting for the risks prevail-ing in these settings. By providing critical early capital and hands-on supervision andadvice, aggressively managing their portfolio (divesting poorly performing assets andreinvesting in successful ones over time), and racing to the most profitable exits, they rep-resent, in the words of Gompers and Lerner (2000), the ‘Money of Invention’. How muchis created thus depends on the value increase from the time of the investment(s).

The first issue to be tackled in measuring financial returns to venture capital activitiesis thus the valuation of early-stage, privately held companies. The valuation exercise israrely conducted in the context of a ‘market’ in the economics sense, not even a veryimperfect one. First of all, the number of potential participants on either side of the deal(buyers or sellers) is too small to justify the term of market. In many instances, a singlebuyer and a single seller will be involved. Second, efficient markets suppose the existenceof sufficient information for both parties to properly evaluate the entity to be traded.Unfortunately, the amount and quality of information available to estimate the trueworth of a private entity is often very limited. The typical valuation context is then one


Table 9.2 US investment horizon returns as of 31 December 2004 (in per centper annum)

Venture Economics’ US Private Equity Performance Index (PEPI)

Fund Type 1 Yr 3 Yr 5 Yr 10 Yr 20 Yr

Early/Seed VC 1.4 �5.5 �8.6 45.8 19.8Balanced VC 5.8 1.2 �4.2 17.0 13Later Stage VC �0.4 0.6 �6.6 15.2 13.7All Venture 3.6 �1.4 �6.3 25.4 15.6Small Buyouts 24.1 5.4 1.6 8.7 26.7Med Buyouts 17.8 4.3 �3.2 10.6 17.7Large Buyouts 16.8 9.6 0.9 10.9 14.5Mega Buyouts 20.6 9.0 2.7 7.7 9.7All Buyouts 19.8 8.5 1.8 8.7 13.0Mezzanine 8.5 3.7 1.8 6.9 9.2All Private Equity 14.0 5.3 �0.5 12.5 13.8NASDAQ 0.3 2.7 �15.3 9.4 11.4S&P 500 4.8 1.0 �4.7 9.0 10.8

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

Source: Thomson Venture Economics/National Venture Capital Association

of bargaining under incomplete and asymmetric information, a field of study that hasreceived a great deal of attention from academics but has so far not been able to come upwith more than general guidance on how to put a price on a firm.

New valuation guidelines have been adopted recently by the industry, focusing on theconcept of Fair Value (EVCA Valuation Standards, 2005), also known as Fair MarketValue or cash value in the US (PEIGG Valuation Guidelines, 2004). EVCA defines FairValue as the amount for which an asset could be exchanged between knowledgeable,willing parties in an arm’s length transaction. The estimation of Fair Value does notassume either that the underlying business is saleable at the reporting date or that itscurrent shareholders have an intention to sell their holdings in the near future. The objec-tive is to estimate the exchange price at which hypothetical market participants wouldagree to transact. Fair Value is not the amount that an entity would receive or pay in aforced transaction, involuntary liquidation or distressed sale. Although transfers ofshares in private businesses are often subject to restrictions, rights of pre-emption andother barriers, it should still be possible to estimate what amount a willing buyer wouldpay to take ownership of the investment.

In estimating Fair Value for an investment, EVCA recommends a ‘methodology that isappropriate in light of the nature, facts and circumstances of the investment and its mater-iality in the context of the total investment portfolio and should use reasonable assump-tions and estimates’. This definition stresses the subjective nature of private equityinvestment valuation. It is inherently based on forward-looking estimates and judgementsabout the underlying business itself, its market and the environment in which it operates,the state of the mergers and acquisitions market, stock market conditions and otherfactors. Due to the complex interaction of these factors and often the lack of directly com-parable market transactions, judgement needs to be exercised. Ultimately, it is only at real-ization that the true performance of an investment is apparent.

Issue #2: Extensive use of contingent valuation techniquesStandard valuation methodologies, from discounted cash flows to earnings multiplesand real option formulae, are only as good as the fundamental assumptions and dataused to feed them, that is in general very poor. The high level of uncertainty that pre-vails in the world of venture capital is an intrinsic part of that world, and will not dis-appear. Hence the very slow adoption of the most sophisticated valuation techniques,which are for the most part seen as ‘technical overkill’. Early stage financings (venturecapital, angels, and so on) have earned a very distinctive (and deserved) reputation assome of the more obscure, if not outright esoteric, dimensions of the field. Start-upfirms are a study in paradox, known as much for the passion and drive of their wizard-driven teams, the revolutionary technologies they hatch and their blind pursuit of theopportunities they generate as for their bad habit of failing in droves, burning cash as ifthere were no tomorrow, and ultimately not delivering the promised bounties, or onlyafter excruciating delays and sufferings. So, how does one go about analysing andproviding financing to such ‘outliers’ in terms of financial risk? To a large extent, theinevitable valuation inaccuracies and differences of opinion are ‘hedged’ throughsophisticated contracting schemes which, in effect: (1) provide for ‘contingent repricing’through time as the venture develops, reallocating cash flow and control rights whenneed be; and (2) provide effective screening and incentive mechanisms, helping to ‘smoke


out’ entrepreneurs with lesser quality projects or venture capitalists with low add-onvalues (Cossin, Leleux and Saliasi, 2003).

While there is comfort in knowing that initial valuation errors will be corrected overtime, how should venture capitalists report actual deal valuations for the purpose of finan-cial performance measurement? A first conceptual approach would be to value independ-ently the multiple options that make up standard investment contracts. But for the verysame reasons that valuations are difficult, derivative valuations are even more uncertain.A second approach, less elegant but more applicable, consists in ignoring the contractualcontingencies and reporting only the point valuations (that is share prices) at the time ofthe deal. While this ignores most of the value-related covenants, the valuation error wouldonly affect the initial reporting of the deal value: upon exit, the true value creation will berecognized.

Issue #3: IRR-boosting cash flow management techniquesMeasuring the financial performance of a venture capital fund requires taking into con-sideration the industry’s unique set of operating procedures which impact these reportedperformances. The latter include: (1) the progressive commitments, draw-downs andinvestments of funds from investors into ventures; (2) the selective re-investments anddivestments from ventures; and (3) the exits and distributions to investors. All the para-meters of the investment cycle are managed by the venture capitalists to optimize not onlyreported IRRs on the fund but also the investment multiple, the two key performancemetrics most watched in the industry.

Venture capitalists’ need to manage IRR translates into a progressive commitment anddrawdowns of the investors’ funds. The ‘clock’, in terms of return on capital, only startsticking when the venture capitalist has the use of investors’ money in hand, hence a greatreluctance to take the commitments in cash upfront. Funds either draw down the fundson the basis of a fixed schedule (for example 12 equal quarterly instalments) or more oftenon the basis of cash calls on an as-needed basis, with a 30- to 90-day payment basis.

Venture capitalists’ insistence on progressive capital commitment to a venture is notonly a risk management and control tool but also a cash disbursement mechanism.Associated with direct monitoring of the ventures, the objective is to minimize the periodof capital usage and maximize its value creation efficiency.

At the end of the process, venture capitalists need to exit the investments and distrib-ute the proceeds back to investors (Leleux, 2002). Exits happen in a number of ways:a private recapitalization, a merger with or sale to an acquirer, or in a public offering(IPO). The exit strategy most frequently chosen in the US is a public offering, otherwiseknown as an IPO, since an IPO will provide investors with the highest overall returns.Once the investment is exited, the venture capital firm must then decide when and how todistribute the returns to its investors. A venture capital firm can either sell the stock anddistribute the cash proceeds to the investors or it can distribute the stock directly to theinvestors. Stock distributions are most commonly selected because they provide the great-est benefits to the fund’s limited partners. Due to Securities and Exchange Commission(SEC) restrictions, a venture capitalist cannot easily liquidate its entire position. Ininstances when it can sell stock, a large block sale by a venture capitalist would negativelyimpact the stock price. However, a venture capital firm can distribute the shares of a port-folio company to its limited partners, who can then sell these shares without restriction.


If an investor still believes in the long-term prospects of the company, he can also holdthe stock for sale at a later date. Another benefit of this strategy is that a tax liability isnot created until the stock is actually sold. Clearly, the above evidence supports theclaim that a venture capitalist chooses a stock distribution for the benefits it provides toinvestors.

As with most debates, there is another perspective to the distribution strategies chosenby venture capitalists and that is one which is self-serving. In taking a portfolio companypublic, a young venture capital firm improves its fundraising prospects (Gompers,1996). By distributing shares instead of cash, a venture capitalist can increase its com-pensation, satisfy its largest institutional clients, and increase its overall personal returnon investment.

Issue #4: Collecting and aggregating individual fund IRRsVenture capital funds belong to the generic ‘private equity’ or ‘alternative assets’ portfolioallocation class. By definition, that industry deals primarily with private equity situations,that is situations where information disclosures are going to be extremely limited. In prac-tice, only limited partners in a fund would receive detailed information as to the actualperformance of the fund they are invested in. Only large institutional investors, such asmajor university endowments or fund-of-fund managers would ever accumulate asufficiently large number of positions in funds to be able to generate meaningful com-parisons internally. A number of trade groups, such as EVCA and NVCA, often with thehelp of specialist advisory boutiques, such as Venture Economics or Almeida Capital, aregenerating their own ‘industry’ performance numbers. In doing so, they face the samedifficulties in accessing the basic fund performance information and have to rely on vol-untary disclosure by member firms. For example, EVCA and PricewaterhouseCooperstapped all national private equity and venture capital associations to identify all com-panies that participated in private equity activities during 2002 (for the 2002 AnnualEuropean Private Equity Survey, published as the 2003 EVCA Yearbook). A total of 1528eligible companies were contacted and 73 per cent of the firms, or 1112, responded to thetwo-part, self-completion survey. While it would be difficult to criticize the organizationsfor the non-respondents, it is fair to question whether self-disclosure leads to censoring ofthe performance distribution curve, for example if non-respondents were primarily fundswith low performance during the year.

Issue #5: Industry performance and correlation with other asset classesPerformance and risk can only be evaluated in the context of the correlation of theventure capital asset class with respect to other major sectors. In particular, if venturecapital exhibited a low level of correlation with respect to these assets, a high proportionof its risk can be diversified away in a well-balanced portfolio. Unfortunately, the evidencein this respect is not as encouraging as some would pretend. First of all, the performanceof the venture capital industry is highly correlated to that of technology-rich stockmarkets, so that venture capital positions do not provide much diversification to aNasdaq-rich portfolio. The best diversification is obtained with respect to portfolios ofreal estate or long-term fixed income instruments. Correlations to key equity indices arein general positive and relatively high (0.5 to 0.7), so that the benefits in including venturecapital in the portfolio are actually relatively minimal.


ConclusionsIn this chapter, we document the extent of contributions to understanding the issues inmeasuring performance in the venture capital industry. In particular, we highlight theunreliability of the performance measures in general and the difficulty to access fund leveldata. Despite these shortcomings, a rich literature has emerged to identify key drivers ofperformance at the fund level or at the level of the investee companies.

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133–56.Gompers, P. and J. Lerner (1998), ‘What drives venture capital fundraising?’, Working Paper, Harvard

University.Gompers, P. and J. Lerner (2000), The Money of Invention: How Venture Capital Creates New Wealth, Boston,

MA: Harvard Business School Press.Gompers, P. and J. Lerner (2001), ‘The venture capital revolution’, Journal of Economic Perspectives, 15(2),

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and the United States’, Working Paper, RICALFE-European Commission DG Research.Hochberg, Y., A. Ljungqvist and Y. Lu (2004), ‘Who you know matters: venture capital networks and invest-

ment performance’, Working Paper, Stern School of Business.Jeng, L. and P. Wells (2000), ‘The determinants of venture capital funding: evidence across countries’, Journal

of Corporate Finance, 6, 241–89.Kaplan, S. and A. Schoar (2005), ‘Private equity performance: returns, persistence, and capital flows’, Journal

of Finance, 60(4), 1791–823.Kaplan, S. and P. Strömberg (2000), ‘How do venture capitalists choose investments?’, Working Paper,

University of Chicago.Kaplan, S. and P. Strömberg (2003), ‘Financial contracting theory meets the real world: evidence from venture

capital contracts’, Review of Economic Studies, 70(2), 281–316.Leleux, B. (2002), ‘Note on distribution strategies of venture capital firms’, IMD Working Paper Series GM-1120.Leleux, B. and B. Surlemont (2003), ‘Public versus private venture capital: seeding or crowding out? A pan

European analysis’, Journal of Business Venturing, 18(1), 81–104.Leleux, B., D. Muzyka and S. Birley (1996), ‘Trade-offs in the investment decisions of European venture cap-

italists’, Journal of Business Venturing, 11, 273–87.Lerner, J. (1995), ‘Venture capitalists and the oversight of privately-held firms’, Journal of Finance, 50, 301–18.Lerner, J., A. Schoar and W. Wong (2004), ‘Smart institutions, foolish choices?: the limited partner performance

puzzle’, NBER and Harvard University Working Paper.


Ljungqvist, A. and M. Richardson (2003), ‘The investment behaviour of private equity fund managers’,Working Paper, Stern School of Business.

Nahata, R. (2004), ‘The determinants of venture capital exits: an empirical analysis of VC backed portfoliocompanies’, Working Paper, Vanderbilt University.

PEIGG Valuation Guidelines (2004), Private Equity Industry Guidelines Group, www.peigg.org.Romain, A. and B. Van Pottelsberghe de la Potterie (2004), ‘The determinants of venture capital: additional evi-

dence’, Working Paper, Solvay Business School.Shepherd, D. and A. Zacharakis (2002), ‘Venture capitalists’ expertise – a call for research into decision aids and

cognitive feedback’, Journal of Business Venturing, 17, 1–20.Sirri, E. and P. Tufano (1998), ‘Costly search and mutual fund flow’, Journal of Finance, 53 (October), 1589–622.Stevenson, H., D. Muzyka and J. Timmons (1987), ‘Venture capital in transition: a Monte Carlo simulation of

changes in investment patterns’, Journal of Business Venturing, 2(2), 103–21.Wang, C. and B. Ang (2004), ‘Determinants of venture performance in Singapore’, Journal of Small Business

Management, 42(4), 347–63.Zacharakis, A. and D. Meyer (2000), ‘The potential of actual decision models: can they improve the venture

capital investment decision?’, Journal of Business Venturing, 15(4), 323–46.Zacharakis, A. and D. Shepherd (2001), ‘The nature of information and overconfidence on venture capitalists

decision making’, Journal of Business Venturing, 16, 311–32.


10 An overview of research on early stage venturecapital: Current status and future directionsAnnaleena Parhankangas1

IntroductionEntrepreneurship can be seen as an engine of innovation and growth, and a provider ofeconomic and social welfare (Schumpeter, 1934; Birch, 1979; Birley, 1986; Kortum andLerner, 2000). Entrepreneurs developing revolutionary new products require a substan-tial amount of capital during the formative stages of their companies’ life cycles. Eventhough most entrepreneurs prefer internal to external funding, few entrepreneurs havesufficient funds to finance early stage projects themselves. It is also at this stage of devel-opment, when collateral-based funding from banks, the second most preferred source offunding by entrepreneurs (Myers, 1984), is often inappropriate or even potentially life-threatening to the new firm (Gompers, 1994; Murray, 1999). Therefore, the alternativeprovision of venture capital has become an attractive source of finance for potentiallyimportant companies operating on the frontier of emerging technologies and markets(Tyebjee and Bruno, 1984; Bygrave and Timmons, 1992; Murray, 1999).

However, the management of early stage venture capital investments has proved to bechallenging. Early stage investors are obliged to deal with multiple sources of uncertaintyspanning the commercial, technical and managerial aspects of the new enterprise (Storeyand Tether, 1998). Early stage investments typically involve new products targeted to non-existing markets developed by management teams with little or no prior history, exposinginvestors to significant information asymmetries (Chan, 1983; Amit et al., 1990; Chanet al., 1990; Sahlman, 1990; Amit et al., 1998). In addition, it will usually take several yearsto transform an early stage company to a firm capable of being floated or sold to a tradebuyer (Dimov and Murray, 2006). As a result, early stage venture capitalists are faced withthe combination of long term commitment in a young venture and a considerable likeli-hood of failure. The venture capital industry has partly responded to these challenges byrejecting early stage financing activity as too uneconomic (Dimov and Murray, 2006).Some go as far as to state that efficient markets do not exist for allocating risk capital toearly-stage technology ventures and that most funding for technology development in thephase between invention and innovation comes from angel investors, corporations andfederal governments, not venture capitalists (Branscomb and Auerswald, 2002).

Given the significant challenges and opportunities associated with early stage venturecapital, the volume of research on this topic is increasing, whether measured in terms ofpublished research articles, publication outlets, or support provided by private donors orpolicy. The initial empirical research was mostly conducted during the 1980s, four decadesafter the first venture capital firm was established in the United States. The pioneers inearly stage venture capital research focused on fundamental questions, such as ‘what doventure capitalists do’ and ‘how do they add value in their portfolio companies’. Forinstance, the seminal paper of Tyebjee and Bruno (1984) developed a model of venture

253

capital activity involving five sequential steps: deal origination, deal screening, dealevaluation, deal structuring and post-investment activities. MacMillan et al. (1985; 1987)analyzed the criteria used by early stage venture capitalists to evaluate new venture pro-posals. Bygrave and Timmons (1986) and Gorman and Sahlman (1989) focused on therole of venture capitalists in promoting innovation and growth in early stage companies.Bygrave (1988) investigated the logic of syndication in the early stage venture capitalindustry. It is noteworthy that these questions still continue to attract the attention of newgenerations of researchers.

The pioneers in early stage venture capital research focused primarily on the USmarket. However, the diffusion of US style venture capital practices to other nations wasfollowed by a stream of international venture capital research describing the Europeanand Asian context (Muzyka et al., 1996; Sapienza et al., 1996; Brouwer and Hendrix,1998; Bruton and Ahlstrom, 2002; Kenney et al., 2002a; 2002b; Wright et al., 2005). Thesestudies typically address the cross-country differences in early stage venture capital activ-ities and the role of the early stage venture capital investments in revitalizing the entre-preneurial systems of Europe and Asia.

Another significant trend in (early stage) venture capital research is the sharpening dis-tinction between research on early stage and later venture capital activities, perhapsreflecting the recent tendency of venture capitalists to shift away from early stage invest-ments to later stage deals (Tyebjee and Bruno, 1984; Bygrave and Timmons, 1992; Campand Sexton, 1992; Gompers, 1994; Mason and Harrison, 1995; Sohl, 1999; Gompersand Lerner, 2001; Balboa and Marti, 2004). As the original definition of venture capitalinvolves investments in young firms characterized with high risk and pay-off (Crispin-Little and Brereton, 1989; Bygrave and Timmons, 1992; Gompers et al., 1998; Sahlman,1990; Wright and Robbie, 1998; Gompers and Lerner, 2001), investments in early stagefirms may be regarded as classic venture capital. Later stage investments, in turn, aresometimes labeled as private equity (Lockett and Wright, 2001) or merchant capital(Bygrave and Timmons, 1992). It was not until later that the notion of early stage venturecapital emerged as several authors demonstrated that the stage focus of a venture cap-italist is one of the most important features along which venture capital firms could bedistinguished (Robinson, 1987; Ruhnka and Young, 1987; Fried and Hisrich, 1991).

As research on early stage venture capital continues to grow and proliferate, it is import-ant to take a look back and evaluate the progress made and to identify gaps in the exist-ing knowledge. This chapter is based on a review of 179 peer-reviewed articles and otherrelevant publications focusing on early stage venture capital financing.2 Even though agreat effort was taken to provide a reasonable overview of the existing knowledge, the sizeand scope of the research field makes it impossible to provide a detailed description ofevery article reviewed or an exhaustive listing of all studies published on the topic this far.Instead, the focus of the literature review is primarily on scholarly research. It is alsoimportant to note that the studies focusing on the co-evolution of venture capital, regionsand industries (see for instance Manigart, 1994; Martin et al., 2002; Klagge and Martin,2005) and the policy aspects of early stage venture capital are beyond the scope of thisstudy, as these topics will be covered in other parts of this book.

This chapter organizes the literature on early stage venture capital financing by first ana-lyzing the special characteristics of the early stage ventures, investors and funds. Thereafter,I continue with the implications of these differences for managing venture capitalist


investment activity (Tyebjee and Bruno, 1984) over the venture capital cycle (Gompers andLerner, 2001) in different institutional settings. Finally, this chapter is concluded with a syn-thesis and analysis of prior knowledge and suggestions for future research. The approachfor presenting and analyzing prior studies is illustrated in Figure 10.1.

Early stage venture capital industry: key characteristics and challengesIn order to gain a better understanding of the challenges and opportunities faced byearly stage investors, I will first identify those key characteristics that distinguishearly stage ventures from later stage deals. Thereafter, I will discuss the major risksfaced by early stage investors and recent trends in the global early stage investment activ-ity. This subsection ends with a description of the key characteristics of early stageinvestors and funds.

Classification of venture capital investments based on their development stage: early stageventures vs. later stage dealsPrior literature classifies venture capital investments based on the development stage ofthe portfolio company (Robinson, 1987; Bygrave and Timmons, 1992). Stanley Pratt, thepublisher of Venture Capital Journal, distinguishes between ‘seed, start-up, first stage,second stage, third stage and bridge financing’ (Bygrave and Timmons, 1984; Ruhnka andYoung, 1987). These investment stages have been found to differ in terms of their key char-acteristics, developmental goals and major developmental risks (Ruhnka and Young,1987; Flynn and Forman, 2001), as presented in Table 10.1.

The seed, start-up capital and first stage financing are usually considered early stageventure capital (Pratt’s Guide to Venture Capital Sources, 1986; Ruhnka and Young, 1987;Crispin-Little and Brereton, 1989). Seed financing involves a small amount of capital pro-vided to an inventor or an entrepreneur to prove a concept (Sohl, 1999; Branscomb andAuerswald, 2002), before there is a real product or company organized (NVCA, 2005).Ruhnka and Young (1987) found that characteristic for the seed stage is the existence ofa mere idea or a concept, and the absence of the management team beyond the founderand one or more technicians. The critical goals for the seed stage include producing aproduct prototype and demonstrating technical feasibility, as well as conducting a pre-liminary market assessment. Contrary to public perception, seed stage companies are notlikely candidates for venture capital investments, but are more likely to be backed by

An overview of research on early stage venture capital 255

Figure 10.1 Outline for the chapter

Characteristics ofearly stage venture capital

Characteristics of earlystage investments

• Market and agency risks• Information asymmetries

Characteristics of earlystage investors and funds

Management ofearly stage investments

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

Synthesis and analysis ofearly stage venture capitalresearch

• Major themes and findings• Theories and methods• Future research

INSTITUTIONAL SETTING


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

Seed Stage Start-Up Stage First Stage Later Stages

Source of Founder, Angels Angels, VCs Angels, VCs VCs, Privatefunding Equity

Demand 0–$25K $100K–$500K $500K–$2000K >$2000K

Venture • Idea or concept • Business plan and • Market receptive, • Significant salescharacteristics • only • market analysis • some orders/sales • and orders

• No management, • completed • Marketing push • Increasing• founders/ • Prototype under • needed • sales/broaden• technicians only • evaluation/beta • Full management • market• Prototype not • testing • team in place • (Near) break-even• developed/tested • Management team • Ramp-up in • or profitable

• incomplete • manufacturing • Seasoned• Product ready to • needed • management• market, some • Prototype ready • completed/• initial sales • revamped

• Established • product

Major goals • Develop and prove • Complete beta • Achieve market • Increase sales,• the concept • testing/get product • penetration and • growth, market• Produce working • ready to the market • sales goals • share targets• prototype • Make initial sales, • Reach break-even • Need to window-• Market assessment • verify demand • or profitability • dress for IPO,• Assemble • Establish • Increase production • buyout or merger• management team • manufacturing • capacity/reduce • Improve cash• and structure • feasibility • unit cost • flow break-even,• company • Build management • Build sales • profitability• Develop detailed • organization • force/distribution • Diversify products• business plan • systems • Begin major

• • expansion of the• company

Major risks • Workable prototype • Beta tests • Founders are poor • Inadequate• cannot be produced • unsatisfactory • managers/ • management/loss• Potential market • Founders cannot • inadequate • of key • not large enough • attract/manage • management team • management• Development • key management • Product not • Inadequate• delayed, funds run • Potential market • sufficiently • sales/market share• out • size/share not • competitive in the • Unanticipated• Product cannot be • feasible • market • competition• produced at a • Cash used up, • Manufacturing • IPO window• competitive cost • inability to attract • costs too high/ • shuts/ no exit• Founder cannot • additional funding • inadequate profit • vehicle• manage • Inadequate • margin • Cannot achieve• development • marketing/sales • Market not as big • adequate profit

• volume • as projected/slow • margin• Product not cost • market growth • Technological• competitive • Marketing strategy • obsolescence• Unanticipated • wrong/inadequate• delays in product • distribution• development • Excessive burn• Competition • rate/inadequate• develops first • financial controls

informal investors (business angels), family and friends (Tyebjee and Bruno, 1984;Crispin-Little and Brereton, 1989; Sohl, 1999).

Start-up financing provides funds for product development and initial marketing. Inthe start-up stage, the investigation of the feasibility of the business concept has gener-ally progressed to the point of having a formal business plan together with some analysisof the market for the proposed product or service. Major benchmarks for this stageinclude establishing the technological, market and manufacturing feasibility of the busi-ness concept (Ruhnka and Young, 1987; Crispin-Little and Brereton, 1989).

The first stage financing provides funds to initiate commercial manufacturing and sales.The first stage is characterized by having a full management team in place, a market recep-tive to the product, a need for a ramp-up of the production process, and the existence ofa ready prototype for the market (Ruhnka and Young, 1987; Crispin-Little and Brereton,1989; Sahlman, 1990; Sohl, 1999; Branscomb and Auerswald, 2002).

Even though there exists less consensus on the typical characteristics of the ventures inlater stages of their development (Ruhnka and Young, 1987), it is possible to distinguishmore mature portfolio companies from early stage investments. As later stage investmentstargets have already established their market presence, their key developmental goalsinclude achieving market share targets and reaching profitability in order to make it pos-sible for venture capitalists to exit the investment successfully. In comparison to earlystage ventures struggling with challenges related to product, market and organizationdevelopment, the later stage investments face the threat of technological obsolescence andunanticipated competition caused by new entrants (Ruhnka and Young, 1987; Crispin-Little and Brereton, 1989; Branscomb and Auerswald, 2002).

Major risks associated with early stage investments 3

Of all themes related to early stage venture capital research, perhaps most attention hasbeen paid to the nature and extent of risks related to investments in nascent ventures. Itis widely believed that early stage ventures imply higher overall risks and volatility ofreturns than more established portfolio companies (Brophy and Haessler, 1994). Theserisks are particularly serious for new technology-based firms (Bygrave, 1988; Mason andHarrison, 1995; Balboa and Marti, 2004), such as university spin-outs (Wright et al.,2006), due to the long lead time of product development and severe difficulties associatedwith the transfer of technology into the market place.

The high level of risks inherent in early stage venture capital investments can be partlyexplained by the existence of information asymmetries between the venture capitalist andthe entrepreneur (Chan, 1983; Amit et al., 1990; Chan et al., 1990; Sahlman, 1990; Amitet al., 1998). In early stage companies characterized with intangible assets and a heavyreliance on R&D (Gompers and Lerner, 2001), the venture capitalist has only a limitedunderstanding of the quality of the project, and the competence and willingness of theentrepreneur to act in the interest of the other shareholders. Stated differently, early stageventure capitalists are exposed to high levels of ‘hidden information’ and ‘hidden action’on the part of the entrepreneur (Akerlof, 1970; Holmström, 1978). As Amit et al. (1990)put it: an early stage technology investment often involves (Murray and Marriott, 1998)

a technology that has not yet been proven; which is to be incorporated into novel products and/or services which still remain solely in the mind of the entrepreneur; and will eventually be


offered to markets and customers whose existence remains purely hypothetical. On the top ofthese uncertainties, the new enterprise may uncommonly be managed by a technological entre-preneur or a founding team whose experience of commercial practices and disciplines is negli-gible, as are their personal assets by which the venture may be financed or the investmentguaranteed.

The risks inherent in venture capital investments in general and in early stage invest-ments in particular can be further divided to market and agency risks (Gorman andSahlman, 1989; Ruhnka and Young, 1987; 1991; Barney et al., 1994; Fiet, 1995; Murrayand Marriott, 1998; Gompers and Lerner, 2001). Market risk refers to risks due to unfore-seen competitive conditions affecting the size, growth and accessibility of the market, andupon factors affecting the level of market demand. Because of high levels of market risksinherent in young ventures, the early stage investors’ overriding concerns include failuresto capture a large enough market share or to ramp up the production process (Ruhnkaand Young, 1987; 1991; Muzyka et al., 1996).

Agency risk, in its turn, is a risk that is caused by separate and possibly divergent inter-ests of agents and principals (Sahlman, 1990; Fiet, 1995). Agency risks may result inopportunism, shirking, conflicting objectives or incompetence (Parhankangas andLandström, 2004). For example, early stage entrepreneurs might invest in research pro-jects that bring great personal returns but low monetary payoffs to shareholders(Gompers and Lerner, 2001). Agency risks may also result in delays in product develop-ment, or the failure of the founders to comply with the development objectives of theirinvestors (Ruhnka and Young, 1987; 1991; Murray and Marriott, 1998; Gompers andLerner, 2001).

Recent trends in the frequency of early stage investmentsThe market and agency risks inherent in nascent ventures are likely to make investorsdoubtful of their ability to appropriate returns from early stage investments (Branscomband Auerswald, 2002). These doubts may be reflected in the decreasing interest in earlystage investments all over the world. Figure 10.2 shows that the share of early stage invest-ments of the total value of all deals has fallen from approximately 50 per cent in the 1960sto 15 per cent in 2005. The corresponding figure for European early stage investments was12 per cent in 2004 (EVCA/Thomson Venture Economics, 2004).

However, the situation looks less alarming, if the percentage of early stage deals of allinvestments is used as a proxy. As Figure 10.3 shows, 60 per cent of all deals in Europeare seed or early stage investments (Bottazzi et al., 2004).

Characteristics of early stage venture capitalists and fundsAs early stage ventures differ from later stage deals along several dimensions, it shouldcome as no surprise that prior studies also report venture capital firms investing in earlystage companies being fundamentally different from their counterparts focusing on moremature portfolio companies. It has been proposed that early stage investments are typi-cally made by venture capital firms:

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



Source: Venture Economics

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

0%

10%

20%

30%

40%

50%

60%

70%

1960 1980 1990 2005

Source: Bottazzi et al., 2004

Figure 10.3 Venture deals by stage in Europe

Expansion39%

Bridge2%Seed

17%

Start-Up42%

● located in countries with strong laws for contract repudiation and shareholderrights (Cumming, Fleming and Schwienbacher, 2006);

● hiring investors with a higher degree of education than venture capital firms focus-ing on later stage investments (Flynn and Forman, 2001; Bottazzi et al., 2004);

● being older and larger than venture capital firms focusing on later stage deals(Gompers et al., 1998; Dimov and Murray, 2006) and the dominance of older andlarger firms may be explained by their greater expertise and ability to extractbenefits from early stage investments. However, Bottazzi et al. (2004) andSchwienbacher (2002) report some contradictory evidence from the European and

US context, suggesting that young venture capital firms are more likely to engagein seed financing;

● being more often independent than captive (Wright and Robbie, 1996; Kenneyet al., 2002a; 2002b); and

● being less often involved in cross-border investments (Schwienbacher, 2002; Halland Tu, 2003).

In a similar vein, funds focusing on early stage investments tend to have some distinctcharacteristics. Prior research has paid a significant amount of attention to the relationshipbetween fund size and early stage investments, producing somewhat mixed results. Somestudies suggest that as venture capital funds become larger, their interest and involvementin early-stage investments fades (Bygrave and Timmons, 1992; Elango et al., 1995). Thisaversion is closely related to the fact that early stage investments are typically very small andhighly uncertain in terms of their outcome. For growing funds, such investments are oftenuneconomic given the diversion of scarce investment manager talent (Gifford, 1997).However, Dimov and Murray (2006) found a U-shaped relationship between fund size andthe number of seed investments; even though the number of seed investments decreases asthe amount of invested capital increases, seed investments nevertheless become a viableinvestment option after some minimum capital point has been reached. This finding is con-sistent with the idea that funds with a seed focus need to have a minimum scale of efficiencygiven their fixed cost structures (Murray and Marriott, 1998; Murray, 1999).

Studies focusing on the management of the early stage venture capital investmentsAs information asymmetries, market risks and agency risks are an integral part of youngventures, much of the prior literature highlights how venture capitalists may deal withthese challenges over the venture capital cycle and in their relationship with the entrepre-neur. In particular, special attention will be paid to fund raising, appraisal strategies,structuring the deal, monitoring and adding value, as well as exit strategies deployed bythe early stage venture capitalists (see Figure 10.4). The availability and feasibility of theserisk reduction strategies depend, to a large extent, on the institutional context of earlystage investors. Therefore, this section ends with a review of management practicesapplied by early stage venture capitalists embedded in different institutional contexts.

Fund raisingFunds to be invested in early stage ventures may be raised from pension funds, insurancecompanies, banks, government agencies, private individuals or corporate investors. Priorresearch reports that corporate and individual backed funds, academic institutions and,in some cases, pension funds, prefer investments in firms at an early development stage,whereas banks more often invest in later stage deals (Mayer et al., 2005; Schertler, 2005;Cumming, 2006a).

Venture capital commitments to early stage firms have been highly variable over time(Gompers and Lerner, 2001) and across countries (for example, Black and Gilson, 1998;Jeng and Wells, 2000; Megginson, 2004; Mayer et al., 2005). Even though the UnitedStates dominates the early stage scene by the sheer volume of funds directed to nascentventures, the share of early stage venture capital of GDP is even higher in many otherindustrialized nations (Figure 10.5).



Figure 10.4 Managing early stage investments

Structuring

Monitoring andadding value

Exit

Fund raising

Appraisal

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

Figure 10.5 Early stage venture capital investment by country (Percent GDP, 2004)

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These drastic cross-national and temporal variations may partly explain the fact thatseveral studies focus on the role played by various macro-economic and institutionalfactors (for example Söderblom and Wiklund, 2006) in either alleviating or aggravatingrisks associated with investments in young ventures. In a similar vein, investors’ experi-ence, size and prior performance (for example Gompers et al., 1998; Marti and Balboa,2000; Kaplan and Schoar, 2005) seem to facilitate commitments to venture capital funds.A more detailed review on early stage fund raising activities will be provided in the sectiondedicated to institutional environment and the management of venture capital activities.

Appraisal of early stage dealsPrior research has identified several stages of venture capitalists’ appraisal process, includ-ing deal generation, initial screening, second/detailed screening and deal approval(Bygrave and Timmons, 1992; Fried and Hisrich, 1994; Wright and Robbie, 1996).Traditionally, little time was spent on searching for deals, as most proposals received byearly stage venture capitalists were referrals from third parties (Tyebjee and Bruno, 1984).However, increasing competition between the venture capitalists has created a need toallocate more time to the deal generation process (Sweeting, 1991; Shepherd et al., 2005).In a similar vein, early stage venture capitalists exposed to information asymmetries andadverse selection problems (Amit et al., 1990) spend a significant amount of time andeffort in evaluating and screening early stage investment opportunities (Carter and VanAuken, 1994; Kaplan and Strömberg, 2001).

In deal generation and initial screening phases, early stage venture capitalists typicallyfocus on rather general (non-financial) investment criteria, which enable them to concludewhether a proposal is viable for further consideration (Zacharakis and Meyer, 2000). Suchgeneral evaluation criteria include a wide variety of factors, such as:

● completeness and track record of the management team;● attractiveness of the business opportunity and industry;● liquidity of the venture;● possession of proprietary products and product uniqueness;● innovation output; and● similarity of the founding team in comparison to the investor (Tyebjee and Bruno,

1984; MacMillan et al., 1985; 1987; Sandberg et al., 1988; Rea, 1989; Fried andHisrich, 1991; Elango et al., 1995; Muzyka et al., 1996; Zacharakis and Meyer,1998; Shepherd et al., 2000; Kaplan and Strömberg, 2001; Engel and Keilbach,2002; Franke et al., 2002).

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


evaluation criteria presented above. For instance, the study by Zacharakis and Shepherd(2005) suggests that the more munificent the environment, the more importance theventure capitalist attaches to general experience in leadership. In addition, start-up expe-rience may in some cases substitute leadership experience.

Prior studies give us a reason to believe that the evaluation criteria applied by earlystage venture capitalists differ fundamentally from those employed by later stageinvestors. For instance, Birley et al. (1999) found that the leadership potential and opera-tional skills of entrepreneurs dominate when making investments in early stage ventures.However, when evaluating buyouts, the leadership capability of the whole team increasesin importance. In addition, several researchers suggest that early stage investors attachmore importance to the possession of proprietary products, product uniqueness, highgrowth markets and the quality of the entrepreneurial team, whereas late stage investorsare more interested in demonstrated market acceptance, profitability and cash flow as wellas relatively short exit horizons (Fried and Hisrich, 1991; Bygrave and Timmons, 1992;Elango et al., 1995; Wright and Robbie, 1996).

For early stage venture capitalists, the single most important source of information isthe business plan, projecting the future of the company (MacMillan et al., 1985; 1987;Wright and Robbie, 1996). An adverse selection problem arises, as venture capitalists haveto rely greatly on information provided by the entrepreneur. Therefore, venture capitalistsexercise considerable efforts in due diligence in order to verify the robustness of reportedaccounting information, especially profit and cash flow forecasts (Wright and Robbie,1996; Manigart et al., 1997). The due diligence process often involves auditing the macroand legal environment, as well as financial, marketing, production, and managementaspects of a firm (Harvey and Lusch, 1995). In company valuations, venture capitalistsuse various standard methods for valuing investments, such as variations of price earn-ings ratio multiples and capitalized maintainable earnings (EBIT) multiples. However, ithas been found that venture capitalists focusing on early stage investments place signifi-cantly less emphasis on valuation methods based on past performance information(Wright and Robbie, 1996; Wright et al., 1997). When assessing the quality of humancapital, past oriented interviews and work samples tend to increase the decision accuracyfor early stage investors (Smart, 1999), even though this process is usually less time-consuming for seed and start-up investments with smaller entrepreneurial teams withlittle or no track record (Cumming, Schmidt and Walz, 2006).

The valuation processes of early stage investments are intrinsically difficult (Tyebjeeansd Bruno, 1984; Branscomb and Auerswald, 2002). Paradoxically, prior literature hasidentified situations where these difficulties have led to a herd mentality (Lerner et al.,2005) creating an overflow of venture capital in particular sectors (Sahlman andStevenson, 1987). It is more common, however, that venture capitalists impose higherminimum internal rates of return (IRR) and market size hurdles on new, technology-based firms to compensate for higher levels of risk (Elango et al., 1995; Fiet, 1995; Murrayand Lott, 1995; Wright and Robbie, 1996; Manigart et al., 1997; Lockett et al., 2002).According to a British study, two-thirds of early stage investors look for rates of returnof at least 46 per cent, whereas 75 per cent of later stage investors settle for an IRR of35 per cent or below (Wright and Robbie, 1996). As a result, information asymmetriesbetween investors and entrepreneurs are often cited as one of the major reasons for whichpositive net cash flow projects fail to get funded (Leland and Pyle, 1977; Amit et al., 1998).


While relatively little attention is paid to the role of the entrepreneur in the early stagesof the venture capital process, Timmons and Bygrave (1986) and Smith (1999) report thatentrepreneurs evaluate venture capitalists in terms of their value-added, reputation,industry specialization, the amount of capital, experience, and physical location. It hasbeen argued that the entrepreneurs are more likely to accept offers from venture capital-ists with a good reputation, often at a substantial discount of the venture’s value (Hsu,2004). Finally, entrepreneurial teams may also assume an active role in signaling the valueof their venture to prospective investors (for example, Amit et al., 1990; Busenitz et al.,2005). In some cases, third parties, such as technology transfer offices, may assist new ven-tures in the signaling process by participating in screening and preparation of proposalsfor venture capitalists (Wright et al., 2006).

Venture capitalists seem to be relatively skilled in picking the most successful new ven-tures in the industry (Timmons and Bygrave, 1986; Timmons, 1994; Amit et al., 1998).Their superior screening skills may partly explain the growing research interest in the cog-nitive processes of early stage venture capitalists embedded in highly uncertain andambiguous environments conducive to cognitive biases and the use of heuristics indecision-making (Baron, 1998). As a starting point for this stream of literature is thenotion of a venture capitalist as an intuitive decision-maker (Khan, 1987), who does notunderstand his or her decision process (Zacharakis and Meyer, 1998). Reliance on intu-ition may stem from information richness or ‘information overload’ surrounding new ven-tures, making it impossible for investors to increase the quality of decision making bycollecting and processing more information (Zacharakis and Meyer, 2000; 1998). Priorstudies have identified several heuristics characteristic to the venture capitalist’s decisionmaking, such as representative and satisfying heuristics (Gompers et al., 1998; Zacharakisand Meyer, 2000). Even though these heuristics may speed up the decision making processand allow more time for value-adding activities, they may also lead to the underestima-tion of risks and a herding phenomenon (see Chapter 6 by Zacharakis and Shepherd). Ithas also been found that venture capitalists may suffer from overconfidence and attribu-tion bias, causing them to overestimate the likelihood of success and to attributefailure to external, uncontrollable events, rather than to their own actions or incompe-tence (Zacharakis et al., 1999; Zacharakis and Shepherd, 2001; Shepherd et al., 2003).

Within this cognitive research stream, there are also studies analyzing the attempts ofseed and early stage investors to reduce ambiguity surrounding their investment decisions.For instance, Fiet (1995) focuses on the reliance of formal and informal networks inventure capital decision making. Moesel et al. (2001) and Moesel and Fiet (2001), in theirturn, set out to explore how early stage venture capitalists use various sense-making tech-niques to perceive and interpret different forms of order amidst the apparent chaos of theemerging industry segments. Finally, there is a growing stream of literature analyzing howventure capitalists may use various decision aids to improve their decision making quality(Khan, 1987; Zacharakis and Meyer, 2000; Shepherd and Zacharakis, 2002; Zacharakisand Shepherd, 2005).

Structuring early stage investments and investment portfoliosPrior literature has extensively scrutinized how venture capitalists structure individualventure capital investments and investment portfolios as a safeguard against moral hazardand information asymmetries inherent in early stage investments (Sahlman, 1990; Kaplan


and Strömberg, 2001; Cumming, 2005b). Prior studies have identified four major mecha-nisms of risk reduction: 1) contractual covenants included in the venture capitalcontracts; 2) the use of preferred convertible stock; 3) staged capital infusion; and 4) com-pensation schemes aligning the interests of venture capitalists and entrepreneurs.

First, venture capital contracts typically give investors cash-flow rights, voting rights,board rights, liquidation rights, as well as non-compete and vesting provisions (Sahlman,1990). Prior studies suggest that these rights are more often granted to early stageinvestors, fraught with information asymmetries and hold-up problems (Carter and VanAuken, 1994; Kaplan and Strömberg, 2001; Cumming, Schmidt and Walz, 2006). Second,there is some empirical evidence indicating that convertible preferred equity may mini-mize the expected agency problems associated with start-up and expansion stage invest-ments (for example, Sahlman, 1990; Gompers, 1997; Bascha and Waltz, 2001; Kaplan andStrömberg, 2001; Cumming 2002),4 whereas debt and common stock are more appropri-ate at the later stages of venture financing (Trester, 1998). Third, staged capital infusiongives investors the option to cut off badly performing ventures from new rounds of financ-ing (Sahlman, 1990; Gompers, 1995; Gompers and Lerner, 2001), thus minimizing thelosses carried by the early stage venture capitalist. Fourth, while both venture capitalistsand entrepreneurs receive a substantial fraction of their compensation in the form ofequity and options, they also have an additional incentive to maximize the value of theportfolio company. The venture capitalist may also employ additional controls on com-pensation, such as vesting of the stock option over a multi-year period, making it impos-sible for the entrepreneur to leave the firm and take his or her shares (Gompers and Lerner,2001). It is interesting to note that similar compensation schemes contingent on perform-ance, contractual covenants and high levels of monitoring are also applied to mitigateagency problems between venture capitalists and their fund providers (Sahlman, 1990;Robbie et al., 1997; Wright and Robbie, 1998).

Venture capitalists may also manage risks on the portfolio level by focusing on partic-ular industries or geographical areas, limiting the size of investments, or by investing insyndicates. For instance, there are studies indicating that venture capitalists preferless industry diversity and a narrower geographical scope, when dealing with high risk(early stage) investments (Gupta and Sapienza, 1992; Norton and Tenenbaum, 1992).According to Robinson (1987), venture capitalists generally favor a larger number ofsmaller investments in early stage ventures in comparison to larger investments in moremature portfolio companies. Ruhnka and Young (1987), in their turn, suggest that venturecapitalists may elicit risks by distributing their investments across various investmentstages. Finally, several authors suggest that the risk sharing motivation for syndication issignificantly more important for early stage venture capitalists than for venture capitalfirms investing in later stages only (Bygrave, 1988; Lerner 1994; Gompers and Lerner,2001; Lockett and Wright 2001; Lockett et al., 2002; Kut et al., 2005; Cumming, 2006a;Cumming, Schmidt and Walz, 2006).

Monitoring and adding value in early stage investmentsIt is argued that venture capital investors may address the problems of asymmetric infor-mation not only by intensively scrutinizing firms before their investment decision andstructuring their investment portfolios with great care, but also by monitoring their port-folio companies afterwards (Lerner, 1999). As evidence of a more hands-on role of early


stage investors, several scholars found that they spend more time with their portfolio com-panies than later stage investors (Barney et al., 1989; Gorman and Sahlman, 1989;Sapienza and Gupta, 1994). In a similar vein, early stage investors are reported to be moreeager to require corrective actions, such as changes in management, if the new venturefails to live up to the expectations (Carter and Van Auken, 1994; Hellman and Puri, 2002).However, some contradicting evidence exists suggesting that portfolio companies receivemore venture capitalists’ attention as they mature (Gomez-Mejia et al., 1990). In addition,some studies propose that the differences in the level of venture capital involvement arenot stage-related (MacMillan et al., 1988; Fried and Hisrich, 1991; Sapienza, 1992), butdepend on a host of other factors, such as the size of the venture capital firm, its level ofexperience, the size of the investment, the power of the board of directors or the charac-teristics of the portfolio company (Flynn, 1991; Fiet et al., 1997; Flynn and Forman,2001). For instance, Sweeting and Wong (1997) demonstrate that venture capitalistsadopting a hands-off approach tend to focus on companies that are well-managed and ledby experienced teams with proven track records.

In addition to intensive monitoring, early stage venture capitalists may attempt toincrease the value of their investment by providing several ‘value-added services’ to theirportfolio companies. Several scholars conclude that venture capitalists investing in earlierstages take a more active managerial role in a young firm (Rosenstein et al., 1993; Carterand Van Auken, 1994; Sapienza and Gupta, 1994; Sapienza et al., 1994; Elango et al.,1995; Sapienza et al., 1996). The value-adding activities provided by venture capitalistsinvolve evaluating and recruiting managers after the investment decision, negotiatingemployment contracts, contacting potential vendors, evaluating product market oppor-tunities, or contacting potential customers (Timmons and Bygrave, 1986; MacMillanet al., 1988; Gorman and Sahlman, 1989; Fried and Hisrich, 1991; Elango et al., 1995;Kaplan and Strömberg, 2001; Hellman and Puri, 2002). Flynn (1991) goes as far as tostate that early stage venture capitalists take a leadership role in administrative and strate-gic responsibilities of a new firm. It seems that the level of early stage venture capitalists’involvement in value-adding activities is determined by various human capital and fundcharacteristics: prior consulting, industry and entrepreneurial experience of the venturecapitalist contribute to a higher level of value-adding activities. Prior studies also reportthat investment managers of diversified portfolios and captive funds spend less time withtheir portfolio companies (Sapienza et al., 1996; Lockett et al., 2002; Megginson, 2004;Knockaert et al., 2006).

The active involvement of the venture capitalist in the operations of a new ventureseems to matter from a financial point of view (Barney et al., 1994; Flynn and Forman,2001; Cumming et al., 2005). It has been suggested that the involvement of venture cap-italists may help the professionalization of young firms and speed up the commercializa-tion of innovations (Timmons and Bygrave, 1986; Cyr et al., 2000; Engel and Keilbach,2002; Hellman and Puri, 2002). Venture capital financing may enhance the portfoliocompany’s credibility in the eyes of third parties, such as suppliers, customers and otherinvestors, whose contributions will be crucial for the company’s success (Megginson andWeiss, 1991; Steier and Greenwood, 1995; Black and Gilson, 1998). Flynn (1995) providespreliminary evidence that the degree of analysis, assistance in the articulation of strategy,and pressure to view issues from a longer term perspective by the venture capitalist arepositively associated with the overall performance of a new venture.


Prior studies also emphasize the importance of the relationship quality betweenthe venture capitalist and the entrepreneur (for example, Fried and Hisrich, 1995). Sapienzaand Koorsgaard (1996) highlight the importance of entrepreneurs’ timely feedback ofinformation in building trustful relationships with the investor and securing future funding.Higashide and Birley (2002) argue that conflict as disagreement can be beneficial for theventure performance, whereas conflict as personal friction is negatively associated withsuccess. In a similar vein, Busenitz et al. (2004) report a positive association between newventure performance and procedurally just interventions by venture capitalists.

Exit strategies and performance of early stage investmentsThere exists some evidence suggesting that early stage venture capitalists view either tradesales or initial public offerings (Carter and Van Auken, 1994; Murray, 1994; Amit et al.,1998; Black and Gilson, 1998; Das et al., 2003) as their preferred route to exit.Surprisingly enough, very few early stage venture capitalists regard later stage investorsas an attractive exit option (Murray, 1994). In their study focusing on the duration ofventure capital investments, Cumming and MacIntosh (2001) found that earlier stagedeals are likely to be held for a shorter period of time than later stage investments, sug-gesting significant culling of early stage deals.

Several scholars report higher returns to later stage investments in comparison to earlystage deals (Murray and Marriott, 1998; Murray, 1999; Cumming, 2002; Manigart et al.,2002; Hege et al., 2003; Cumming and Waltz, 2004). However, early stage investors in theUnited States tend to outperform their colleagues focusing on later stage deals andinvestors in other parts of the world. These differences in performance may reflect thesuperior ability of the US investors to manage early stage investments (Sapienza et al.,1996) or, alternatively, structural issues related to the minimum viable scale for atechnology-based venture capital fund (Murray and Marriott, 1998; Murray, 1999). Theperformance of the US and European venture capital funds by stage of investment isdepicted in Table 10.2.

A wealth of studies focuses on the determinants of returns to venture capital invest-ments (for example, Cumming, 2002; Gottschalg et al., 2003; Ljungqvist and Richardson,2003; Kaplan and Schoar, 2005). However, it is important to note that these studies focus


Table 10.2 European and US private equity funds’ pooled internal rates of return(IRR%) by stage of investment in 2003

USEurope Europe Europe Europe US US US 10-1-Year 3-Year 5-Year 10-Year 1-Year 3-Year 5-Year Year

Stage IRR IRR IRR IRR IRR IRR IRR IRR

Early stage �1.0 �8.8 �5.5 �0.6 38.9 �7.7 �1.5 44.7Balanced 0.5 �5.7 �0.9 10.3 14.7 0 0.4 18.2Buyout 22.8 2.6 5.7 12.5 12.2 2.8 1.0 8.6

Note: The sample includes funds created in 1980–2003.

Source: EVCA/Thomson Venture Economics

on venture capital funds in general, not on early stage funds in particular. These studiesreport that:

● specialization exerts a positive impact on returns, possibly due to learning curveeffects enjoyed by venture capitalists accumulating superior knowledge in a specificindustry sector (Gupta and Sapienza, 1992; De Clerq and Dimov, 2003);

● successful venture capitalist firms outperform their peers over time, suggesting ‘per-sistence phenomena’ or the development of core competences that cannot be easilyimitated (Gottschalg et al., 2003; Ljungqvist and Richardson, 2003; Cumminget al., 2005; Diller and Kaserer, 2005; Kaplan and Schoar, 2005);

● the relationship between experience and performance is ambiguous. For instance,Manigart et al. (2002) and Diller and Kaserer (2005) report a positive relationship,Fleming (2004) reports no relationship and De Clerq and Dimov (2003) an adverserelationship between experience and performance;

● larger funds outperform smaller funds, but only up to a point, suggesting aninverted U-shaped relationship between fund size and performance (Gottschalget al., 2003; Hochberg et al., 2004; Laine and Torstila, 2004; Kaplan and Schoar,2005);

● fast fund growth is negatively associated with performance (Kaplan and Schoar,2005);

● the number of portfolio companies per investment manager and performanceexhibit an inverted U-shaped curve (Jääskeläinen et al., 2002; Schmidt, 2004);

● performance is positively associated with the number of endowments and nega-tively associated with the number of banks investing in the fund (Lerner et al.,2005); and

● narrow geographical focus is associated with lower performance (Manigart et al.,2002).

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


Institutional context and the management of early stage investmentsCross-national differences in the management of early stage investments have received afair amount of attention in venture capital literature. Prior studies report that suchdifferences may exist in the way in which the venture capital firms are organized, as well asin fund raising, deal generation, deal screening, investment structure and post-investmentactivities. On the whole, these institutional differences may play a major role in deter-mining the ability of early stage investors to shield themselves from risks and profit fromtheir investments.

For instance, Megginson (2004) shows that venture capital firms in the United Statesusually take the form of independent limited partnerships and obtain their funding frominstitutions, such as pension funds. This structure and larger average fund size offer sub-stantial contracting benefits for investors operating under information asymmetries anduncertainty (Murray and Marriott, 1998; McCahery and Vermeulen, 2004; Söderblomand Wiklund, 2006). Europeans, in their turn, organize their venture capital firms asinvestment companies or subsidiaries of larger financial groups (Wright et al., 2005).

Factors promoting fund raising activities include GDP growth and the growth rate ofR&D (Gompers et al., 1998; Jeng and Wells, 2000; Romain and Pottelsberghe, 2004),favorable tax, regulatory and legal environments (La Porta et al., 1997; Gompers et al.,1998; Marti and Balboa, 2000; Da Rin et al., 2005, forthcoming), and government pro-grams facilitating investments in young ventures (Lerner, 2002; Leleux and Surlemont,2003; Cumming, 2006b, forthcoming). Commitments to early stage ventures are nega-tively affected by labor market rigidities (Black and Gilson, 1998; Jeng and Wells, 2000;Romain and van Pottelsberghe, 2004), high capital tax gains (Gompers et al., 1998), and,in some cases, the presence of government programs crowding out private venturecapital investors (Armour and Cumming, 2004). There is some disagreement among theresearchers regarding the role of deep and liquid stock markets. While some researchersargue that venture capital fund raising is boosted by well-functioning public markets thatallow new firms to issue shares (Black and Gilson, 1998; Armour and Cumming, 2004;Da Rin et al., 2005, forthcoming), others argue that this positive effect exists only for laterstage investments and not for early stage deals (Jeng and Wells, 2000). As the aforemen-tioned determinants of fund raising have mostly been studied in the context of venturecapital in general,5 future research should confirm these results for early stage venturecapital in particular.

It is worth mentioning that the studies focusing on the determinants of funds raised byearly stage venture capitalists largely ignore cultural and social factors (Wright et al.,2005). A notable exception is the study by Nye and Wassermann (1999) showing thatdiffering levels of cultural learning contribute to different rates of growth of venturecapital industries in India and Israel. In a similar vein, cultural factors may play a signifi-cant role in either promoting or hindering entrepreneurship, thus affecting the supply ofhigh quality investment opportunities available for early stage venture capitalists (Acs,1992; Baygan and Freuedenberg, 2000; Hayton et al., 2002; Kenney et al., 2002b).

Relative to deal generation, deal screening and valuation, several researchers concludethat venture capitalists in the United States apply a more comprehensive set of criteria forevaluating risks associated with new ventures than their colleagues in other parts of theworld (Ray, 1991; Ray and Turpin, 1993; Knight, 1994; Hege et al., 2003). Also the rela-tive importance of evaluation criteria may vary across nations. Americans tend to value


potential for significant market growth, whereas venture capitalists in transitioneconomies rely on foreign business education or exposure to Western business practicesas an important signal of managerial ability. Asian venture capitalists, in their turn, seekpersonality compatibility when assessing management teams (Ray, 1991; Knight, 1994;Bliss, 1999). In addition, prior studies suggest that venture capitalists in developedmarkets use external specialists for investment appraisal and apply sophisticated valua-tion procedures based on standard corporate finance theory. Investors in emergingventure capital industries, in their turn, rely on their own expertise and cash flow methodsfor valuation and put greater emphasis on information related to product, market andproposed exit (Ray, 1991; Ray and Turpin, 1993; Wright and Robbie, 1996; Karsai et al.,1997; Manigart et al., 2000; Lockett et al., 2002; Wright et al., 2004).

Variations in corporate and tax law environments may have implications for the financ-ing structure of venture capital investments (Wright et al., 2005). For example, convert-ible instruments are more widely used in common law countries than in civil law countries(Cumming, 2002; Cumming and Fleming, 2002; Hege et al., 2003; Kaplan et al., 2003;Cumming, 2005a; Lerner and Schoar, 2005). Kaplan et al. (2003) report that venturecapital contracts vary across legal regimes in terms of the allocation of cash flow, board,liquidation and other control rights. However, more experienced venture capitalists allover the world seem to implement US-style contracts regardless of the legal regime.Finally, the motivations for and the use of syndication strategies tend to differ dependingon the institutional context (Manigart et al., 2006).

Although investors’ monitoring behavior shares many similarities across nations (Ray,1991; Pruthi et al., 2003; Bruton et al., 2005), there exist some differences relative to thenature of post-investment relationship between the entrepreneur and the venture capital-ist. The active managerial role adopted by the venture capitalist tends to be particularlyvisible in the US high-tech industries, where many senior partners have become legendaryfor their skills in finding, nurturing and bringing to market high-tech companies(Megginson, 2004). In line with this reasoning, Sapienza et al. (1996) found that venturecapitalists in more developed venture capital markets (the United States and the UnitedKingdom), are more involved in their portfolio companies and add more value than theircolleagues in less developed venture capital markets (France). Hege et al. (2003) andSchwienbacher (2002), in their turn, report that US venture capital firms, in comparisonwith European firms, are more likely to take corrective actions in their portfolio compa-nies. Unlike Westerners, Asians view capitalist firms and their portfolio as a single collec-tive entity, which reduces the need to manage and control the agency risks (Bruton et al.,2003). This greater relationship orientation stemming from a more collectivistic culture isalso reflected in the value-added services provided by venture capitalists while Americanventure capitalists are more involved in serving as a sounding board to the venture and infinancially oriented services, Asian venture capitalists emphasize the efforts to build rela-tionships both inside and outside of the firm. Prior research also reports cross-nationalvariations in preferred exit strategies and the timing of exit (Cumming and MacIntosh,2003; Cumming, Schmidt and Walz, 2006). For instance, IPOs are reported to be a morecommon exit vehicle in countries where legal investor protections are strong, whereas buy-backs gain importance in countries with a weaker legal framework protecting the interestsof investors.

The effect of various environmental and institutional factors on fund performance is


mostly indirect in nature (Söderblom and Wiklund, 2006). However, there is someevidence that overall business cycles, industry cycles and stock market cycles (Gottschalget al., 2003; Avnimelech et al., 2004; Diller and Kaserer, 2005; Kaplan and Schoar, 2005)directly influence the returns to early stage funds. A factor that also seems to have a majorimpact on fund performance is the allocation and level of funds. Several researchers showthat an increase in the allocation of money exerts a significant negative impact on fundperformance (Gompers and Lerner, 2000; Ljungqvist and Richardson, 2003; Hochberget al., 2004; Da Rin et al., 2005, forthcoming; Diller and Kaserer, 2005). Finally, legal pro-tections available for investors have been reported to contribute to the superior perform-ance of venture capital funds (Armour and Cumming, 2004; Kaplan et al., 2003;Cumming and Walz, 2004; Lerner and Schoar, 2005).

To sum up the discussion above, investors in successful early stage venture capitalmarkets (in terms of the volume of and return on investments) tend to be more active inalleviating risks associated with early stage venture capital investments. This more exten-sive reliance on risk reduction strategies may be explained by the superior skills ofinvestors operating in mature markets and institutional environments with favorable legis-lations, government policies and tax regimes. It is noteworthy, however, that the verynature of risk, or at least the perception of it, may differ depending on the institutionalenvironment. Therefore, the solutions originating mostly from the Anglo-Saxon contextmay not be readily applicable in nations with drastically different normative, cognitive andregulatory institutions.

Conclusions and discussionThe purpose of this chapter was to review decades of research on early stage venturecapital, basically focusing on two major research themes. The first one describes thedifferences between investments in early stage ventures and later stage deals. The seconddominant theme identifies several management practices available for early stage venturecapitalists exposed to high levels of information asymmetries and related risks. I will firstsummarize the key findings emerging from these two research streams. Thereafter, I willcontinue with some theoretical and methodological considerations, as well as suggestionsfor future research.

Summary of key findingsBased on the studies discussed above, it is possible to argue that early stage investmenttargets, investors and funds differ from those involved in later stage venture capital activ-ities. Perhaps most importantly, early stage ventures struggle with challenges associatedwith new product and market development, building up a competent management teamand managing growth, making them more susceptible to market and agency risks thanmore mature investment targets. The venture capital firms focusing on early stage invest-ments tend to be shielding themselves from these risks by relying on their experience andsize. In a similar vein, there seems to be a minimum scale of efficiency, after which earlystage investments become a viable option for venture capital funds. Early stage venturecapital has also been found to flourish in institutional environments enjoying favorabletax, regulatory and legal environments, providing investors with incentives and protectionfrom various market and agency risks.

Prior literature suggests that early stage venture capitalists actively seek to reduce the


risks and uncertainties at every stage of the venture capital cycle. First, prior studies listseveral criteria along which early stage venture capitalists and entrepreneurs may assesseach other’s potential. The most recent literature pays increasing attention to the cog-nitive processes of venture capitalists in highly uncertain decision contexts. Second,early stage investors may alleviate information asymmetries and risks through contrac-tual covenants included in the venture capital contracts, the use of preferred convertiblestock and staged capital infusion, as well as compensation schemes aligning the inter-ests of venture capitalists and entrepreneurs. Venture capitalists may also attempt tocontrol the risks by focusing on particular industries or geographical areas, limiting thesize of the investments, or investing in syndicates. Third, early stage venture capitaliststypically devote a substantial amount of time to monitoring and value-adding activitiesin the post-investment phase. Finally, relative to the exits and fund performance, earlystage investors are reported to severely under-perform in later stage deals. In a similarvein, American early stage funds enjoy significantly higher returns than their counter-parts in Europe. The factors determining the performance of early stage venture capitalinvestments include the characteristics of venture capital firms and funds, the manage-ment of the investment process, as well as various macro-economic and institutionalfactors.

Theoretical and methodological considerationsResearch on early stage venture capital has been conducted by scholars representing manydifferent disciplines, most notably finance and economics, entrepreneurship and cognitivepsychology. First, finance scholars (for example, Chan, 1983; Amit et al., 1990; 1998;Lerner, 1994; Gifford, 1997; Gompers, 1995; 1997; Elitzur and Gavious, 2003; Hsu, 2004)have primarily relied on asymmetric information, signaling and agency theories whentrying to explain the nature of the relationship between venture capitalists and early stageventures. Given this theoretical orientation, the focus tends to be on the dark side of theventure capitalist–entrepreneurship interaction and how venture capitalists may alleviateproblems associated with moral hazard and asymmetric information all over the world(for example, Cumming and Fleming, 2002; Hege et al., 2003; Kaplan et al., 2003; Lernerand Schoar, 2005).

Second, entrepreneurship scholars have traditionally taken a rather atheoreticalapproach (for example, Camp and Sexton, 1992; Carter and Van Auken, 1994; Elangoet al., 1995; Brouwer and Hendrix, 1998; Balboa and Marti, 2004) or borrowed from‘Stages of Development Theories’ of new ventures (Ruhnka and Young, 1987; Flynn andForman, 2001), when describing the global trends in early stage venture capital invest-ments or identifying characteristics distinguishing early stage ventures from laterstage deals. However, more recently, entrepreneurship scholars have turned to strategyand sociology literature – drawing mostly on the resource-based theory, procedural justicetheory and institutional theory, when analyzing the intricacies of the social relationshipsin early stage venture capital investments (Fiet et al., 1997; Karsai et al., 1997; Bruton andAhlstrom, 2002; Bruton et al., 2002; Busenitz et al., 2004; Manigart et al., 2002; Brutonet al., 2005). Unlike the studies conducted by finance scholars, this research stream tendsto emphasize more the sunny side of early stage venture capital investments as engines ofgrowth and innovation and the crucial role of venture capitalists as providers of value-added services to nascent ventures.


It is important to note that both finance and entrepreneurship scholars emphasizeissues embedded in the venture capitalist–entrepreneur relationship and the externalenvironment surrounding nascent ventures. An emerging stream in early stage venturecapital research has taken a more introspective view by focusing on the role of cognitiveand sensemaking processes of venture capitalists (for example Zacharakis and Meyer,1998; Moesel and Fiet, 2001; Moesel et al., 2001; Zacharakis and Shepherd, 2001). Thisshift in focus is hardly unexpected, as cognitive processes are likely to play a crucial rolein the reduction of uncertainty and chaos surrounding new ventures.

In terms of research methods used, there is relatively little variation in early stageventure capital research. A vast majority of studies reviewed adopt a quantitativeapproach relying on information derived from surveys or data base data. Only a fractionof papers represents either a purely theoretical or qualitative approach. However, it seemslikely that as our need for a more in-depth understanding of early stage venture capitalgrows, other research methods, such as experiments and ethnographies, will increase inimportance in the future.

Moving forward: Suggestions for future researchAfter decades of research, our knowledge on early stage venture capital remains limited.For instance, although several scholars have acknowledged the recent declining trend ininvestments in early stage ventures, we still know very little about the reasons underlyingthis development. Therefore, future studies should set out to identify changes in the incen-tive systems and governance structures within the venture capital industry, potentiallyexplaining the relative decline in investments in young ventures. Approaching this ques-tion would also necessitate a shift toward more longitudinal research methods than hith-erto applied in early stage venture capital research.

Second, several studies suggest that the financial needs of early stage ventures might bebest addressed by a combination of public funding schemes and informal venture capital(Branscomb and Auerswald, 2002). An interesting area for future research would thus beaddressing the complementarities between public funding and early stage venture cap-italists (Lerner, 2002) or the synergies between business angel funding and early stageventure capital (Harrison and Mason, 2000).

Third, there seem to be significant regional differences in the operations and perform-ance of early stage venture capitalists. On the one hand, prior literature gives us a reasonto believe that the Anglo-Saxon nations in general and the United States in particular havemanaged to create an institutional environment conducive to early stage venture capital,and therefore, could act as role models for other nations. On the other hand, it is also pos-sible to argue that nations with institutional environments drastically different from thatof the United States should develop their own versions of early stage venture capital. Aninteresting avenue for future research would thus involve exploring how this modifiedversion of venture capital should look, operate and help investors deal with risks inher-ent in early stage investments.

Fourth, the greatest challenges associated with early stage venture capital investmentsare cognitive in nature. These challenges relate to the perceptions of risks and sense-making processes of venture capitalists facing chaotic environments surrounding newventures. As Fried and Hisrich (1994) put it, successful venture capitalists are, above all,efficient information processors and producers. This gives us a reason to believe that


research on early stage venture capital will continue to benefit from borrowing fromresearch on human cognition and information processing mechanisms.

Notes1. The author would like to thank Hans Landström, Mike Wright, and the participants of the Workshop on

Venture Capital Policy in Lund for their invaluable comments on the earlier version of this chapter.2. I used ABI Inform/Proquest, JSTOR, Google Scholar and SSRN electronic databases to identify suitable

references. In addition, I reviewed the reference sections of all articles to find more relevant references. Themain focus of the literature search was on papers focusing explicitly on early stage venture capital and onarticles comparing early stage venture capital to investments in later stage deals.

3. Strictly speaking, there is a distinction between uncertainty and risk: risk is an uncertainty for which prob-ability can be calculated (with past statistics, for example) or at least estimated (doing projection scenarios).However, for uncertainty, it is impossible to assign such a (well grounded) probability (www.wikipedia.org).In this chapter, these two terms are often used as synonyms, reflecting their usage in prior studies.

4. However, Norton and Tenenbaum (1993) and Cumming (2005a; 2006a) found that the use of preferredstock is not more frequent in early stage ventures.

5. The studies reviewed herein focus on the performance of venture capital funds, excluding buyouts. However,these studies do not focus solely on seed, start-up and first stage investments.

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11 Private equity and management buy-outsMike Wright

IntroductionManagement buy-outs and related transactions involve simultaneous changes in the own-ership, financial structure and incentive systems of firms. Although buy-outs can betraced back to the eighteenth and nineteenth centuries, the modern phenomenon beganto appear in the late 1970s in the US and diffused to the UK in the early 1980s (Wrightet al., 1991). Buy-outs represent an important part of private equity markets internation-ally, yet present major challenges that may differ from investing in early stage entrepre-neurial ventures (see Chapter 10).

In terms of their importance to private equity markets, buy-outs have accounted formajor shares of both the volume and value of transactions since the 1980s (Wright et al.,2000a). In many European private equity markets they account for the majority of fundscommitted annually (EVCA, 2004). Buy-outs have played an important role in the tran-sition from Communism in Central and Eastern Europe from the beginning of the 1990s(Wright et al., 2002a). Buy-outs offered a mechanism to effect transition that wouldenhance the ownership and control of enterprises where there were strong insider inter-ests and often an absence of external buyers. For similar reasons, further privatization andrestructuring activity has seen the spread of buy-outs to Africa (Wright et al., 2000c).Buy-outs are now spreading in significant numbers to Asia in both developed markets thatneed to restructure, such as Japan and Korea, as well as emerging and transitioneconomies such as China (Wright et al., 2003a).

By enabling corporations to restructure, buy-outs have become an important part ofthe overall mergers and acquisitions market, for example, accounting for the majority oftransactions in the UK (CMBOR, 2005). The incentive and monitoring mechanisms theyintroduce may help to enhance firm performance. These mechanisms, coupled with thelower risk from investing in established firms, have contributed to private equity firms’buy-out portfolios outperforming other venture capital investment stages (EVCA, 2004;BVCA, 2004).

In terms of challenges, buy-outs raise a number of important issues across the privateequity investment life-cycle that may differ from those relating to early stage investments.Buy-outs involve more established businesses that reduce some of the problems associ-ated with early stage ventures such as the identification of a new market and the valua-tion of businesses with little or no cash-flow. However, buy-outs raise challenges thatrelate, for example, to the identification of ways to generate capital gains in mature busi-nesses, to whether managers of existing businesses can make the transition to owner-managers and become entrepreneurial, to achieving the appropriate balance of debt andequity financing in structuring transactions, and to the identification of suitable means toobtain capital gains from businesses that may be difficult to exit through an IPO.

This chapter examines the issues relating to private equity and management buy-outs.The buy-out literature can be characterized as having two main streams, a finance stream

281

and an entrepreneurship stream. In the US, buy-outs have traditionally been viewed as acorporate finance phenomenon (Jensen, 1989; 1993). The major focus of much researchis on financial aspects relating to buy-outs at the bought out firm level. This research hasexamined in detail the antecedents of buy-outs and their performance effects. In Europe,buy-outs have tended to be viewed as an entrepreneurial phenomenon with the privateequity market having a long-standing involvement (Wright and Coyne, 1985). Thischapter seeks to integrate these streams and generate themes for further research. Thereis relatively little work, however, that considers the whole of the private equity investmentlife-cycle. Similarly, little work has examined the role of private equity financiers and themanagers and entrepreneurs in the bought out companies.

The structure of the chapter is as follows. The first section provides an overview of thedevelopment of buy-outs, starting with a consideration of definitions of buy-outs. This isfollowed by a brief elaboration of a framework for analysing the factors leading to thedevelopment of a private equity-based buy-out market and a review of the developmentof the main private equity-backed buy-out markets. The second principal section analy-ses private equity and buy-outs using a life-cycle perspective. Specifically, this section con-siders buy-out deal generation and antecedents; screening and negotiation; valuation;structuring; monitoring and adding value; and exit and longevity. Both theoretical per-spectives and empirical evidence are considered. Finally, some conclusions are presentedand areas for further research outlined.

The development of private equity and buy-outsThis section begins by defining different forms of buy-out. It goes on to outline the factorsinfluencing the development of a private equity-based buy-out market and then summa-rizes the trends in the international growth of buy-out markets.

Definitions of buy-outsIn general, buy-outs involve the creation of a new independent entity in which ownershipis concentrated in the hands of management and private equity firms, if present, with sub-stantial funding also provided by banks. Private equity firms become active investorsthrough taking board seats and specifying contractual restrictions on the behaviour ofmanagement which include detailed reporting requirements. Lenders also typicallyspecify and closely monitor detailed loan covenants (Citron et al., 1997).

As shown in Table 11.1, buy-outs may take a number of forms. In a leveraged buy-out(LBO), typically a publicly-quoted corporation or a large division of a group is acquiredby a specialist LBO association. In the US, the resulting private company is typically con-trolled by a small board of directors representing the LBO association, with the CEOusually the only insider on the board (Jensen, 1989; 1993). As the name suggests, thesedeals are generally highly leveraged, with the LBO association acquiring a significantequity stake. The same institutions may be involved as debt and equity subscribers – undera so-called ‘strip financing’ arrangement – or, alternatively, specialist institutions may beinvolved with debt instruments ranging from secured loans to junk bonds (Jensen, 1989).

By contrast, a management buy-out (MBO) usually involves the acquisition of adivested division or subsidiary or of a private family-owned firm by a new company inwhich the existing management takes a substantial proportion of the equity. In place ofthe LBO association, MBOs usually require the support of a private equity firm. The


former parent may retain an equity stake, perhaps to support a continuing trading rela-tionship. In smaller transactions management are likely to obtain a majority of the votingequity (CMBOR, 2005). MBOs typically involve a small group of senior managers asequity-holders but depending on circumstances equity-holding may be extended to othermanagement and employees, creating a management–employee buy-out (MEBO).MEBOs may occur, for example, where it is important to tie in the specific human capitalof the employees or where a firm is widely spread geographically, making direct manage-ment difficult, or on privatization where there is a need to encourage trade unions tosupport the transfer of ownership (for example, in bus services and transportation).

A management buy-in (MBI) (Robbie et al., 1992) is simply an MBO in which theleading members of the management team are outsiders. Although superficially similarto MBOs, MBIs carry greater risks as incoming management do not have the benefits ofthe insiders’ knowledge of the operation of the business. Venture capitalists have soughtto address this problem by putting together hybrid buy-in/management buy-outs (so-called BIMBOs) to obtain the benefits of the entrepreneurial expertise of the outsidemanagers and the intimate internal knowledge of the incumbent management.

Investor-led buy-outs (IBOs) involve the acquisition of a whole company or a divisionof a larger group in a transaction led by a private equity firm and are also referred to asbought deals or financial purchases. The private equity firm will typically either retainexisting management to run the company or bring in new management to do so, oremploy some combination of internal and external management. Incumbent manage-ment may or may not receive a direct equity stake or may receive stock options. IBOsdeveloped in the late 1990s when private equity firms were searching for attractive dealsin an increasingly competitive market and where corporate vendors or large divisionswere seeking to sell them through auctions rather than giving preference to incumbentmanagers.

Leveraged build-ups (LBUs) involve the development of a corporate group based onan initial buy-out or buy-in which serves as a platform investment to which are added aseries of acquisitions. LBUs developed as private equity firms sought new means of gen-erating returns from buy-out type investments. The initial platform deal may need to beof a sufficiently large size for it to attract the management with the skills and experienceto grow a large business through acquisition. LBUs may be attractive in fragmented

Private equity and management buy-outs 283

Table 11.1 Definitions of buy-outs

Management Buy-out (MBO) Existing Management Main Non-Venture Capital OwnersManagement Buy-in (MBI) Outside Individuals Main Non-Venture Capital OwnersManagement Employee Buy-out Existing Management and Employees Significant Owners

(MEBO)Leveraged Buy-out (LBO) Outside LBO Association Main Owners; high debtInvestor-led Buy-out (IBO) Venture Capital Firm Initiates Transaction; Management

Some EquityLeveraged Build-up (LBU) Initial Buy-out Used as a Platform to Develop Larger

Group By AcquisitionsBuy-in Management Buy-out Hybrid Buy-in/Buy-out

(BIMBO)

industries with strong demand prospects. The potential problems with LBUs relate to theidentification, purchase and subsequent integration of suitable acquisition candidates.

Factors influencing the development of a private equity-based buy-out marketWright et al. (1992) develop a framework to examine the factors influencing thedifferential development of management buy-out markets. They identify three mainfactors that need to be present for a buy-out market to develop:

● The generation of deal opportunities is likely to be heavily influenced by both thesupply of deal flow from different vendor sources and the demand for private equityin terms of the willingness of managers to take risks and their willingness to buyenterprises.

● The infrastructure to complete transactions includes sources of funding both inrespect of private equity and the availability of senior and mezzanine debt. It alsocovers the nature of legal and taxation regimes, including corporate reportingregimes, and the existence of advisors who can both identify and negotiate buy-outs.

● The existence of suitable exit routes comprises the availability of stock markets,mergers and acquisitions markets and the scope for recapitalizations through sec-ondary buy-outs.

Using this model, Table 11.2 provides an illustrative comparative synthesis of thefactors influencing the development of private equity-based buy-out markets in UK,Germany, Central and Eastern Europe (CEE) and Japan which represent different insti-tutional contexts. A detailed comparison of the factors influencing the development of allmarkets is beyond the scope of this chapter (for further discussion see Wright et al., 1992;2003a; 2004; 2005).

Panels A and B in Table 11.2 relate to the generation of deal opportunities. Panel Aillustrates the important differences between these countries in terms of the supply of buy-out opportunities. For example, in the UK the strongest supply of opportunities was therestructuring of diversified groups, with going private transactions becoming moreimportant latterly. In contrast, in Germany the need to deal with succession problems infamily-owned firms was relatively more important. In CEE, the transition from commu-nism initially created opportunities to privatize state-owned assets. In Japan, the need torestructure the keiretsus provides major scope for divestment buy-outs.

Panel B examines the demand side and in particular emphasizes differences in attitudesto entrepreneurial risk and the willingness of management to undertake a buy-out. Themost notable distinction is that in the UK these factors were considerably more positivethan in the other countries, but some change in attitudes there is noted.

Panel C relates to the infrastructure to complete deals. Again, the UK has more devel-oped private equity and debt markets, better intermediary networks and more favourablelegal and taxation frameworks than in continental Europe. It is notable that in the othercountries, changes are underway to make this infrastructure more favourable. Thesechanges reflect the pressures from the potential supply of deals to enable industrialrestructuring to take place noted in Panel A.

Finally, Panel D relates to the existence of suitable exit routes and their importance forprivate equity firms to realize their gains in buy-out investments. There are notable



Table 11.2 Comparison of factors affecting MBO market development in WesternEurope, CEE and Japan

Panel A: Supply of opportunities

Supply ofopportunities UK Germany CEE Japan

• Need to deal Moderate need High need Low need Moderate• with family• succession • problems• Need to Established Becoming Increasingly Substantial and• restructure patterns established from established in increasing from• diversified groups throughout mid-1990s early 2000s 2000

period• Need to privatize Well established Former GDR Bulk of Low, slowly• state-owned programme apart, relatively privatizations gaining• companies from 1980s; little completed momentum

now complete under theKoizumiAdministration

• Scope for ‘going- Large stock Relatively small Many candidates; Moderate but• private’ market; few number of specific growing since• transactions initial deals now quoted opportunities 2003

significant companies must grow• Development Highly developed Becoming active Relatively active Active in light • stage of M&A of need for• markets restructuring

Panel B: Demand for private equity

Demand for privateequity UK Germany CEE Japan

• Attitude to Was very Traditionally Positive and Traditionally • entrepreneurial positive from low, changing growing very low; very • risk early 1980s slowly slow change• Willingness of High Starting to High, but Increasing in • managers to buy develop lacking light of

financial frustrations in means larger groups &

perceived greater rewardsavailable

Panel C: Infrastructure to complete deals

Infrastructure tocomplete deals UK Germany CEE Japan

• Private Equity Grew rapidly Traditionally Small but Significant • and Venture from early small & not developing recent entry of


Table 11.2 (continued)

Panel C: Infrastructure to complete deals (continued)

Infrastructure tocomplete deals UK Germany CEE Japan

Capital market 1980s MBO funds for MBOsorientated

• Supply of debt High Tradition of Low but Banks high leverage growing undergoing

major restructuring but buy-outs seen as attractive option

• Intermediaries Highly Fragmented Highly Quite developed• network developed developed• Favourability of Favourable Moderately Favourable Recent positive• legal framework favourable changes in buy-

out specific aspects; efforts to increaseflexibility

• Favourability of Favourable Reforms in Moving to Reforms in• taxation regime progress favourable progress

with EUreforms

Panel D: Realization of gains

Realization of gains UK Germany CEE Japan

• Stock markets Receptive to New issues Growing Recent private equity sparse; domestic developmentcos. From secondary tier capital pool aiding buy-out mid-1980s; market closed and appetite exitnow more difficult

• Trade sales Highly active M&A market Highly active Activedeveloping

• Secondary Increasing Possible route Possible Beginning to • buy-outs/ interest exit route appear• restructuring

Source: CMBOR

differences in the role of stock markets in facilitating IPOs. However, even developedstock markets provide limited opportunities to exit buy-out investments, unless they arelarger, fast growing businesses. Accordingly, acquisitions markets assume an importantrole to enable businesses to be sold to other corporations. As many corporations begin tocomplete their restructuring and as markets become more concentrated and global, thereis less scope for the trade sale exit route, especially for smaller deals. This shift has seenthe emergence of the secondary buy-out or buy-in where an initial deal is sold to anotherprivate equity firm enabling the first to achieve an exit. This option is important in themore developed UK market but as the other markets become more mature and need toseek exits, the ability to achieve a secondary buy-out may be useful in an environment ofrelatively weak stock and corporate acquisition markets.

Trends in the development of private equity-based buy-out marketsIn this section, the development of private equity-based buy-out markets in differentcountries is discussed.

Buy-outs in the US Although buy-outs were present in the US during the 1960s and1970s, the major period of growth was in the 1980s with the taking private of listed cor-porations a prominent feature (Figures 11.1 and 11.2). The US economy of the 1980swas characterized by extensive (hostile) corporate takeovers and restructuring. Jensen(1991) argues that during this period, LBOs and MBOs functioned as the necessary cat-alyst for change in inefficient conglomerate firms. The US market developed with thegreater use of senior and mezzanine debt than in Europe and a concentration on maturesectors with low investment needs. The existence of a quoted market for high yielddebt enabled very large transactions to be completed and allowed LBO specialists and


Figure 11.1 Value of LBOs in the US

0

20

40

60

80

100

120

140

160

180

200

1988 1990 1992 1994 1996 1998 2000 2002 2004

Value $bn

management teams to compete with corporate acquirers (Kaufman and Englender,1993; Baker and Smith, 1998). The culmination of the 1980s LBO wave was associatedwith many bankruptcies and fierce public and political resistance (anti-takeover legisla-tion) such that activity slowed abruptly (Kaplan and Stein, 1993). From 1997 onwards,there was a modest rise in both public to private (PTPs) and divestment buy-outs inthe US, with a sharp increase taking place in 2003 to 2005 in both value and volume.The concept became more associated with seeking growth opportunities than withcost reduction and asset stripping as previously (Kester and Luehrman, 1995).Correspondingly, private equity firms have also emerged as more important financiersin the US buy-out market. Since 2000, PTPs were initially motivated by the decline ofthe stock markets which seems to make the sale of public equity too costly as a sourceof funds. The implementation of the Sarbanes-Oxley Act which tightened disclosurerequirements for listed corporation following corporate governance concerns in thewake of the Enron scandal is said to increase the costs of a listing substantially. Thelevel of buy-outs of private companies is very low in the US compared to most othercountries.

Buy-outs in the UK Wright et al. (2000a) identify four phases in the development ofthe UK buy-out market. The first phase involved initial market development in the early1980s. In the context of deep recession, many deals involved failed firms or firmsrestructuring to avoid failure. Relaxation of the prohibition on firms providing finan-cial assistance to purchase their own shares in 1981 reduced the barriers for lenders toobtain security for the funds they advanced. The second phase involved rapid marketgrowth from the mid-1980s to the end of the decade. Buy-outs were increasingly theresult of considered refocusing strategies and a first peak was reached in 1989. Dealnumbers rose throughout the 1980s up to 1990. The advent of specialist private equityand mezzanine funds together with entry by US banks from the mid-1980s helped fund


Figure 11.2 Number of LBOs in the US

0

100

200

300

400

500

600

700

800

900

1988 1990 1992 1994 1996 1998 2000 2002 2004

number

this development. The shift to buy-out funds reflected a need for specialized managerswho can provide professional monitoring and advice. In addition, funds enabled largerdeal sizes to be completed than were typically feasible with straight captive funding byparent banks or insurance companies. Further, the raising of funds by former captives(to create semi-captives) provides a mechanism to tie executive remuneration moreclosely to returns from investment, which may not be possible within an overallbank/insurance company corporate remuneration structure. The third phase involvedthe collapse of large deals and resurgence of deals involving distressed firms in the reces-sion of the early 1990s. The ending of the recession in 1994 saw the emergence of afourth phase involving rapid growth in market value, which reached a new peak in 2000.Greater focus on larger transactions by market players saw deal numbers fall. Beyondthe period covered by Wright et al. (2000a), the years after 2000 marked a majorreassessment of the market in the wake of the collapse of the dot.com boom and itswider repercussions.

In contrast to the US, divestments from larger groups have been more importantsources of buy-out in the UK. Toms and Wright (2005) attribute this difference to anumber of factors relating to financing availability and taxation differences. In the UK,both buy-outs involving divestment and those involving family-owned firms have becomeless important in recent years. Correspondingly, secondary buy-outs and public to privatebuy-outs in particular became more important from the mid-1990s. The lack of liquidityand the need for expansion capital as a consequence of the cut-off of institutional equityfinance, is argued to have pressured small listed companies to respond to advances byprivate equity firms. However, this is only part of the explanation as increasingly largercorporations are being targeted (CMBOR, 2005).

Continental Europe The continental European buy-out market was generally slower todevelop but some countries saw more active buy-out markets much earlier than others,such as the Netherlands and Sweden (Tables 11.3a and 11.3b) (Wright et al., 1991). TheFrench market began to develop from the mid-1980s as concerns about succession infamily businesses led to the introduction of fiscal incentives to undertake buy-outs.Market growth was also fuelled by a change to a more positive entrepreneurial culturetowards buy-outs. The French private equity industry grew rapidly from the mid-1980s,with lawyers particularly playing an important role in the diffusion of the buy-outconcept. Development of the Second Marché and the Nouveau Marché enhanced thescope for the realization of buy-out investments although partial sales have provided afrequent realization route for investors. Buy-out activity could be identified in Germanyin the early 1980s, but it was only from the early 1990s that the market began to show sig-nificant growth leading to a peak in 2000 before market value halved the following year.In contrast to the UK and France, the willingness of German managers to undertake buy-outs has traditionally been low but is changing as the growth of corporate restructuringhas significantly reduced managerial security of tenure. The infrastructure to completeGerman deals was for a long time less than favourable – few intermediaries, an under-developed private equity market and high rates of taxation. Many of these restrictions didnot begin to ease until the mid-1990s, such as relaxation of the capital gains tax regimerelating to share disposals. Stock markets in Germany have traditionally been less devel-oped than in the other two countries.



Table 11.3a Number of buy-outs/buy-ins

Country Name 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Austria 4 6 7 5 4 13 7 17 12 14Belgium 2 11 10 19 16 18 25 24 20 36Denmark 7 14 16 13 18 18 11 18 12 16Finland 21 25 33 16 19 15 23 29 28 27France 95 115 137 155 147 128 126 123 142 150Germany 79 73 97 79 51 66 90 102 104 110Ireland 7 9 9 15 9 12 16 19 14 9Italy 12 23 25 33 42 29 17 38 43 43Netherlands 59 56 61 74 65 78 59 60 74 68Norway 6 7 6 4 8 7 9 12 16 11Portugal 8 5 3 6 6 5 1 6 5 3Spain 14 13 23 39 30 28 37 42 51 33Sweden 14 16 21 23 33 24 48 25 23 39Switzerland 45 53 65 51 56 54 50 35 30 28

Total (CE) 373 426 513 532 504 495 519 550 574 587UK 598 646 707 688 653 614 638 628 699 686

Total (inc UK) 971 1072 1220 1220 1157 1109 1157 1178 1273 1273

Source: CMBOR/Barclays Private Equity/Deloitte

Table 11.3b Value of buy-outs/buy-ins (€m)

Country Name 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Austria 56 68 128 95 680 734 47 150 303 88Belgium 14 147 414 823 2595 337 1744 517 1448 2266Denmark 54 388 263 269 2165 1313 498 1391 848 335Finland 189 723 455 559 1085 675 1047 460 1039 977France 1424 2189 5250 6198 8375 6448 6405 15550 8768 11878Germany 1208 1704 3523 5313 4660 15076 7500 8121 11578 17912Ireland 172 116 97 258 1475 259 5021 4918 779 935Italy 271 1115 3115 695 2714 2550 737 3428 7770 2472Netherlands 857 988 1059 3435 2901 1739 4428 1793 4958 6936Norway 18 316 181 23 226 1004 1371 142 301 427Portugal 344 154 64 84 206 83 2 26 54 8Spain 241 227 374 861 1713 944 1530 2069 970 2791Sweden 685 700 1551 928 2926 3164 3000 1116 2223 1813Switzerland 712 1276 2426 1347 1013 1772 715 2764 864 1327

Total (CE) 6245 10111 18900 20888 32734 36098 34045 42445 41903 50165UK 9012 12602 17109 23265 26750 38339 31334 24823 23518 30074

Total (inc UK) 15257 22713 36009 44153 59484 74437 65379 67268 65421 80239


The overall European trend in buy-out vendor sources is shown in Tables 11.4aand 11.4b. In France, deal opportunities initially arose from a need to sell businesses bythe owners of family firms facing succession problems. Succession and portfolio reorgan-ization issues in the large number of family-controlled listed companies in France alsocontributed to a marked growth in buy-outs from this source. Divestments from corpor-ations have now become a major part of the French private equity market associated withgrowing competitive pressures on French industry and increasing focus on corporate gov-ernance and shareholder value.

Reluctance by founders of small and medium sized firms in countries like Germany,Spain and Italy both to let go and to sell to private equity firms has restricted marketgrowth. Buy-outs from family firms have become relatively less important as divestmentshave become more important alongside secondary buy-outs. The European market forPTP transactions is still small, in part because Continental European countries have fewer


Table 11.4a Continental European buy-outs/buy-ins by source: number of deals

Type 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Family & Private 87 96 125 167 126 117 92 88 114 136Foreign parent 56 63 73 74 69 69 96 102 99 85Local parent 149 153 203 162 168 176 210 198 188 218Privatization 16 8 8 9 4 4 3 3 4 1Public buy-in 0 2 3 3 1 8 2 2 2 2Public to Private 2 8 8 5 31 20 14 13 18 10Receivership 16 22 14 10 11 8 11 43 21 14Secondary Buy-out 5 7 10 22 29 30 30 29 61 68Unknown 42 67 69 80 65 63 61 72 67 53

Total 373 426 513 532 504 495 519 550 574 587


Table 11.4b Continental European buy-outs/buy-ins by source: value (€m)

Type 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Family & Private 1473 2870 5503 6867 5686 2508 3496 4314 4025 6695Foreign parent 1144 940 2865 3616 5059 5584 4676 3925 4253 3965Local parent 2784 4430 5898 6741 13456 14945 16176 18575 18236 16340Privatization 226 238 2289 1259 387 1092 97 2441 989 4Public buy-in 0 10 121 204 32 904 173 237 571 1070Public to Private 47 259 286 477 5248 6204 7502 6676 3788 7928Receivership 159 203 93 85 85 79 58 1688 945 105Secondary Buy-out 71 360 1264 654 1934 3709 1376 4066 8413 13054Unknown 340 800 581 984 849 1073 491 523 683 1004

Total 6244 10110 18900 20887 32736 36098 34045 42445 41903 50165


listed companies. Culture may also be important, with managers in some countrieswishing to avoid the burden of a listing in the first place while in others managers may betoo proud of their listing to even rationally consider going private (CMBOR, 2002).

Buy-outs worldwide The buy-out concept has also spread to Japan as the country facedmajor problems of corporate reorganization in the light of macro-economic problems.The country saw occasional buy-outs during the early 1990s but 1998 marked the realbirth of the market. The market continued to grow from 2000, and by 2003 67 deals werecompleted with the total value increasing almost five-fold over the previous year to 520billion yen (€4200 million). Divestments by Japanese corporations have consistently pro-vided the largest source of buy-outs to date. An important development from late 2000was the appearance of buy-outs of whole listed companies. Buy-outs of failed firms alsocontribute an important element of the market being facilitated by the establishment ofthe Civil Rehabilitation Law in 2000, which provided a more flexible in-court corporaterescue scheme to help deal with the problem of distressed firms resulting from thecountry’s macro-economic difficulties. Buy-outs of privately-owned (family) firms havealso increased in relative importance.

Despite these growth trends, the maturity of different buy-out markets varies quitemarkedly. An indicator of relative market maturity is the ratio of the value of buy-outtransactions to a country’s GDP across Europe (Figure 11.3). The UK is by far the largestsingle buy-out market as a proportion of GDP, while the French and German marketsfare less well compared to their overall buy-out market size. Most notably, Spain and Italyas relatively large economies are seen to have very undeveloped buy-out markets.

SummaryThis section has shown the heterogeneity of the buy-out concept and demonstrated itsapplicability to different firm and country contexts. The heterogeneity of market devel-opment shown in Figure 11.1 strongly reflects the impact of the differences in the factorsinfluencing the development of buy-out markets outlined earlier in the section. Thepattern of individual market development over time suggests that changes in these factorsdo help to stimulate market growth. Those countries with low buy-out market value toGDP ratios may need to consider how some of these factors can be relaxed to facilitatethe development of buy-out markets to address needs for restructuring corporations andeffecting ownership transition in family firms.

The buy-out life-cycleTo examine the issues relating to private equity and management buy-outs, we adopt alife-cycle perspective of the buy-out process (Wright and Robbie, 1998). Essentially, thelife-cycle perspective involves the deal generation; screening and negotiation; valuation;structuring; monitoring and adding value; and exiting and longevity. We discuss each ofthese stages in the life-cycle in turn. The discussion encompasses examination of buy-outsof listed firms that are taken private and buy-outs of privately-owned firms.

Buy-out deal generation and antecedentsBuy-out deal opportunities which developed in the 1980s were linked to agency cost prob-lems and a failure of firms’ internal control mechanisms (Jensen, 1993). In particular, the


multi-divisional firm was argued to be failing to deliver shareholder benefits (Thompsonand Wright, 1988). Although the multi-divisional firm was hypothesized to reduce man-agerial discretion, many firms nominally structured in this way in practice lacked the controland incentive mechanisms that were conceptually necessary to generate performanceimprovements (Hill, 1985). Moreover, the comparative advantage of the internal capitalmarket, a central feature of resource allocation in multi-divisional firms, was argued to havedeclined with improvements in the efficiency of external markets (Bhide, 1992).


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

Figure 11.3 Buy-outs as a percentage of GDP

0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50% 4.00% 4.50%

UK

Netherlands

Germany

Belgium

France

Finland

Sweden

Ireland

Switzerland

Spain

Norway

Italy

Denmark

Austria

Portugal

2004 2003 2002

Jensen (1989) argued that these problems were particularly acute in mature businesseswhich generated free cash flows since these firms would tend to engage in unprofitablediversification rather than disgorge the cash in abnormally large dividends. This diversi-fication may be beneficial to managers remunerated on the basis of firm size but not forshareholders. Similarly, a multi-product firm with satisfactory overall cash flow and weakgovernance may experience considerable inertia in taking decisions to reorganize its activ-ities in line with changing market conditions (Jensen, 1993).

These situations generated the conditions for buy-outs to improve efficiencies. First,reconcentration of equity in the hands of insiders and/or with private equity firms with aclose association with the new firm provides the incentive to seek profitable opportunities.Second, private equity firms become active monitors, unlike passive shareholders in alisted corporation, and have the specific skills to undertake this monitoring. Third, thelarge-scale substitution of debt, quasi-debt and quasi-equity, for ordinary equity in thefinancing of the buy-out carries a commitment to meet servicing costs which reduces man-agerial discretion and places pressure on management to perform. Fourth, management’sequity stake may also be based on performance outcomes, according to a performance-contingent contract or ratchet mechanism (Thompson et al., 1992). Finally, where thereis a trading relationship with a former parent, a divestment buy-out may have an increasedincentive to perform where it is heavily dependent on its former parent and where theformer parent retains an equity interest (cross-holding) (Wright, 1986).

The failure of internal control systems may also be seen in more innovative firms. In large,integrated diverse organizations, bureaucratic measures may be adopted to try to ensureperformance but these measures may restrict experimentation and constrain innovativeactivity (Francis and Smith, 1995). Managers in the pre-buy-out situation thus face invest-ment restrictions from headquarters, particularly where their firms are peripheral to themain product line of the parent company (Wright et al., 2001). These problems may beeased after the buy-out. Instead of obeying orders from headquarters that block innova-tion and investment in order to optimize the goals of the diversified parent company, thebuy-out creates discretionary power for the new management team to decide what is bestfor the business, how to organize and lead the company, and how to set up a business planthat is most profitable for themselves and the firm (Wright et al., 2000b; 2001).

Several further arguments have been advanced to explain buy-outs, particularly thoseinvolving the taking private of listed corporations. First is the tax hypothesis. As the vastmajority of PTP transactions take place with a substantial increase in leverage, theincrease in interest deductions constitutes an important source of expected wealth gains.Interest tax deductibility on the new loans constitutes a major tax shield increasing thepre-recapitalization value.

Second is the transaction cost hypothesis associated with the direct costs of maintain-ing a stock exchange listing (DeAngelo et al., 1984). The transaction costs hypothesis sug-gests that the wealth gains from going private are largely the result of the elimination ofthe direct and indirect costs associated with maintaining a stock exchange listing.

Third is the defence against hostile takeover hypothesis which suggests that the premi-ums in PTPs reflect the fact that the management team may intend to buy out the othershareholders in order to insulate itself against an unsolicited takeover. Lowenstein (1985)reports that some corporations have gone private via an MBO as a defensive measureagainst a hostile takeover threat.


Fourth is the undervaluation hypothesis which states that when the pre-transaction firm’sstock is underperforming, the management or an LBO specialist are able to pay higher pre-miums in a PTP transaction as they are expected to create additional shareholder value oncethe firm is private. There may be asymmetric information between management and out-siders about the maximum value that can be realized with the assets in place. Managementwith superior private information may perceive that the share price is undervalued in rela-tion to the true potential of the firm. This problem may be exacerbated where listed corpor-ations find it problematical to use the equity market to fund expansion, as it may be difficultto attract the interest of institutional shareholders and fund managers. The lack of interestin such shares creates illiquidity and implies that they are likely to remain lowly valuedwhich provides an impetus to go private. Lowenstein (1985) argues that management mayemploy specific accounting techniques to depress the pre-announcement share price, suchas manipulating dividends and deliberately depressing earnings.

Fifth is the wealth transfer from other stakeholders hypothesis. A firm going privatecan transfer wealth from bondholders to stockholders by issuing debt of higher or equalseniority. In PTPs, the third mechanism in particular can lead to substantial bondholderwealth expropriation.

Sixth, potential financial distress costs may deter firms from going private and hencethe expected benefits associated with this form of organizational structure may not berealized (Opler and Titman, 1993).

Much of the evidence relating to deal generation concerns the antecedents to the takingprivate of listed firms in the US. US studies of the role of free cash flow in the decision togo private have produced mixed results. Lehn and Poulsen (1989) and Singh (1990) reportthat firms going private have greater free cash flow than firms remaining public, but lowersales growth. However, Kieschnick (1998) reworked Lehn and Poulsen’s sample using aweighted logistic regression and found free cash flow and sales growth to be insignificant.In addition, Opler and Titman (1993) find that leveraged buy-outs are more likely toexhibit only the combined characteristics of low Tobin’s Q and high cash flow than firmsremaining public. Further, Halpern et al. (1999) also find no evidence to support the freecash flow hypothesis. This US evidence, therefore, suggests that going private is not beingdriven by the need to return free cash to the shareholders.

Kaplan (1989b) estimates the tax benefits of US PTPs to be between 21 per cent and72 per cent of the premium paid to shareholders to take the company private for the firsthalf of the 1980s. Singh (1990) reports that US MBOs were significantly more undertakeover pressure prior to the MBO than a sample of matched firms. DeAngelo (1986) findsno evidence of systematic manipulation of pre-buy-out accounting data by incumbentmanagement. Wu (1997) does show evidence consistent with the view that managers manip-ulate earnings downwards prior to the MBO proposal. Asquith and Wizman (1990), Cooket al. (1992) and Warga and Welch (1993) show that bondholders with covenants offeringlow protection against corporate restructuring lose some percentage of their investment.

UK evidence indicates that firms that go private through a buy-out are more likely thanthose that remain listed to have higher CEO ownership, higher institutional ownershipand more duality of CEO and chairman (Weir et al., 2005a). These firms did not haveexcess free cash flows or face a greater threat of hostile acquisition but they did have lowergrowth opportunities. In a related study, Weir et al. (2005b) find that managers’ percep-tion that the market undervalued the company was significantly associated with going


private. Renneboog et al. (2007) find for a sample of UK PTPs completed between 1997and 2003 that the main sources of the shareholder wealth gains are undervaluation of thepre-transaction target firm, increased interest tax shields and incentive realignment. Incontrast, they find that an expected reduction of free cash flows does not determine thepremiums nor are PTPs a defensive reaction against a takeover.

The buy-out concept may also apply to private family-owned firms. There is increasingrecognition that there may not be suitable family members willing or able to take on theownership and management of the business (Wright et al., 1992; Bachkaniwala et al.,2001). In mature private family firms, growth opportunities may have been exhausted andfounders somewhat detached from the running of the business as they begin to pursueother interests. Second tier management may possess greater information about therunning of the business and possess the managerial skills to introduce needed professionalmanagement but not be in a position to take appropriate decisions (Howorth et al., 2004).A management buy-out may be a means of effecting succession and be acceptable tothe founder as the best way to preserve their psychic income through maintaining thecompany’s independent identity and culture, as well as continuing to be involved in thebusiness. However, dominant founders may not have developed strong second tier man-agement who could become owner-managers. If this is the case, a management buy-inmay be needed (Robbie and Wright, 1996).

Screening and negotiating buy-outsIn appraising potential investments, private equity firms are faced with an adverse selec-tion problem (Amit et al., 1993). In contrast to early stage owner-managed ventures,private equity firms considering funding management buy-out proposals need to taketheir decisions on the basis of observed managerial performance in post, expectationsabout whether improving managerial incentives will improve performance and manage-ment’s willingness to take on the risk of a buy-out in order to secure the fruits of theirhuman capital. Management buy-ins typically focus on enterprises which require turn-around and restructuring, but as the buy-in entrepreneur comes from outside there areproblems of asymmetric information, both in relation to their true skills and because ithas not been possible to observe the manager in post. These problems create uncertaintyfor the private equity financier about whether the deal in which they are investing is whatthey thought it was, which may be difficult to address before they commit their funds.

In a management buy-out, private equity firms may be guided by incumbent manage-ment’s deep knowledge of the business (Birley et al., 1999). Management may not necessar-ily have clear incentives to reveal truthful information since they may either wish to underplayproblems in their anxiety to make the deal appear viable or overplay problems in order toreduce the transaction price. However, detailed probing may enable the private equity firmto uncover major difficulties and approach an accurate assessment of the true state of affairs.By investing in insiders, private equity firms may be able to reduce uncertainties more thanis the case for management buy-ins. Management buy-in entrepreneurs may be able to reducesome of the problems of asymmetric information where they have detailed knowledge aboutthe industry sector but even here, information availability for private firms may be limited(Robbie and Wright, 1995). In such cases they may be able to use personal networks to carryout informal verification about the state of the target enterprise. These problems may arisein both buy-outs of listed corporations and those involving private firms.


One way to improve the chances of success in negotiating a buy-out of a listed corpor-ation is to seek irrevocable commitments from significant shareholders to accept thebidder’s bid before the offer is made public. Gaining these commitments means that thebidder is sending a signal to other non-committed shareholders that the deal is a goodone. The announcement of substantial irrevocable commitments may also make otherpotential bidders less likely to enter the contest with an alternative bid. The initial com-mitment ensures that, without any higher alternative bid, the agreement to sell the sharebecomes binding. Private equity bidders for listed companies may use irrevocable com-mitments in an attempt to ensure the success of a PTP proposal and reduce the costs asso-ciated with failure, as well as avoiding a bidding contest that would potentially reducetheir returns from the investment. Weir et al. (2007) find that those proposing a manage-ment buy-out (MBO) are more likely to gain the backing of other shareholders the greaterthe bid premium and the more reputable the private equity backer.

Informational asymmetries between vendors and purchasers may impact buy-outsinvolving private family firm succession. Flows of information may impact both succes-sion planning and buy-out negotiation process. A number of negotiation issues are raised,which centre around information asymmetries between founders and managers, as well asthe extent to which negotiations are dominated by one or other party or whether they arecollaborative (Howorth et al., 2004). Scholes et al. (2005) find lower information asym-metry problems if family firm vendors and the existing management team are equallyinvolved in succession planning. However, they found that negotiations were less likely toinvolve a mutually agreed price where the succession process was driven by the vendor.

ValuationPrivate equity investors need to value potential deals in order to consider whether theyare likely to achieve their target rates of return. Private equity firms typically use a com-bination of price/earnings multiples and discounted (free) cash flow multiples (Manigartet al., 1997). Other things being equal, the higher the premium that purchasers pay, themore that needs to be done post-deal to achieve target rates of return. At the same time,vendors, seeing that the private equity and management purchasers are undertaking abuy-out as they believe they can enhance performance, may seek to capture some of thesefuture gains by seeking a higher price before being persuaded to sell their shares.

For listed corporations, the value vendors place on a business is reflected in the shareprice response to the announcement of an attempt to take a firm private. A series of USstudies (DeAngelo et al., 1984; Kaplan, 1989a; Lehn and Poulsen, 1989; Marais et al.,1989) finds a large abnormal gain for the target’s shareholders when a going private LBOdeal is announced. Kaplan (1989a) reports a median abnormal gain of 42 per cent for76 US buy-outs in the period 1980–86. Similar stock market studies of voluntary divest-ments as LBOs by diversified companies (for example Hite and Vetsuypens, 1989;Markides, 1992) reveal small but significant positive announcement effects. This USevidence is also reflected in the UK. Renneboog et al. (2007) examine the valuation ofbuy-outs of listed corporations in the UK during 1997–2003 and find that the share pricereaction to the PTP announcement is about 30 per cent.

There is the possibility of systematically lower premiums where insiders involved in thebuy-out take action to reduce the apparent valuation in order to buy out at a price that isadvantageous to themselves. This could be passive, where managers simply exploit asset


prices which appear (to them) to be too low or it could be the result of some deliberatemisrepresentation or concealment by them. Evidence on the former has been obtainedfrom abnormal stock market returns for announced and then withdrawn LBOs(DeAngelo et al., 1984; Marais et al., 1989). Smith (1990) argues that abandoned, hidden-information buy-outs should show the same subsequent performance gains as completedones and hence the same market response, assuming the buy-out is solely motivated byinsider information. She finds no such evidence and hence concludes against the hiddeninformation view. However, the stock market response appears to depend substantially onwhether or not a subsequent bid occurs (Lee, 1992), whilst existing owners’ returns aregreater when competitive bids are received (Easterwood et al., 1994).

Insiders may manage earnings prior to a management bid in order to reduce the profitsbase for valuing the business. The evidence is somewhat contradictory: DeAngelo (1986)reports none whilst Perry and Williams (1994) find evidence of consistent falls in the lastcomplete financial year prior to an announcement. Kaplan and Stein (1993) analyse thestructure of MBO pricing across the whole of the 1980s. They suggest that deal prices rosewith the level of leverage leading to over-heating and a sharp rise in the failure rate at theend of the decade. Thus if there were initial transfers from the pre-MBO owners, thistrend was reversed across the period.

StructuringThe structuring of buy-out deals involves both the combination of financial instrumentsrequired to effect the purchase and the contractual mechanisms introduced by privateequity firms which give them various cash flow and control rights. The latter may be eitherattached directly to particular financial instruments or be included in the corporatecharter, shareholders’ agreement, or articles of association.

In the US, Cotter and Peck (2001) show that active monitoring by a buy-out specialistsubstitutes for tighter debt terms in monitoring and motivating managers of LBOs. Buy-out specialists that control a majority of the post-LBO equity tend to use less debt intransactions. Buy-out specialists that closely monitor managers through stronger repre-sentation on the board also tend to use less debt.

In the UK, where evidence is most comprehensive, the majority of buy-outs are backedby private equity firms and hence are likely to use equity and quasi-equity instruments.The probability of receiving equity backing increases with size (CMBOR, 2005). While inthe late 1990s, about a half of buy-outs with a transaction value of less than £10mreceived private equity backing, this proportion had fallen to about one fifth a decadelater. At the largest end of the market, it is relatively rare for deals with a transaction valueabove £100m to be wholly debt funded (Tables 11.5a and 11.5b).

In contrast to early stage venture capital deals, buy-outs tend to make use of a widerrange of financial instruments comprising equity, quasi-equity (for example redeemable andconvertible shares), quasi-debt (various layers of privately and publicly placed mezzanineor subordinated debt), senior debt (various layers of secured debt with different maturitiesand return characteristics) and asset-based financing such as leasing (Wright et al., 1991).The relative importance of these financial instruments is shown in Tables 11.6a and 11.6bwhich provide mean deal structuring data for all UK buy-outs completed in each year.

Although continental Europe has a bank-based system (Black and Gilson, 1998), USbuy-outs typically involve greater levels of debt. In the US, banks appear to be more



Table 11.5a Share of UK buy-outs that are private equity backed

1997 2000 2002

Deal Size VC Total % VC VC Total % VC VC Total % VC Range Backed Deals Backed Backed Deals Backed Backed Deals Backed

Less than £10m 277 548 50.5 134 424 31.6 113 493 22.9£10m – £25m 65 74 87.8 69 89 77.5 44 67 65.7£25m – £50m 32 38 84.2 22 27 81.5 22 28 78.6£50m – £75m 22 22 100.0 20 26 76.9 14 16 87.5£75m – £100m 10 11 90.9 7 7 100.0 5 6 83.3Over £100m 15 16 93.8 40 45 88.9 24 27 88.9


Table 11.5b Share of UK buy-outs that are private equity backed

2003 2004 2005

Deal Size VC Total % VC VC Total % VC VC Total % VCRange Backed Deals Backed Backed Deals Backed Backed Deals Backed

Less than £10m 108 569 19.0 105 506 20.8 115 497 23.1£10m – £25m 43 54 79.6 51 72 70.8 46 63 73.0£25m – £50m 31 39 79.5 37 45 82.2 38 47 80.9£50m – £75m 18 23 78.3 20 24 83.3 14 16 87.5£75m – £100m 5 5 100.0 7 7 100.0 11 11 100.0Over £100m 20 21 95.2 43 47 91.5 48 51 94.1


Table 11.6a UK buy-out/buy-in deal structures, less than £10m financing

Type of Finance (Average %) 1993 2000 2001 2002 2003 2004

Equity 41.0 54.4 41.1 30.4 43.1 41.1Mezzanine 3.4 4.6 1.8 1.7 0.6 1.0Debt 36.2 35.0 46.6 48.9 47.8 44.8Loan Note 7.4 3.6 2.8 10.5 3.0 7.1Other Finance 14.1 3.0 7.5 8.5 5.6 6.0Total financing (£m) 265 331 402 290 223 228Vendor contribution 10.8 2.7 4.1 6.6 2.8 7.2Management contribution 16.0 6.3 5.0 7.6 3.5 8.6Proportion of equity held 68.7 63.7 61.8 78.4 66.8 61.8

by management


willing to lend on the basis of stable cash flow and the ability to sell assets in liquid cor-porate asset markets at going concern value. In the bank-based systems of continentalEurope, asset markets are much less liquid, and collateral value may be more likely to bebased on estimated distress value. In continental Europe, the mezzanine finance providers,which can help increase the debt available in buyouts, are relatively less well-developedand unbundling deals involving the sell-off of surplus assets post-buy-out are quiteunusual compared to the US (CMBOR, 2005).

As Kaplan and Strömberg (2001) find for venture capitalists, Sahlman (1990) andRobbie and Wright (1990) indicate that private equity investors in buy-outs also usevarious contractual mechanisms to encourage entrepreneurs both to perform and toreveal accurate information. These mechanisms include staging of the commitment ofinvestment funds, convertible financial instruments (‘equity ratchets’) which may givefinanciers control under certain conditions, basing compensation on value created, pre-serving mechanisms to force agents to distribute capital and profits, and powers writteninto Articles of Association which require approval for certain actions (for example acqui-sitions, certain types of investment and divestment, and so on) to be sought fromthe investor(s) (Robbie and Wright, 1990). In addition to such structural mechanisms, theprocess of the relationship with the investee company is also an important aspect of thecorporate governance framework.

Monitoring and adding valueIn this section we consider the mechanisms and processes of monitoring and addingvalue, the effects of monitoring and investor involvement, and aspects relating to restruc-turing failure.

Mechanisms and process Active private equity investor monitoring in buy-outs and buy-ins has some similarities with that undertaken by venture capital firms in early stage ven-tures. Sahlman (1990) in comparing LBO Associations with venture capitalists notes thatexecutives in the former may typically assume control of the board of directors but are gen-erally less likely than venture capitalists to assume operational control. UK evidence in


Table 11.6b UK buy-out/buy-in deal structures, £10m or more financing

Type of Finance (Average %) 1993 2000 2001 2002 2003 2004

Equity 33.2 43.3 37.2 37.6 41.6 39.9Mezzanine 4.5 4.7 5.0 4.6 3.6 5.2Debt 47.5 46.4 46.6 50.2 49.3 50.7Loan Note 8.6 1.7 4.0 3.2 2.8 1.9Other Finance 8.2 3.8 7.3 4.4 2.7 2.3Total financing (£m) 1905 13339 13614 9934 10922 11463Vendor contribution 5.1 2.3 4.3 3.4 1.2 2.9Management contribution 2.4 5.3 2.1 2.0 3.1 2.7Proportion of equity held 27.6 32.1 36.8 35.7 27.7 33.0

by management


buy-outs and buy-ins shows that board representation is the most popular method of mon-itoring investee companies, with there also being a requirement for the regular provision ofaccounts to the private equity investor (Robbie et al., 1992). However, reflecting the greaterasymmetric information issues in buy-ins, private equity firms exercise a greater degree ofcontrol than for buy-outs (Robbie et al., 1992). Equity ratchets are also found to be morefrequently used in buy-ins, reflecting the greater uncertainty about their future performance.

With respect to the process of monitoring, evidence from buy-outs and buy-ins empha-sizes the extent of keeping the private equity firm informed of developments throughregular contact. Hatherly et al. (1994) show that on balance the relationship betweenfinancial institutions and management buy-outs involves partnership and mutual interestwith devices to control agency problems generally being used in a flexible manner.However, in smaller buy-ins in particular, private equity firms do not appear to be particu-larly active in responding to signals about adverse performance or in developing rela-tionships with entrepreneurs (Robbie and Wright, 1995). In larger buy-ins there isevidence of extensive and repeated active monitoring (Wright et al., 1994). This differenceillustrates the comparative cost–effort–reward trade-offs involved in the active monitor-ing of large and small investments.

Bruining and Wright (2002) provide exploratory case study evidence suggesting howprivate equity firms can enhance the entrepreneurial orientation through integrating thecontributions of specialist top management decision-making, influencing the leadershipstyle of CEOs, keeping value added strategy on track and assisting in new ventures, andin broadening market focus. Bruining et al. (2004) also provide detailed case analysis ofhow private equity firms can contribute to the development of management controlsystems that facilitate strategic change in different types of buy-outs.

Effects of monitoring and involvement Research on US LBOs during the 1980s indicatessubstantial mean improvements in profitability and cash flow measures over the intervalbetween one year prior to the transaction and two or three years subsequent to it (Kaplan,1989a; Muscarella and Vetsuypens, 1990; Smith, 1990; Opler, 1992; Kaplan and Stein,1993; Smart and Waldfogel, 1994). Similarly, UK evidence indicates the vast majority ofbuy-outs show clear improvements in profitability and working capital management(Wright et al., 1992). Wright et al. (1996a) concluded that firms experiencing an MBOgenerated significantly higher increases in return on assets than comparable firms that didnot experience an MBO over a period from two to five years after buy-out. In the Frenchmarket, Desbrieres and Schatt (2002) find that firms that were acquired outperform com-parable firms in the same industry both before and after the buy-out. However, in con-trast to findings relating to US and UK LBOs, the performance of French MBO firmsdeclines after the transaction is consummated, but this downturn seems to be less detri-mental to former subsidiaries of groups than to former family businesses, the latterforming a more important part of the French market.

Buy-outs are a means for refocusing the strategic activities of the firm (Seth andEasterwood, 1993; Phan and Hill, 1995). Both Wright et al. (1992) and Zahra (1995) findthat buy-outs are followed by significant increases in new product development and otheraspects of corporate entrepreneurship.

Buy-outs also improve productivity. Lichtenberg and Siegel (1990) found that totalfactor productivity for plants involved in LBOs rose from 2 per cent above its industry


control pre-LBO, to 8.3 per cent above over the first three years of post-LBO operation.For the UK, Wright et al. (1996a), Amess (2003) and Harris et al. (2005) show that man-agement buy-outs are associated with improvements in total factor productivity. Harriset al. (2005) show, in contrast to US evidence, that MBO establishments were approxi-mately 2 per cent less productive than comparable plants pre-LBO but experienced asubstantial increase in productivity of approximately 90 per cent post-LBO. US evi-dence strongly supports the view that capital investment falls immediately following theLBO as a result of the increased leverage (Kaplan, 1989a; Smith, 1990). The evidenceon UK MBOs is rather different. Wright et al. (1992) report that asset sales are offset bynew capital investment, particularly in plant and equipment. The effect of buy-outs onR&D is less clear, although on balance there seems to be a reduction (Smith, 1990;Lichtenberg and Siegel, 1990; Long and Ravenscraft, 1993). However, as many LBOsare in low R&D industries, the overall effect may be unsubstantial. There is some evi-dence that in buy-outs that do have R&D needs, this expenditure is used more effectively(Zahra, 1995).

There is mixed evidence on the effects of buy-out on employment. Kaplan (1989a),Smith (1990), and Opler (1992) – but not Muscarella and Vetsuypens (1990) – report smallincreases in total firm employment following LBOs. Kaplan (1989a) and Smith (1990),however, report that buy-outs do not expand their employment in line with industry aver-ages. Lichtenberg and Siegel (1990) report an 8.5 per cent fall in non-production workers,over a three-year period, with production employment unchanged.

Early UK evidence suggested that job losses occur most substantially at the time of thechange in ownership (Wright et al., 1992). Amess and Wright (2007) show in a panel of1350 UK buy-outs covering the period 1999–2004 that employment growth is 0.51 of apercentage point higher for MBOs after the change in ownership and 0.81 of a percent-age point lower for MBIs. These findings are consistent with the notion that MBOs leadto the exploitation of growth opportunities, resulting in higher employment growth. Thesame patterns do not emerge from MBIs, typically because the latter transactions involveenterprises that require considerable restructuring.

The wealth of existing bondholders will be adversely affected if new debt, issued atthe time of the restructuring, impacts adversely on the perceived riskiness of the origi-nal debt. Marais et al. (1989) fail to detect any such wealth transfer but Asquith andWizman (1990) report a small average loss of market value but those original bonds withprotective covenants showed a positive effect. As buy-outs typically substitute debt forequity they tend to reduce corporate tax liabilities but this tax saving generally accountsfor only a small fraction of the value gain in buy-outs (Schipper and Smith, 1988;Kaplan, 1989b).

Some indications of the effects of monitoring mechanisms introduced in buy-outs aregiven by comparing alternative organizational forms. For example, leveraged recapital-izations, which simply substitute debt for equity in quoted companies, have been shownto raise shareholder value (Denis and Denis, 1993) but they do not appear to have thesame performance impact as LBOs, which also involve managerial ownership and insti-tutional involvement (Denis, 1994). Similarly, defensive Employee Share Ownership Plans(ESOPs), in which leveraged employee share purchases are used to forestall takeovers, donot appear to perform as well as LBOs (Chen and Kensinger, 1988). Thompson et al.(1992) found that the management team shareholding size had by far the larger impact


on relative performance in UK MBOs. Similarly, Phan and Hill (1995) found thatmanagerial equity stakes had a much stronger effect on performance than debt levels forperiods of three and five years following the buy-out.

Nikoskelainen and Wright (2007) examine the role of corporate governance in enhanc-ing the real returns to exited buy-outs and find an average (median) return of 22.2 per cent(�5.3 per cent) net of market index returns based on a sample of 321 exited buy-outs inthe UK between 1995 and 2004. Their analysis shows that a balance of interrelated firm-level corporate governance mechanisms (including gearing, syndication and managementownership) is critical for value-increase in buy-outs, and the importance of these mech-anisms for enhancing returns is context-dependent in relation to the size of the transac-tion, among other things.

Cumming and Walz (2004) assess the returns to buy-outs from the investor’s perspec-tive based on a sample of 39 countries around the world. For the subset of the buy-outdata from the US and the UK which spans the 1984–2001 period, they find an average(median) return to LBOs to be 26.1 per cent (31.4 per cent) and an average return toMBOs/MBIs to be 21.5 per cent (18.5 per cent) net of market index returns. This studyalso shows that the average returns to earlier stage venture capital investments are signifi-cantly greater than the average returns to buy-outs, whereas the median returns to buy-outs are greater than the median returns to earlier stage venture capital investments.Cumming and Walz (2004) find that returns are high for syndicated investments but lowerfor co-investments, which suggests the capital from a follow-on fund is used to bail outthe bad investments from earlier funds. Knigge et al. (2006) show that, in contrast toventure capital funds, the performance of buy-out funds is largely driven by the experi-ence of the fund managers regardless of market timing.

Restructuring and failure High leverage in the structuring of buy-outs may mean thatfinancial distress is signalled sooner than if an enterprise were funded substantially byequity (Jensen, 1991). A firm which defaults on interest and loan payments may still retaingreater value and stand a better chance of being reorganized, than one which is finallyforced to waive a dividend. Kaplan and Stein (1993) in a study of larger US buy-outs andWright et al. (1994) for the UK provide strong evidence that higher amounts of debt wereassociated with an increased probability of failure or needing to be restructured. Many ofthese firms may be restructured and sold as going concerns (Citron et al., 2003). However,a problem of enforcing restructuring is that it may be difficult to agree with other partieswhat form it should take, especially in smaller investments where management are usuallyimportant majority shareholders. If institutions are a controlling shareholder, as isusually the case in larger buy-outs and buy-ins, making changes is theoretically straight-forward. However, in cases with large syndicates of financiers, restructuring may bedelayed or may take a particular direction because of differences in the attitudes of syn-dicate members (Wright and Lockett, 2003).

An important issue in dealing with investees that are in distress concerns whether or notto replace the CEO. Larger management buy-ins may be able to bear extensive restructur-ing, and it may be economical for institutions to invest the effort to undertake it, whereasthe possibilities may be very limited for smaller cases. In small buy-outs and buy-ins, man-agement may own the vast majority of the equity and a very small group of managers maycarry out the major functions, thus making it difficult to remove underperforming


management or to enforce a trade sale until a pressure point arises which cannot berelieved by other funding sources. In larger buy-outs and buy-ins, no single manager maybe indispensable and it may thus be easier for institutions to exert pressure to removeunder-performing senior managers.

Exit and longevityThere is some debate about whether buy-outs are a long or short term form of organiza-tion (Jensen, 1989; Rappaport, 1990). Evidence suggests that the longevity of buy-outs isheterogeneous, with some remaining with the buy-out structure for long periods, whileothers change quite quickly (Kaplan, 1991; Wright et al., 1995). Important issues relateto the need to understand the influences on this longevity and the effects on performanceonce the firm has exited from the buy-out structure.

With respect to the first point, Wright et al. (1993) suggest that a range of institutionalfactors including the state of development of asset and stock markets, legal infrastruc-tures affecting the nature of private equity firms’ structures and the differing roles andobjectives of management and private equity firms influence the timing and nature ofexits from buy-outs. Importantly, private equity firms’ desire for realization in order toachieve their target returns may influence the nature of their involvement to achieve atimely exit (Wright et al., 1994). Buy-outs funded through closed-end funds may especiallyseek exit within a given time period compared to those funded through other sources offinance (Chiplin et al., 1995). In order to achieve timely exit, private equity firms are morelikely to engage in closer (hands-on) monitoring and to use exit-related equity-ratchets onmanagement’s equity stakes (Wright et al., 1995).

With respect to what happens following exit from the private buy-out structure,Holthausen and Larcker (1996) find that while leverage and management equity fallswhen buy-outs return to market (reverse buy-outs), they remain high relative to compa-rable listed corporations that have not undergone a buy-out. Pre-IPO, buy-outs’ account-ing performance is significantly higher than the median for the buy-outs’ sector. Followingthe IPO, accounting performance remains significantly above the firms’ sector for fouryears but declines during this period. Consistent with other studies, they find that thechange is positively related to changes in insider ownership but not to leverage. Brutonet al. (2002) also find that agency cost problems did not reappear immediately followinga reverse buy-out but rather took several years to re-emerge.

Venture-backed MBOs in the UK tend to IPO earlier than their non-venture-backedcounterparts (Jelic et al., 2005). There is some evidence that they are more underpricedthan MBOs without venture capital backing but not that they perform better than theirnon-venture capital-backed counterparts in the long run. In contrast to the grandstand-ing hypothesis (Gompers, 1996), private to public MBOs backed by more reputableventure capitalists in the UK tend to exit earlier, and these MBOs performed better thanthose backed by less prestigious venture capitalists.

SummaryThis review has shown that there has been differential research attention to the differentelements of the buy-out life-cycle. There has been extensive attention to the deal gener-ation and antecedent aspects, the premiums paid and the performance effects of buy-outsin particular. There has been relatively little work relating to the valuation mechanisms


used by private equity firms, structuring of deals and the processes by which value isadded by both entrepreneurial management and private equity firms. This different degreeof attention reflects the emphasis, especially in the US literature, on buy-outs as a finan-cial rather than an entrepreneurial phenomenon. More recent evidence suggests a ques-tioning of the dominance of the traditional financial, agency cost-based arguments forbuy-outs. This has been notable, for example, in respect of the role of managers’ privateinformation and perceived undervaluation of shares in the decision to take a companyprivate as well as with respect to the creation of value post-buy-out. Most research hasalso focused on buy-outs involving public corporations but there is growing recognitionof the distinctive nature of buy-outs involving family firms. This increasing attention hasbeen associated with attention to the buy-out negotiation process but little work has beenconducted on such aspects as the role of auctions involving private equity firms and theirimpacts on valuations and financial structuring.

Conclusions and topics for future researchThe theoretical and empirical discussion in this chapter indicates that private-equitybacked buy-outs can yield large gains in shareholder value and operating performance. Inthis section we draw on the findings presented above to consider topics for furtherresearch. Broadly following the structure of the chapter, this section considers the mainresearch gaps under the principal headings of the development of private equity and buy-outs, and the life-cycle of buy-outs to be in terms of: changes in deal characteristics overtime; international developments, sources of buy-outs; organizational forms of buy-outfinanciers and their involvement; generating value; and exiting buy-outs.

The development of private equity and buy-outs

Changes in deal characteristics over time The discussion of the trends in private equitybacked buy-outs showed that the characteristics of deals have changed over time withprivate equity firms adapting the types of deal in which they invest. As private equity firmsbecome more involved in buy-outs, there may be scope for deals in more innovative sectors(Robbie et al., 1999). There is a need for further research to address questions such as: howdo private equity-driven MBOs differ in the 1990s/2000s from those of the 1980s? Whatfactors are influential in determining private equity deals now compared to the 1980s?Comparative analysis of the 1980s with the current period might usefully examinedifferences in vendor and sector deal source and consider to what extent these are associ-ated with changes in the generation of deal opportunities, changes in regulatory conditions,developments in financing techniques and entry of new types of financiers, and so on.

International aspects As has been shown, buy-out markets are developing internation-ally as countries come under increasing pressure to restructure their economies. Public toprivate LBOs have been occurring in significant volumes over the past five years in coun-tries where they were previously absent. These developments add to the growing interestin the influence of contextual factors in finance and governance. How do the determinantsof private equity deals in different countries differ from those relating to the US?

The international spread of the buy-out phenomenon raises the role of international-ization by private equity firms which at present is little understood (Wright et al., 2006).


Internationalization may take different forms and may involve different scope anddifferent modus operandi. What determines the decisions by private equity firms to inter-nationalize? What resources distinguish those private equity firms that internationalizefrom those that do not? How do private equity firms investing in buy-outs decide on whichmarkets to enter and what mode of entry to adopt?

Sources of MBOs The focus in this chapter has been on two main sources of buy-outs,public to private transactions (PTPs) and buy-outs of family firms. The regulatory costsassociated with a stock market listing have important implications regarding the attrac-tiveness of the stock market for firms. Modest sized firms with growth and restructuringopportunities may find it difficult to raise funds. Emphasis on accountability may stiflethe ability of firms to realize entrepreneurial opportunities. In these circumstances,private equity investors can provide both finance to realize growth opportunities as wellas active governance. What is the impact of regulatory changes on developments in publicto private transactions?

Further examination is required relating to the attractiveness to private equity firms ofsecondary buy-outs which, as we have noted, have become a major feature of buy-outmarkets. Relatedly, a further neglected area concerns the low levels of purchases by buy-out funds from early stage venture capital funds. Murray (1994) suggests that greatervalue can be obtained through IPO or sale to a trade buyer. But we know from statisticsprovided by country venture capital associations that by no means all exits from earlystage funds are via these exit routes. It may be that buy-out funds do not possess theappropriate skills to continue to develop relatively early stage growing firms (Lockett etal., 2002). Detailed examination of the links between early stage venture capital funds andbuy-out funds might provide useful insights into this part of the private equity market.

Internationally, transactions involving family firms facing succession problems accountfor significant shares of buy-out markets, yet relatively little work has been focused on thisaspect. Increasing recognition of agency issues in family firms (Schulze et al., 2003) drawsattention to the information asymmetry problems that may occur in negotiating buy-outson succession. What are the implications of pre-buy-out governance and ownership struc-ture in family firms for the scope for a management buy-out in addressing successionissues? How do venture-backed and non-venture-backed buy-outs of family firmscompare in terms of negotiating a deal that is satisfactory to both the family owners andthe non-family owners buying out?

The buy-out life-cycle

Life-cycle behaviour and organizational forms of financiers Perhaps because of the USemphasis of much of the work on buy-outs there has been little attention to the natureand effects of the organizational form of the private equity firms involved. Private equityfirms can take several organizational forms including: independent limited partnershipsestablished and managed by professional private equity firms or leveraged buy-out asso-ciations that act as general partners in managing the fund on behalf of the limited part-ners; captive firms that obtain their funding from a parent financial institution;semi-captive firms that obtain their finance partly from their parent and partly by raisingclosed-end funds; and public sector firms. How do different organizational forms impact


private equity firms’ investment behaviour including the types of deals sought, screeningof investments and the sources of deal value that are sought, the degree of their involve-ment in monitoring and value adding activities, and their investment time horizon?Relatedly, to what extent are these different dimensions associated with the use of differentforms of financial instruments and incentives for management? Further work is alsoneeded to examine systematically how the structure of buy-outs funds and limited partneragreements differ from the structure of early stage venture capital funds. Similarly, thereis an absence of work that compares the contractual structures used by buy-out firmscompared with those used by early stage venture capital firms.

The attractive risk–return trade-offs available from private equity transactions havealso encouraged new types of entrants seeking to emulate these returns. Hedge funds inparticular have become attracted to making private equity investments, yet raise anumber of issues regarding their transaction oriented nature and their ability to addvalue to investees. Further research might usefully compare the role of private equityfirms and hedge funds in the buy-outs market. What is the impact of large funding avail-ability and the entry of new types of competing bidders, such as hedge funds, on privateequity deal pricing, and expected and realized returns? Relatedly, what are the implica-tions of new forms of financial instruments and the holders of these instruments, suchas hedge funds? For example, how are distressed private equity deals restructured? Howdo private equity firms and hedge funds compare in terms of providing governance forinvestee firms?

Adding value in MBOs Our analysis has suggested there may need to be greater empha-sis on entrepreneurial activity to improve the upside potential of these firms. Evidence onthe total factor productivity improvements in buy-outs has so far not teased out the con-tribution of innovative activities. Research in this area may require the construction ofnovel datasets involving the integration of multi-level, multi-source data. Quantitativeresearch is also required to consider the generalizability of qualitative findings regardingthe role of private equity firms in enhancing entrepreneurial behaviour by buy-outs.

Private equity firms may have a role in preserving value, especially where buy-outsencounter problems. What role do private equity firms play relative to that of securedcreditors in reorganizing distressed buy-outs? To what extent is there evidence of conflictsbetween the interest of the secured lender and the private equity firm? To what extent dothese cases represent examples where the private equity firm did not engage in sufficientmonitoring? To what extent were the problems the result of the private equity firm failingto identify issues at the initial due diligence stage? In addition, how successful have privateequity firms been in successfully turning around failing businesses or exiting distressedbusinesses through sale to another corporation?

Research at the private equity firm level is probably where the greatest gap exists. A startin this area has been made by Berg (2005) who presents a framework based on Porter’svalue chain approach to look at private equity firms’ strategies using evidence from theirwebsites. Further research might adopt alternative frameworks such as a resource-basedapproach (Barney et al., 2001) and undertake more systematic survey research to providericher insights. For example, in the light of Lei and Hitt’s (1995) argument that LBOs maylead to a reduced resource base for organizational learning and technology development,to what extent do private equity firms help fill this gap?


Wright et al. (2000b; 2001) theorized the need for different types of mindsets fordifferent types of buy-outs. Further systematic analysis is required to test these argumentsand to identify the effects of these different types of entrepreneurs. As markets matureand extensive exits from earlier deals become prevalent, an emergent phenomenon ofserial buy-out or buy-in entrepreneurs is occurring (Wright et al., 1997a; 1997b; Wrightet al., 2000d; Ucbasaran et al., 2003a; 2003b). How do entrepreneurs involved in privateequity-backed secondary buy-outs differ from those in first time buy-outs in terms of theirmotivations and strategies to create value? How and to what extent do serial buy-out/buy-in entrepreneurs learn from their previous experience and how is this reflected in the buy-out/buy-in opportunities in which they invest, the strategies they adopt and subsequentperformance? How do private equity firms identify and screen experienced entrepreneursfor buy-out and buy-in investments and how does this differ from their approach to serialstart-up entrepreneurs?

Exiting MBOs Finally, changes in stock and takeover markets also introduce issues con-cerning the ability of private equity firms to realize the gains from their investments, espe-cially for modest sized deals in mature sectors, while at the same time meeting investors’expectations of significant returns within a particular time period. As such, private equityfirms have had to develop new forms of exit, such as the widespread growth in secondarybuy-outs, but these raise questions concerning the returns that can be generated and thewillingness of limited partners to invest in the same deal a second time through a follow-on fund. At present, there is limited research on these phenomena. What is the role of sec-ondary LBOs and releveraging in enhancing the longevity of private equity deals? Whatare the implications of secondary LBOs for returns to private equity funds and LimitedPartners?

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PART III

INFORMAL VENTURECAPITAL

12 Business angel research: The road traveled andthe journey aheadPeter Kelly

An enduring phenomenon

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

Can you imagine what it must have been like for Henry Ford to find backers for his entre-preneurial dream more than a century ago? Finding an individual with cash to invest,expertise to share and who is not related to you, a business angel in accepted parlance oftoday, must have been a severe challenge for him. What is particularly striking is that ifHenry asked a business angel researcher where to find backers, our suggestions would belittle different than today. Tap into your own network of contacts for leads. Look aroundyour neighborhood for people that live in large houses or, in his day, those who owned atelephone. His search would have probably been confined geographically as he wasproposing to create a mass-market transportation revolution. Once located, the dealwould be consummated in a wood paneled room in private.

Fast forward 100 years. In today’s world of modern communications, Henry couldconduct a google search on the terms ‘business angel’ and ‘business angel network’ whichwould produce 45 million and 20 million hits respectively. For perspective, he could pickup a copy of a growing number of popular books about business angels (Benjamin andMargulis, 1996; 2005; Coveney and Moore, 1998; van Osnabrugge and Robinson, 2000;Amis and Stevenson, 2001; May and Simmons, 2001; Hill and Power, 2002). If he wantedto locate angel capital in the US or Europe, he could log onto www.eban.org andwww.angelcapitalassociation.org for leads and advice. For a snapshot of market activity,he could also navigate through numerous analytical reports from the Centre for VentureResearch (www.unh.edu/cvr). In venture finance circles, business angels are and continueto be front page news. In no small measure, this growing awareness of the critical role busi-ness angels play in supporting the growth ambitions of entrepreneurs has been fueled bya substantial and sustained body of research undertaken by scholars around the worldover the past 15 years.

Business angel research traces its roots back to the early 1980s and a pioneering studyconducted by William Wetzel (1983) in New England. This first ABC-study (attitudes,behaviors, characteristics) provided insights into what had been, up to that time, a largelyneglected phenomenon. Wetzel discovered that business angels were difficult to identifyas they preferred to operate anonymously, shared common traits as they were typicallywealthy, self-made males, were highly active, invested locally and early on, and reliedheavily on their network to undercover investment opportunities. In putting some bound-aries on our ignorance, Wetzel’s (1983) work spurred replication efforts in California

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(Tymes and Krasner, 1983), the Sunbelt region (Gaston and Bell, 1986), the Great Lakesregion (Aram, 1987), and the East Coast (Haar et al., 1988).

Significantly, much of this research was funded by the US Small BusinessAdministration who took an early and active interest to support research efforts aimed atunderstanding the size and underlying dynamics of the business angel phenomenon(Gaston and Bell, 1988). Collectively described as the informal venture capital market,business angels were recognized from the outset to be a specialized species of equityfinancier, quite distinct in character from venture capital financiers. Of perhaps greatersignificance, this pioneering work in the US market spurred research efforts internation-ally in the UK (Mason et al., 1991), Canada (Riding and Short, 1987), Sweden(Landström, 1993), Finland (Mason and Lumme, 1995), Norway (Reitan and Sørheim,2000), Germany (Brettel, 2003), Australia (Hindle and Wenban, 1999), Japan (Tashiro,1999), Singapore (Hindle and Lee, 2002), among others.

On the back of this first generation of demographic studies that described what busi-ness angels look like (Mason and Harrison, 2000), researchers increasingly turned theirattention towards understanding how the informal venture capital market operates. Anumber of these second generation studies focused on the investment decision-makingprocess (Riding et al., 1994; Landström, 1995; 1998; Mason and Rogers, 1996; vanOsnabrugge, 2000). Others were directed at policy-makers aimed at reducing the searchcosts incurred by entrepreneurs and investors alike through the development of businessangel networks and stimulating market activity (Harrison and Mason, 1996a). Yetanother significant stream of research that was undertaken at this time explored the extentto which theoretical perspectives such as decision-making (Landström, 1995; Feeneyet al., 1999), agency theory (Landström, 1992; Fiet, 1995; van Osnabrugge, 2000), socialcapital (Sætre, 2003; Sørheim, 2003), and signaling (Prasad et al., 2000) could be usefullyapplied into the domain of business angels.

2006 will mark the 25th anniversary of Wetzel’s pioneering study that stimulated thecreation of a specialized field of study, informal venture capital. In his pioneering study,Wetzel (1983) spoke of ‘putting boundaries on our ignorance’. The first objective of thischapter is to put some boundaries on our knowledge. What have we learned about theinformal venture capital phenomenon over the past quarter century? Having said this, weas researchers are trying to describe a largely invisible market that is only partially visibleto the eye. The second objective of this chapter is to highlight some of the burning issuesthat we need to tackle to further the development of this field of study. Finally, I want todraw out some of the implications of why research in this domain is vital for practition-ers and policy-makers alike.

Boundaries on our knowledgeBusiness angel research has followed a distinct pattern over time. The formative studieswere conducted in the early 1980s in the US and sought, in the first instance, to estimatethe size of the informal venture capital market and to describe the ABCs (attitudes, behav-iors, and characteristics) of business angels themselves. Public policy-makers, in particu-lar the Small Business Administration (SBA), took an active interest in funding researchprojects throughout the US. What early researchers discovered was that across all regionsstudied in the US, the informal venture capital market was large, very active, discrete innature, and that business angels shared similar traits.


Market scaleRelying on a market-based approach, Wetzel (1986) estimated that the angel market in theUS involved 100 000 individuals investing a total of $5 billion. In arriving at this estimate,he made assumptions about the proportion of start-ups that need external finance (5 percent), the average amount they raised ($200k), and estimates about the proportion andinvestment activity levels of the population based on the Forbes 400 list of richest people.Relying on SBA Dun’s Market Identifier data (Gaston, 1989b) employed a firm-basedapproach extrapolating the observed propensity of firms in his sample to raise businessangel finance to the nation as a whole. On this basis, he estimated that 720 000 privateinvestors made 490 000 investments totaling $32.7 billion in equity and $23 billion in debtfinance to some 87 000 ventures. Another estimate (Ou, 1987) based on data obtainedfrom the 1983 Survey of Consumer Finance, concluded that two million families in theUS held investments totaling some $300 billion in privately-held businesses in which theinvestor had no management involvement. In terms of size, the informal venture capitalmarket in the US was some eight to fifteen times larger, measured in terms of numberof investments made, than the formal venture capital industry. Interestingly, more con-temporary research in the US reaffirms both the scale and highly active nature of theinformal venture capital market, estimating that 300 000 to 350 000 angels invest about$30 billion a year in 50 000 ventures (Sohl, 2003).

Mason and Harrison (2000) took a slightly different tack to estimate the size of theinformal venture capital market in the UK by extrapolating from the activity levelsobserved in the visible part of the market, namely among business angels registered inbusiness angel networks. Based on assumptions regarding the proportion of businessangels that participate in BANs, their estimates ranged from 20 000 to 50 000 investorsinvesting £500 million to £2 billion. Van Osnabrugge and Robinson (2000) estimated thatbusiness angels do thirty to forty times as many deals as venture capital funds. Recentresearch completed in Sweden (Avdeitchikova and Landström, 2005) based on a large rep-resentative sample of the Swedish population, estimated that approximately 2.5 per centof the population aged 18 to 79 (150 000�) have made informal investments totaling inexcess of $11 billion. Getting a handle on market scale is important as it has provided astimulus among policy-makers, entrepreneurs, business angels and by implication,research funding bodies, that the informal venture capital phenomenon needs to bedefined and understood before it can be properly stimulated.

Attitudes, behaviors and characteristics: business angels in profileFor the most part, formative angel research followed a familiar pattern. Business angelswere uncovered through a combination of direct (contacts made through referrals, mainlybusiness angel introduction services) and indirect (wealth indicators) approaches. Earlyresearchers quickly discovered that business angels typically know other business angels;hence the adoption of the term ‘snowball sampling’. The challenge of finding businessangels persists today both for researchers seeking insights and for entrepreneurs seekingcapital. By its very nature, the business angel market is discrete in nature; it is an elusivephenomenon to study, but perhaps that is inevitable.

Based on convenience samples, a number of studies have been completed around theworld, relying, for the most part, on survey instruments with little theoretical guidancesoliciting the views of business angels about their background, interest and means of

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

● A typical business angel is a middle-aged male (40�) with entrepreneurial streetsmarts (new venture experience).

● The investment decision is motivated by the prospect of financial return and sig-nificant non-financial motivations (psychic hot buttons to use William Wetzel’sterminology).

● Business angels rely on a close circle of business associates and friends to referpotential investment opportunities to them.

● A typical deal involves a syndicate of business angels and is usually made in ven-tures close to the home base of the investor(s).

● Angels are attracted to proposals where they can apply their knowledge, skills andexperience thus bringing value added benefits to the venture.

● A substantial minority of business angels (up to 40 per cent or more) have yet to maketheir first investment, variously described as latent angels or virgin angels (Freearet al., 1994; Coveney and Moore, 1998; van Osnabrugge and Robinson, 2000).

While it is appealing to conclude that business angels as a group across a number of coun-tries share similar traits, the evidence collected to date supports the notion that the businessangel market is rather heterogeneous in character (Wetzel, 1994). One of the early pieces ofresearch that explored this issue (Postma and Sullivan, 1990) identified three distinct groupsof business angels based on their motivation for investment – financial, altruistic or self-oriented. Gaston (1989a) developed a ten-category classification scheme based on metricsrelated to investment activity, post-investment involvement, and personal characteristics.1

In much the same spirit, Benjamin and Margulis (1996) developed a nine-category classifi-cation scheme of their own.2 Coveney and Moore (1998) highlighted an important, yetlargely neglected, category of business angel, namely those that want to make investmentsbut have not yet done so.3 Early research from Freear et al. (1994) coined the term ‘virginangels’ to describe these latent investors. Other authors (Kelly and Hay, 1996a; 1996b) havefocused on the active market element, so-called serial investors, who have completed anumber of deals. Finally, Sørheim and Landström (2001), have developed a four-categoryclassification scheme based on investment activity and investor involvement. To them, abusiness angel is defined as being both highly active and highly involved.

This early base of research, or first generation studies, provided a necessary foundationfor future work, as researchers:

● Demonstrated that the informal venture capital market was large and very active,particularly in the crucial early stages of venture development.

● Confirmed that indeed informal venture capital is a global phenomenon.● Developed a common basis for defining the terms ‘business angel’ and ‘informal

venture capital’.


● Highlighted the heterogeneous nature of the market and some of the practicaldifficulties undertaking research on a largely invisible population.

● Articulated questions for future research based on insights and observations frommapping the terrain.

Beyond ABCs: second generation studiesMoving beyond describing the informal venture capital phenomenon, researchers beganto turn their attention to issues related to: (1) how the informal venture capital marketoperates in practice (Riding et al., 1994; Mason and Harrison, 1996; van Osnabrugge,2000); (2) the role of public policy-makers in stimulating and supporting market devel-opment (Harrison and Mason, 1996b; Wetzel and Freear, 1996); and (3) the introductionof an element of theoretical rigor into the field (Landström, 1992; 1995; Fiet, 1995; vanOsnabrugge, 2000; Kelly and Hay, 2003). In many respects, first generation studies werethe pilot from which researchers developed increasing levels of sophistication in termsof the choices made with respect to: i) framing research questions; ii) data collection; andiii) analysis. In addition a great impetus for these second generation studies, was thegrowing number of academic outlets in which to publish this work. Informal venturecapital research was coming of age as a field of academic study. What have we learnedfrom this large and growing body of second generation studies?

How do they do it?Early work in Canada (Riding et al., 1994), provided some insights into the business angeldecision-making process. The authors concluded that business angels are highly selectiveinvestors who form initial assessments based on concept feasibility, management cap-ability, and prospective financial return. The perceived attractiveness of a given opportun-ity also appears to be influenced greatly by deal referrers. While adopting a ratherinformal approach to due diligence, a key factor in the decision to invest is the personalchemistry that develops between the entrepreneur and the angel.

Mason and Harrison (1996) reached broadly similar conclusions as Riding et al. (1994)in their study of angel decision-making behavior in the UK. Relying on verbal protocoltechniques, they concluded that angels form opinions about the potential trustworthinessof the entrepreneur rather quickly, so-called swift trust (Harrison et al., 1996). Early on,angels look for deal killers and over time make an assessment of both the attractivenessof the opportunity and the perceived level of competence of the management team toexploit it.

Van Osnabrugge and Robinson (2000) conducted a large scale comparative study con-trasting the decision-making approaches of business angels and venture capitalists. Whileboth were attracted to opportunities with strong growth potential and driven by capablemanagement teams, business angels spent less time investigating and relied less on outsideparties to assess the attractiveness of a given investment opportunity.

Landström (1995) identified two distinct strategies used by business angels to aid themin making investment decisions. Specialist investors choose to limit their activity in areasrelated to their particular market and/or technical expertise. Compared to investors thatsought portfolio diversification, specialists examined fewer proposals and exhibited ahigher propensity to invest than explicitly diversified investors. Having said this, the twogroups relied on broadly similar criteria to evaluate opportunities.


Public policyA second body of work focused on some of the challenges that impede the developmentand growth of the informal venture capital market and discussed some of the mechanismsby which public policy can alleviate this situation. Broadly speaking, the challenges to beaddressed include: i) conditions of excess demand for equity capital in the early stages, thecapital problem; ii) the difficulties encountered in trying to bring suppliers and users ofcapital together, the search problem; and iii) finding ways to stimulate market activity, theincentives problem.

The capital problem was diagnosed as early as the 1930s by the Macmillan Committeeon Finance and Industry of the UK government and is most acutely felt in early stagetechnology-based ventures requiring less than $500 000 in equity and that have exhaustedother financing sources including own funds and those provided by friends and family.Mason and Harrison (1994) also confirm the existence of this gap in the UK. Sohl (1999)has also identified the appearance of a second equity gap for ventures seeking between $2and $5 million, an amount that is too large for consideration by business angels and toosmall to attract the attention of venture capital funds in the US. That the capital problempersists may be symptomatic of the complex and dynamic nature of the interplay betweenlove money (founders, family and friends), soft money (government), play money (angels)and custodial money (venture capitalists). In fact, I believe there is a strong basis to con-clude that researchers and public policy-makers will always be grappling with this issuegiven the dynamism of the problem we are trying to solve.

The search problem arises from the fact that given the largely invisible character of theinformal venture capital market, it is difficult for business angels and entrepreneurs to findeach other. Developing forums through which capital seekers and providers can meet hasbeen a longstanding concern of scholars both in the US (Wetzel and Freear, 1996) andthe UK (Harrison and Mason, 1996a; 1996b). Governments around the world have keenlyembraced the development of business introduction services and business angel networksto alleviate the search problem for entrepreneurs and business angels alike. Generallyspeaking, these mechanisms provide a forum for entrepreneurs and angels to develop theirnetworks. While differing greatly in terms of size, scope and method of operation, mostof these forums provide guidance to entrepreneurs seeking cash and opportunities to beintroduced to prospective investors.

Increasingly, business angel networks have begun to address the incentives problem,acting as an important conduit through which lobbying efforts have been made to influ-ence policy. The introduction of various forms of tax relief for business angel investing inthe UK owe much to the work of Harrison and Mason and to the growing number ofhighly active business angel networks operating in the UK. More research needs to beundertaken to determine the impact these incentives have both in terms of expanding thenumber of investments made and importantly the quality and sophistication of dealmaking in the informal venture capital market.

Building bridges to theoryAs researchers moved beyond fact gathering to more theoretically grounded studies,a growing body of research looked to other fields of study for guidance including agencytheory (Landström, 1992; Fiet, 1995; van Osnabrugge, 2000; Kelly and Hay, 2003), socialcapital (Kelly and Hay, 2000; Carter et al., 2003; Sætre, 2003; Sørheim, 2003), and


signaling theory (Prasad et al., 2000). Each of these theoretical anchors will be discussedin turn, beginning with agency theory.

Agency theory On the face of it, the domain of the business angel is potentially rife withagency risks. Investors and entrepreneurs alike find it very difficult to identify all of theoptions available to them (Harrison and Mason, 1996b). Once identified, it also appearsdifficult for business angels to fully assess the intentions and competence of the entrepre-neur and vice versa (van Osnabrugge, 2000). Moreover, business angels are very activeparticipants in the venture development process; involvement that can be seen as bothmaking a value added contribution to the venture and as a means for investors to keeptabs on or monitor the activities of the entrepreneur. Finally, the most significant negoti-ating issue between the parties is the distribution of equity stakes, in other words, theincentive structure (Benjamin and Margulis, 1996), a central pillar of agency theory.

In a comparative study of venture capitalists and business angels, Fiet (1995) examinedthe extent to which investors relied on themselves as opposed to others for obtainingmarket (unforeseen competitive conditions) and agency (the possible divergence of inter-ests between investor and entrepreneur) risk reducing information. He found that agencyrisk was the primary preoccupation for business angels whereas venture capitalists weremuch more concerned about market risk.

Landström (1992) surveyed firms that received business angel finance. Relying onagency theory, he hypothesized that business angels would be more involved in venturesthat were: a) highly innovative; b) early stage; c) operating in turbulent environments;d) managed by inexperienced entrepreneurs with lower equity stakes in the venture;e) located close to the investor’s home base of operation; and f) competing in an indus-try familiar to the investor. He found support only for the geographic proximity andindustry familiarity predictors. In interpreting the findings, Landström concluded that:‘it is not the required level of control which is most influential in determining the fre-quency of contacts and (level of) operational work. It is rather the feasibility for activeinvolvement that seems to be most influential’ (1992, p. 216). Moreover, he stated thatthe relationship between the parties is highly personal and infused with trust, calling intoquestion the inherently negative assumptions about people upon which agency theory isbased.

Van Osnabrugge (2000) found support for the notion that compared to venture capi-talists, business angels work from a notion that contracts between themselves and theentrepreneur are necessarily incomplete (the incomplete contracts approach). For busi-ness angels, control over the entrepreneur’s behavior and the venture’s development is bestachieved through being actively involved in the venture post-investment as opposed todevoting undo time, attention and detail to crafting a comprehensive contract ex ante (theprincipal–agent approach).

In their study, Kelly and Hay (2003) found support for a central notion of agencytheory, namely that the relative equity stakes of the parties matter. The higher the equitystake of the investor(s), the more attention to contractual detail particularly with regardto specific provisions that could, in some way, impact the relative equity stakesgoing forward. However, he concluded that the economic relationship between investorand entrepreneur appears to be infused with high levels of interpersonal trust fromthe outset; a finding consistent with that of Landström (1992). Moreover, the level


and form of investor involvement with the venture post-investment appeared to bemotivated more from venture need as opposed to being a means of checking up on theentrepreneur.

Social capital The intuitive appeal of social capital perspectives into the field of infor-mal venture capital is quite clear. Entrepreneurs and business angels alike need to developand manage their network of connections to support the development of their venturesand portfolios respectively (Birley, 1985). The notion of social capital is also captured inthe work of Politis and Landström (2002), who regard informal venture capital investingas part of one’s entrepreneurial career. The accumulated experience and connections anindividual makes building a business as an entrepreneur, prove to be an invaluable andtransferable resource that can be leveraged as a business angel.

In his examination of the pre-investment behaviour of business angels, Sørheim (2003)unpacked the notion of social capital into structural (network ties), relational (trustwor-thiness of the parties to the deal) and cognitive (shared vision or common ground) dimen-sions. A key finding of his work, based on interviews with experienced business angels inNorway, is that the development of common ground is a necessary antecedent for build-ing a long-term trusting relationship between the business angel and entrepreneur.

Based on interview data obtained from companies that received angel investment inNorway, Sætre (2003) introduced the notions of competent and relevant capital. By com-petent capital, he means the base of new venture, general management, educational andexperience gained as a business angel investor that an individual brings to the venture.What is an even more valuable commodity for entrepreneurs is business angels that bringa base of experience in the industry in which the venture competes, so-called relevantcapital.

Social capital has also been used as a lens to examine the challenges that female entre-preneurs face in their quest to secure equity financing (Carter et al., 2003). Raising equityfinance necessitates developing and utilizing one’s social network, an area where femaleentrepreneurs appear to be disadvantaged (Brush et al., 2002). Establishing network con-nections appears to be an important conduit for entrepreneurs to uncover the informalventure market (Amatucci and Sohl, 2004). From the capital supply perspective, Harrisonand Mason (2005) concluded that male and female business angels differ very little butthat there are gender differences evident in networking behaviors, with females being lessconnected with or knowing other business angels.

Signaling theory There is an obvious intuitive appeal to exploring the potential utility ofsignaling theory in the informal venture capital domain. Entrepreneurs and investorsalike need to be able to provide informative signals as to the quality of the opportunityand their capability to successfully exploit it. Prasad et al. (2000) argued that priorresearch demonstrates that the proportion of equity retained by the entrepreneur is asignal of project quality when personal funds available to invest in the project are unlimi-ted. They develop a model that relaxes this assumption and concluded that a moreappropriate signal in the domain of the business angel is the proportion of the entrepre-neur’s wealth invested in the venture. The higher the proportion, the stronger the signalof both the venture’s perceived value and the entrepreneur’s commitment to the venture.It is important to note that this model is developed from the entrepreneur’s perspective


only and focuses on the utility of a one-dimensional signal, proportion of personal wealthinvested.

That researchers have looked to theoretical perspectives developed in other fields ofstudy is in itself a signal of the growing maturity of informal venture capital as a field ofstudy. Building on this base of emerging knowledge, where do we go from here? It is tothis question that we now turn our attention.

Research agenda

Bridging the gap between FFFs and business angelsA recent research report (Bygrave et al., 2003) based on data collected as part of theGlobal Entrepreneurship Monitor (www.gemconsortium.org) research initiative high-lighted the importance of informal investment across a sample of 18 countries where datahad been provided by 40 or more informal investors. Annual informal investment for theperiod 1997–2001 was estimated to be almost $200 billion, two-thirds of which occurredin the US. The vast majority of informal investment made (88 per cent) was from familymembers, relations, friends and neighbors. Raising money from the three Fs (family,friends and fools), is the predominant source of start-up finance, an observation consis-tent with analysis of sources of funding for the Inc 500 listing of America’s fastestgrowing private companies (Inc, 2000).

Sohl (2003) highlighted the gap between what might be termed founding capital (FFFs)and business angel finance. The GEM study demonstrates that founding capital appearsto be a necessary pre-condition to start-up, yet there appears to be a significant discon-nect when time comes for an entrepreneur to raise money from business angels. What arethe causes of this disconnect? On what terms and conditions is founding capital raised?To what extent is founding capital and business angel capital compatible? It is, in somerespects, very remarkable that we know virtually nothing about the founding capitalphenomenon despite the fact that this source invests more than $150 billion annually andis, in essence, a feeder to the business angel market.

Demographic research: mapping the terrainTwo other significant strands of research also follow from the GEM research initiative.First, we should undertake business angel demographic studies beyond developedeconomies to include developing nations such as Korea ($17 billion annual informalinvestment), Mexico ($3 billion�), Argentina ($1 billion�) and Brazil ($1 billion). Suchresearch will help us to better understand the influence that contextual and environmen-tal variables have on business angel investment activity. What framework conditionsencourage or discourage business angel investment activity?

A second strand of research springs forth from the finding that across the entire sampleof 29 nations (including the 11 nations where the number of informal investors surveyedwas less than 40), almost one-third of informal investors are female. Most of the receiveddemographic studies conducted to date have concluded that the population of businessangels is predominantly middle-aged males. Female business angels appear to be a sig-nificant source of capital for entrepreneurs. To date, very few studies have been con-ducted to contrast the approach of female versus male business angels (Harrison andMason, 2005).


Public financiers: help or hindranceYet another under-researched area is the role and impact of public sector funding instru-ments targeted at bridging the equity gap between founders’ capital and obtaining busi-ness angel finance. European governments have been particularly active in this regard,establishing a wide variety of financing programs to stimulate regional entrepreneurship,the development of technology-based ventures, and university spin-outs, among count-less other objectives. For example, in Finland an entrepreneur can raise money frompublic agencies to build a prototype and hire consultants to develop a business plan. InSweden, the number of programs and support services have become so numerous thatconsultants have established thriving practices helping entrepreneurs successfully to navi-gate this highly crowded field.

Having said this, a number of important questions need to be addressed. When is gov-ernment support most needed, wanted and in what form(s)? To what extent are the goalsof government funding bodies compatible with those of the entrepreneur and professionaloutside investors? What implications does the decision to raise funds from public sectorsource have in terms of subsequent fund raising? Signaling theory may be a potentiallyuseful lens through which to address these issues. In what circumstances does the presenceand involvement of a public sector catalyst send a positive or negative signal to follow-onfinanciers? This line of research enquiry could also be usefully extended to consider towhat extent the presence and involvement of a particular business angel(s) sends positiveor negative signals to other external investors. It is to a discussion of the relationshipbetween business angels and venture capitalists to which we now turn our attention.

Bridging the gap between business angels and venture capital fundsWe know that business angels tend to invest earlier, in smaller amounts and in more busi-nesses than venture capital funds (van Osnabrugge and Robinson, 2000). A typical angeldeal occurs at the seed or early stage of development in the range of $100 000 to $2 millionfrom a syndicate of six to eight investors (Sohl, 2003). The observed differences in invest-ment preferences have led some authors to conclude that business angels are the farmsystem for venture capitalists and thus complementary in nature (Freear and Wetzel,1990; Harrison and Mason, 2000). Given the entrepreneurial background and experienceof angels and their desire to be actively involved in the venture post-investment, there isgood reason to believe that raising angel capital should enhance the fundability of a pro-posal by raising valuations to a level that warrants much larger venture capitalist follow-on investment.

However, the extent to which the business angel and venture capital markets are indeedcomplementary in nature is still an open area for further research (Harrison and Mason,2000). A consequence of the rapid growth in the venture capital industry, particularly inthe US, is that there has been a continual movement towards larger deals at later stages ofventure development. The venture capitalist comfort zone appears to be later stage dealsthat require $10 to $15 million in investment. Sohl (2003) has concluded that a secondary(and growing) funding gap exists for ventures requiring between $2 and $5 million, anamount too large for angels but too small for venture capital funds to provide economi-cally. Rather than being complementary, the two markets may in fact be moving towardsbeing distinctly different in character, a theme that Jeffrey Sohl will explore in Chapter 14.We know that both business angels and venture capitalists are attracted to proposals


driven by a talented team exploiting high growth opportunities. We also know that bothbusiness angels and venture capitalists expend effort evaluating opportunities, albeit theformer in a much less formal and comprehensive manner (van Osnabrugge, 2000) and thatan important motivation for investing is capital gains appreciation. However, the infor-mal and formal venture capital market differs in two key respects: i) angels do not face thesame pressures to invest as it is their own capital at risk; and ii) angels participate for thefun element and the prospect of capital gain whereas venture capitalists are motivated, inlarge part, by the latter. On the face of it, the formal and informal venture capital marketsappear to be complementary (Harrison and Mason, 2000) but are they in fact compatible?

Further research needs to explore in what ways the informal and formal venture capitalmarkets work together or at cross purposes. Allow me to highlight some interesting ques-tions that, to date, have not been addressed. Complementarity presumes that businessangels invest early and bring venture capitalists in as equity financiers later. We desper-ately need more longitudinal research to satisfy ourselves that this is, in fact, the case.Second, assuming that bridges exist between the informal and formal venture capitalmarkets, it raises the question as to how this hand-off between business angel and venturecapitalist can best be achieved and by whom. Third, it appears that the emerging venturecapital financier start-up model implies a fund placing many large bets in a given oppor-tunity space to achieve a hit. This approach is fundamentally at odds with that of busi-ness angels who prefer to invest smaller amounts of capital early on. Which raises thequestion, is one approach better than the other? Do these distinct styles of start-upfinance actually place business angels and venture capitalists in a competitive as opposedto cooperative relationship? Fourth, what role, if any, is there for public policy-makers tostimulate more deal flow from angels to venture capital funds and vice versa (Harrisonand Mason, 2000)? In short, we need to understand better how to create an environmentthat nurtures and supports the development of rapid growth ventures, particularly inrapidly changing knowledge-based economies.

Tapping into experienceAnother consistent theme that has been highlighted in emerging research is that a sub-stantial minority of individuals who deem themselves business angels have yet to con-summate their first investment, so-called latent or virgin angels (Freear et al., 1994;Coveney and Moore, 1998; van Osnabrugge and Robinson, 2000). Moreover, based onestimates in the US (Sohl, 2003), some 2 million individuals fit the business angel profilebut in any given year only some 250 000 are active market participants. There is immenseuntapped potential in the informal venture capital market, which gives rise to a numberof important research questions.

First, it appears that business angel investing is a learning-by-doing experience (Kellyand Hay, 1996a; 1996b). Starting out an individual needs to learn how to tap into sourcesof deal flow, once uncovered evaluate opportunities, structure sensible deals, help entre-preneurs build value and hopefully realize successfully on the value created as a result. Ifindeed angels learn through practice, researchers ought to be focusing more attention onthe minority of business angels that are highly active, so called serial investors (Kelly andHay, 1996a; 1996b; van Osnabrugge, 2000) or deal-makers (Kelly and Hay, 2000). My ownresearch tends to support the view that successfully cashed out entrepreneurs whose ven-tures relied on external equity to support growth become very active business angels soon


after cashing out. Do these wealthy and highly experienced entrepreneurs turned investorsshare common traits? Do they go about the task of finding, evaluating and closing dealsin a different way from less wealthy and less experienced counterparts? Are these types ofindividuals more compatible in approach with venture capital funds, having probablyraised money from this source before as an entrepreneur? My sense is that we have onlybegun to tap into this most discrete and most active segment of the business angel market.

Second, we know that business angels are increasingly using syndication as means ofdiversifying risk, participating in larger deals than they might otherwise be able to,sharing information, and as a means for building their network of relationships withother business angels and capital providers. While the advantages of syndication areclear-cut, our understanding of how they come about and operate is rather limited. Howdo business angels choose syndicate partners? How are the goals of individual syndicatemembers reconciled? How should the interface between the syndicate and the entrepre-neur be optimally managed? Does the presence of a syndicate encourage or deter follow-on financiers?

Third, we need more detailed research profiling the similarities and differences ofthe distinct subsets of business angels identified as a result of previous research efforts(Coveney and Moore, 1998; van Osnabrugge and Robinson, 2000; Sørheim andLandström, 2001). In what ways are latent or virgin angels different from highly activebusiness angels? One of the key advantages of raising money from business angels is theability to tap into a base of personal experience building new ventures. As a prospectivebusiness angel with new venture experience, how can I best use it? As a prospective busi-ness angel lacking this experience, how can I compensate for it?

Sharing entrepreneurial knowledgeResearchers often use the term smart money to describe business angel finance. Angelsare attracted to proposals where their experience can be applied so as to enhance theprospects of creating economic value both for themselves and the entrepreneur. When allis said and done, the decision to invest is a highly personal one influenced to a great degreeby gut feeling, particularly as it is the business angel’s own capital that is put at risk. Toooften, in my opinion, we consider business angel investments as business transactions,ignoring the mating and relationship rituals that cause them to happen. Perhaps we oughtto look to fields like psychology and sociology for guidance in exploring why certain busi-ness angels and entrepreneurs connect while others fail to do so. As most business angelsare highly experienced in building new ventures from scratch, in choosing to back a par-ticular entrepreneur, an angel is choosing to share their entrepreneurial experience andknowledge with them. What triggers this highly personal decision? What sort of know-ledge and experience matters most in favorably skewing the odds of success? How bestshould this knowledge and experience be shared? Acting as a sounding board and beinga mentor to the entrepreneur are often cited as key contributions made by business angels(Coveney and Moore, 1998; van Osnabrugge and Robinson, 2000; Hill and Power, 2002).What specifically does this mean in practice? On what issues are business angels soundedout? How is the relationship between angel and entrepreneur managed in practice? Onlyby getting a clearer picture of what goes on both inside an angel’s head and between themand the entrepreneurs they back can we understand the dynamics of how the informalventure capital market operates in practice.


Revisiting methodological approachesVery early on, the pioneer of business angel research, William Wetzel, observed that theinformal venture capital market is largely invisible in nature. As a result, the size and char-acteristics of the angel marketplace is ‘unknown and probably unknowable’ (Wetzel,1983). In the absence of knowing what the population looks like, any sample thatresearchers have drawn upon for insight is, by definition, unrepresentative and will,despite our best efforts, remain so in the future.

As our body of accumulated research grows, so too does our understanding of how theinformal venture capital market operates. Early efforts to define market demographicsrelied on replicating studies made in the US in the early 1980s. For the most part,researchers have relied on surveys administered to convenience samples drawn mainlyfrom formalized networks of angels, business introduction services. As the received baseof business angel research has grown, so too has our sophistication in identifying anddealing with some of the significant methodological challenges we face. In an effort toguide future research efforts with the aim of expanding and deepening our knowledge ofa complex social phenomenon, I wish to highlight a number of issues here.

First, by relying on insights from business angels who have chosen to register in a formalnetwork, we may be excluding a substantial proportion of deal-makers (van Osnabrugge,1998; Kelly and Hay, 2000; Sørheim and Landström, 2001) who appear to have little needfor the services of network providers such as business angel networks to generate invest-ment leads. A convenience sample drawn from a network is, pardon the pun, convenient.Future research efforts should consider ways to engage business angels that have, so far,eluded our attention. One potentially useful resource to identify new leads is to engageand identify active business angels from within a university’s alumni base.

Second, in markets where numerous studies of business angels have been conducted,particularly in the US, UK, Canada and Scandinavia, there has, at times, been heavyreliance on respondents drawn from similar network organizations over time. To theextent that these networks attract new blood, fresh insights are obtained. We must bemindful, however, of the potential biases introduced by continuing to seek out informa-tion from individuals positively inclined to participate in any and all research studies.

Third, much of the received research undertaken to date has been cross-sectional innature. That is to say, we rely too much on surveys designed to collect data at a particu-lar moment in time. In doing so, we tend to have focused on informal venture capital asan economic transaction as opposed to a highly fragile, personal commitment of twoparties to work together. What is desperately needed is longitudinal transaction-basedresearch relying on the deal as the unit of analysis. With this longitudinal perspective, weare better able to understand the complex dynamics of what brings entrepreneurs andbusiness angels together, what keeps them together, what drives them apart and why somedeals succeed while others fail. To capture the richness and complexity of these relation-ships, researchers should undertake more studies that employ structured interviewing andparticipant observation, among others.

Fourth, the primary focus of research undertaken to date has sought out the views ofinvestors only. While this is eminently sensible in situations where an individual alonedecides whether to invest or not and on what terms, we need to balance the views of capitalproviders with that of entrepreneurs in need of capital. We know that both angels andentrepreneurs find it very difficult to find each other in a timely manner. A great deal of


literature has examined the role of network intermediaries to facilitate this introduction.Having said this, a number of pressing research questions remain. Why do deal-makersappear to shun network intermediaries? How do deal-makers build their network? Howdo entrepreneurs seeking funding build their network? We know a great deal about whatattracts angels to particular investment proposals. On the flip side, what attracts a particu-lar entrepreneur to an angel? We also know that angels, at least the successful ones, wantto be actively involved in the venture post-investment. How do entrepreneurs feel aboutthis interaction? How do they manage it? There also appears to be a growing consensusthat business angels tend to want to invest in a project with other business angels. Howdo entrepreneurs manage a syndicate?

Business angel research: the journey aheadLooking back, considerable progress has been made mapping the business angel terrain,but much work remains to be done. We have reached what Malcolm Gladwell has termeda ‘tipping point’ where both the volume and sophistication of business angel research isset to explode. We know that business angels are the second most important source ofcapital next to founders, family and friends. We know that business angels fill the ever-increasing vacuum being left by venture capital fund managers funding seed stage ven-tures. We know that business angels are a difficult domain to study and a difficult force tomobilize given the discrete and invisible nature of informal venture capital. Researchers,practitioners and policy-makers alike have a shared interest to cultivate a deeper under-standing of how the informal venture capital operates. Developing this understandingentails significant challenges for all of these three interlinked stakeholder groups.

If informal venture capital is to develop into a mainstream field of academic study,researchers will need to pay more attention to the following issues. The term ‘businessangel’ has, at times, been expanded to include related investors such as family and friends.My preference is to see the term ‘business angel’ retained for arm’s length investors andthat related investors be explored as a distinct class of investor. Second, researchers willneed to move beyond convenience surveys to employ more sophisticated sampling andresearch designs. Third, we need to anchor more studies in theoretical perspectives drawnfrom other fields and importantly, developed within the informal venture capital fielditself. For practitioners, including business angels and various intermediaries who seek tobring investors and entrepreneurs together, three significant challenges need to beaddressed. First, I believe we are working under the presumption that market trans-parency is a desirable end objective; with clarity more deals would be consummated. Theventure capital market is highly transparent but for most entrepreneurs inaccessible. Myown belief is that the invisible character of the informal venture capital market is both itsdefining trait and an important stimulus for investment itself. In short, business angels areattracted to invest in private companies precisely because the market is demonstrablyinefficient. Second, mechanisms need to be explored to facilitate the sharing of experienceand risk-taking among active business angels and importantly between active and virginbusiness angels. Third, business angels and particularly intermediaries, have a crucial rolein bridging the two gaps between FFFs and venture capital funds.

Public policy-makers will need the courage to move beyond promoting business angelcapital as an important source of finance to creating conditions where business angelcapital can be optimally mobilized. My sense is that we treat business angel finance at


times as a public good finding ways to make the market more visible (like that for venturecapital) and more active. My own view is that the market is attractive for business angelsbecause it is difficult to access. Public policy-makers also need to look at the impact thattax incentives and other stimuli have on business angel investing activity. I also believepublic policy-makers have a vital role to play to provide transactional lubrication betweenlove money (FFFs) and custodial money (venture capital). Finally, I appeal to the publicsector to continue to fund business angel research as we are only now beginning to attackthis challenging field of study in the sophisticated manner in which research has beenundertaken in the venture capital field over the past 30 years. Our journey has just begun.

Notes1. ‘Devils’ – angels who gain control of the company; ‘Godfathers’ – successful, semi-retired consultants or

mentors; ‘Peers’ – active business owners helping new entrepreneurs, with vested interest in the market,industry, or individual entrepreneur; ‘Cousin Randy’ – a family-only investor; ‘Dr Kildare’ – professionalssuch as MDs, CPAs, lawyers and others; ‘Corporate Achievers’ – business professionals with some successin large corporate organizations but who want to be more entrepreneurial and in top-management roles;‘Daddy Warbucks’ – the minority of business angels who are as rich as all angels are commonly, andincorrectly, believed to be; ‘High-Tech Angels’ – investors who invest only in firms manufacturing high-technology products; ‘The Stockholder’ – an angel who does not participate in the firm’s operations; and‘Very Hungry Angels’ – angels who want to invest over 100 per cent more than deal flow permits.

2. ‘Value-Added Investors’ – very experienced individuals who invest in syndicates and want to be activelyinvolved in the venture development process; ‘Deep-Pocketed Investors’ – individuals who have built andsold a business of their own, have corporate experience, seek control and some level of involvement withthe venture; ‘Consortium of Individual Investors’ – individuals who have built new ventures, prefer passiveinvolvement with the business and who invest as a group in a wide variety of different proposals includingearly stage ventures; ‘Partner Investors’ – a buyer in disguise who has high needs for control, wants an exec-utive position but lacks the funds to buy out a business outright; ‘Family of Investors’ – represents a poolof funds supplied by family members, astutely managed and desirous of being intensely involved over shortperiods of time; ‘Barter Investors’ – focus on early-stage growth businesses providing needed resources tosupport growth in exchange for equity; ‘Socially Responsible Investors’ – seek intense interaction with ven-tures that share a common cause with them; ‘Unaccredited Investors’ – less experienced, less affluent indi-viduals who invest small amounts of capital in a diversified manner; and ‘Manager Investors’ – individualswho have a low tolerance for risk and want to buy into a challenging job by making one personally signifi-cant investment in a venture in which they are actively involved.

3. ‘Virgin Angels’ – individuals with funds available who are looking to make their first investment; ‘LatentAngels’ – rich individuals who have made angel investments, but not in the past three years; ‘WealthMaximizing Angels’ – rich individuals and experienced businessmen who invest in several businesses forcapital gain; ‘Entrepreneur Angels’ – very rich, very active entrepreneurial individuals who back a numberof businesses both for the fun of it and as a better option than investing in the stock market; ‘Income SeekingAngels’ – less affluent individuals who invest some funds in a business to generate an income or even a jobfor themselves.

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

IntroductionIt is widely acknowledged that business angel investors (BAs) are important sources offinancing for early-stage growth-oriented new businesses (see Chapter 12 by Kelly). Thefocus of this chapter is to review the research literature with respect to the investment deci-sion-making process employed by business angels. This is important for several reasons.First, understanding business angels’ decision-making is important to public policymakers. Governments have recognized the importance of business angels and are seekingways of encouraging higher levels of business angel investment activity. This goal promptstwo debates. One issue is whether governments ought to encourage participation of morebusiness angels; the other issue is how to encourage additional investment by businessangels. As to the first issue, Gompers and Lerner (2003) argue that encouraging amateurinformal investors may be counterproductive from a societal perspective in part becausetheir investment decisions may not be well-founded. As to the second issue, Bygrave andHunt (2005) advocate a ‘tax break and other [unspecified] incentives’ for business angelsand other informal investors (examples of which are described by Lipper and Sommer,2002); however, the design of any such incentives should be grounded in a thoroughunderstanding of business angels’ motivations, decision-making processes and criteria.Accordingly, understanding business angels’ decision-making process may be a key to theappropriate design of public policy initiatives that seek to expand the supply of businessangel investment without encouraging less-than-competent informal investors.

Second, the study of the decision process employed by business angels is of potentialimportance to researchers. As van Osnabrugge (2000) observes, decision-making at thislevel provides a unique laboratory in which to examine the impacts of agency theory andhow investors deal with agency risk. At the heart of the process, a single business angelinvestor must decide whether or not to invest personal funds in a risky venture. This venuestrips away the effects of a corporate environment in which investment decisions are oftenmade by a group of managers in the context of a stewardship function. Likewise, the busi-ness angel situation differs from the setting faced by institutional venture capital investorswho typically make investment decisions as agents of the funds providers. Accordingly,the decision processes and criteria employed by business angels potentially provide a base-line setting against which investment decisions of other types of investor may be com-pared and thereby gain an improved understanding of investment decision-making ingeneral and of principal–agent relationships in particular.

Third, gaining a still better understanding of business angels’ decision-making is ofpotential value to entrepreneurs and to business angels themselves. To the extent thatentrepreneurs understand the kinds of information that business angels seek and howvarious components of information are weighted in business angels’ decisions, they maybe better able to present the relevant information and to negotiate from a better informedperspective.

332

Therefore, this chapter examines the recent literature with regards to how businessangels make investment decisions. To provide a framework for the review of research liter-ature that comprises the task of this chapter, the five-stage structure shown in Table 13.1will be employed. In drawing on this five-stage categorization, it is not intended that thisshould be construed as ‘the’ model of angels’ decision-making process; rather, it is simplya means of structuring this particular review of the literature. To report on the state ofresearch about the decision process, this paper is organized such that the research liter-ature relating to each of these stages is described in turn. First, to provide a setting for thisdiscussion, a brief consideration of business angels’ investment process is in order.

On business angels’ investment processWithin the research literature, there are few models of the process by which businessangels make investment decisions. In most instances the models are essentially based onprior models of how institutional venture capitalists make decisions (Tyebjee and Bruno,1984 and their successors). For example, among the first to model business angels’ invest-ment decision process were DalCin et al. (1993) and Duxbury et al. (1997). Based on in-depth interviews from a national (Canadian) survey of almost 300 business angels thisresearch team outlined one plausible model of business angels’ decision process. Theyconcluded that the decision process could reasonably be characterized as a five-activity,or five-step, linear process.

The stages were: (a) deal origination and first impressions; (b) review of business plan;(c) screening and due diligence; (d) negotiation; and (e) consummation and deal struc-turing. DalCin and her colleagues argued that business angels in fact make investmentdecisions at several stages as the process unwinds and that criteria would logically differfrom stage to stage. At each stage, the business angel investor could decide immediatelyto invest, immediately to reject, or to continue on to the next stage. This research appearsto be the only published study that documents business angels’ rejection rates at each stageof the investment process.

This process is echoed in van Osnabrugge’s (2000) comparison of the decision-makingprocesses employed by business angels and venture capitalists. Agency theory predictsthat business angels and institutional venture capitalists differ in fundamental ways (vanOsnabrugge, 2000). Business angels invest personal funds and are principals in theprocess, coping with incomplete contracts through active involvement in the firms inwhich they invest. Venture capital fund managers, as paid employees, act as agents onbehalf of their funders and create more ‘professional’, often bureaucratic, decision struc-tures. Accordingly, the decision-making process and criteria are also likely to differ.However, implicit in van Osnabrugge’s reasoning is a five-stage investment process muchlike that developed by DalCin et al. (1993) and Duxbury et al. (1997). Table 13.1 summa-rizes this investment process and suggests ways in which business angels and institutionalventure capitalists might differ at each point.

In addition to the investment process models postulated by DalCin and her colleaguesand van Osnabrugge, other researchers have advanced models, explicitly or implicitly, ofthe business angel decision process; however, these models are quite similar to thatdescribed in Table 13.1. For example, Stedler and Peters (2003) implicitly model theprocess as a linear progression that proceeds from deal flow to due diligence to monitor-ing. Likewise, Amatucci and Sohl (2004) invoke a process that is comparable to that

Investment decision making by business angels 333

334

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depicted in Table 13.1. A common element of all approaches is that they depict the deci-sion process as proceeding in a linear stepwise manner from deal sourcing through exit.As van Osnabrugge (2000, p. 98) points out, however, a linear model would not capturethe fact that there may be feedback and looping within each activity and presumablyinvestors may cycle across stages and activities. Alternatively, it is conceivable that stagescould be skipped entirely. It also seems reasonable to expect that criteria may vary acrossstages. Further, one could conceive of the decision process as being populated by multi-ple participants on both the supply side (business angels, syndicate members, advisors,angels’ family members) and the demand side (business owners, partners, advisors).

Even though these models of the decision process argue that investors make decisionsat various stages, most research studies focus on particular stages in the investmentprocess without necessarily situating the work in the context of a decision-makingprocess. For example, several studies have undertaken to document angels’ decision crite-ria, often without consideration of the stage of the decision process; others have soughtto document non-financial contributions, and others have tried to measure realized ratesof return and exit mechanisms. Landström (1998, pp. 322–3) observes that ‘there are fewstudies which have attempted to bring out the nuances in informal investors’ decision-making criteria by considering investment as a process in which decision-making criteriamay vary in the course of time.’

Consequently, it would appear that there remains considerable room for research on thenature of the investment process itself. Research might profitably investigate the invest-ment process from both the investor and entrepreneur perspectives. Moreover, both mar-keting and social psychology have posited models of how individuals arrive at decisions,models that do not as yet appear to have been considered with respect to business angels.Further study is indicated on how the various decision criteria are weighted at differentpoints in the process. It would also be of considerable interest to understand better howthose individuals who work with angels (such as lawyers, accountants, family) and thosewho might work with the entrepreneurial team (consultants, family, partners, and so on)might interact as the decision process progresses. In this context, decision models such asthe theory of planned behaviour first developed by Ajzen (1988) and Fishbein and Ajzen(1981) might provide a means of assessing how the relative weightings of the investors’values, salient others, and perceived feasibility are weighted throughout the decisionprocess.

Deal sourcing and initial screeningThe first opportunity at which business angels can make a decision is when they initiallylearn of the investment opportunity – at first sight and even before they have read a pro-posal document or a business plan. While business angels rarely make the decision toinvest at this point, they frequently make decisions to reject the opportunity. DalCin andher colleagues (1993) found that, on average, 70 per cent of rejections occurred out ofhand – on first sight of the proposal, confirming that investment decisions were being ren-dered even as deals are being sourced. Riding et al. (1997) report that at the initial screen-ing stage, ‘the most important criterion . . . is the fit between proposal and investor.’

There is evidence that rejection rates depend on the mechanism by which businessangels learn of an opportunity (Riding et al., 1997). Van Osnabrugge and Robinson(2000, pp. 77–84) list and describe ten ways, including professional networks, through


which business owners seeking informal investors find potential investors (though theypresent no data on relative frequencies). Since Wetzel’s (1983) seminal study, it is gener-ally accepted that the primary means by which investors learn about potential investmentopportunities is through referrals from business associates (DalCin et al., 1994; Masonand Harrison, 1994; 1996a; Sohl, 1999). DalCin et al. (1993, p. 195) conclude that busi-ness angels prefer to rely on close associates ‘with whom they have had extensive invest-ment experience’. However, she also notes that introductions from acquaintances weremore typical of business angel informants but that referrals from close associates were rel-atively rare. She nonetheless suggests that entrepreneurs would be well advised to seekintroductions to angels through angels’ close associates. This is consistent with the findingthat rejection rates were lower for opportunities that were referred to investors from busi-ness associates (Riding et al., 1997).

It is worth noting that most of the research on business angels’ investment process isbased on data gathered from business angels: there is little information that outlines thedeal origination process from the viewpoint of the entrepreneur. With that caveat, thereis a high level of consistency to the effect that individual business angels do not generallyseek out potential investments; on the contrary, business angels are often profiled as desir-ing anonymity. More generally, entrepreneurs seek out business angel investors, withpotential investors frequently being approached to consider a wide range of investmentopportunities.

There is evidence that this process of deal origination is changing. Two forces aredriving these changes. First, governments at all levels and trade associations have sup-ported business angel matchmaking initiatives. The last fifteen years have witnessed aproliferation of market-making facilities that range from the equivalent of computerdating services, to business angel networks (BANs) that are national in scope, to localizedintroduction mechanisms that also include early stage entrepreneur training and pre-screening. Mason and Harrision (1996b) review several of these market-making initiativesand Sohl provides an updated and comprehensive review in Chapter 14 of this volume.

Second, business angels – once loosely and informally networked – are increasinglyentering into more formal business angel groupings. Sohl (1999) and de Noble (2001,p. 362) have both commented that formal angel ‘clubs’ and ‘groups’, as well as angel sidefunds, are becoming increasingly important sources of potential deals, most notably inthe US. Other countries appear to be lagging in this regard. There is little publishedresearch that examines the decision-making process and criteria of these more formal syn-dicates – another potential area for future research.

Evaluation and due diligenceThose potential deals that have survived the initial screening stage then become subjectto more detailed evaluation and due diligence. DalCin et al. (1993) report that another20 per cent of investment opportunities are rejected at this stage of the process.

Due diligenceThis stage often involves extensive information gathering by investors. Little theoreticalwork has been reported about business angels’ evaluation and due diligence processes.Prasad et al. (2000, p. 167) are among the few to use a theoretical approach to explorebusiness angel decision-making. They use a signaling theory approach to suggest that the


proportion of the entrepreneur’s initial wealth invested in the project ought to be animportant criterion for angels because ‘it indicates both the project’s value and the entre-preneur’s commitment to the project’. It will be seen that there is little work that exam-ines this factor directly and that other factors appear to be more important.

Van Osnabrugge (2000) used an agency-theoretic approach to derive a series ofhypotheses that compared the approaches of business angels with those of institutionalventure capitalists. He argues (p. 99) that managers of institutional venture capital fundswho act as agents working on behalf of the fund providers (principals) ‘must demonstratecompetent behaviour’. This entails (p. 99) ‘an additional level of the agency relationshipfor VCs [venture capital managers] to deal with that BAs do not’. As a result of this rea-soning, van Osnabrugge contends that business angels would conduct relatively less, andless formal, pre-investment due diligence than would managers of institutional venturecapital funds. Van Osnabrugge hypothesizes that business angels would place moreemphasis on ex post involvement in the firms. Empirically, he found support for thishypothesis but that differences may be sensitive to the regional business and legal context:‘it is apparent that BAs [business angels] in the UK tend to be less sophisticated andmore ad hoc in their due diligence activities than VCs and possible BAs in other countries’(p. 103).

In the Canadian setting, Haines et al. (2003) find support for van Osnabrugge’s pre-diction and report that business angel investors use a wide range of due diligenceapproaches. At one extreme, business angels indicate that their due diligence process isad hoc and informal: the business angels ‘go over’ the financial statements and projectionsthat are available about the potential opportunity, they ‘meet with the principals and getto know them’ over a period of time, and they conduct informal reference checks on thetrack records of the principals. Using these informal approaches, some business angelinvestors indicate that they depend on ‘gut feel’ and have to trust the people involved inpotential deals and have to want to work with them. This same wording was alsoexpressed by van Osnabrugge (2000, p. 104) that ‘they (business angels) invest on a gutfeeling rather than based on comprehensive research’. At the other extreme, a smallnumber of business angels who participated in the study by Haines and his colleaguesindicated that their due diligence process is very sophisticated and involved extensivechecklists, thorough documentation checks and an active search for independent evidenceabout the principals of the firm seeking investment. These tended to be larger scaleinvestors.

Decision criteriaThis discussion of how business angels conduct due diligence and arrive at investmentdecisions prompts an examination of their investment criteria. Most of the studies of thebusiness angel decision process have indeed focused on the decision criteria that businessangels employ.

In an early study, Mason and Harrison (1994) adopted a case study approach andanalysed the transcripts of interviews with one experienced private investor in the UK.They found that the majority of the investment proposals (22 out of 35) were rejected fol-lowing a detailed examination of the business plan. Of the remaining 11 proposals whichpassed the initial review, nine were rejected after the syndicate had conducted its ownresearch on the marketplace and the principals.


In subsequent work, Mason and Harrison (1996a; 1996c) returned to the issue of busi-ness angels’ decision criteria. In their 1996a study, Mason and Harrison drew on inter-view data with 31 business angels who made investments in unquoted companies as wellas with 28 owner-managers who had raised capital from private investors. They found that‘the key considerations in the investors’ decisions to invest were associated with the attrib-utes of the entrepreneurs and the market-product characteristics of the business’ (p. 109).The most important attributes of the entrepreneurs were their expertise, their enthusiasm,and other personal qualities of honesty and trustworthiness. The growth potential of thebusiness idea was the most important of the business attributes. Mason and Harrison(1996c, p. 45) also noted that ‘the most common deal rejection factors are associated withthe entrepreneur/management team, marketing and finance’. Among the most frequentlymentioned deal killers were: ‘one man shows’ and where there were significant gaps in themanagement team; flawed or incomplete marketing strategies; and incomplete or unreal-istic financial projections.

In their 1997 article, Harrison, Dibben and Mason explore the question of trust as afactor in business angels’ investment decision. Harrison et al. (1997, p. 67) define trust as‘the expectation that arises, within a community, of regular honest and cooperative behav-ior, based on commonly shared norms, on the part of other members of that community.’Although the research reported by Harrison et al. (1997) and Dibben et al. (1998) focusedon the initial screening stage – at which time the above authors show swift trust to be themost frequently invoked trust concept – it seems clear that trust is also relevant in sub-sequent stages. Drawing on both a theoretical framework and the use of a real-time verbalprotocol analysis of a business angel’s decision process, this work found that ‘the buildingof trust relationships between the entrepreneur and the informal investor appears to beessential for successful capital investments on the part of the investor to take place’ (p. 77).

Several other teams of researchers have also sought to examine the decisioncriteria employed by business angels (Haar et al., 1988; Harrison and Mason, 1992; vanOsnabrugge, 1998; Erikson et al., 2003). There is a high level of agreement among thesestudies: business angels attach great importance to the competence, integrity and capabil-ity of the management team and to the market potential of the firm’s product or service.

Stedler and Peters (2003) present data from Germany that show that German angelsare influenced by a greater number of factors than have been identified in earlier studiesbased on UK, Canadian and US data. In Germany, key decision factors include: theentrepreneur/management team, product/service uniqueness and competitiveness, growthpotential, profit margins and being able to move into a profitable position quickly. Stedlerand Peters also note that the opportunities’ exit options, rates of return, and degree ofself-financing are also important. It is therefore possible that decision processes and cri-teria vary across cultures.

Also, angels are not a homogeneous population. Hence, it is reasonable to expect thatdecision criteria would vary across different types of business angels. For example, vanOsnabrugge (1998) compared decision criteria employed by ‘serial angels’ with those usedby ‘non-serial angels’. He found that serial angels are ‘less concerned with agency risksand more concerned with market risks’ than their less-experienced counterparts (p. 23).He also found that, relative to non-serial angels, serial angels appear to conduct moreresearch, are more likely to co-invest, and are less concerned with the location of theventure.


Two further issues arose. The first is the extent to which criteria change as the processunwinds. The second is whether factors leading to rejection differ from factors leading toacceptance.

In terms of the first issue, Harrison and Mason (2002) and Fiet (1995) both contendthat business angels emphasize the qualities of the entrepreneurial team more than theproduct or service itself. This conclusion is also consistent in spirit with van Osnabrugge(2000). In particular, the role of trust in the decision process appears to be a non-compensatory decision criterion in that trust is a prerequisite for investment (Manigartet al., 2001; Kelly and Hay, 2003). While the development of trust is initiated during thedue diligence/evaluation process, it is furthered in the negotiation and consummationphase.

However, the debate over which matters most – the importance of the business or thequality of the entrepreneur(s) – is perhaps addressed by Mason and Harrison (1996a) whonoted that decision criteria vary by the stage of the decision process, that what mattersmost changes over the unwinding of the process: ‘deals rejected at the initial review stagetended to be on the basis of the cumulation of a number of deficiencies rather than for asingle reason; conversely, opportunities rejected after further research were more likely tobe characterised by a single deal killer.’

This result is consistent with the findings of Duxbury et al. (1997) who also found thatcriteria weights used by informal investors shifted across stages and that as the processunwinds the importance of the principals and of financial rewards both increase.

These findings suggest that researchers’ conclusions about the importance of particu-lar factors depend on the stage of the investment process being considered. This is a resultthat might usefully guide future research in that it would appear that identification andimportance of decision criteria are both dependent on the stage of the investment processand the context.

Feeney et al. (1999) sought to address the second issue: whether factors leading to rejec-tion differ from factors leading to acceptance. To identify factors that discouraged privateinvestors from making investments, they asked a sample of 115 ‘active’ business angelinvestors and 38 ‘occasional’ business angel investors: ‘In your experience, what are themost common shortcomings of the business opportunities you have reviewed recently?’To identify attributes that prompted investors to decide to invest, they asked: ‘What arethe essential factors that prompted you to invest in the firms you chose?’ The researchersconcluded that informal investors consider both the attributes of the business and theattributes of the entrepreneur as important when they consider whether to invest in orreject a proposal. Mason and Stark (2004) reinforce these findings in their analysis of whatattributes of entrepreneurs’ business plans business angel investors sought. They report(2004, p. 240), ‘BAs [business angels] . . . emphasize financial and market issues . . . [and]give . . . emphasis to investor fit considerations.’

Negotiation, consummation, and deal structureThe next stage, negotiation and potential consummation, occurs when the investor(s) havecompleted enough of the due diligence process to undertake formal pricing negotiations.This can be a contentious stage in the investment process. This is often because foundersand business angels disagree about the relative values of their respective contributions to thefirms. Typically, founders provide the original innovation and energy about a potential


product or services. Angel investors then provide the capital necessary (as well assubstantive non-financial contributions) to take the innovation to commercialization.Mason and Harrison (1996c, p. 42) reported that the overriding issue at this stage of thedecision process was disagreement on valuation and that this led to a high proportion ofproposals not being consummated. DalCin et al. (1993) confirm this observation and reportthat of the 10 per cent of investments that reach the negotiation stage, half of those do notsurvive negotiations.

Elitzur and Gavious (2003) address this through a game-theoretic analysis of theprocess of negotiation and consummation between an entrepreneur and a potential angelinvestor. They argue that the process will result in a moral hazard problem, where moralhazard is defined (2003, p. 718) as ‘the form of post-contractual opportunism that ariseswhen actions required or desired under the contracts are not freely observable’. Certainkinds of behaviour are specified which alleviate the moral hazard problem: payment inthe form of stock options, the angel sitting on the board of directors of the business inwhich the angel has invested, specialization by the angel, staged financing rather thanall-in-one financing, and use of convertible preferred stock. Conceivably, this explains thewidespread use of shareholder agreements. Hatch and MacLean (1995) provide asummary of the typical attributes found in shareholder agreements and the high fre-quency with which business angels remain actively involved in the firms in which theyinvest (van Osnabrugge, 2000; Madill et al., 2005).

Elitzur and Gavious also analyse a situation where the initial investment by an angel isfollowed by a later investment by a venture capitalist. They conclude (2003, p. 721): ‘thatthe opportunistic behavior of both the entrepreneur and VC leads to a moral hazardproblem, with these two players becoming “free riders”, coasting on the investment madeby the angel.’

The argument that moral hazard issues may arise during the negotiation and consum-mation phase of the decision process is particularly interesting in the light of the relevanceof the concept of trust. In addition to the work of Harrison et al. (1997), Manigart et al.(2001) investigated the impact of trust on private equity contracts. They concluded:

Trust between investor and entrepreneur is essential to help overcome control problems, espe-cially in an environment with severe agency risks and incomplete contracts. In this study . . . wefind that trust has an impact on the desired contracts of entrepreneurs, but not on that ofinvestors. [The] findings suggest that for parties, faced with potentially large agency problems(investors), trust and control seem to play complementary roles. On the other hand, for partieswith smaller agency problems (entrepreneurs), trust seems to be a substitute for control.

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


provisions; approval for senior hires/fires; need for investors to countersign bank cheques;equity ratchet provisions; specification of dispute resolution provisions.

It is interesting that Kelly and Hay (2003) conclude that contracts are a complement tohigh degrees of involvement. Van Osnabrugge (2000) regards active involvement of busi-ness angels as a key means of reducing ex ante uncertainty. Empirical findings of theimportance of active involvement by business angels are reported by Haines et al. (2003,pp. 24–5). Their work, based on analysis of qualitative interview data with businessowners and business angels suggests that the opportunity for the business angel to be ableto add significant non-financial value may be so important as to qualify as a decisioncriterion, one that is especially significant at the negotiation stage. This latter result is inkeeping with van Osnabrugge’s (1998) hypothesis that business angels would stress post-investment involvement as a factor in their decision criteria.

Post-investment involvementIt is important to include a discussion of post-investment involvement in this discussionof business angels’ investment decision process. This is so for three reasons. First, busi-ness angels’ investment decision must take account of the moral hazard problem inherentin such investments. Perhaps the single most effective means of dealing with the moralhazard problem is to reduce the information asymmetry between the founders and theinvestor, and the best way to do so is to become a principal within the firm. Second, andto some extent related to the moral hazard issue, recall that Madill and her colleagues(2005) have found that the opportunity to add mentoring and other forms of non-financial value-added appears to be a parameter of the decision process itself. Third,(DalCin et al., 1993) found that business angels have high internal loci of control as wellas high needs for achievement. The fact that angels have their own funds at stake such thatthey are principals, rather than agents, provides them with incentive to help the firmsprosper. Again, this suggests that post-investment involvement plays an important role inthe decision process. With expectations of a 30–40 per cent annualized rate of return, highneeds for achievement, internal loci of control, and in the face of moral hazard it appearsreasonable to expect angels to take on proactive roles in the firms in which they invest.Landström (1998, p. 328) reports that ‘informal investors tend to see their investments as“subjects”, where the prime motive to invest is the chance to create business opportuni-ties and a desire to participate in the process.’

In this regard, it is widely accepted and understood that angels do make non-financialcontributions to the firms in which they invest. Wetzel (1994), Mason and Harrison(1996a), and Lumme and her co-workers (1998) are among those who argue that the non-financial role of angels can be important to themselves and to the business enterprise.

Mason and Harrison (1996a) explored this in their study of both the supply side (angelinvestors) and the demand side (businesses that had received angel investment). From asample of 20 dyads and eight additional owner-managers, Mason and Harrison identifiedcontributions that included: strategic advice, networking, marketing, management func-tions, finance and accounting functions, financial advice, and general administration.A minority of investors made no contributions aside from their financial stake. Half ofthe entrepreneurs reported that the investors’ contributions were either helpful orextremely helpful. Likewise, Madill et al. (2005) document contributions that include:ongoing advice particularly with respect to financing and business strategy; contacts that


include additional sources of financing as well as potential customers; participation onboards of directors; involvement in hands-on day-to-day operations of the firm; businessand market intelligence; and, credibility.

Given the frequency of high levels of post-investment involvement, the question arisesas to whether firms financed by business angels exhibit superior performance. There issome evidence to this effect.

First, Farrell (1998) found that the incidence of business failure among 264 firms thathad not received ‘private investment’ (in Farrell’s study, it is not clear if this is exclusivelyfrom business angels) was 20.5 per cent while the failure rate among 46 enterprises thathad received private investment was lower, 17.4 per cent. However, this small differencemay equally be attributable to the counterfactual problem: that firms that had receivedbusiness angel financing may have been, in the first place, better quality investments.

Second, Madill and her colleagues (2005) report that firms financed by business angelswere more likely to obtain institutional venture capital than other firms. Again, it is pos-sible that the counterfactual is attributable for this but it is also possible that non-financialcontributions of angels may better qualify such firms for being able to grow and accessinstitutional venture capital.

Third, firms financed by business angels may experience better exit events. Landström(1993) reports on expected rates of return and holding periods for business angels.According to various studies, modal expected rates of return appear to be in the range of30 to 40 per cent on an annualized after-tax basis. However, a small but significant frac-tion of angels expect a rate of return of less than 20 per cent, while others expect a rateof return of over 60 per cent.

Aside from the exploratory study by Lumme et al. (1996), Mason and Harrison’s (2002)study appears to be the only published examination of realized rates of return and exits.Their work was based on 127 exits reported by 126 Scottish angels. They found that tradesales of the businesses was the most frequent form of profitable exit. They also demon-strated that business angels experienced superior returns to those obtained from a sampleof UK venture capital firms, finding that 34 per cent of angels’ reported exits were totallosses, but that 23 per cent were exits in which the annualized rate of return exceeded50 per cent.

It is difficult to find other studies reporting realized rates of return on the part of infor-mal investors. This is an important topic for future research. This importance stems fromthe growing realization by policy makers of the importance of business angels and theirattempts to stimulate business angel investment. Likewise, there is a need to addressGompers and Lerner’s (2003) questioning of public policy initiatives that seek to‘encourage amateur informal investors’. The informal market comprises a variety ofinvestor types that include business angels as well as the category sometimes referred toas ‘family, friends, and fools’. Examination of realized returns is one way of informingthis discussion.

Post-investment involvement appears to be an important aspect of business angels’investment decision process. Through this involvement, business angels are better able toassess and control the moral hazard inherent in such investments. Because business angelshave high internal loci of control as well as high needs for achievement, they have power-ful incentives to help actively with the development of the firms. There is some prelimin-ary evidence to the effect that angel-financed firms perform relatively well. Accordingly, it


seems reasonable that Madill and her colleagues (2005) have found that the opportunityto add mentoring and other forms of post-investment non-financial value-added may bea parameter of the decision process itself.

Conclusions and directions for future researchThis chapter has provided a review of the state of the literature regarding investment deci-sion-making by business angels. Table 13.2 provides an overview of this process and a


Table 13.2 Business angel investment decisions: key references

Stage Events Key References

Sourcing of This stage involves encountering DalCin et al. (1993)potential deals and engaging businesses in which Mason and Harrison (1994; 1996b)and first investments might follow and a Fiet (1995)impressions ‘first sight’ informal evaluation. Riding, Duxbury and Haines (1997)

Sohl (1999)Van Osnabrugge and Robinson (2000)

Evaluation of This stage involves examination of Haar, Starr and MacMillan (1988)the proposal the business plan and conducting Harrison and Mason (1992)

due diligence. Investors meet with DalCin et al. (1993)the founders, consult with potential Mason and Harrison (1994;syndicate partners as appropriate, 1996a; 1996c)and conduct external and internal Harrison, Dibben and Mason (1997)evaluation of the opportunity and Van Osnabrugge (1998; 2000)the entrepreneurial team. Feeney, Haines and Riding (1999)

Prasad, Bruton and Vozikis (2000)Manigart, Korsgaard, Folger,Sapienza and Baeyens (2001)Erikson, Sørheim and Reitan (2003)Haines, Madill and Riding (2003)Kelly and Hay (2003)Stedler and Peters (2003)Mason and Stark (2004)

Negotiation In this stage, the investor(s) and the Mason and Harrison (1996c)and entrepreneur(s) negotiate the terms Harrison, Dibben and Mason (1997)consummation of the deal. Manigart, Korsgaard, Folger,

Sapienza, and Baeyens (2001)Elitzur and Gavious (2003)Kelly and Hay (2003)

Post-investment In this stage, the investor(s) work with Landström (1993)involvement the firm in various capacities and in Mason and Harrison (1996a)

various levels of involvement to Farrell (1998)develop the business further. Madill, Haines and Riding (2005)

Exit At this point, the business Lumme, Mason and Suomi (1996)angel sells the investment of Mason and Harrison (2002)the firm (or writes it off!).

tabular summary of some of the key references. An overview of this literature revealsseveral recurring issues that researchers have not yet fully surmounted. Each of thesetherefore provides fertile ground for future work.

This review suggests that one important direction for future research lies in the devel-opment of a comprehensive model of investment decision-making. Several models ofdecision-making have been developed in other fields, some of which have been applied toentrepreneurship research (but not to research on business angels). For example, Orseret al. (1998) successfully applied the theory of planned behaviour (Fishbein and Ajzen,1981; Miniard and Cohen, 1981) to entrepreneurs’ decision of whether or not to pursuegrowth as an objective for their firms. This approach allows for both the primary players(investors and firm founders) to have a role but also allows for the participation of others(syndicate partners, spousal partners, and so on) to have input into decisions. This mayprove to be a fruitful direction for future work.

A second direction relates to the identification of the ways in which decision criteria(or the weightings accorded these criteria) might systematically change as the decisionprocess unwinds. Previous research has suggested that such changes occur; however,this line of enquiry does not appear to have been pursued to the extent that might bepossible.

A third area of enquiry relates to the ways in which post-investment involvement miti-gates the moral hazard problem. While it appears that business angels are activelyinvolved in the firms in which they invest, it is not clear to what extent this is a responseto the moral hazard aspect of the investment process. The moral hazard issue can beaddressed through contracting or through monitoring mechanisms. An alternative expla-nation for active involvement could relate business angels’ high internal loci of controland their high needs for achievement.

Fourth, there is virtually no work on the ways in which business angels, founders andlater stage investors interact. Findings that firms financed by business angels are morelikely to obtain institutional venture capital prompt the need to examine how the foundersand the angels comprise a team that together seeks to ensure success of the enterprise. Tothe extent that this is true, the role of business angels in economic development may con-tinue to be underestimated. A related aspect of this issue is the ways in which businessangels’ roles might change with the arrival of venture capital. While not strictly related tothe issue of decision-making, this topic is nonetheless a potentially useful direction forfuture research.

Methodological issuesNotwithstanding the many potential directions for future research, ongoing investigationof business angel decision-making must contend with several important methodologicalchallenges, problems that pervade much of the literature on business angel decision-making.

First, much of the work is empirical and lacks a theoretical framework. While there areobvious exceptions to this rule, studies that are rooted in a theoretical perspective are rare.This is particularly surprising when it comes to modelling the investment decision process.The literature of social psychology and marketing is rich with theory-based models ofdecision-making; yet none appear to have been applied to the business angel context.Examples of potential models include the theory of planned behaviour (Fishbein andAjzen, 1981) among other possible frameworks, some from the theories of consumer


decision-making. This appears to be one area in which future research might help usbetter understand the decision-making process.

Second, almost all of the empirical studies (again with a few notable exceptions) usedata drawn exclusively from the supply side of the informal market. While this may beappropriate for many of the research objectives, it is not sufficient to address otherresearch goals. In particular, one-sided data cannot fully characterize the decision process,nor can it fully describe business angels’ non-financial value added. Useful directions heremight be examination of the factors that prompt business owners to seek business angelsas financing sources and the examination of how attributes of firms financed by businessangels might differ from other firms.

Third, definitional problems and inconsistencies persist. The terms ‘informal investor’and ‘business angel’ are often used interchangeably; but just as often are distinguished onefrom the other. Studies of business angels refer to them as informal investors, and viceversa. Business angels and other types of informal investor do differ in significant ways(Erikson et al., 2003) including how they make decisions (van Osnabrugge, 1998). Thisdebate prompts the need to decompose the informal market into relevant segments andto examine more precisely the behaviour and experiences of investors in each of the con-stituencies of the informal market.

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14 The organization of the informal venture capitalmarketJeffrey E. Sohl

IntroductionIn spite of the volume of business angel investing, the early stage equity market is fraughtwith inefficiencies. For firms with established financial records and tangible assets, finan-cial markets supply an extensive assortment of financing instruments. These markets arerelatively accessible and the owner is left to decide the optimum mix of a financial struc-ture based on the cost of capital (Brophy, 1997). However, the high growth entrepre-neurial firm seeking early stage equity capital is faced with significant problems in findingthis risk capital due to the inefficiency of the early stage equity market. Thus, the type ofearly stage financing required by high growth entrepreneurial firms, namely high riskequity capital, is not readily available. While variations in the availability of early stagecapital exist across countries, and regionally within countries, overall there is a persistentlack of high risk capital for entrepreneurial ventures (Riding and Short, 1987; Gaston,1989; Mason and Harrison, 1992; Harrison and Mason, 1993; Landström, 1993; Freearet al., 1994a). Business angels, who collectively comprise the informal venture capitalmarket, are the major supply of early stage equity capital, and improvements in theefficiency of this market will increase both the size and the accessibility of early stageequity capital.

There are three main reasons for the inefficiencies, and thus the lack of early stagecapital, in the informal venture capital market. First is the invisibility of business angels,second, the high search costs for both business angels seeking investment opportunitiesand entrepreneurs seeking investors and third, an inadequate supply of capital (Freearet al., 1994b; Mason and Harrison, 1995). As a consequence of the suppliers of capital(business angels) seeking a degree of anonymity consistent with the need to maintain rea-sonable deal flow, information flows very inefficiently (Freear et al., 1994b; Mason andHarrison, 1996a). This difficulty in finding business angels and the lack of ‘investor ready’quality deals, combined with an inadequate supply of capital, results in a primary seedgap. Further compounding the inefficiencies in the informal venture capital market is asecond funding gap, the secondary post-seed gap. These larger capital requirements havetraditionally been considered too large for business angels and, as the venture capitalindustry migrates to later stage and larger deal size, are deemed too small for venture cap-italists. Recent research indicates that business angels are increasing their investments inthis secondary post-seed gap (Table 14.1) as market conditions require business angels toprovide some follow-on financing for their investments (Center for Venture Research,2004; 2005). However, this movement by business angels to second stage financing is aredistribution of risk capital and as such, exacerbates the primary seed gap (Sohl, 2003).

These systemic market inefficiencies and persistent funding gaps (primary seed gapand secondary post-seed gap) have led the angel market to adopt various organizational

347

structures and market mechanisms to increase the efficiency of quality deal flow andincrease the availability of capital. Adapting to changing market conditions, multifacetedangel organizations, or angel portals, have evolved. Collectively, the business angel portalscomprise today’s business angel market. These portals represent how entrepreneurs findpotential investors, how business angels find and screen deals, how they syndicate intosmall groups to make an investment and how business angels interact within the largerangel market. Angel portals shed considerable light on the angel market and provide apotential lens to the future of the market.

The scope of this chapter is a discussion of the current structure of the business angelmarket with respect to the various types of angel portals in existence today. A businessangel portal is an organization that provides a structure and approach for bringingtogether entrepreneurs seeking capital and business angels searching for investmentopportunities. The primary goal of angel portals is to increase the efficiency in the earlystage market, increase deal flow for business angels and provide entrepreneurs with accessto angel capital. The portals range from informal collections of business angels to dues-paying members with investment requirements for each member. Most require their busi-ness angel members to meet a minimum net worth/income requirement, which serves asa proxy for ascertaining if the business angel has sufficient knowledge of the risks andilliquidity inherent in angel investing. The remainder of the chapter is organized asfollows: an examination of the previous research on business angel portals, a discussionof the types of business angel portals that exist today including a description, an exampleand a discussion of the effectiveness of each type, and some concluding remarks.

Early research on business angel portalsThe early research on angel portals focused on measuring the effectiveness of businessintroduction services in various countries (Blatt and Riding, 1996; Landström andOlofsson, 1996; Mason and Harrison, 1996a; Wetzel and Freear, 1996). In general, thesestudies define effectiveness as meeting the needs of the angel market. Although theseneeds vary across countries, the literature has considered effectiveness to include changeswith respect to higher quality deal flow, improving the efficiency of the angel market,raising the awareness of business angels as a source of equity financing, and increasingthe availability of angel capital and the level of angel investments.

Initiatives in the United StatesThe first angel portal in the world, Venture Capital Network, was organized in 1984 as anot-for-profit matching network affiliated with the Center for Venture Research at theUniversity of New Hampshire in the United States. An evaluation of the operations ofVenture Capital Network (VCN) noted some of the problems with both assessing the


Table 14.1 Funding gaps

% of angel investments

2002 2003 2004 2005

Primary seed gap 50% 52% 43% 55%Secondary post-seed gap 33% 35% 44% 43%

effectiveness of networks and in developing and growing a matching network (Wetzel andFreear, 1996). In the case of VCN, investment security regulations prohibited VCN fromany role in the process beyond the initial introduction. As such, data on the success orfailure of the introduction, the quality of the deal flow as perceived by the investors andthe amount of funding generated were difficult to obtain. However, research indicates thatit was difficult and time consuming to find investors to join the network, that funding foroperations was a persistent issue and the likelihood of profitability was slight, and thatthere was an acute need to demonstrate to investors an adequate level of high quality dealflow (Wetzel and Freear, 1996). In a study of VCN investors it was determined thatapproximately 10–15 per cent of entrepreneurs received funding through the matchingservice and approximately 40 per cent of the entrepreneurs received funding through theventure forum format (Sohl, 1999). However, it is important to note that the ventureforum format included fewer entrepreneurs, higher levels of screening, and receivedcoaching from VCN before their presentation to investors.

Initiatives in CanadaOne of the early studies on the effectiveness of an angel portal was the examination of theCanada Opportunities Investment Network (COIN), a national angel network (Blatt andRiding, 1996). The goal of COIN was the development of a matching service to meet theunsatisfied demand by Canadian entrepreneurs and to access the large pool of privatesavings held by Canadians. Unfortunately, these goals were not realized. Research indi-cates that investors did not consider COIN to be a valuable service. Over 60 per cent ofinvestors surveyed reported that it was difficult to find high quality investment opportun-ities within the COIN network and most did not find COIN to be an essential, or evenimportant, component of their investment sourcing (Blatt and Riding, 1996). In addition,business angels registered with COIN noted that they often used their own leads and refer-rals to find deals. It appears COIN was ineffective in that it was designed to solve aproblem that did not exist. COIN sought to increase the opportunity for business angelsand entrepreneurs to make contact, but the underlying problem was not the inability ofbusiness angels to contact entrepreneurs, but rather the scarcity of high-quality invest-ments. In essence, the low barrier of entry with respect to entrepreneurs submitting busi-ness plans and little screening of these ventures resulted in investors concluding thatCOIN was of little value (Blatt and Riding, 1996).

Initiatives in the United KingdomIn contrast to the COIN approach (building a national network that seeks to addressneeds at a local level), the Local Investment Networking Company (LINC) in the UKadopted the strategy of aggregating local enterprises into a national business introduc-tion service. Founded in 1987, LINC offers several approaches to assist entrepreneurs,including a matching service, an investment bulletin (a short description of firms seekingcapital) and the venture forum format. Early research on the effectiveness of LINC indi-cated that the impact on marshaling the pool of angel capital had been modest (Masonand Harrison, 1996b). Reasons for this modest impact included the relatively smalldatabase of firms and investors that existed, a limited marketing budget that resulted ina low awareness among investors and entrepreneurs, a need to be more selective inaccepting firms for listing and a fragmented organizational structure. On the positive

The organization of the informal venture capital market 349

side, it is noted that LINC was a relatively efficient source for investors and that entre-preneurs received several ancillary benefits from LINC membership, especially theadvice from the LINC business advisors and feedback from investors (Mason andHarrison, 1996b).

Similar to the bottom-up approach of LINC, an early initiative in facilitating thegrowth of the angel market in the UK was the Department of Trade and IndustryInformal Investment Demonstration Projects. This program provides direct governmentfinancial assistance to create a number of local business angel networks. An evaluation ofthese demonstration projects found the initiative to be quite successful. Specifically, itappears that the Informal Investment Demonstration Projects have resulted in a signifi-cant pool of capital, have stimulated demand for equity capital and succeeded in facili-tating an increase in the level of angel investment activity (Harrison and Mason, 1996).However, it should be noted that these conclusions are based on a small number of pro-jects (5) and it is possible that a substantial expansion of this program could result in somediminishing returns or possibly an overcapacity of government subsidied angel networkscompeting with each other for the same market.

Initiatives in SwedenIn contrast to the proliferation of angel networks in the UK, Sweden has shown less of apenchant for these introduction services. In an early study of individual investors inSweden, very few business angels noted the need for an introduction service since thesearch for new investments was not considered troublesome in the informal market(Landström and Olofsson, 1996). Previous research on the first angel network in Sweden,the Chalmers Venture Capital Network (CVCN), appeared to corroborate this lack ofneed. The CVCN had the primary goal of facilitating the commercialization of technol-ogy that originated in the Chalmers University of Technology. A classic matchingnetwork modeled after the Venture Capital Network in the US, the CVCN was a two-stagecomputerized subscription network that matched entrepreneurs with angel investors.Research indicates that CVCN is relatively unknown within the angel community, par-tially as a result of a small regional focus. More importantly, given that proposals are notevaluated before inclusion in the listing, there exists a high potential for low quality in thedeals offered to investors (Landström and Olofsson, 1996).

Initiatives in DenmarkDanish business angels invest in a robust cross-section of business sectors, with a majoremphasis on the seed and start-up stage. The holding period of 3–6 years compares favor-ably with business angels in other countries, as does the sale of the company as the majorexit vehicle (Vækstfonden, 2002). For business angels in Denmark, networking amongbusiness associates is the dominant form of finding investment opportunities. However, itappears that this informal networking does not have the optimal impact since over 40 percent of Danish business angels claim they have difficulty in identifying potential entre-preneurs and investment opportunities (Vækstfonden, 2002). In addition, two thirds ofbusiness angels in Denmark co-invest with other business angels, which is a higher syndi-cation rate than business angels in the UK but less than those in the US (Vækstfonden,2002). Research also indicates that capital from Danish business angels is availableprovided that quality investments can be found (Koppel, 1996). Thus, the desire for


syndication and the need for a more efficient method to find investments indicate thatangel portals should have a place in the Danish informal venture capital market. In add-ition, research indicated that Danish business angels noted the need for a governmententity to act as an intermediary or facilitator between business angels and entrepreneurs(Koppel, 1996). In 1991, with the support of the National Agency of Industry and Trade,the Business Innovation Center initiated the Business Introduction Service (BIS). The BISwas created for the purpose of assisting entrepreneurs in developing their financial plan,introducing the entrepreneur to a potential business angel, and mediating the negotiationbetween the entrepreneur and business angel. Despite the apparent need and desire for abusiness angel portal the BIS initiative was not successful for a number of reasons(Koppel, 1996). First, the description of the investor’s criteria for investments was toonarrow, resulting in a decreased chance of finding a suitable proposal. Second, the workinvolved in matching entrepreneurs and business angels is labor intensive and reliesheavily on the personal characteristics of the entrepreneur and business angel. Thisresulted in a considerable expense to the BIS and the business angels were not interestedin paying for the full cost of this service. Third, the pool of business angels in the BIS wasnot large enough to provide a reasonable chance for the entrepreneur to receive financing(Koppel, 1996).

Initiatives in FinlandResearch on business angels in Finland identified several key factors for the successfulimplementation of an angel portal. Among Finnish business angels the favored model foran angel portal is a computer based matching service (Lumme et al., 1998). In this typeof angel portal (discussed in detail in the following section) the entrepreneur submits anexecutive summary of the business plan, along with a short form detailing some key char-acteristics of the business. The computer system matches the investment preferences ofbusiness angels with those of the submitted business plans. If the business angel is inter-ested, then the matching service provides the introduction. It is interesting to note thatventure forums, essentially forums for pre-screened entrepreneurs to present their busi-ness concept to an audience of business angels, did not appear to be of particular inter-est to Finnish business angel service (too much effort to attend), nor did on-line data bases(too complex to use) (Lumme et al., 1998). In 1996 a consortium of public and privatesector entities launched Matching-Palvelu, a Helsinki based computer matching servicefor business angels and entrepreneurs. Venture forums were also part of Matching-Palvelu. Based on an evaluation of Matching-Palvelu, it appears to be quite successful forseveral reasons (Lumme et al., 1998). First, the service was designed based on research onthe needs of the business angel. Second, heavy investor recruitment to Matching-Palveluwas conducted through an investment fair. Third, extensive media coverage and presen-tations on the concept to business organizations helped to develop interest and awarenessof Matching-Palvelu. A similar model has also enjoyed success in Finland. Sitra PreSeedFinance introduced INTRO Venture Forums. Every 12 months five INTRO VentureForums are organized to bring pre-screened entrepreneurs to present their businessconcept to business angels. Sitra PreSeed Finance also coordinates the investment nego-tiations between the entrepreneur and business angel. To date, the INTRO VentureForums have been quite successful, with one out of every three companies securing financ-ing (Sitra PreSeed Finance, 2006).


Initiatives in SingaporeBusiness angels in Singapore represent a significant source of funding for entrepreneurs,with a mean investment amount of S$350 000 and a total investment amount close to S$30million, which indicates that a substantial business angel market exists in Singapore(Hindle and Lee, 2002). In 2001 the Business Angel Network Southeast Asia (BANSEA)was established to promote development of the angel investment community in Asiathrough education and facilitating the matching of start-ups with angel investors (Kamand Ping, 2003). BANSEA also initiated the BANSEA Mentoring Program to assistentrepreneurs in the development of start-ups to provide quality deal flow to businessangels. To date there has not been any independent evaluation of the effectiveness ofBANSEA. It is important to note that while business angels in Singapore are similarto their western counterparts, a distinguishing characteristic is the prior relationshipswith the entrepreneur. The majority of business angels in Singapore have an establishedrelationship with the entrepreneur prior to the investment, with more than 80 per centknowing the entrepreneur at least one year prior to the investment, and over half havingknown the entrepreneur for more than five years (Hindle and Lee, 2002). In addition,54 per cent of the business angels invested in ventures started by friends or neighbors and40 per cent in ventures begun by family members (Kam and Ping, 2003). These findingson the prior relationship appear to indicate that any evaluation of the effectiveness ofangel portals in Singapore must adopt a long term approach. That is, while the businessangel network is in the business of introducing business angels to entrepreneurs with thegoal of securing an investment for the entrepreneur, the measurable effects of these ini-tiatives would likely not occur for over a year, and may take close to five years to come tofruition. Thus, researchers should be cautioned when conducting an evaluation of angelnetworks in Singapore, and possibly in Asia in general, since such analysis would need tobe longitudinal and conducted over a considerable period of time.

Initiatives in AustraliaBusiness angels in Australia, while similar to business angels in other countries,have several distinguishing characteristics (Hindle and Wenban, 1999). Most notably,Australian business angels are younger than the average business angel. In terms of edu-cation, Australian business angels fall into two distinct categories: older business angelswith little more than a high school education but with much entrepreneurial work experi-ence and highly educated young professionals. With respect to the size of investments twocategories emerge: business angels that tend to make only large investments in the rangeof $200 000 to $500 000 and those that restrict their investments to much smaller amounts,typically below $50 000 (Hindle and Wenban, 1999). Of note is that the size of the busi-ness angel market in Australia appears to be 35 to 50 per cent of the venture capitalmarket, which is significantly lower than that of Canada, the US and UK (CaslonAnalytics, 2006). To provide these business angels with investment opportunities there hasbeen a proliferation of business angel portals in Australia with 16 angel portals in oper-ation today. The largest of these portals is the Founders Forum, which operates in threeregions of Australia: Brisbane, the Gold Coast and Perth. Started in 2000, the FoundersForum has invested over $20 million in entrepreneurial ventures (Founders Forum, 2006).Another large business angel portal is Enterprise Angels, which provides a range of ser-vices, including an online matching service for companies seeking less than $2 million in


angel investment (Murphy, 2003). While there is a wide range of angel portals in oper-ation in Australia, to date there does not exist any comprehensive research on theeffectiveness of these portals.

Initiatives in GermanyThe predominant angel portal in Germany is BAND (Business Angel NetworkDeutschland) which is affiliated with, and provides services for, over 40 business angelnetworks in Germany and is involved with providing introduction services between busi-ness angels and entrepreneurs. BAND was established in 1998 and operates under thepatronage of the Federal Ministry for Economy and Labor and is financed by sponsor-ship and member fees. The multi-faceted goals of BAND include the establishment ofcontacts between business angels and young innovative ventures, services to the businessangel networks throughout Germany, engagement in political lobbying and public rela-tions, and the development of workshops for both business angels and entrepreneurs(Günther, 2005). Research indicates that BAND and its affiliated networks play animportant role in the German business angel community. While business contacts provideGerman business angels with over 90 per cent of the investment opportunities and closeto 80 per cent of the investments, investment clubs and matching services account for35 per cent of the investment opportunities and close to 20 per cent of the investments(Brettel, 2003). In a similar study, 41 per cent of German business angels use networks togain access to potential investments (Stedler and Peters, 2003). In addition, over half ofGerman business angels work in syndicates, predominately for the purpose of raisingsufficient funds to make an investment (Brettel, 2003). The type of activities, findinginvestment opportunities and syndication, valued by German business angels, are activ-ities that BAND has been an active participant in. Since the inception of BAND in 1998the concept of business angels has gained traction and BAND has raised the interestof the individuals in the angel market, and the economy has responded successfully(Kosztopulosz, 2004).

Lessons from early business angel networksSome valuable lessons can be learned from the early attempts to develop business angelnetworks, many of which are pertinent in today’s informal venture capital market. One ofthe greatest, and lasting, contributions of the early angel portals was to increase theawareness of business angel investing and the important role played by business angels inthe early stage equity financing of entrepreneurial ventures. Thus, while the majority ofthe early attempts at angel portals were not necessarily successful in their stated goals,many did have some modest ancillary effects with respect to awareness elevation amongentrepreneurs and potential business angels. In addition, these early angel portals pro-vided the foundation for both the design and success of many of the later attempts.

The lessons that can be gleaned from the early angel portals are centered on four issues:investor membership, quality deal flow, funding and awareness. Much of the earlyresearch on angel networks points to the difficult, and time consuming, task of findinginvestors to join the network. As a result, many of these networks had a small data baseof business angels. Networks that were successful, such as Matching-Palvelu, conductedintensive investor recruitment through venture fairs and the media. Quality deal flow wasa persistent problem for the early networks. It was often cited that the low barrier of entry


for entrepreneurs to submit business plans and the difficulty for the networks in findingquality deals resulted in an overall lack of quality deals in the data base. The general con-clusion is that the networks either did not evaluate the business plans before they were pre-sented to investors or that the network operators needed to be more selective in decidingwhat investments to offer to their members. Thus, the underlying problem was not neces-sarily the inability of business angels to contact entrepreneurs, but rather the paucity ofhigh-quality investments. Funding was also a continuing issue for these early networks.Funding issues centered on the general lack of funding for operations, a limited market-ing budget and the labor-intensive, and thus costly, nature of matching entrepreneurs withinvestors, finding quality deals and screening potential investment opportunities. Theawareness of the existence and value of the networks among the business angel commu-nity was perceived to be low for many of the early networks. Thus, investors did not per-ceive the networks as providing value to them and often used their own leads and referralsto find deals rather than the network. It should be noted that this inability to createsufficient awareness of the existence and value of the networks is likely to be related to theinability of the networks to attract a substantial membership of angel investors. Thosenetworks that were successful, such as LINC and Matching-Palvelu, undertook extensiveefforts to develop interest and awareness.

The early work on evaluating the effectiveness of angel portals raises five serious con-cerns that should be addressed during any evaluative study. First, most of the angelportals do not have a cost effective mechanism to track the investments of their businessangel members and thus any data needed to conduct an evaluation is difficult to obtain.Second, since business angel investments often take over five years to reach an exit, anycomprehensive evaluation of the portal must be conducted over the long term.Unfortunately, the inherent long term nature of the evaluation process does not oftenmatch the short term needs of the angel portal in judging effectiveness. Third, any rea-sonable and accurate evaluation of the effectiveness of an angel portal requires a signifi-cant commitment of funds and is labor intensive, two resources that angel networks havein short supply. Fourth, developing measures of success pose a significant challenge, andthis is compounded by the fact that it is often difficult to even determine the goals of theangel portal, let alone the measures of success. Lastly, in any evaluative study the import-ance of an independent third party assessment is critical, which would require fundingfrom an equally independent source and not from any organization with an inherent inter-est in the success of angel portals.

Types of angel portalsThe angel market can be characterized along six different forms of angel portals, each rep-resenting a distinguishable type of angel portal through which business angels interactwith entrepreneurs. The primary goal of each of these types of portals is to increasethe efficiency in the early stage market, increase deal flow for business angels andprovide entrepreneurs access to angel capital. With high transaction costs for the entre-preneur, raising private equity capital involves a costly and time-consuming personalnetworking process. For the investor considerable time and dollars are spent searchingand evaluating investment opportunities. Angel portals seek to mitigate some of thesetime-consuming activities. Preservation of the anonymity of angel investors is also animportant consideration in the structure of these portals. The six types of portals or angel


organizations may be categorized as: matching networks, facilitators, informal angelgroups, formal angel alliances, electronic networks and individual angels. Table 14.2 pro-vides a summary of the characteristics of the types of angel portals. In Table 14.2 fivecharacteristics are used to describe angel portals: the proportion of total market invest-ments, membership criteria, visibility, organizational structure and the percentage oflatent angels. The proportion of total market investments is a measure of the marketshare, in terms of the total number of investments made by members of the angel portalas a percentage of the total investments by all types of angel portals. Membership crite-ria is defined as the criteria that members of the angel portal must have. Thus, a rating of‘high’ for membership criteria indicates that the portal requires the members to meetseveral requirements, such as minimum yearly investment activity, annual dues and/orcontributions to an investment fund. Visibility is the degree of awareness that entrepre-neurs and business angels have of the existence of the portal. Organizational structure isthe level of structure in the angel portal. An angel portal with a high organizational struc-ture would include such organizational components as a paid executive director, the elec-tion of officers, a formal investment committee and organization bylaws that govern theactivities of the portal. The percentage of latent angels is the percentage of the individ-ual members of the angel portal that have the necessary net worth, but have never madean investment.

Matching networksMatching networks, or business introduction services, are the oldest form of an angelportal and for a decade after their inception they were the only type of organized angelportal in existence. The matching networks represent the first attempt to increase theefficiency of the early stage market by providing a mechanism for investors to evaluateopportunities, and for entrepreneurs to gain access to business angels. These networks aretypically not-for-profit organizations with an established connection to the investor andentrepreneur community in their respective region. The first matching network, founded


Table 14.2 Angel portals

Proportion oftotal market Membership Organizational Percentage ofinvestments criteria Visibility structure latent angels

Matching LOW MED HIGH HIGH MEDnetworks

Facilitators MED LOW MED LOW MED-HIGHInformal angel HIGH LOW MED LOW LOW

groupsFormal angel MED HIGH HIGH HIGH HIGHalliances

Electronic VERY LOW MED HIGH MED HIGHnetworks

Collection of HIGH LOW LOW LOW LOWindividualangels

at the University of New Hampshire by William Wetzel in 1984, at that time called theVenture Capital Network (VCN), provided the model for matching networks that is stillfollowed today. VCN was based on four fundamental principles: the need to protectinvestor anonymity, to provide access to capital for entrepreneurs, to have an efficientmechanism for business angels to screen investment opportunities and the importance offace-to-face interaction between business angels and entrepreneurs. These principles setthe stage for the foundation for the majority of matching networks in operationtoday, such as Business Angels Party Limited in Australia, Halo in Northern Irelandand Euregional Business Angel Network in Germany. Over time, this last principle,face-to-face interaction, has been demonstrated to be a key element of angel investing.Amit et al.’s (1990) examination of the implications of the relationship between entre-preneurs and venture capitalists found that the significant information asymmetries inher-ent in the private equity market highlight the importance of the principal–agentrelationship and allow for significant agency risks, particularly adverse selection prob-lems. Business angels attempt to overcome these inherent difficulties with an increasedreliance on personal communications with the entrepreneur and the ability to judge thecharacter through face-to-face communications and interactions in a variety of settings.Bearing out this point, the angel market has been one that conducts business on a face-to-face level for both deal sourcing (Freear et al., 1994a; Coveney and Moore, 1998;Reitan and Sørheim, 2000; Sørheim and Landström, 2001) and investment decisions(Landström, 1992; Fiet, 1995a; Harrison and Mason, 2002). Likewise, business angelstend to depend on the entrepreneur to protect them from losses due to market risk andare thus more concerned with agency risk than market risk. To accomplish this, businessangels develop a close working relationship with entrepreneurs in the post-investmentstage as a way to mitigate risk and bring value to the investment (Fiet, 1995b).

To address the need to protect investor anonymity, provide access to capital for entre-preneurs, have an efficient screening mechanism and the face-to-face interaction, VCNimplemented a three-tiered approach: (i) a matching database; (ii) the venture forumformat; and (iii) educational seminars.

The matching database requires the submission of an executive summary of the busi-ness plan by the entrepreneur. Investors list investment preferences, including size, stageand location. The network screens for those business plans that match investor criteriaand forward an anonymous copy of those business plans satisfying the criteria to theindividual investor. The investor, if interested, contacts the network for information onthe entrepreneur and the network facilitates the introduction and then exits from theprocess. All subsequent contact is between the investor and the entrepreneur directly(Sohl, 1999).

These matching networks initiated the venture forum format, where pre-screened entre-preneurs are given the opportunity to present their business plan to groups of early stageinvestors. In this context, investors were afforded the opportunity to have a face-to-faceinteraction with several entrepreneurs, to view several presentations within a reasonableperiod of time, and initiate contact if the venture appeared promising. The venture forumalso provided the opportunity for investors to interact with each other and to syndicatearound a deal.

The importance of education was underscored, and the matching networks werethe first to produce educational seminars, for both the entrepreneur and investor, on


investing in the early stage market, market trends, and similar timely investment infor-mation. These educational seminars became an integral component of the matchingnetwork concept.

At the high point of their tenure matching networks were the dominant form of angelportal for nearly a decade. During that time, in terms of facilitating early stage invest-ments, statistics indicate that the success rate for the network member entrepreneur inreceiving equity financing was in the 10 to 15 per cent range for the matching service andapproximately 40 per cent for the venture forum format (Freear et al., 1994a).

Today, very few classic matching networks are in existence in the US, although theirnumbers are greater in Europe. Some have evolved into providing only venture forums oreducational seminars, while others have ceased to exist. However, the importance of thisinitial effort to increase the efficiency of the angel market cannot be understated. This firstmodel spawned an entire industry. The unique combination of matching service, ventureforum format and educational initiatives set the stage for the development of theseimportant initiatives that have educated a generation of entrepreneurs and investors onthe central mysteries of angel investing. Also, the initial success of the venture forum hasbeen adopted as one of the predominant mechanisms in today’s market for bringing entre-preneurs and investors together.

FacilitatorsThe second model of angel portal, facilitators, is one of the least organized of the angelportals. These facilitators generally do not have any formal angel membership but rathermaintain a list of interested parties, including private investors, entrepreneurs and serviceproviders. They are often considered ‘event planners’ in the sense that they plan eventsthat seek to bring business angels and entrepreneurs together. These events are organizedaround a specific issue, with a speaker, or panel of speakers, addressing a topic germaneto the angel market. These topics include valuations, setting terms and conditions, prepar-ing a presentation and organizing a business plan. Thus, to some extent, facilitatorsprovide educational opportunities for the angel and entrepreneur community. Theseevents will also include the venture forum format. With ample time for networking, thereal focus of these facilitators is to assist, in a passive manner, the introduction of entre-preneurs to business angels. Examples (cases) of facilitators are the Technology CapitalNetwork and the 128 Innovation Capital Group in the US, the ‘netzwerknordbayern’ inGermany and Gate2Growth in Belgium.

These facilitators take on two organizational forms: private sector for profit organiza-tions and public/private sector hybrids. The hybrids, often some form of economic devel-opment agency, have as their primary focus the fostering of economic development intheir geographic area. Examples of this type of facilitator are International AngelInvestors in Tokyo, Japan and TechInvest in Wales, UK. The geographic footprint can beas small as a mid-sized town of 150 000 residents to as large as a state or province. Whileangel investing is not their core business, they often view angel capital as a key compon-ent in increasing the economic vitality of their region. The facilitators embark on initia-tives to begin to encourage angel investing in the community or, within an establishedentrepreneurial sector, to sustain and grow angel investing. At the present time, there areclose to 100 active angel portals in the US that would be considered facilitators and prob-ably as many in Europe (Sohl, 2003).


It is difficult to assess the effectiveness of the facilitators since they often do not keeprecords of their success in these entrepreneur and angel interactions. One of thedifficulties is that the business angel–entrepreneur interactions are serendipitous in natureand the facilitators do not have a formal list of either their entrepreneur or business angelmembers. It does appear that these facilitators have been successful in three facets of thebusiness angel market. First, the facilitators have raised the visibility of the business angelcommunity in the region within which they operate. Second, they provide an informalmeeting structure for business angels to meet other business angels and possibly syndicatewith each other around a particular deal. Third, the facilitators provide a venue for entre-preneurs to present their business concept, and through interactions with the businessangels and entrepreneurs at the meetings they often gain an assessment of the quality oftheir presentation and the business plan.

Informal angel groupsThe third type of angel portal is the myriad collection of informal angel groups. Thesegroups have members, although the membership criteria are quite broad, typically involv-ing attendance at meetings and an interest, ability, and net worth, to engage in angel invest-ing (Table 14.2). These groups can be as small as a handful of members to as large as50 private investors (Center for Venture Research, 2005). Collectively, informal angel groupsrepresent the second largest of the six types of angel portals, in terms of total number ofmembers and investment activity. In the US there are several hundred of these informalangel groups. Examples of informal angel groups are Envestors in London, UK, CatCap inGermany, Founders Forum in Australia, and eCoast Angels and Walnut Ventures in the US.

The key distinguishing feature of the informal angel group, in addition to their size, isthe reliance on members to perform many of the ‘back office’ functions of the portal. Theinformal angel groups rely on the members to bring the majority of the investment oppor-tunities to the group for investment consideration. Thus, initial screening is the memberreferral, and in some cases, the commitment of one member to invest funds is requiredbefore the entrepreneur can present to the group. As such, the trust relationship amongmembers appears to be a mechanism to mitigate some of the risk inherent in angel invest-ing. Members perform due diligence and are free to invest when they wish, usually withoutany stated minimum investment activity required to remain a member of the group.Members often syndicate with other members of the group based on a specific deal, withone of the business angels assuming the role of lead investor. However, not all membersof the group invest in all deals, thus preserving the ability to manage their own angelinvestment portfolio. The informal angel group affords the opportunity for members toarchive a level of sector diversification through this co-investing. That is, research indi-cates that business angels typically invest in technologies in which they have experiencethat has been garnered either as former successful entrepreneurs in the particular indus-try or through prior sector investing experience. Thus, through a reliance on othermembers with expertise in the particular industry, and the trust relationship they havedeveloped, business angels can achieve some industry-level portfolio diversification. Theventure forum format, although quite informal in nature, is the predominant mechanismfor assessing the investment opportunity. These informal angel groups have a smallnumber of latent angels, indicating that investment activity, while not a formal require-ment for membership, appears to be at least an implicit one.


The informal angel groups have been quite effective in several facets of the angelmarket. Since the screening of the investment opportunities is through a member referralor a commitment of one member to invest funds, the investment opportunities presentedto their members are consistently of high quality. Informal angel groups also offer busi-ness angels the opportunity to achieve some market diversification through co-investingwith other members. In addition, since most informal angel groups have a low percentageof latent angels, the entrepreneur has a higher chance of securing investment capital.

Formal angel allianceThe fourth model of angel portal is the formal angel alliance. These alliances are distin-guishable from the informal angel groups in that they tend to have a larger membershipper group and have a higher degree of visibility. However, the collective membership (andinvestment activity) of informal angel groups and the individual angel market (discussedbelow) exceeds that of the formal angel alliances.

The angel alliance phenomenon began in 1994 with the formation of the Band ofAngels in Silicon Valley by Hans Severiens. The original concept was to form a group ofprivate investors with a ‘storefront’ that gives visibility to the group but not to the indi-vidual members, and to have a more rigid organizational structure than the informal angelgroup. This formalized organizational structure is a distinguishing feature of the formalangel alliance. Most alliances have specified articles of incorporation and are organizedas limited partnerships, general partnerships, limited liability corporations or corporateentities (Table 14.2). The alliances often have criteria for membership in addition toaccredited investor status. These additional requirements include education, referral by amember in good standing and past investment experience. Members may also includeventure capitalists and most alliances have some form of annual membership fee.Decisions on investments include individual member decision making, voting bymembers, or decisions by an investment committee. The high visibility of the formal angelalliance was conceived as a mechanism to attract deal flow but had the unintended con-sequence of attracting a multitude of deals with variegating quality, resulting in the needfor screening committees, staff support and the increased burden of screening these deals.This deal flow volume and entrepreneur inquiries led to the need for paid back office staff,board of directors and an executive director that assumes the ‘face’ of the portal for theentrepreneurial community. Examples of the formal angel alliance include the AngelsForum and BlueTree Allied Angels in the US, Advantage Business Angels and LondonBusiness Angels in the UK, Nippon Angels Forum in Japan, and Mentor InvestorNetwork Events for Business Angels in New Zealand.

The original concept of the formal angel alliance has spawned a myriad of hybridalliance organizations that can be categorized by membership investment requirements,investment decisions and the source of capital. The classic angel is an individual thatmanages their own money and decides when, and how much, risk capital to invest in entre-preneurial ventures. Some of the hybrid formal angel alliances have increased the burdenon members by specifying a minimum number, and size, of annual investment activity. Anexample of this type of hybrid is the Tech Coast Angels in the US. This requirement maylead to less than optimal investment decision making since angel investments are relatedto the portfolio of private equity holdings of the individual angel and the investmentopportunity, rather than an artificially imposed investment frequency.


In another hybrid of the angel alliance, the decision making ability of the individual isoften restricted by certain forms of group decision making. Robin Hood Ventures in theUS operates as this type of hybrid. These group decisions take the form of voting, eitherby members or by an investment committee, with a positive vote requiring all members toinvest in the venture. As such, the individual angel’s decision making authority is usurpedby the alliance.

The last form of hybrid angel alliance results from the pooling of funds. In thisinstance, all members are required to invest in the angel alliance fund and this fund is thesole source of capital for alliance investments. An example of this type of angel portal isthe Mid Atlantic Angel Group in the US. In some cases business angels may make anadditional investment, but only after the fund has decided to make the investment. In thiscase, angel investing has morphed into classic venture capital funds, with limited/generalpartners (the general partners are wealthy individuals), and the name ‘angel fund’ is theonly similarity to angel investing. These ‘angel funds’ result in a reallocation of angelcapital away from individual investing (and possibly seed stage investing) to venturecapital fund investing. While the investment objective of the fund may be seed stage, fundsize may dictate later stage investing and a diminishment in the value-add of the angelinvestor.

The formal angel alliance has achieved much success, but this success is not without acost. The formal angel alliance has increased the visibility of angel investing and hasachieved a large number of member business angels per angel portal. However, while thisincreased visibility has increased the number of deals for the alliance, this has not corres-ponded with an equal increase in the quality of the deals. This variability in deal qualityhas necessitated the initiation of screening committees and additional staff to review thequality of the investment opportunities, which has resulted in increased operating costs.In addition, the rigid organizational structure of the formal angel alliance is not in align-ment with the general individualistic behavior of business angels and as such, these formalangel alliances may be more attractive to inexperienced wealthy individuals seeking apassive investment vehicle, rather than a value-added and active angel investor.

Electronic networksThe fifth, and smallest in terms of investment activity, type of angel portal is the electronicnetwork. These electronic networks were a product of the Internet bubble of 2000 and areclose to extinction in today’s angel market. Electronic networks were largely a misguidedeffort and in some cases an attempt to profit from the irrational behavior of unseasonedinvestors that entered the angel market during the dot.com bubble of 1999/2000. Duringtheir peak in 2000 about thirty of these electronic networks sprouted on the World WideWeb (Sohl, 1999). The electronic networks attempted to mirror the matching networksthrough the medium of the Internet. Examples of electronic networks include Local Fundand Funding Match in the US, and the Private Equity and Entrepreneur Exchange andAussie Opportunities in Australia. Unlike the matching networks, these electronic net-works typically do not engage in any educational function nor do they use the ventureforum paradigm. Requirements for the entrepreneur cover the spectrum from the sub-mittal of a two-page executive summary to detailed business plans. Pending investoraccreditation and an annual fee, individual investors peruse the network for investmentopportunities.


Electronic networks have been largely unsuccessful, with less than 1 per cent of equitycapital raised harvested on-line (Private Equity Week, 1998). Several factors attributed tothe demise of the electronic network. Strategies of many electronic networks were todevelop a national angel market operating with one platform and structure, which failedto address the regional nature of the market and the necessity of being grounded in theregional entrepreneurial market. One especially misguided government-sponsored effortenvisioned a central database for the US and over 50 local networks, the majority of whichhad absolutely no understanding of the angel market. Also, angel investing is a face-to-face phenomenon and no amount of electronic interfacing, in the present form, willreplace a seasoned investor’s ability and desire to review the deal, and the entrepreneur,up close. In addition, in light of the overwhelming success of the venture forum format,electronic networks provide no such venue. The future for electronic networks most prob-ably lies in providing an efficient method for deal screening. Unfortunately, in many, if notall, of the initiatives, the failure to grasp key concepts of the angel market resulted in poorstrategic selection and hampered the penetration of electronic networks into the earlystage equity market.

Collection of individual investorsThe last type of angel portal, the collection of individual investors, is the largest andoldest segment of the angel community. This is also the least understood of the angelportals, since the individual angel market is largely invisible, and reliable data is difficultto acquire. The individual investor portal accounts for the majority of deals and invest-ment dollars in the angel market. Although the largest segment of the angel market, thiscollection of individual angels is the least organized of the angel portals. These individualangels are not directly affiliated with any angel portal, although loose connections withinformal angel groups and, to some extent, formal angel alliances, do exist and the indi-vidual angels may co-invest with members of these other portals.

Despite the lack of organization, deal flow does not appear to be an issue, and the dealsmay be of higher quality, on average, than those of the other portals (Table 14.2). Drawingon their social and human capital, individual angels rely on referrals to generate deal flow.These gatekeepers, such as other entrepreneurs, lawyers and service providers, oftenprovide that crucial initial introduction for the entrepreneur. Since the referral sources areoften trusted friends and business associates, who know what type of deals they invest inwith respect to sector, stage and size, there appears to be less need for screening. Tappinginto the individual angel portal is often a random occurrence and a time-consumingprocess punctuated by many misguided approaches. As such, transaction costs for theentrepreneur may be substantial.

ConclusionSystemic market inefficiencies and two persistent funding gaps – the primary seed gap andthe secondary post-seed gap – have led the angel market to assume several organizationalstrategies to increase the efficiency of quality deal flow and increase the capital available.Adapting to changing market conditions, multifaceted angel portals have evolved.Collectively, individuals and angel portals comprise today’s angel market. Angel portalshave increased the visibility, and importance, of business angels, and have provided entre-preneurs with a venue in their search for seed funding. An examination of these types of


angel portals sheds considerable light on the angel market and provides a potential lens tothe future of the market. Six types of angel portals – matching networks, facilitators, infor-mal angel groups, formal angel alliances, electronic networks and individual angels – wereexamined. Hybrid forms were noted where appropriate. The existence and market pene-tration of these types of portals vary across nations. In the future, it is important to under-stand why some angel portals may be more apposite for certain regions and countries andnot for others.

Implications for portalsBased on this examination of angel portals it appears that for angel portals to be effectivein solving the primary seed gap and the secondary post-seed gap they should adopt somebasic features that reflect the fundamental tenets of the angel market. Perhaps mostimportantly, angel portals should maintain an informal structure that has few rules orrestrictions for membership, such as minimum investment requirements, member votingfor deal investment approval and conditions that all portal members invest in all the dealsthat are approved by the membership. Business angels invest in markets where opportu-nities exist, such as in the primary seed gap and secondary post-seed gap, and thus restric-tions on investment activities would prevent capital from being used where it is mostneeded.

The three portal types, informal angel groups, the collection of individual angels andmatching networks, are most suited for investing in the primary seed gap. It is in thisprimary seed gap that the angel and entrepreneur relationship is most critical and the pos-ition where business angels can be most effective in their value-add. That is, since businessangels bring much start-up experience to their investments, this experience and expertiseis most effective in the early stages of development of the entrepreneurial venture. In add-ition, this start-up experience affords business angels the opportunity to use their exper-tise in evaluating the potential investment opportunity. In contrast, the formal angelalliance, and in some instances the matching network, are best positioned in investing inthe secondary post-seed gap. The formal angel alliance, with extensive membership cri-teria including minimum investment requirements and the presence, in many cases, of aninvestment fund, allows the angel alliance to participate in these larger post-seed invest-ment rounds. However, it is important to note that this extensive organizational structureof the formal angel alliance may have some unintended consequences. Specifically, these‘angel’ funds can be viewed as venture capital funds with wealthy individuals as limitedpartners and such a structure represents a redistribution of business angel capital awayfrom the individual angel investor to a fund structure. Such redistribution would onlyresult in an exacerbation of the persistent, and troublesome, seed financing gap facingentrepreneurs seeking early stage capital. This potential institutionalization of the busi-ness angel market could present a significant impediment to the viability of the businessangel investor as the major provider of seed capital to entrepreneurial ventures (Amatucciand Sohl, forthcoming).

There are four key considerations for angel portals to be successful. First, portalsshould be based on a regional model, rather than one that is national or state/province inscope. Since business angels predominately invest in deals within a half-day travel timefrom their principal residence, this regional approach is most appropriate and would assistin solving local capital gap issues. Second, angel portals need to provide for a face-to-face


interaction between business angels and entrepreneurs since the investment decision oftenrelies on the quality of the management team. Certainly, angel groups should be con-nected to the regional entrepreneur and angel community and strive to develop an under-standing of these regional communities within which they operate. Related to thisconnection to the angel and entrepreneur community, angel portals should undertake amarketing effort that includes building awareness among angels and those entrepreneursoffering quality deal flow. Such a marketing effort requires an allocation of resources tomarketing initiatives. Third, portals should strive to provide quality deal flow for theirmembers. As such, angel portals should conduct some level of screening and developsome hurdles for entrepreneurs to increase the proportion of proposals that are investor-ready. This screening should focus on deals that occupy the primary seed gap and sec-ondary post-seed gap, since this spectrum is where business angels have the opportunityto be effective and realize returns commensurate with the risk they face. Fourth and mostimportant, portals must remember that they are collections of angel investors who makeindividual investment decisions and that they are not venture capitalists that manage apool of capital. Such movement to the institutionalization of the angel market would haveserious consequences for the supply of critical seed and start-up capital. In the worst case,an institutionalization of the angel market could result in a movement to later stageinvestments, which would only exacerbate the primary seed and secondary post-seed gaps.Once angel portals adopt the basic tenets outlined above for an organizational structure,they will be in a better position to solve some of the inherent inefficiencies and capitalshortages that exist in the two capital gaps.

While angel portals have emerged, and evolved, over the years, and the angel markethas gained visibility, the angel market is still very informal, and relies on a collection ofindividuals who are willing to invest a portion of their portfolios in high risk entrepre-neurial ventures. Business angels are independent by nature and they invest their ownmoney where and when they want to. The market is a highly personalized one character-ized by individuals (business angels) investing in individuals (entrepreneurs). When busi-ness angels syndicate around a deal, they syndicate with other trusted business angels oftheir choosing. The value-added component of angel investing, and the psychic incomethe business angel acquires from investing is derived from the individual angels workingwith the entrepreneurs they invest in. These individuals are the real adventure investors intoday’s market for risk capital.

Policy implicationsPublic policy can play a role in facilitating the development of a vibrant and active angelmarket at a regional level and enhancing the flow of early stage equity capital to entre-preneurial ventures. Specifically, four levels of policy recommendations are offered:(i) linkages; (ii) research; (iii) education; and (iv) monetary incentives. With respect tolinkages, an active angel market requires the presence of innovators who develop the idea,entrepreneurs who form a business around the innovation, and business angels whoprovide the capital to move the idea from the laboratory to the marketplace. While some,or all of these, are present in communities, it is important that the linkages between thesegroups be established and public policy can play a role in fostering and nurturing theselinkages. Specifically, an active public policy to support the development of the businessside of the innovation (the innovator to entrepreneur linkage) would support both an


information clearing house for innovators and entrepreneurs to find each other, and asponsored venue for these meetings to take place. In addition, a physical location, such asan accelerator, would further the development of the innovator–entrepreneur interaction.To foster the growth of the business angel linkage with both the innovator and entrepre-neur requires a pro-active public policy to facilitate, and act as a catalyst for, theseinteractions to take place. Also, since angel investing requires substantial screening ofopportunities, public support of this screening function would assist business angels intheir search for quality deals.

Public policy can also play a role in supporting research to increase the understandingof the changing nature of the angel market. The angel market is a myriad collection ofangel portals and a difficult market to gain access to for research purposes. Researchefforts in this context are labor intensive, costly and must be longitudinal in nature. Suchan extensive and comprehensive research undertaking is beyond the purview and theresources of local governments and private sector firms. Research efforts of this magni-tude are best supported through public policy agencies or a public/private sector part-nership to provide the patient capital to design and undertake business angel research ona national scale. This research can assist governments in making informed policy deci-sions regarding the growth and sustainability of the business angel market.

Educational programs should be developed that target both the supply and demand.Namely, education should be directed to latent angels to assist in understanding thecentral mysteries of angel investing and for entrepreneurs to appreciate the requirementsnecessary to become investor ready. Successful educational programs would result inan increase in both available capital and quality deal flow. There exist some limitedprivate sector initiatives in this area, such as the Power of Angel Investing in the US andAngel Academies in Europe. While private sector initiatives can play a limited role in edu-cation, the public sector is uniquely positioned to marshal the appropriate individuals andgarner the resources necessary to develop and implement a comprehensive educationprogram that is available to all entrepreneurs and business angels at a subsidized price. Thepublic sector, in combination with existing research and funded research projects, canensure the consistency of the educational content. In addition, public sector involvementand funding of educational programs will ensure that the content is based on researchstudies, avoiding the incidence of anecdote-based training that occurs in a number ofexisting private sector programs.

Public policy monetary incentives should focus on enhancing the flow of early stageequity capital to entrepreneurial ventures. First, to increase a supply of start-up capitaland to leverage existing angel resources, a pool of capital, the Archimedes Fund, needs tobe created at a regional or national level. This Archimedes Fund would be the source ofleverage for angel investors. The creation of a fund with a 3 to 1 leverage would bothincrease the available start-up capital and provide a form of downside risk protection forangel investors. As an example, in an investment of US$1 000 000 the angel would provideUS$750 000 and draw US$250 000 (3 to 1 match) from the Archimedes Fund. At the exitevent, any capital gains would be redistributed to the Archimedes Fund, in the 3 to 1 ratio,for future investments. It is important to note that the Archimedes Fund is not a venturecapital fund, but rather a matching fund for business angels. As such, management of thefund would be substantially less burdensome than a classic venture capital fund. It isimportant that the source of capital for the Archimedes Fund be corporate partners or


governments and not individual investors, to enhance the creation, rather than the redis-tribution, of equity capital. An example of such a monetary initiative is the ScottishEnterprise Business Growth Fund and the Scottish Co-investment Fund. These two fundsaccounted for 7 per cent of the total monies invested in Scottish early stage companies in2004 and were represented in 55 per cent of all the deals recorded (Don and Harrison,2006). In addition, the leverage effect of the Scottish Co-investment Fund is substantial,with the average business angel deal size in 2004 increasing from £179 to £475 when busi-ness angels co-invested with the fund (Don and Harrison, 2006).

Second, to enhance the quality of deal flow, it is suggested that a web-based system becreated for entrepreneurs to submit business plans for potential angel funding. Utilizingthe resources of university business schools, students would provide initial screening anddue diligence for the proposals and complete a short assessment of the investment oppor-tunity. This assessment would be available to business angels to help manage deal flow andalso available to entrepreneurs as a timely feedback mechanism in their search for equitycapital. Funds for this web-based screening system can be garnered from a small man-agement fee that is part of the Archimedes Fund and government support.

Future researchWhile the angel portal has received considerable attention from researchers, there existmany potential research topics that would add greatly to the understanding of thisimportant equity market. Much of the angel portal research to date has been based on across-sectional analysis of the market taken at various points in time. A longitudinalapproach would provide for the opportunity to track changes in various portals over time.One potential approach for longitudinal investigation is using the deal level as the unit ofanalysis. In this scenario, the angel deal from each angel portal is tracked from the timeof investment to the exit. Such an approach would provide valuable insights into chang-ing valuations and understanding the conditions for deals that exit when funding isrestricted to angel portals without any institutional venture capital. This longitudinal dealtracking would also illuminate some of the conditions why an angel deal was not suc-cessful across portals. Through longitudinal tracking at periodic intervals of time, infor-mation as to how and why angel deals fail with respect to the type of angel portal wouldbe available for study.

With respect to the myriad of angel portals that exist, it is important to understand whysome angel portals may be more appropriate for certain regions and not for others. In thiscontext, regional level angel portal investment data, combined with regional R&D invest-ments, measures of the entrepreneurial climate, industry infrastructure, workforce charac-teristics and other economic variables could help in explaining the differences betweenangel portals. In addition, such an analysis would provide economic planners with a poten-tial map of how best to organize business angels within their region.

Another potential area of future research is the evolving relationship between angelportals and venture capitalists. While these two entities are understood to be comple-mentary and to occupy different places in the private equity market, these lines are becom-ing less distinct, especially with the emergence of the formal angel alliance and the angelfund. The potential for conflict exists and an understanding of the nature of these venturecapital–angel portal relationships and how best they can be nurtured for the benefit ofboth parties would be an important contribution to the literature.


Another potentially interesting line of inquiry is the role of angel portals in regionaleconomic development. While angel portals typically restrict their investment activity tothe regions within which they operate, there has been little study on how angel portalsinteract within the larger sphere of regional economies and with other portals within theregion. Screening and due diligence conducted by angel portals has often been studiedthrough interviews and cases. Research into the actual due diligence, through the directanalysis of actions (reject, continue due diligence or invest) by the screening and due dili-gence committees of angel portals, could assist entrepreneurs in developing business plansmore compatible with the criteria of the type of angel portal that is their target. While ithas been noted that the angel market is experiencing an increase in organization, thepotential for the institutionalization of the angel market and the subsequent abandon-ment of the seed and start-up stage market has serious considerations. Research into thispotential institutionalization, the conditions for development and the consequenceswithin angel portals, are of vital concern to the future of the angel market.

There exists a notable lack of a theoretical framework for business angel research ingeneral and for angel portals in particular. Since angel portals are essentially collectionsof individuals that operate within a group, one potential theoretical development forangel portals is the effectiveness of group structure on the investment decision process.The concept of the interplay of group dynamics and the interaction within and amongportals could also provide a valuable theoretical perspective. While it may be possible toexamine which portal structure operates best with respect to the quality and quantity ofinvestments, theories of group dynamics and efficacy could provide the why behind theseempirical findings. It appears that social capital also has an important role in businessangel investing. Many of the sources of deals are from referrals from trusted associatesand the practice of angels syndicating around a deal is a relationship based on trust.Theories of social capital and social networks, as a way of building trust within these busi-ness angel relationships, has the potential for providing a valuable lens into this behavior.In a similar context, social networks and homogeneity theory may provide a foundationfor the differences between male and female angel portals with respect to the seek ratesfor women entrepreneurs. To clarify, would women entrepreneurs be more likely to seek,and receive, funding from angel portals that have a high proportion of women businessangels? Following this gender construct, feminist theory would be helpful in exploringwhether structural and social barriers impede women’s access to angel portals or theirability to pass the screening process in these portals, and thus they may seek funding fromangel portals at a lower rate than men.

Business angels invest in the entrepreneur, in the context of agency theory, as a means tomitigate the risk inherent in investing in early stage ventures with little or no historical finan-cial or operating data. Extending the principal–agent theory to angel portals is a potentiallyfruitful area of research. In this context, angel portals appear to be conducting a heightenedlevel of screening of entrepreneurs before presenting these investment opportunities to theirmembers, partially as a means to reduce the risk for business angels. Could this additionalscreening change the dynamics of the principal–agent relationship away from the businessangel–entrepreneur framework? That is, would the principal–agent relationship shift to onebetween the angel and the deal and mitigate the influence of the entrepreneur?

While there is considerable knowledge about the angel market, there remain manyfacets that are misunderstood and much research to be undertaken. Through high quality,


well designed and timely academic research, business angels, entrepreneurs and policy-makers will be in a better position to make informed decisions regarding their role in thedevelopment of a vibrant, and sustainable, angel market.

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PART IV

CORPORATE VENTURECAPITAL

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

IntroductionCorporate venture capital, that is, equity or equity-linked investments in young, pri-vately held companies, where the investor is a financial intermediary of a non-financialcorporation, has become an increasingly important phenomenon in venture capital.Although many active companies scaled down their corporate venture capital after thepeak of the IT bubble in 2000, when the annual global corporate venture investmentsreached over 20 billion dollars or over 15 per cent of the whole venture capital market,corporate venture capital has still remained as an important tool in the corporateventuring toolbox of many major corporations (Chesbrough, 2002; Maula and Murray,2002; Dushnitsky and Lenox, 2005a). Recently, after a few slower years followingthe burst of the IT bubble, many corporations have again started to set up new corpor-ate venture capital funds, such as Intel Capital, which has established four new corpo-rate venture capital funds targeted in China, India, the Middle East and Brazil in2005–2006.

Before the latest wave of corporate venture capital investment, research on corporateventure capital was quite limited (for some early contributions, see Fast, 1978; Rind, 1981;Hardymon et al., 1983; Siegel et al., 1988; Winters and Murfin, 1988; Sykes, 1990).However, during the past few years the research on corporate venture capital has becomesignificantly more active (for example, Maula, 2001; Hellmann, 2002; Maula and Murray,2002; Maula et al., 2003a; 2003b; 2005; Dushnitsky, 2004; Dushnitsky and Lenox, 2005a;2005b; Hill et al., 2005; Rosenberger et al., 2005; Schildt et al., 2005; Bassen et al., 2006;Dushnitsky and Lenox, 2006; Mathews, 2006; Maula et al., 2006b; Schildt et al., 2006;Riyanto and Schwienbacher, forthcoming). However, the body of literature on corporateventure capital is still quite fragmented and has not been systematically reviewed. It is thepurpose of this chapter to summarize and synthesize the literature on corporate venturecapital with a particular emphasis on research examining corporate venture capital fromthe corporate perspective.1

The rest of the chapter is structured as follows. After the introduction, a brief discus-sion of the definitions of corporate venture capital is provided. Thereafter, the researchon the motives of corporations to invest in corporate venture capital is reviewed. Then,the factors influencing the decisions of corporations to invest in corporate venture aresummarized. Thereafter, research examining how corporations invest in corporateventure capital is reviewed. This is followed by a review of the research on the perform-ance of corporate venture capital. Then, the theories and methods applied in the researchon corporate venture capital are reviewed. Finally, some concluding remarks are madeand potential avenues for future research are discussed.

371

Defining corporate venture capitalBefore analyzing the role of corporate venture capital as a specific tool in the corporate ven-turing toolbox of corporations, it is important to clarify our understanding of the domainand the terminology of corporate venturing. To sharpen the picture, an important distinc-tion made in the earlier literature on corporate venturing is the distinction between internalcorporate venturing and external corporate venturing (Ginsberg and Hay, 1994; Sharmaand Chrisman, 1999; Keil, 2000; Miles and Covin, 2002). Internal corporate venturing refersto new innovations developed at various levels of the firm but within the boundaries of thefirm (Burgelman and Sayles, 1986; Keil, 2000). Sharma and Chrisman (1999) defined inter-nal corporate venturing as ‘corporate venturing activities that result in the creation oforganizational entities that reside within an organizational domain’. However, corporateventure capital is clearly a boundary spanning operation and belongs to the other class ofventuring tools labeled as external corporate venturing. Sharma and Chrisman (1999)defined external corporate venturing as ‘corporate venturing activities that result in the cre-ation of semi-autonomous or autonomous organizational entities that reside outside theexisting organizational domain’. Based on extensive case research of seven leading corpo-rations in the information and communications technology sector in the United States andEurope, Keil (2000) developed a classification of external corporate venturing modes. Theclassification is shown in Figure 15.1 (direct corporate venture capital is in bold).

In this framework, Keil (2000) first distinguished external venturing from internal ven-turing and thereafter grouped external venturing modes into three: corporate venturecapital, venturing alliances and transformational arrangements. Corporate venture capitalresembles the operations of traditional venture capital firms in referring to programs resid-ing at various levels of corporations where investments are made in independent externalcompanies. In the case of corporations, investments were made directly into ventures orindirectly through dedicated funds or pooled funds managed by external venture capitalfirms. These modes are fairly well in line with the extant literature on corporate venturecapital (Bleicher and Paul, 1987; Sykes, 1990; McNally, 1997; Kann, 2000). Some additionaldistinctions have been made concerning the organization of direct investments. McNally(1997) proposed distinction between ‘ad hoc’ investments and a more formal fund.


Corporate venturing

Internal venturing External venturing

Corporate venturecapital

Venturing alliances Transformationalarrangements

Third partyfunds

Dedicatedfunds

Self-managed

funds

Non-equityalliances

Directminority

investments

Jointventures

Acquisitions Spin-offs

Source: Adopted from Keil (2000)

Figure 15.1 External corporate venturing modes

Similarly, Winters and Murfin (1988), Sykes (1990), and Mast (1991) recognized varyinglevels of formality in the organization of corporate venturing activities. An important pointto remember from these distinctions is that the present chapter focuses on the direct invest-ments made by corporations. This focus is highlighted in bold in Figure 15.1.

To summarize, in this chapter, corporate venture capital is considered as a specific toolin the external corporate venturing tool portfolio as outlined by Keil (2000). However, italso recognizes that corporations have varying motives for making corporate venturecapital investments (Siegel et al., 1988; Winters and Murfin, 1988; Sykes, 1990; Alter andBuchsbaum, 2000; Kann, 2000; Keil, 2000; Maula and Murray, 2002; Dushnitsky andLenox, 2006), and varying strategies regarding the level of hands-on involvement with theventures in addition to financial investment (McNally, 1997; Kann, 2000; Kelley andSpinelli, 2001; Henderson and Leleux, 2002). Relationships stemming from corporateventure capital investments made for financial purposes may develop over time into rela-tionships that may appear more like a direct minority investment (McNally, 1997; Kann,2000; Kelley and Spinelli, 2001; Henderson and Leleux, 2002).

Furthermore, there are several ways to define and map the concept of corporate venturecapital. The two main alternative perspectives are viewing corporate venture capital: (1) asa mode of external corporate venturing from the perspective of the corporation (forexample, Kann, 2000; Henderson and Leleux, 2002; Keil, 2002; Keil et al., 2004;Dushnitsky and Lenox, 2005a; 2005b; Schildt et al., 2005; Dushnitsky and Lenox, 2006);or (2) as an alternative source of funding from the perspective of an entrepreneurialcompany (for example, Gompers and Lerner, 1998; Maula, 2001; Maula and Murray,2002; Maula et al., 2003a; 2005; 2006a; Rosenberger et al., 2005). This chapter primarilyemploys the former perspective, while the next chapter in this Handbook (Chapter 16)examines the entrepreneur’s perspective.

Why do companies invest in corporate venture capital?In the research on corporate venture capital, one of the most active areas of research hasbeen the stream on the goals and objectives of corporations that invest in corporateventure capital. Several studies have compared the relative importance of the variousgoals corporations have for their corporate venture capital operations (Siegel et al., 1988;Sykes, 1990; Silver, 1993; McNally, 1997; Bannock Consulting, 1999; Alter andBuchsbaum, 2000; Kann, 2000; Keil, 2000; Chesbrough, 2002; Dushnitsky and Lenox,2006). However, no single goal appears to be consistently most important. Instead, cor-porations tend to have multiple goals and different strategies in their corporate venturecapital activities. For instance, Siegel et al. (1988) found that return on investment wasthe most important goal of corporations, followed by exposure to new technologies andmarkets. Sykes (1990) found that identifying new opportunities and developing businessrelationships were the most important goals for corporations investing directly. Silver(1993) found in his survey that finding acquisition targets, getting exposure to newmarkets, adding new products to existing distribution channels, externalizing R&D,exposing middle management to entrepreneurship, training managers, and utilizingexcess plant space, time and people were the most important objectives. McNally (1997)surveyed UK corporations regarding their goals and found that identifying new markets,exposure to new technologies, financial return, identifying new products, and developingbusiness relationships were the five most important corporate objectives for direct

Corporate venture capital as a strategic tool 373

corporate venture capital. Bannock Consulting (1999) found in their survey of 150European corporations that on average 62 per cent had strategic goals, and 27 per centhad financial goals, as their primary motivations for corporate venture capital invest-ments, while many had several goals. In her analysis of 152 observed corporate venturecapital programs, Kann (2000) classified 45 per cent of the programs as being primarilyfocused on external R&D, 30 per cent as investing with the goal of accelerated marketentry, and 24 per cent investing in order to enhance demand for their products.

Comparing the role of financial goals and various strategic goals, recent research hasshown that strategic and financial objectives are not substitutes; instead both arevery important motivations for corporations (Bannock Consulting, 1999; Alter andBuchsbaum, 2000; Keil, 2000). Keil (2000) concluded that, while strategic objectives areoften the driver for setting up a corporate venture capital program, investments are oftenmade using financial criteria. Financial investment goals and investments in the financiallymost promising companies give a window to the best companies (where there is more tolearn from) and minimize conflicts of interests (Keil, 2000).

Most of the research on corporate objectives has been based on rankings of long listsof potential objectives by the respondents (Siegel et al., 1988; Sykes, 1990; Silver, 1993;McNally, 1997). Besides these long lists and the distinction between strategic and finan-cial objectives, some more fine-grained classifications of goals have also been made in therecent literature (Kann, 2000; Keil, 2000).

Based on an extensive archival research of 152 corporate venture capital programs,Kann (2000) distinguished three classes of strategic objectives for corporations; externalR&D, accelerated market entry, and demand enhancement. External R&D is the most‘aggressive’ goal referring to the intent of corporations to enhance their internal R&D byacquiring resources and intellectual property from ventures. Accelerated market entryrefers to corporations trying to access and develop resources and competences needed toenter a new product market. Enhancing demand refers to corporations leveraging theirstrong resource base and stimulating new demand for their technologies and products bysponsoring companies that use and apply those technologies and products.

Finally, Keil (2000; 2002) identified four primary strategic objectives; monitoring ofmarkets, learning of markets and new technologies, option building, and market enactment.Monitoring of markets refers to a warning system or antenna for gathering weak signals onthe future developments of the markets. Learning new markets and technologies refers tolearning from the relationships with ventures and requires more collaboration with them.Options to expand refers to placing bets to be ready if certain markets prove important andvaluable. Market enactment refers to a more proactive approach where corporate venturecapital investments are used to shape markets, set standards and stimulate demand.

In the following, the literature on corporate venture capital goals is summarized and asummary classification is illustrated in Table 15.1.

In this classification, the first distinction is between strategic and financial goals. Financialgoals of corporate venture capitalists have been reported in several studies; the term refersto gaining financial gains from investments (Siegel et al., 1988; Silver, 1993; McNally, 1997;McKinsey & Co., 1998; Bannock Consulting, 1999; Alter and Buchsbaum, 2000; Keil, 2000).However, there are a wide variety of strategic goals reported in the extant literature. In thisclassification, strategic goals are divided into three main categories; learning, option build-ing and leveraging. All these main categories have subcategories, which are discussed below.


Learning motivesLearning can take place in corporate venture capital investments in many ways (Keil et al.,2004). Three categories of learning benefits in this classification are market-level learning,venture-specific learning and indirect learning.

Market-level learning refers to learning from constantly monitoring the new venturesand therefore being exposed to developments of markets, technologies and business


Table 15.1 Potential benefits for corporations from corporate venture capital

Objectives Examples

Financial objectivesFinancial gains • (Siegel et al., 1988; Silver, 1993; McNally, 1997; McKinsey & Co.,

• 1998; Bannock Consulting, 1999; Alter and Buchsbaum, 2000;• Keil, 2000)

Strategic objectivesLearning

Market-level • Radar-like identification of, monitoring of, and exposure to newlearning • technologies, markets, and business models (Winters and Murfin,

• 1988; Sykes, 1990; Silver, 1993; McNally, 1997; Keil, 2000; Maula • et al., 2003b)

Venture-specific • External R&D (Sykes, 1990; Silver, 1993; McNally, 1997; McKinsey &learning • Co., 1998; Kann, 2000), Improving manufacturing processes (Siegel

• et al., 1988; McNally, 1997)Indirect learning • Change corporate culture (Sykes, 1990; McNally, 1997)

• Train junior management (Silver, 1993)• Learn about venture capital (Sykes, 1990; McNally, 1997)• Improve internal venturing (Winters and Murfin, 1988; Keil, 2000)• Complementary contacts (Winters and Murfin, 1988)

Option buildingOptions to acquire • Identify and assess potential acquisition targets (Siegel et al., 1988;companies • Winters and Murfin, 1988; Sykes, 1990; Silver, 1993; McNally, 1997;

• Alter and Buchsbaum, 2000; Maula and Murray, 2000; Benson and• Ziedonis, 2004)

Options to enter • Accelerated market entry (Kann, 2000)new markets • Option to expand (Sykes, 1986; Chesbrough, 2000; Keil, 2000)

LeveragingLeveraging own • Increase demand for technology and products (Kann, 2000; Keil, 2000;technologies and • Chesbrough, 2002; Gawer and Cusumano, 2002; Riyanto andplatforms • Schwienbacher, forthcoming)

• Shape markets (Kann, 2000; Keil, 2000; Maula et al., 2006b)• Steer standard development (Kann, 2000; Keil, 2000)• Support development of new applications for products (McKinsey &• Co., 1998)

Leveraging own • Add new products to existing distribution channels (Siegel et al., 1988;complementary • Winters and Murfin, 1988; Sykes, 1990; Silver, 1993; Alter andresources • Buchsbaum, 2000)

• Utilize excess plant space, time, and people (Silver, 1993)

models (Winters and Murfin, 1988; Sykes, 1990; Silver, 1993; McNally, 1997; Keil, 2000;Keil et al., 2003; Maula et al., 2003b; Keil et al., 2004; Schildt et al., 2005; Schildt et al.,2006). Some corporations use their corporate venture function to support their strategyprocess (Keil, 2000). Weak signals can be derived from deal flow, without having to investin every opportunity in order to learn (Keil, 2000; Maula et al., 2003b). This allows invest-ments in the financially most attractive companies while still delivering strategic benefits(Keil, 2000).

Venture-specific learning refers to learning from the relationships with portfolio com-panies. Some corporations use corporate venture capital as a form of external R&D todevelop their knowledge base, competencies, technologies, products and processes (Siegelet al., 1988; Sykes, 1990; Silver, 1993; McNally, 1997; McKinsey & Co., 1998; Kann, 2000;Dushnitsky and Lenox, 2005a; 2005b). Realizing this type of benefit often requires closercollaboration and frequent communication with portfolio companies (Sykes, 1990; Kann,2000; Keil, 2000). Most investments with the goal of venture-specific learning and exter-nal R&D are made in ventures operating in the same or related industries (Kann, 2000).

Indirect learning refers to learning from the corporate venture capital process.Corporate venture capital has been used to change corporate culture (Sykes, 1990;McNally, 1997), train junior management (Silver, 1993), learn about venture capital(Sykes, 1990; McNally, 1997), support the development of internal venturing processes(Winters and Murfin, 1988; Keil, 2000), and to provide contacts with related actors likeinvestment banks, scientists and venture capitalists (Winters and Murfin, 1988).

Option building motivesThere are two categories of option building; options to acquire companies and options todiversify to new markets. These are explained in the following.

Options to acquire companies refers to corporate venture capital investments made asoptions to acquire the portfolio company later if it proves strategically valuable.Identification and assessment of potential acquisition targets has been reported as a goalof corporations in several studies (Siegel et al., 1988; Winters and Murfin, 1988; Sykes,1990; Silver, 1993; McNally, 1997; Alter and Buchsbaum, 2000). However, many studieshave also argued that this goal does not work well because of the inherent conflicts of inter-est with entrepreneurs and other, financially oriented, investors (Winters and Murfin, 1988;Sykes, 1990; Keil, 2000; Maula and Murray, 2000). Maula and Murray (2000) found thatonly a very small share of acquired corporate venture capital-backed companies had beenacquired by one of the corporate venture capital investors. Most of the acquisitions hadbeen made by outsider companies. Similarly, Intel Capital had acquired only two compa-nies from the 450 companies in their portfolio by 2000 (Christopher, 2000). It has been sug-gested that a more successful way to view corporate venture capital as a supportive tool foracquisitions is to refer potential acquisition targets identified in the deal flow to the M&Adepartment or business units of the parent corporation (Maula and Murray, 2000).

Options to enter new markets refers to another form of options to enter new businesses.Besides building options to acquire portfolio companies, corporations can also prepare forentering new markets and use corporate venture capital investments as probes (Brown andEisenhardt, 1997; Eisenhardt and Brown, 1998) to learn the necessary skills and ensureright timing (Kann, 2000; Keil, 2000). Investments made with the goal of facilitatingpotential entry to new markets are made in ventures operating in industry sectors different


from those in which the corporation currently operates (Kann, 2000). Extant literaturedemonstrates that corporations use pre-entry alliances with new firms to prepare for enter-ing new markets (Mitchell and Singh, 1992). Similarly, corporations use corporate venturecapital to hedge their bets and to ensure that they have some stakes in emerging techno-logical platforms, in order to be prepared when the dominant design emerges (Keil, 2000).

Resource leveraging motivesThere are two categories of leveraging; leveraging own technologies and platforms andleveraging own complementary resources. These categories are explained in the following.

Leveraging own technologies and platforms refers to corporations using corporateventure capital to stimulate demand for their technologies and products by sponsoringcompanies using and applying them (McKinsey & Co., 1998; Kann, 2000; Keil, 2000;Maula et al., 2006b). Corporations can also use corporate venture capital to shapemarkets proactively, and steer and promote the development of de facto standards aroundtheir technologies, by supporting favorable companies through corporate venture capital(Kann, 2000; Keil, 2000). As an example of proactive shaping of the industry, Intel, whohas been highly dependent on the development of Microsoft operating systems in theirown development, recognized the emergence of Linux as an alternative and made veryearly phase corporate venture capital investments in the most promising Linux operatingsystem supplier, Red Hat Linux in 1998 (Young and Rohm, 1999). Thereafter, Intelinvested in many other Linux companies together with other companies, such as IBM,Compaq, Dell, Oracle and Novell, who also wanted to reduce their dependence onMicrosoft operating systems. These investments have been critically important in makingthe Linux a more credible alternative in the corporate world (Young and Rohm, 1999).

Leveraging own complementary resources refers to corporations leveraging their com-plementary assets such as distribution channels and production facilities. Companies havebeen reported to use corporate venture capital to add new products to existing distribu-tion channels (Siegel et al., 1988; Winters and Murfin, 1988; Sykes, 1990; Silver, 1993;Alter and Buchsbaum, 2000) and find use for excess plant space, time and people (Silver,1993). Technology-based ventures are acknowledged to be better at adopting and com-mercializing new technology than large corporations, meaning that they are superior inpursuing the highly focused rapid paced development of new product opportunities afterthe research phase is complete. This process often leads to opportunities for the corporateinvestor to acquire licenses for state-of-the-art technologies (Winters and Murfin, 1988).Furthermore, technology-based new ventures have often limited distribution networks, atleast when compared to any multinational corporation acting as a corporate venturecapital investor. Even if the start-up would not like to license the technology, there is anopportunity for marketing agreements, especially in areas that the start-up could nototherwise access. This is especially important when the start-up operates in a small homemarket and has a foreign or global corporation as an investor.

Taken together, these studies show that the goals of corporations engaging in corpor-ate venture capital has been one of the most actively researched areas of corporate venturecapital. The research clearly highlights that companies typically have multiple goals whenengaging in corporate venture capital. While financial goals often play some part in moti-vating corporate venture capital programs, in order to be sustainable, corporate venturecapital activity should have a strategic role for the parent corporation. While many goals


have been recognized, there is still quite limited understanding on the circumstances underwhich different goals can create value for corporation as well as the proper design ofeffective corporate venture capital programs depending on the goals and other circum-stances.

When do companies invest in corporate venture capital?

Cyclical history of corporate venture capitalWhen examining the history of corporate venture capital, three different ‘waves’ of cor-porate venture capital activity have been identified (Gompers and Lerner, 1998; Maulaand Murray, 2002; Dushnitsky and Lenox, 2006). First, in the late 1960s, corporationsengaged in corporate venture capital in order to gain a ‘window on technology’. Morethan 25 per cent of the Fortune 500 corporations were engaged in corporate venturecapital activities in the late 1960s and early 1970s (Gompers and Lerner, 1998). Followingthe collapse in the market for initial public offerings in 1973, the returns on venture capitalrapidly declined and most of the corporate venture capital programs were soon dissolved.The second wave in corporate venture capital took place in the 1980s, when it was used asa diversification tool. This wave peaked in 1986 when 12 per cent of the total venturecapital investments were managed by corporate venture capital programs (Gompers andLerner, 1998). However, not a great number of the corporate venture capital programswere successful and most of them were again quickly dissolved after the stock marketcrash at the end of the 1980s. Finally, during the latter half of the 1990s, corporate venturecapital emerged again, this time in a much larger scale than ever before, both in absoluteterms, and in relative terms compared to traditional venture capital. Direct venture capitalinvestments made by the subsidiaries and affiliates of industrial corporations more thandoubled during each of the last six years of the decade. However, after the peak in 2000,the economic slowdown resulted in a rapid decrease in the volume of corporate invest-ments in the beginning of 2001. Since then, the number of active firms and the amountof annual investments have stabilized on a level that still exceeds the levels before 1999.For many major corporations corporate venture capital has been a strategic instrumentand the activity has been sustained independent of the financial cycles. The developmentof corporate venture capital is depicted in Figure 15.2.

Industry and firm level drivers of corporate venture capital investmentAlthough aggregate statistics highlight the overall cyclicality and the impact of economicclimate on corporate venture capital investment, from a corporate perspective it is import-ant to understand the firm and industry level circumstances that influence the usefulnessand effectiveness of corporate venture capital. Although there are not many studies exam-ining the determinants of corporate venture capital investments, there are a few recentstudies that have examined this issue (for example, Chesbrough and Tucci, 2004;Dushnitsky and Lenox, 2005a; Basu et al., 2006; Gaba and Meyer, 2006; Li and Mahoney,2006). Some of the findings of this stream of research are summarized in Table 15.2.

In their recent study, Dushnitsky and Lenox (2005a) examined the firm and industry leveldrivers of corporate venture capital investments. At the industry level, it has been foundthat weak intellectual property protection, high technological ferment and high importanceof complementary distribution capability are positively related to the level of corporate


venture capital investments (Dushnitsky and Lenox, 2005a). Similarly, Maula et al. (2006b)argue that the systemic nature of innovations in an industry increases the usefulness of cor-porate venture capital. At the firm level, it has been found that firms’ cashflow and absorp-tive capacity are positively related to the level of corporate venture capital investments(Dushnitsky and Lenox, 2005a). At the firm level, several studies suggest that corporateventure capital investments will be actively used by companies who are in a position to drivea market ecosystem (Chesbrough, 2002; Gawer and Cusumano, 2002; Maula et al., 2006b).

Taken together, research on explaining the development of corporate venture capitalinvestments has evolved from focusing on the cyclicality of corporate venture capitalinvestments over time to developing increasingly sophisticated theory-based explanations


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Source: Based on Venture Economics data, May 2006

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

Table 15.2 The determinants of corporate venture capital investments

Level Factor Examples

Industry Industry IPR regime Weak intellectual property protection (Dushnitsky andLenox, 2005a)

Industry capability needs Importance of complementary distribution capabilityand types of innovations (Dushnitsky and Lenox, 2005a)

Systemic nature of innovations (Maula et al., 2006b)Industry dynamics High technological ferment (Dushnitsky and Lenox,

2005a)

Firm Firm free cash flow Firm’s free cash flow (Dushnitsky and Lenox, 2005a)Firm absorptive capacity Firm’s absorptive capacity measured as Internal R&D

(Chesbrough and Tucci, 2004; Dushnitsky and Lenox, 2005a) or patent stock (Dushnitsky and Lenox, 2005a)

Firm size Firm size (Dushnitsky and Lenox, 2005a)

of under what circumstances corporations invest in corporate venture capital. The indus-try and firm level determinants of corporate venture capital investments have started toreceive increasing attention in the evolving literature. Quite recently this area has becomean active area of research with several theory-based analyses on the drivers of corporateventure capital investments employing robust longitudinal research designs. However,despite the recent new theory-based studies on the determinants of corporate venturecapital investments and adoption of corporate venture capital programs (for example,Basu et al., 2006; Gaba and Meyer, 2006; Li and Mahoney, 2006), the research on whenand why corporations invest in corporate venture capital is far from saturated.Limitations in current empirical data and methods as well as various competing explana-tions suggest that more research is still needed to develop a full understanding of thedrivers a corporate venture capital programs and investments.

How do companies invest in corporate venture capital?From the corporate perspective, corporate venture capital is one important tool in the cor-porate venturing toolbox used to develop new business (Roberts, 1980; Rind, 1981;Roberts and Berry, 1985; Venkataraman and MacMillan, 1997; Keil, 2002; Maula et al.,2006b). Other tools in this ‘toolbox’ include activities like internal corporate ventures,acquisitions, joint ventures, alliances, research collaboration, and spin-offs as outlinedearlier in Figure 15.1.

As shown in the same figure, there are several ways in which corporations can engagein corporate venture capital. Many companies start by making arm’s-length investmentsin independent funds to learn the venture capital game; move on to co-investments withtheir venture capital partners; and once they have sufficient experience, establish their owncorporate venture capital fund. At each stage, the strategic and financial upside potentialincreases. Finally, some corporate investors like Intel Capital and Nokia Venture Partnershave established new funds co-financed with external partners. These independentinvestors give the fund financial autonomy, which helps insulate the corporate venturecapital program from abrupt changes in the parent company’s fortunes. They also makethe corporate venture capital operation more sustainable by providing strategic benefitsat lower cost. Importantly, this structure allows the corporate venture capital operationto offer competitive compensation schemes to help retain a successful investment team.

In corporate venture capital programs, there are also a number of design parametersthat corporations can adjust depending on the objectives of the program (Birkinshawet al., 2002; Keil et al., 2004). In a recent conceptual paper, Keil et al. (2004) presented amodel of organizational learning in corporate venture capital. Adopting a program-levelperspective and applying the organizational learning theory, their paper suggests that cor-porate venture capital investments can result in both explorative and exploitative learn-ing. The relationship between corporate venture capital and organizational learning ismoderated by the investment portfolio and the organization of the corporate venturecapital program. Concerning the corporate venture capital program portfolio, the paperhighlights the moderating roles of relatedness, dispersion, and the development stage ofthe ventures. Concerning the program, the paper highlights the roles of structural auton-omy, knowledge integration and absorptive capacity.

In terms of empirical research, the organizational design of corporate venture capitalprograms has received relatively little attention, which is probably due to the difficulty of


getting information concerning the organization of the programs. Most of our knowledgeof corporate venture capital has been based on anecdotes and industry reports such as thereport by Corporate Executive Board (2000) which provides very interesting examples onhow companies such as Intel, Novell, Motorola, HP and United Parcel Service haveorganized some aspects of their corporate venture capital programs. For example, Intelincluded investment professionals in strategy development of business units to help themidentify strategic investment targets; Novell aligned investments and strategy by requir-ing the venture group to collaborate with senior managers; UPS required board observa-tion rights for senior business unit managers; Motorola improved knowledge transfer byemploying a knowledge transfer team with the responsibility of transferring knowledgebetween portfolio companies and parent firm; and HP tracked investments against strat-egic objectives to make informed portfolio-management decisions. However, there is rel-atively little empirical research that explains why corporations organize their corporateventure capital activities in a certain manner and what the performance implications ofthe organization are. In particular, there is very little quantitative research on the way cor-porations organize their corporate venture capital activities.

The survey of 95 corporate venturing programs (both corporate venture capital andother types of venturing programs) by Birkinshaw et al. (2002) is one of the rare excep-tions. The report provides a wealth of descriptive statistics of the organization of differenttypes of program showing for instance that most of the employees and the funding of theprograms tend to come from the parent corporation, deal flow comes quite evenly frominside and from collaborating venture capital, and that most common compensation isstill straight salary although many programs also have other types of incentives includingcarried interest. Similarly, EVCA (European Private Equity and Venture CapitalAssociation) (EVCA, 2001) has surveyed European corporate venture capital investorsand has reported various descriptive statistics showing that more than one third of theirdeals were syndicated, three quarters of the corporate venture capital programs wereorganized as a subsidiary, the average corporate venture capital unit consists of 7 employ-ees responsible for about a €50 million portfolio, and that interest in using carried inter-est as a compensation method was increasing, with more than a third of the corporateventure capital programs already using it. Another recent empirical study examining thestructure of corporate venture capital programs is the case study by Henderson andLeleux (2002) in which they carry out an in-depth analysis of six corporate venture capitalprograms highlighting the arrangements concerning research transfers between venturesand parent organizations of the corporate venture capital program.

In addition to design characteristics, some scholars have recently started to examine therequired capabilities and their development. Based on two longitudinal case studies oflarge corporations operating in the information and communication technology sector inEurope, Keil (2004) developed a model emphasizing the learning processes that enablefirms to build up an external corporate venturing capability, by utilizing learning strat-egies both within and outside venturing relationships. To build this new capability, firmsengage in acquisitive learning, and the capability is deepened by adapting all knowledgeto the firm-specific context through experiential learning mechanisms. Keil also highlightsthe importance of initial conditions and knowledge management practices influencingthe direction and effectiveness of learning processes that lead to an external corporateventuring capability.


Demonstrating some of the tensions related to the design of corporate venturecapital programs, Dushnitsky (2004) showed that some design choices such as tight inte-gration to the parent firm that would aid the corporation in assessing and benefiting fromcorporate venture capital activity inhibit an investment relationship with many such ven-tures that would be most relevant from the learning point as a result of self selection byentrepreneurs.

Taken together, despite the acknowledged difficulties of organizing a performing andsustainable corporate venture capital program, there are perhaps surprisingly few pub-lished articles on how corporations actually implement corporate venture capital pro-grams. There is still quite a limited literature on the actual choices companies make andthe design and management of corporate venture capital programs. Most of the existingknowledge is based on anecdotes and examples. However, theory-based and/or represen-tative quantitative research is largely missing, perhaps given the obvious large difficultiesin accessing such rich internal company data that would be needed for studies analyzingthe organization of corporate venture capital programs, the determinants of the waysthese programs are organized, and the performance of the organizational choices.Therefore, the organization and management of corporate venture capital is clearly anarea of research that has still a lot of room to expand.

How has corporate venture capital performed?One of the most discussed areas of corporate venture capital is the performance of cor-porate venture capital activities. Following increased interest and mixed perceptions,different dimensions of performance have received increased attention in research duringthe past few years. In the following two subsections the studies examining performanceand the determinants of performance are reviewed.

Performance of corporate venture capitalThe performance of corporate venture capital and its determinants have become import-ant research topics in corporate venture capital during recent years (Gompers and Lerner,1998; Maula and Murray, 2002; Dushnitsky and Lenox, 2005b; Dushnitsky and Lenox,2006; Wadhwa and Kotha, 2006). In contrast to earlier dominant perception of corpo-rate venture capital being ‘dumb money’ and leading to poor results, most of the neweracademic studies have analyzed the outcomes of corporate venture capital and venturecapital-backed companies and found that corporate venture capital investments had ahigher likelihood of initial public offerings and higher IPO market valuations when con-trolling for various other factors (Gompers and Lerner, 1998; Maula and Murray, 2002).These studies are summarized in Table 15.3.

Dushnitsky and Lenox (2005b) analyzed a large panel of public firms over a 20-yearperiod and found that increases in corporate venture capital investments are associatedwith subsequent increases in firm patenting. They also found that these programs areespecially effective in weak intellectual property regimes and when the firm hassufficient absorptive capacity. In another paper Dushnitsky and Lenox (2006) examinedthe value creation by corporations from corporate venture capital programs by exam-ining the impact of corporate venture capital on Tobin’s q (market value of a firmdivided by total assets). Using a panel of corporate venture capital investments theyfound evidence that corporate venture capital investment will create greater firm value


when firms explicitly pursue corporate venture capital to harness novel technology com-pared to other goals.

Maula et al. (2003b) examined the impact of corporate venture capital on recognizingtechnological discontinuities early. Based on a longitudinal study of information andcommunications technology firms, established companies’ position in venture capital net-works is related to the early recognition of technological discontinuities. Incumbents’absorptive capacity moderates this relationship. In another study, Keil et al. (2003) inves-tigated the impact of different governance modes for external corporate ventures andventure relatedness on innovative performance of the firm. Building on studies that havesuggested that external corporate ventures enhance the innovative performance of thefirm, the paper argued that governance modes and venture relatedness interact in theireffect on innovative performance. In their empirical analysis of a panel of the largest firmsin the information and communication technology sector during 1990–2000, they foundthat corporate venture capital investments had a positive impact on patenting and thatthe impact was moderated by the relatedness of the ventures. Finally, Schildt et al. (2005)examined the antecedents of explorative and exploitative learning of technologicalknowledge from external corporate ventures. They compared different forms of externalcorporate venturing, namely corporate venture capital investments, alliances, joint ven-tures, and acquisitions, as alternative avenues for interorganizational learning, and testedthe effects of multiple relational characteristics on the type of learning outcomes usingcitations in patents filed by a sample of 110 largest US public information and commu-nications technology companies during the years 1992–2000. They found that corporateventuring mode and technological relatedness have significant effects on the likelihood ofexplorative learning.


Table 15.3 Performance of corporate venture capital programs

Study Sample Finding

Gompers and Lerner 32364 venture capital and Higher share of IPOs in corporate(1998) corporate venture capital venture capital investments than

investments in the in traditional VCUnited States

Maula et al. (2003b) A panel of 110 largest US ICT Positive impact on recognizingcompanies 1990–2000 technological discontinuities

Keil et al. (2003) A panel of 110 largest US ICT Positive impact on patentingcompanies 1990–2000

Wadhwa and Kotha A panel of 36 corporations An inverted U-shaped relationship(2006) between 1989–1999 in the between CVC investments and

telecommunications equipment patentingindustry

Dushnitsky and Lenox A panel of US public firms Positive impact on Tobin’s q from(2006) during the period 1969–1999 the founding of a CVC program

Dushnitsky and Lenox A panel of US public firms Positive impact on patenting(2005b) during the period 1969–1999

Schildt et al. (2005) A panel of 110 largest US ICT Positive impact on explorativecompanies 1990–2000 learning from target companies

Taken together, the studies on the performance of corporate venture capital have shownprimarily positive effects although it has been shown that there may be diminishingreturns to corporate venture capital (Wadhwa and Kotha, 2006). However, furtherresearch on the longer time horizons is warranted. Furthermore, the research contrastingthe costs and benefits of corporate venture capital under different circumstances is stillquite limited. Overall, the measurement of performance measurement of corporateventure capital is quite challenging. The majority of the performance studies have inferredthe effects from quantitative analyses of different dimensions of corporate performancecontrolling for other performance determinants. However, future research could alsoattempt to develop more direct measures of performance for corporate venture capital(see Allen and Hevert, 2006, and Bassen et al., 2006, as two recent examples).

Performance determinants in corporate venture capitalThe research on corporate venture capital has increasingly examined the determinants ofthe performance of corporate venture capital programs. A brief summary of the researchis provided in Table 15.4.

In one of the earliest widely cited studies on corporate venture capital, Siegel et al. (1988)received survey responses from 52 corporate venture capitalists and, based on their analy-ses, concluded that performance is influenced by the autonomy of the program, skills (thatis venture capital expertise/background of employees), compensation and incentives,primary focus on financial returns so that potential strategic goals do not interfere with theinvestment activity. In another survey, Sykes (1990) received responses from 31 corporateventure capital programs and found that the choice of primary strategic objective, type and


Table 15.4 Determinants of performance in corporate venture capital investments

Determinant Examples

Long term focus (Ernst et al., 2005)Sufficient autonomy (Siegel et al., 1988; Birkinshaw and Hill, 2005;

Hill et al., 2005)Sufficient absorptive capacity (Maula et al., 2003b; Dushnitsky and Lenox, 2005b)Strong ties to venture capital community (Maula et al., 2003b; Birkinshaw and Hill, 2005; Hill

et al., 2005)Appropriate compensation systems (Block and Ornati, 1987; Siegel et al., 1988;

Birkinshaw and Hill, 2005)Strategic objectives that enable aligned (Sykes, 1990; Dushnitsky and Lenox, 2006)

objectives with portfolio companiesActive involvement and frequent (Sykes, 1990; Henderson and Leleux, 2002; Wadhwa

communications with portfolio and Kotha, 2006)companies

Team members with venture capitalist (Siegel et al., 1988; Birkinshaw and Hill, 2005)background

Relatedness of portfolio companies Positive relationship: (Gompers and Lerner, 1998)Inverted-U-shaped relationship: (Keil et al., 2003;

Keil et al., 2004; Hill et al., 2005)Industry sectors with weak IP regime (Dushnitsky and Lenox, 2005b)

frequency of communications with the ventures or limited partners, return on portfolioinvestment, and the mode of investment (direct investments or indirect investments viaindependent venture capital fund) influenced the performance of the programs.

In a stream of newer studies employing longitudinal analyses employing corporateventure capital investment data and patent data, Keil et al. (2003) analyzed the impact ofdifferent types of external corporate venturing activities on the patenting rates of firms.In their longitudinal analysis of the 110 largest companies in four information and com-munications sectors, they found that corporate venture capital has a positive effect andthat the relatedness of the corporate investor and the portfolio company had an invertedU-shaped relationship. Dushnitsky and Lenox (2005b) tested the impact of corporateventure capital on patenting and found that weak IP regime in the industry as well as highabsorptive capacity increased returns to corporate venture capital investment. Finally,Wadhwa and Kotha (2006) analyzed the impact of corporate venture capital on patent-ing. In their analysis of 36 telecommunications equipment companies over time, theyfound that the number of corporate venture capital investments had an inverted U-shapedrelationship with patenting. They also found that this relationship was moderated posi-tively by corporate involvement with portfolio companies (board seats and alliances withcorporate venture capital portfolio companies).

Based on a recent global survey of corporate venture capital investors, Birkinshaw andHill (2005) analyzed 95 corporate venturing programs including a large number of corpor-ate venture capital programs and found that three key success factors hold across multiplesub-types of corporate venture units: giving venture units substantial autonomy, creatingstrong ties to the venture capital community, and structuring appropriate compensationsystems. In another paper Hill et al. (2005) analyzed separately the drivers of strategic andfinancial performance of the corporate venture capital programs in the sample and foundthat financial performance had an inverted U-shaped relationship with the relatedness ofthe ventures and positive relationship with vertical autonomy (that is autonomous struc-tural position). Strategic performance similarly had an inverted U-shaped relationshipwith relatedness. In addition, strategic performance was positively related to communica-tions with venture capital community, negatively related to vertical autonomy and posi-tively with horizontal autonomy (that is how extensively other business units within theparent company were involved in corporate venture capital unit decision-making). Theauthors concluded that the financial and strategic outcomes of corporate venture capitalprograms need to be understood in terms of distinctive sets of investment and organiza-tional antecedents. Finally, in a recent German study, Ernst et al. (2005) analyzed 21 cor-porate venture capital programs in Germany and came to the conclusion that a short-termfocus on financial objectives of these corporate venture capital programs prohibits theachievement of long-term strategic benefits from external innovation.

Taken together, studies on the performance determinants of corporate venture capitalhave relatively strong convergence concerning the importance of certain design character-istics on the performance of corporate venture capital programs. For instance, most of thestudies have raised strategic relatedness or complementarity of the portfolio companies,close interaction with the ventures and/or venture capital community as well as a sufficientautonomy of the corporate venture capital operation as success factors. However, there aremany other factors that only some studies have included and found significant. Overall,there is still lack of convergence in the understanding of the circumstances under which


corporate venture capital can provide financial or strategic benefits. In addition to furthertesting of suggested determinants, there are further challenges that should be taken intoaccount when trying to improve the understanding of performance determinants. First, itis important to take into account the potential contingencies that influence the optimalorganizational configurations. Depending on the goals and organizational and environ-mental circumstances, the optimal organizational structure and management of corporateventure capital programs is likely to differ between companies and even within companiesover time. Furthermore, when examining the performance implications of strategicchoices, the endogeneity of the choices should be accounted for (Hamilton and Nickerson,2003). Finally, while some studies find determinants that improve performance, the studiesshould also take into account the costs and risks associated with the strategic or oper-ational choices to give a balanced picture of the effects of the choices. Given all these chal-lenges, the analysis of performance determinants of corporate venture capital programscontinues to be an important and developing research stream.

Theoretical perspectives applied in research on corporate venture capitalUntil recent years, the limited research on corporate venture capital was primarily descrip-tive. However, following the most recent wave of corporate venture capital activity, theresearch on corporate venture capital has both increased in volume and has become moredeeply rooted in various theoretical perspectives. The theoretical perspectives that haveso far been applied in research on corporate venture capital have been summarized inTable 15.5.

Analysis of the literature suggests that so far different strands of learning theories havebeen the most commonly applied perspectives in the analysis of corporate venture capitalfrom a corporate perspective. This is well in line with learning being the most commonstrategic goal for corporations in corporate venture capital. In terms of learning litera-ture, interorganizational learning and particularly absorptive capacity (Cohen andLevinthal, 1990) are commonly invoked concepts. Recently the dynamic capabilities viewhas also received attention in the analysis of corporate venture capital.

Another theoretical base that has been used, but significantly less often, is the theoriesof economics of information including adverse selection, moral hazard and signaling. In


Table 15.5 Theoretical perspectives applied in research on corporate venture capital

Theoretical base Examples

Learning theories (Keil et al., 2003; Keil et al., 2004; Schildt et al., 2005;Gaba and Meyer, 2006; Wadhwa and Kotha, 2006)

Absorptive capacity (Maula et al., 2003b; Keil et al., 2004; Dushnitsky andLenox, 2005b; Lim and Lee, 2006; Schildt et al., 2006)

Dynamic capabilities (Keil, 2004)Economics of information (Dushnitsky, 2004)

(adverse selection, moral hazard,signaling)

Network theories (Maula et al., 2003b)Real options (Basu et al., 2006; Li and Mahoney, 2006)Institutional theory (Gaba and Meyer, 2006)

addition, network theories have so far received very little attention. The same is also thecase with real options as well as with institutional theory.

Taken together, it appears that the literature on corporate venture capital is still veryyoung and underdeveloped when it comes to its theoretical underpinnings. Followingthe development path common in many other areas of management research, the earlyliterature was primarily descriptive. Only recently has the research on corporate venturecapital become more connected to theoretical literature. Although it appears that mostof the major theoretical lenses of management theory have been recently applied at leastonce in research of corporate venture capital, there is clearly more work to do in rootingthe understanding of corporate venture capital better in management theory.

Research designs and methods applied in research on corporate venture capitalAs with research on many other phenomena, early research on corporate venture capital waslargely descriptive, attempting to chart what kind of companies engage in corporate venturecapital and how they do it. The research methods were typically surveys or case studies. Theresearch settings were frequently cross-sectional. As the field has started to mature duringrecent years, the research settings have more frequently become longitudinal, allowing for abetter control for unobserved heterogeneity and measurement of change over time (forexample, Dushnitsky and Lenox, 2005a; 2005b; Keil et al., 2005; Schildt et al., 2005;Dushnitsky and Lenox, 2006; Schildt et al., 2006; Wadhwa and Kotha, 2006). Improved dataavailability has allowed large scale panel datasets combined with other databases.

In the future, it can be expected that research designs will become increasingly longitu-dinal. Controls for the endogeneity of investment decisions are likely to become increas-ingly standard features of quantitative research designs. The realization of the fact thatone size does not fit all means that future research will increasingly focus on contextualdeterminants that influence the design of programs and their effects on the performance(see for example, Keil et al., 2004; Wadhwa and Kotha, 2006). Although most of corpor-ate venture capital research focused on US companies, some recent studies have alsoexamined it in other regions, for example, Germany (Weber and Weber, 2005; Reichardtand Weber, 2006), Korea (Lim and Lee, 2006) or taking a more global perspective(Birkinshaw et al., 2002).

Although longitudinal quantitative research designs are going to have an importantrole in theory testing, it is also expected that in-depth qualitative research can deepen ourunderstanding of the choices and solutions in the design and management of corporateventure capital programs (see for example, Keil, 2002; 2004). As noted above in sectionsreviewing literature on different facets of the corporate venture capital phenomenon,there are many areas where we still have very limited knowledge of the practices of cor-porations and the determinants of those practices. Furthermore, the limitations in theavailable large scale datasets will continue to provide many research opportunities forthose researchers who gather in-depth primary data from corporations active in corpor-ate venture capital.

Conclusions and avenues for future researchAlthough corporate venture capital has a cyclical history with mixed success in compa-nies, corporate venture capital remains an important tool in the corporate venturingtoolbox of corporations. While some corporations have engaged in corporate venture


capital opportunistically following good returns from the venture capital markets duringboom periods, many other corporations have taken a much more strategic approach anduse corporate venture capital as an important tool to support their strategy independentof fluctuations in financial markets. However, as research has shown, there is often a longand sometimes costly learning curve to climb before becoming a successful private equityinvestor. While there are strategies that may be more effective for certain corporationsthan others, even they may not necessarily be feasible from day one. However, the researchand practices of corporate venture capital have become increasingly sophisticated, andmany corporations have learned how to use corporate venture capital properly as a toolto support the corporate strategy and innovation while also gaining financial returns.

When assessing the existing body of literature on corporate venture capital, it appearsthat there is a relatively convergent stream of literature answering why corporations investin corporate venture capital. Corporations often have multiple goals for corporate venturecapital, but most often it is more for strategic than financial reasons that corporationsengage in corporate venture capital. The research on when corporations engage in cor-porate venture capital is newer, but it has started to develop and test multiple determin-ants on industry and firm levels based on several theoretical lenses including learningtheories, institutional theory and real options. The research on how corporate venturecapital should and has been organized is still relatively underdeveloped, and provides cur-rently primarily descriptive insights and examples. Research on how corporate venturecapital has performed has developed rapidly and has become increasingly sophisticated.This stream of literature has found corporate venture capital to have positive effects onseveral tested performance measures including patenting and firm value creation. Also theresearch on the performance determinants of corporate venture capital has producedseveral commonly agreed performance determinants, but there are also many areas wherefuture research is needed.

Theoretical understanding of corporate venture capital has developed significantly andthe studies have developed from descriptive analyses to testing the applicability of broadertheoretical frameworks from economics, sociology and management theory as well as todevelop specific theory on corporate venture capital, or even to contribute to the devel-opment of broader management theories based on insights made in the analysis of cor-porate venture capital.

Similarly, methodologically the literature on corporate venture capital has evolved likemany streams of research that focus on a certain phenomenon. From the early pioneer-ing that qualitatively describes the phenomenon, the research has subsequently advancedthrough wider cross-sectional surveys and in-depth case studies to increasingly longitu-dinal research settings frequently testing alternative theoretical explanations employinglarge panel datasets.

While recently activated research on corporate venture capital has answered many pre-viously puzzling questions, there remain many avenues for future research that can helpcompanies use corporate venture capital more successfully to create value in collaborationwith entrepreneurs and the venture capital community.

Some of the areas for future research on corporate venture capital include the analysisof benefits over costs under different circumstances including various firm and industrylevel determinants and different corporate venture capital strategies. Overall, priorresearch suggests that there are many alternative models of corporate venture capital that


can be feasible, but the research on the circumstances under which each model is optimalis still underdeveloped. Furthermore, the performance measurement is in general an areathat requires additional research. There is still relatively little research examining theimpact of corporate venture capital on the performance of corporations. Even more so,the cost side, including the indirect costs from leveraging corporate resources, has beenlargely neglected. Furthermore, the long run effects of corporate venture capital for theperformance of corporations are still an under-researched area.

Another area of development is how corporations manage and should manage theircorporate venture capital operations including investment processes, the use of corporateresources to facilitate corporate venture capital activity, knowledge integration from cor-porate venture capital investments, as well as internal performance measurement. Thereare many tensions concerning various choices inherent in corporate venture capital. Forinstance, if a corporation wants to learn from corporate venture capital, how should itarrange the activity to get to see the most interesting deals (Dushnitsky, 2004)? While thereis already some theoretical research examining the organizational choices related todifferent learning goals (Keil et al., 2004), there is a need to understand more broadly howcorporate venture capital should be organized depending on different goals and circum-stances. Furthermore, empirical research in this area is still nearly non-existent. Also therole of corporate venture capital in the broader toolbox of corporations and the pros andcons of different external venturing modes and their interactions are still relatively unex-plored areas of research (Dushnitsky and Lavie, 2006; Keil, 2002; Keil et al., 2003; Schildtet al., 2005).

Overall, although the research on corporate venture capital, both from corporate andentrepreneurs’ perspectives, has developed rapidly during the past few years, there are stillmany important areas warranting further research. I believe that corporate venturecapital continues to be an interesting research area given the economic importance formany major corporations as well as the complexities and practical challenges in manag-ing it successfully.

Note1. For another parallel review of literature on corporate venture capital, see Dushnitsky (2006).

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

IntroductionThe relationship between industry incumbents and new ventures has been a subjectof much interest in the literature (Zahra et al., 1995; Gompers and Lerner, 1999;2001; Zahra, 2006a; 2006b). Traditional analyses have emphasized the potential role ofnew ventures in displacing industry incumbents as a natural part of the process ofSchumpeterian creative destruction (Christensen, 1997). More recent analyses highlight a‘co-specialization’ dynamic, where new ventures excel in discovery and invention andincumbents are better equipped to successfully exploit and commercialize these discover-ies. Research applying the co-specialization dynamic recognizes the rivalrous nature of therelationship that might exist between incumbents and new ventures but also highlightsopportunities for fruitful collaboration (Chesbrough, 2002).

Corporate venture capital (CVC) is one approach some incumbents have used toconnect with new ventures in and outside their industries (Keil, 2002; Dushnitsky, 2004;Keil et al., 2005; Maula et al., 2005; Rosenberger et al., 2005). Maula (see Chapter 15)has comprehensively reviewed and summarized the relationship between CVC and otheractivities that companies undertake to venture into new fields, internally or externally.Maula’s review suggests that companies use CVC for multiple reasons, giving thesetransations distinctiveness. As Maula indicates, CVC refers to equity-linked investmentsthat incumbents make in young, privately held companies – where the investor is a finan-cial intermediary of a non-financial corporation. While CVC programs can generate sub-stantial direct financial gains or losses (Allen and Hevert, 2007), incumbents may also usethese programs to gain access to the knowledge and innovative technologies that new ven-tures create. Researchers examining CVC often frame their analyses within the ‘co-spe-cialization perspective’, positing that these transactions could evolve into ‘win–win’outcomes for both incumbents and new ventures (McNally, 1997; Maula, 2001; Keil,2002). Still, incumbents can use their CVC investments to delay or even thwart newventures’ efforts to develop and introduce new technologies that are viewed as threatsto their market positions or as changing the rules of competition (Gompers and Lerner,1998; 1999).

Objectives, focus and contributionDushnitsky (2006) and Maula in Chapter 15 provide comprehensive and informativereviews of the literature on CVC. Most prior research stresses the role and effective man-agement of CVC in established corporations (Rind, 1981; Winters, 1988; Sykes, 1990;McNally, 1995; 1997; Dushnitsky and Lenox, 2005; 2006). Even though some CVC dealsare purely financial investments, researchers have given special attention to the conditionsunder which established companies learn from CVC investments. Prior analyses, however,

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have given far less systematic attention to clarifying the consequences of CVC for thesuccess of new ventures (McNally, 1995; Ivanov and Xie, 2005; Maula et al., 2006). As aresult, theoretical and empirical research on these issues has been sparse and fragmented,making it difficult to guide future intellectual inquiry and effective managerial practice.This is problematic because new ventures need to assemble resources quickly and usethese resources to develop capabilities which can create and protect a competitive advan-tage (Zahra, 2006a; 2006b). Most new ventures usually have one or a few capabilitiesthat should be kept current while assembling other skills and capabilities through the infu-sion of new knowledge and other resources from external sources or internal develop-ment. CVC enables new ventures to obtain the financial resources and business contactsneeded to assemble and use these skills, deploy them in a timely fashion, and build astrong market presence. McNally (1997), Rosenberger et al. (2005), Dushnitsky (2006),Dushnitsky and Lenox (2006) and Maula et al. (2006) offer detailed discussions of thevarious financial, operational and strategic benefits that new ventures can gain from theirCVC relationships. Concern persists that CVC investments also open the door for oppor-tunism by established companies that could appropriate much of the value of these ven-tures’ intellectual property or stifle their growth.

In this chapter, we hope to fill a gap in the young but growing literature on CVC.Specifically, we adopt the perspective of entrepreneurs to: (1) examine potential financialand non-financial benefits new ventures can gain from CVC investments; (2) discussfactors that can mitigate or limit these potential gains; and (3) consider effective strategiesthat entrepreneurs can use to maximize gains from CVC while curbing possibilities forincumbent partner opportunism.

To accomplish these three objectives, we ground our arguments in the knowledge-based(Grant, 1996) and relational capital (Dyer and Singh, 1998) perspectives. Invoking theknowledge-based view, we propose that a key source of potential value creation for newventures that engage in CVC relationships is the creation of unique and inimitable know-ledge that becomes embedded in their operations. Exploiting this knowledge creativelycan give new ventures competitive advantages over their rivals (Zahra, 2006a). Knowledgecreation per se may not enhance the firm’s value or owners’ wealth. Instead, this know-ledge has to be used in developing and introducing new products, goods or services. Newventures can also ‘sell’ their knowledge through licensing or other means. We invoke therelational perspective to suggest that contracts have limits in curbing opportunism. Whena relationship develops between two or more social actors, it becomes possible for themto share what they know, collaborate, and reveal the ‘hidden code’ in the informationbeing transferred. This makes the information accessible to the recipient, promotingmutual understanding and co-operation. It also makes it easier to use this knowledge,which is important for those new ventures that gain access to their partners’ knowledgethrough relationships. Still, CVC relationships are susceptible to opportunism becauseincumbents and new ventures have different goals and control different resources andknowledge. Therefore, we propose that entrepreneurs can reduce this risk using a varietyof contractual, structural and behavioral mechanisms. Relationships develop over time,giving participants an opportunity to learn about and from each other, decipher theirmental models, and appreciate their intentions and goals. Information gleaned from theserelationships, however, is imperfect because actors have strong incentives not to revealfully what they know or do, limiting others’ ability to comprehend what they are doing.


The fact that information could be gained from these relationships makes it imperativefor new ventures to develop their absorptive capacity to spot, capture, assimilate andexploit relevant and useful knowledge from incumbents (Zahra and George, 2002).

We make three contributions to the literature in this chapter. The first is examining CVCwithin a relational (rather than a merely transactional) framework, making it possible toarticulate the benefits that entrepreneurs can gain from collaboration with incumbents.Other researchers have recognized the merits of this approach and have used it in theiranalyses (Maula et al., 2006; see also Chapter 15). In contrast, transaction-based analysesoften consider formal means of reducing opportunism, taking into account the costs andbenefits involved. These analyses often overlook the dynamics of the relationships thatdevelop among companies or parties to exchange over time. Transaction-based analysesalso highlight the financial costs of opportunism, ignoring the social implications of suchbehavior. We argue that a transactional perspective by either party can be short-sighted,undermining the potentially more valuable, longer term collaborations. When there issufficient goal congruence, a relational perspective provides a better means for analyzingnew ventures and incumbents’ interactions. These relationships are complex and requireconsiderable investments in time, energy and resources for the development and payoff forthe parties involved. Our analyses suggest a number of ways in which new ventures couldbalance transaction and trust-based governance, protecting their intellectual property.

Our second contribution lies in recognizing that differences in the goals between andwithin new ventures and incumbents create unique dynamics that influence the outcomesof CVC relationships. Neither incumbents nor new ventures are homogeneous groups,though prior analyses have often erred in treating them as such. By recognizing the diver-sity of motives of various types of CVC-supported ventures, we set the stage for thought-ful theorizing about the potential vs. realized gains from CVC. This issue has been widelyignored in the CVC literature, creating a serious gap in our understanding of effectiveways that companies can organize and cultivate their relationships and create value.

Our third contribution in this chapter is to explore the limits of the relational capitalperspective in the context of the CVC relationship. Increasingly, some researchers (forexample Maula et al., 2006) have used this perspective in lieu of the transactional costsperspective (Williamson, 1985) in theorizing about the dynamics of the relationshipbetween established and new firms. While relational capital can enhance trust and reducepartner opportunism, some recent analyses ignore unique and idiosyncratic qualities ofthe relationship between new ventures and incumbents that make opportunism likely (andperhaps inevitable) in some situations. By considering the limits of the relational per-spective, we provide a more realistic picture of its usefulness especially among new ven-tures. Excessive trust could be as damaging as lack of trust to business and value creation(Zahra et al., 2006b).

The remainder of the chapter progresses as follows. First, we briefly review the growingimportance of CVC, especially in emerging high technology industries. Once we havediscussed the importance of CVC, we analyze entrepreneurs’ objectives related to theseactivities. Specifically, we distinguish between exploratory and exploitative objectives(March, 1991). We use the knowledge based (Grant, 1996) and relational capital per-spectives (Dyer and Singh, 1998) to argue that one of the key benefits of CVC for entre-preneurs is gaining and developing new knowledge that can accelerate their firms’development. While we highlight the relational aspect of CVC investments, we underscore

Entrepreneurs’ perspective on corporate venture capital 395

the conflicting goals of incumbents and new ventures. Our discussion will show how theseconflicting motives may come to bear on new ventures’ potential benefits from CVC-basedrelationships. Our discussion recognizes that entrepreneurs can fail to gain the full rangeof potential benefits in their CVC relationships.

Next, we identify several factors that can contribute to the gap between potential andrealized CVC benefits. We examine differential power, reputations and status as possiblesources of this gap. We also examine how partner opportunism and organizationalprocess (and cultural) dissimilarities can contribute to this gap. To achieve our objective,we turn to transaction cost theories (Williamson, 1985). We also highlight how differencesacross industries in the strength of intellectual property protection regimes can contributeto the gap between potential and realized benefits of CVC.

Finally, we discuss key strategies that entrepreneurs can use to reduce the potentiallydysfunctional side of CVC relationships. We cover the importance of due diligence inpartner selection, syndicated investment with independent venture capitalists, governancemechanisms (such as board composition and voting rights), use of proactive relationshipswith a CVC program’s parent organization, and terms of licensing agreements. We con-clude the chapter by summarizing the implications of our arguments for entrepreneursand future research.

Importance and growth of CVCCVC investments grew dramatically during the past decade (see for example Dushnitsky,2006; see also Chapter 15), receiving increased attention from researchers in the fields ofstrategy, innovation and entrepreneurship (Keil, 2002; Chesbrough, 2003; Christensenand Raynor, 2003; Dess et al., 2003; Keil et al., 2005). This interest relates to widerresearch agendas on organizational learning and renewal (Cohen and Levinthal, 1990;March, 1991) and on the different roles incumbent and young firms play in industryecosystems (Hagedoorn, 1993; Zahra and Chaples, 1993; Iansiti and Levien, 2004).

Evidence on the broad patterns of CVC investments during the past decade has severalimplications for new ventures considering funding and for the strategic relationships theymight form with established companies.1 CVC investments were a significant sourceof funding for young companies, primarily in emerging high technology industries. Anestimated worldwide population of 447 programs made some $44 billion of investmentsduring 1994–2003, rising from $120 million in 1994 to a peak of $17 billion in 2000,and falling to a still substantial $2 billion in 2003 (Birkinshaw et al., 2002; NationalVenture Capital Association, 2004).2 US companies accounted for nearly 84 per cent ofinvestments, representing 12 per cent of formal US venture capital activity duringthe 1994–2003 period. While these figures suggest a broad but temporally variable CVCinvestor opportunity space for new ventures, the effective space was narrower becausemore than 70 per cent of the programs were initiated by companies within two economicsectors – information technology-telecom and biotech-pharmaceuticals-chemicals.These programs focused their investments within their respective sectors (Kann, 2000;Birkinshaw et al., 2002). Programs in these two sectors accounted for as much as 90 percent of US CVC investments (Dushnitsky and Lenox, 2006).

New ventures seeking attractive CVC investors should be aware of the diversity amongprograms with respect to scale, experience, longevity and parent funding. Half of the exist-ing CVC programs were small by US venture capital industry standards (for example


cumulative investment was less than $95 million). However, as many as 25 programs investedmore than $500 million (Allen and Hevert, 2007). Most programs were initiated after 1992,roughly half had five or less years of investing experience through 2003, and many werediscontinued after a few years of activity. For example, of the 447 programs identified byBirkinshaw et al. (2002), 31 per cent were inactive or closed by early 2002. While some pro-grams, like independent venture capital funds, received long-term commitments from theirinvestors, many did not (Gompers, 2002). These programs were likely to be more vulnerableto funding volatility or eventual closure (Birkinshaw et al., 2002; Gompers, 2002).

CVC programs that fail to achieve material and sustained funding are less likely to assistnew ventures in establishing alliance activities with parent organizations or to participatein multiple financing rounds. Even though the relative youth of many CVC programsmakes the identification of most attractive partners a challenge, some due diligence canreduce prospects for adverse selection. Other things being equal, the most attractive CVCinvestors are likely to have longer experience, substantial scale (for example $100–500million in cumulative investment over several years), and committed parent funding.Another factor for new ventures to consider is the track record of the CVC program inco-investing with well-regarded venture capital funds (Maula and Murray, 2000). In thiscase, venture capitalists may be signaling their implied endorsement of a CVC program’sstaying power, potential reputational benefits, or record of productively working withyounger companies and their other investors (Breyer, 2000).

Strategic motives for CVC-based relationshipsEstablished companies generally cite both strategic and financial goals in initiating CVCprograms (Siegel et al., 1988; Birkinshaw et al., 2002). Similarly, new ventures have bothfinancial and strategic motives for seeking CVC investments (see Chapter 15). In thissection we set aside the issue of direct financial objectives of corporate investors,3 focus-ing instead on the strategic benefits each party might seek from a CVC investment; situ-ations in which there may be congruence or conflict between the goals of these parties;and how goal congruence–conflict may differ across developmental stages of young com-panies, investment rounds and economic sectors. Consequently, we first consider theobjectives of corporate investors and then the goals of new ventures seeking fundingthrough CVC programs.

Corporate investor perspectivesThe literature highlights different reasons that lead established companies to use CVC(for a detailed discussion see Keil, 2002; Maula et al., 2003; Keil et al., 2005; Maula et al.,2005; see also Chapter 15). It suggests that rapid technological change has encouragedincumbents to search beyond their existing capabilities for innovation. Rapid technologicalobsolescence has made it essential to obtain new and diverse knowledge from externalsources to augment the firm’s internal operations and discoveries. New ventures are a keysource of new knowledge that can be brought into the organization and combined withexisting skills to create new products and services. As noted, the knowledge-based theoryof the firm highlights the importance of exploiting knowledge for creating value (Grant,1996). Combinative knowledge, in particular, can be an important source of value creation(Kogut and Zander, 1992). Some established companies have turned to CVC investmentsbecause their internal R&D activities have failed to recognize serious technological


discontinuities. Even when they did recognize pending technological change, their devel-opment process was sometimes too slow to pre-empt smaller or more flexible rivals (Foster,1986; Gompers and Lerner, 1999; 2001). Several surveys provide rankings of the strategicobjectives cited by companies in initiating CVC programs (Siegel et al., 1988; CorporateStrategy Board, 2000; Kann, 2000; Birkinshaw et al., 2002). Findings from these surveysconverge around three clusters of highly rated objectives. The first and most highly rankedgoal is exposure and access to emerging technologies, including both complementary anddisruptive technologies. Incumbents frequently use their CVC investments to canvass awide range of technological fields and learn more quickly about forthcoming technologicaldiscontinuities (Maula et al., 2003).

The second goal cited by CVC programs is to expose incumbents to new markets andgain access to resources and relationships which can accelerate these firms’ ability to enternew markets. CVC relationships give incumbents opportunities to learn about differentnew ventures, their strengths and weaknesses and their potential to change the dynamicsof industry structure. This information can help incumbents reshape their technologicalportfolios, enter new markets, and identify attractive acquisition targets. The third goalcenters on enhancing the demand for current products or services of the investor. Oneversion of this is ecosystem investing in the information technology sector, in whichthe primary goal is to support a network of suppliers, complementors, customers andinvestors that can help create or defend de facto technology standards for the investingfirm (Chesbrough, 2003).

Some research shows that incumbents attach different priorities to different CVC goals.Kann (2000) found that the importance of these strategic objectives differed significantlyacross industries. For example, gaining timely exposure and access to emerging technol-ogies was the main objective for pharmaceutical and chemical companies, while enhanc-ing demand was the dominant theme among software firms. These differences reflectindustry dynamics and the powerful forces that govern competition.

A key limitation of past research findings is its failure to address the potential for goalcongruence or conflict between incumbents and new ventures. Conflict in goals can under-mine this relationship and lower the potential gains of the corporate investor and newventure. Goals underlying these investments also change over time. Unfortunately, it is notclear from the literature how this congruence (or conflict) may change over developmentcycles and funding rounds. To explore these issues more fully, in Table 16.1 we depictthe perspective of a CVC investor as a function of: (1) strategic investment objectives;(2) potential impact of the investees (new ventures) on strategy of the CVC program’sparent; and (3) preferred timing of investment. Even though Table 16.1 focuses on estab-lished corporate investors, we believe that understanding what these investors seek andhow they make their strategic decisions can help new ventures and their managers refinetheir strategies for collaboration with established companies. Inexperienced new venturesoften fail to consider the consequences of the strategic imperatives CVC investors have onthe decisions these investors make to ensure the flow of funds, resources and knowledgeto the companies in their portfolios.

Focusing on strategic investment objectives (Table 16.1), we distinguish between explor-ation and exploitation (March, 1991). Exploratory investments can be viewed as equityfunded intelligence gathering with the possibilities for follow-up actions and investmentswithin the investor’s parent company and through alliance activity with the new ventures


in their portfolio. This type of investment gives incumbents a window on emerging busi-ness models as well as technological, marketing and business process innovations that couldalter industry dynamics and boundaries. Incumbents may also learn about their rivals’emerging technologies and how they might evolve over time. Exploratory investments canlead to (or occur simultaneously with) exploitative actions. For example, Henderson andLeleux (2003) found that 56 per cent of telecom CVC investors announced collaborationagreements with new ventures in their portfolios. Alternatively, exploratory investmentsneed not result in alliances between incumbents and new ventures because incumbents maydecide to limit the application of any learning they obtain to internal projects.

Exploitative CVC investments do not have to precede exploratory investments(Rothaermel, 2001). In fact, incumbents may elect to wait to invest until later fundingrounds or to seek only licensing agreements. If the objective is other than gaining earlyexposure or obtaining rights to new technologies, later direct exploitation moves may bepreferred. In this vein, Henderson and Leleux (2003) found that decisions to initiateinvestment in later rounds were a significant predictor of the likelihood of collaborationagreements in the telecom sector.4

The second factor we highlight in Table 16.1 is the perceived impact of the entrepre-neurial firm on the strategy of the CVC program’s parent. Hellmann (2002) observes thatnon-contractible activities between CVC investors and new ventures may be comple-mentary or competing. We assume that incumbents’ key decision makers develop percep-tions of the degree to which the new venture is supportive or threatening to their firms’strategy. This perception may result from search and screening processes for initial invest-ments or may emerge over time. Thus, perceived strategic fit can change over time.5 It isalso possible that a CVC program or different business units may have conflicting viewson goal congruence. For instance, the new venture might be seen as an ally of internalunits pursuing a disruptive technology but as a threat to others supporting alternativetechnologies or defending current technology bases within incumbent organizations.Therefore, in Table 16.1, we provide a third category of potential impact reflecting unclearor conflicting perceptions and the possibility of a mixed threat–support situation.

The final factor we highlight in Table 16.1 is the preferred timing of the initial invest-ments. If the initial strategic objective is to gain exposure to new technologies, then theincumbent is likely to invest in early, pre-revenue rounds. Evidence suggests that up to 40 percent of transactions (not value) by CVC investors are in seed money through development


Potential impact of (1) Strategic investment objectivesentrepreneurial firm on

Explores Exploitsstrategy of CVC Early Later Early Laterprogram’s parents

stage stage stage stage

Threatens

Unclear or mixed

Supports

Table 16.1 Perspectives of corporate venture capital investors

rounds, reinforcing an inference of importance for exploratory activities (Gompers andLerner, 1998; Kann, 2000).

Overall, Table 16.1 highlights six different scenarios of CVC investors with differentimplications for preferred timing of initial investments. New venture managers shouldbe aware that the exploration–exploitation dimension may or may not involve pathdependency, depending on the preferences of incumbents’ senior managers. Each of thesix scenarios suggested in Table 16.1 implies a different foundation of common interestsand information upon which to build productive collaborations between incumbents andnew ventures.

The entrepreneurial firm’s perspectiveAs noted, limited research exists on the objectives and priorities that new venturespursue when they seek CVC investors. New ventures are heterogeneous in their ownership,strategic focuses, resources, skills and experiences. Owners and managers may also differsignificantly in their goals; some may want to develop the venture just enough to make ita candidate for acquisition. For others, the goal may be to become a leading player in theirindustries (Zahra, 2006b). These variations can lead to major differences in new ventures’motivations to pursue CVC relationships. The paucity of empirical research on these vari-ations leads us to rely on anecdotal evidence plus studies that address the broader topic ofstrategic alliances between incumbents and young companies. Specifically, we explore thefactors highlighted in Table 16.1 from the new ventures’ perspective and add financing andendorsement needs, which we believe to be unique to this side of the CVC relationship.

It is important to recognize that some subset of CVC relationships may be viewed byboth parties as serving short-term financial and strategic objectives. Long-term learningand collaboration would be viewed as secondary considerations. These investments wouldbe likely to mirror the logic of transaction-cost analysis (Williamson, 1985). Effort andresources would be committed to making the transaction efficient and profitable over ashort time horizon but little attention would be given to developing mechanisms for build-ing a basis for multiple future collaborations. We would expect this type of CVC rela-tionship to make extensive use of traditional contracting safeguards. It may also be moreprone to opportunistic behavior. Whether either of these predictions is true remains anempirical question which has yet to be fully explained by the literature.6

New ventures are needy creatures on several counts. An immediate need is often to avoidrunning out of cash before sufficiently resolving uncertainties surrounding plannedofferings (Kaplan, 1994). This can limit new ventures’ discretion and bargaining power intheir selection of and negotiations with potential investors (Smith, 2001). Lerner andMerges (1998) show this to be a common issue for young biotech firms seeking developmentfunding from larger companies. Kann (2000, p. iv) also observes that CVC investing involves‘collaborative agreements with unequal partners centered on a one-directional equityinvestment’. Under these circumstances, CVC investors may have the upper hand in shapingthe course of negotiations with new ventures, determining the amount of intellectualproperty disclosure, and setting terms for sharing the benefits from collaboration.

Reflecting on Table 16.1, we first consider the various exploitation objectives of newventures in higher goal congruence situations. One key motive is to obtain access to CVCinvestors’ resources and networks. In this case, the preferred timing for seeking investorsis usually at the later development or go-to-market stages. A related goal is often to secure


incumbents’ endorsement of the ventures’ emerging technologies or products (Stuart,2000) and reduce liabilities of newness (Schoonhoven, 2005). These endorsements can sig-nificantly improve the new firm’s name recognition, encourage buyers and suppliers tocollaborate, and increase overall market standing. In this vein, Leibelein and Reuer (2004)provide evidence of small US semiconductor firms initiating equity alliances with largerpartners with a primary goal of increasing foreign sales.

Early-stage, exploratory CVC investments can also offer new ventures prospects forcredible endorsements and access to diverse strategic resources. Still, they may carry higherrisks of opportunistic and harmful behavior by well established partners. Consider, forexample, the information technology sector which is characterized by system-level designrules and horizontal networks of developers of sub-systems and components (Baldwin andClark, 2000). In this sector, CVC relationships can provide an avenue for gaining access totechnology roadmaps of leading firms, access to their promotional activities at tradeshows, and improved prospects for design-in of young companies’ products. In contrast,for young biotech firms, the goal of early stage CVC deals may be gaining access to largercompanies’ capabilities in conducting clinical trials and pilot production for trials. In boththese early-stage situations, the words explore and exploit will be likely to raise few eye-brows in larger companies. Yet, they often raise the pulses of entrepreneurs who areconcerned that larger company exploration can translate into the appropriation of intel-lectual property. Another concern for entrepreneurs is that larger partners, by intent orbecause of internal conflicts, may fail to deliver access to capabilities. These are classicagency issues of adverse selection, moral hazard, and hold-up (Jensen and Meckling, 1976;Kaplan and Stromberg, 2002) but treating new ventures as the principals.

Concerns about harmful behavior by larger, powerful and established partners shouldbe greater when they see new ventures as a threat to their market leadership or growthgoals. When new ventures control innovative and proprietary technologies that can dis-place incumbents, they are likely to be viewed as credible threats. Under these conditions,one would expect new ventures to avoid those prospective investors; but this is not alwaysthe case. There is evidence that low or mixed goal congruence situations are common inthe biotech industry (Pisano, 1991; Lerner and Merges, 1998; Rothaermel, 2001). Thisseems to reflect new ventures’ need to gain access to larger pharmaceutical companies’capabilities as well as long development cycles which often cannot be fully funded fromventure capital and public market sources. In both the information technology and biotechsectors, gaining access to established companies’ marketing, distribution and manufac-turing capabilities, as well as the need for cash, may often trump concerns about largepartner behavior (Kaplan, 1994; Smith, 2001).7 If the new venture has sufficient financingand can choose among different investors, it can employ multiple criteria in searching andscreening for attractive CVC partners or in deciding to avoid potentially opportunisticpartners. Yet, Alvarez and Barney (2001) found that it was not unusual for new venturesto devote as little as half a day to conducting due diligence on a potential alliance partner.While this may reflect limited management time and cash, it can set the stage for a failedrelationship between the venture and its CVC investors.

Effective due diligence by new ventures should go beyond the most tangible issues (forexample financial resources and investment windows) when evaluating potential CVCinvestors. It should probe CVC providers’ track records in working with portfolio firms,transferring knowledge and skills, connecting these companies to potential suppliers and


customers, and contributing to the quality of their management. The quality as well asthe durability of the potential relationship should also be investigated to establish CVCproviders’ claims and credibility.

Do entrepreneurial firms capture CVCs’ strategic benefits?Evidence on the strategic benefits that new ventures gain from CVC-based relationshipsreveals considerable diversity with respect to the particular benefits gained and to thepositive and negative outcomes.8 This supports our portrayal of the diversity of interestsof the parties to CVC relationships and reflects differences in how new technologiesand products are developed and commercialized across industries (Davidson, 1990;Hagedoorn, 1993). Three studies suggest positive effects of CVC investors in informationtechnology and telecom industries. Maula and Murray (2000) found higher post-IPOvaluations for companies financed by multiple CVC investors and by CVC investors andventure capital funds than for those funded only by venture capital funds. Henderson andLeleux (2003) found higher IPO rates for new ventures that also announced collaborationagreements with their CVC investors. Stuart (2000) also found that young semiconductorcompanies that developed technology alliances with large, technically well-endowedpartners benefited in terms of augmented sales growth and patent activity.

Recently, Maula et al. (2005) sought to identify the sources of new venture satisfactionwith CVC investors in relationships that remained active. Two major benefits were found:(1) technological knowledge and social capital in (2) seeking access to additional fundingand (3) to foreign customers. However, market knowledge and social capital in gainingaccess to partners or to domestic markets were not significant in explaining satisfaction.Even though these results attest to key strategic benefits from ongoing alliances, theydo not address survival rates. In contrast, a study by Alvarez and Barney (2001) of 128alliances in the biotech, information technology and oil and gas industries reported that80 per cent of new ventures felt unfairly exploited by their large partners. In some cases,this involved actions detrimental to the long-term success of alliances and, in others, thedisproportionate appropriation of value created in these alliances.

Two linked studies of 200 R&D alliances of young biotech firms provide evidence ofhow the bargaining power of larger partners can negatively impact performance (Lernerand Merges, 1998; Lerner et al., 2003). Large, corporate partners often extracted sub-stantial control rights and received the bulk of these rights when smaller firms had limitedcash reserves and lacked immediate access to public financing. The studies revealed thatalliances that assigned greater control rights to larger partners underperformed in termsof meeting subsequent development milestones. Equally important, underperformancewas substantial when agreements had been signed in poor capital market environments.Discussion of the findings with industry executives supported the interpretation of thenegative impacts of large firm bargaining power on new ventures. Interesting observationsalso surfaced regarding agency problems within large companies’ business developmentgroups. Some executives noted that given long time horizons of alliances and frequent jobchanges of new business development managers, one of the few proxies for success of theiractivities was the toughness of the deals they negotiated. As a result, some business devel-opment officials extracted as many control rights as possible, regardless of how the allo-cation of these rights might influence the joint welfare of the alliance. These findingssuggest that career dynamics within CVC units can have significant implications for the


structure of deals, the evolution of mutually beneficial relationships with new ventures,and the outcomes of these relationships.

Some research also suggests that conflicting interests and incentives within manyindustry-leading companies may influence failures in the development and commercial-ization of new technologies (Christensen, 1997; Leifer et al., 2000; Hill and Rothaermal,2003). This is likely to be an important influence on the track records of smaller partnersin realizing strategic benefits from CVC relationships (Hellmann, 1998). Capturing thesebenefits often requires significant efforts in navigating the complex structures and organ-izations of larger partners which may not act with unified intent. This suggests a need forresearchers to study management of CVC-based relationships at a process level, an areawhich has received little attention to date.

An important variable that can determine new ventures’ capacity to capture value fromCVC relationships is ‘absorptive capacity’ (Zahra and George, 2002). New ventures areusually lopsided in their skills and knowledge bases, having only limited knowledge in oneor two areas. New ventures need to develop and sustain a capacity to identify potentiallyvaluable knowledge from their CVC collaborations, capture that knowledge, assimilate itand use it strategically by building new capabilities and upgrading existing ones (Lim andLee, 2006). Building and honing absorptive capacity can be a costly and time consumingprocess. In turn, this requires entrepreneurs to stay focused on the knowledge flowsemanating from their CVC partnerships and on identifying the most salient types ofknowledge. Doing so demands managerial foresight as well as an understanding of thepotential trajectory of an industry’s evolution. It also necessitates ensuring the rapid andeffective flow of knowledge throughout the firm’s operations, either through internalR&D activities or the use of licensing, alliances or similar means.

Building an effective absorptive capacity does not ensure the creation of value, however.Zahra and George (2002) emphasize the need for having appropriate systems and pro-cesses that transform knowledge into products and goods. Zahra et al. (2006a) argue thatnew ventures have to develop a ‘knowledge conversion capability’ (KCC) for this purpose.KCC denotes a new venture’s capacity to transform research and scientific discoveries intosuccessful products that are quickly and efficiently commercialized. It centers on envi-sioning, conceiving and articulating ways in which knowledge inflows can be creativelyused and then integrating and embedding this knowledge into innovative products, goodsand services that create value. Having and using KCC, therefore, can enable new venturesto exploit knowledge inflows from their CVC relationships.

Another important task for entrepreneurs is to integrate knowledge inflows from CVCrelationships with the knowledge their new ventures have. Integration is more than asimple addition or combination of different types of knowledge. Oftentimes integrationrequires rethinking the nature, content, structure and potential uses of knowledge.Performing each of these activities takes time and entails risks for entrepreneurs and theircompanies. Integration also requires attention to organizational political issues, dealingwith diverse views of knowledge, and different cognitive models that new ventures’employees and managers have. As a result, efforts at integrating internal and externalknowledge might slow new ventures’ quest for successful commercialization and may evenbackfire as the distinctive quality of internal knowledge is lost. Still, integration can yieldnew and radically innovative knowledge that could be used to leapfrog existing productsand the technological paradigms that underlie them.


Achieving productive collaborations with CVC investorsWhat can entrepreneurs and new venture managers do to extract the strategic benefitsfrom CVC relationships while mitigating the risks of harmful behavior by larger partners?Even when trust exists between parties, the threat of opportunism cannot be totallyeliminated. Therefore, we focus our attention on those situations where perceptions ofprospects for joint gains are sufficient to motivate both parties to expend the energy neces-sary to develop and sustain collaborations.9 We explore the merits of four approaches:contracting, unbundling of alliance activity, board membership, and proactive relation-ship management. We also provide some evidence of new ventures using these approachesto reduce the gap between the potential and realized gains from CVC relationships.

ContractingThe venture capital literature provides extensive treatment of how investors use financialcontracting to mitigate agency concerns about new ventures (Sahlman, 1990; Kaplan andStromberg, 2002). Contract negotiations can also provide new ventures with opportun-ities to mitigate agency concerns about CVC investors and to test the prospects for cooper-ative behavior (Cable and Shane, 1997). Lerner and Merges (1998) identify several areaswhere new ventures generally maintain control rights: process development, allianceexpansion, termination of other than focal projects, sub-licensing, ownership of patentsand core technology, and board seats. New ventures often cede control of managementof clinical trials, final product manufacture, marketing and decisions to shelve focalprojects. Clearly, contracting can provide some protection to new ventures. These firmscan also succeed in renegotiating contracts, which may reflect uncertainty reduction aboutalliance value and growing trust between parties (Lerner et al., 2003). Yet, it is importantto recognize the costs and limits of contracting. Complex agreements and protractednegotiations can drain cash and managerial resources of new ventures. Defense ofnegotiated rights can prove costly, and prospects of success will differ across intellectualproperty protection regimes (Cohen et al., 2001).

Katis and Young (2004) interviewed eight veterans of CVC investments, half from eachside of these relationships. Responding managers were unanimous in their views that theburden for capturing value from potential strategic benefits lay with new ventures and thatthey should recognize the need to invest time and travel expenses to accomplish this. Theyalso noted that it was vital to proactively cultivate relations with multiple supporters atbusiness unit levels and that this should begin during the search for potential CVCinvestors. One executive said, ‘Don’t assume that just because the CVC program investedin you that the rest of the company understands your business. You have to articulate andcommunicate your value proposition to particular business units.’ Another manager citeda young company which assigned a relationship manager to work with CVC officials andbusiness units. He talked weekly with them to exchange information on product and cus-tomer activity. These findings reinforce the growing belief in the literature that new ven-tures have to work hard at keeping an on-going dialog with multiple key managers in CVCinvestor companies.

Unbundling of alliance activity into multiple projectsThis approach can mitigate the risks of appropriation of intellectual property. It alsooffers a basis for moving from a one-time contracting approach to a broader relationship


mindset. This mindset develops as partners collaborate, work through their perceived andreal differences and achieve a greater understanding of mutual interests. This process canreduce information asymmetries while building collaboration and mutual trust (Cableand Shane, 1997; Dyer and Singh, 1998).10 One executive of a new venture put it this way:‘An alliance is a broad-based agreement that we will collaborate over a very broad set ofissues. So it is more than just one project, more than one program, more than just onetechnology where we have similar interest areas’ (Alvarez and Barney, 2001, p. 147).

Board membershipBoard membership or observer status can expose CVC investors to discussions about thestrategy that the new venture will follow. It may also give CVC investors valuable insightsinto technology and market developments, barriers to the firm’s attempts to commercial-ize the technology, and conflicts within the top management team. This first-hand expo-sure can be important for recognizing and interpreting tacit knowledge.

However, Gompers and Lerner (2001) identify several drawbacks to board membershipby established companies. Membership exposes the investor company to potential legalliabilities. Entrepreneurs are often uncomfortable with corporate representatives on theirboards. Entrepreneurs also fear the appropriation of proprietary technology and competi-tive information or misuse of this information, for example to pre-empt the younger firms’plans or subsequent merger negotiations. While non-disclosure agreements can addresssome of these concerns, they seldom eliminate them. The more potent antidotes for moralhazards are common interests and mutual trust.

Proactive relationship managementTrust develops over time, based on frequent and mutually beneficial exchanges. Trustrequires credible commitments as well as a mindset that encourages collaborative andsupportive behavior. A new venture seeking long-term, profitable relationships with a CVCinvestor should therefore demonstrate a willingness to build this relationship.

Two types of trust are recognized in the literature. The first is calculative and is basedon a party’s assessment of the potential risks and returns of collaboration. New venturescan induce this type of calculative trust through careful contracting and negotiation, aswe have suggested earlier. The second type of trust is relational in nature. It rests on lateralcommunication, frequent and honest disclosure, and mutual sharing of information andother resources. In developing and sustaining relational trust, calculations are slowlyaugmented by a belief that one party will not take advantage of the other’s vulnerabilitiesand will not exercise its powers to coerce the other into acquiescence or compliance.Rather, emphasis is on developing mutual understanding that fosters joint problemsolving and information sharing. Relational trust generates social capital between theentrepreneurial firm and CVC partner (Maula et al., 2005).

To be effective in building relational trust, a new venture has to be skilled in identify-ing relevant groups and actors within the incumbent’s organization and in its communi-cating with them. Frequently, these actors are placed in the CVC unit and interact withbusiness unit managers and others in the corporation (Gompers and Lerner, 2001).Members of the CVC unit have a vested interest in keeping track of what the ventures intheir portfolio are doing and how well they are progressing in serving their goals. This canset the stage for frequent communication between new ventures and CVC providers’ staff.


Developing relational-based trust is a time consuming process that is fraught withuncertainties. First, the risk of opportunism might decline but it certainly persists.Opportunism is likely as long as actors have access to different types of information, holddifferent perceptions of process or outcomes, or pursue different goals. Second, membersof the incumbent’s CVC unit are under significant pressures to share their findings withthose in their strategic business units, possibly compromising their positions with theirportfolio ventures. Information about what new ventures plan to do with their technol-ogy or in markets could be of great value to incumbents as they explore ways to protecttheir established positions. Sharing that information could compromise the position ofthe CVC unit (or staff) in their communications or other interactions with new ventures.Third, the membership and objectives of the CVC unit are subject to major and some-times frequent changes (Gompers and Lerner, 2001). Companies may change objectivesabout what they want to achieve through their CVC program and the metrics used inevaluating that unit. These changes introduce uncertainty into the communicationsprocess, making relational trust more difficult to sustain over time. Fourth, young com-panies have obvious limits on how much time and how many resources they can devoteto relationship management.

To summarize, our discussion makes clear that entrepreneurs should ‘trust but verify’ theintent and actions of their CVC providers. Transactional cost analysis would favor for-malized, strict monitoring which is difficult to conduct especially where there are consid-erable power, information and resource asymmetries among parties. New ventures may notbe well staffed or have the resources to monitor CVC providers on a consistent basis. Theseventures cannot rely solely on trust, especially when a powerful partner can capture theirknowledge and intellectual property and use it to advantage. However, excessive trust canblind venture managers to the potential opportunism of CVC providers. This absolute trustcan have dysfunctional effects that can undermine the very existence of the new ventureitself. The astute entrepreneur has to balance trust with some of the formal mechanisms wehave just discussed to ensure the protection of the venture’s intellectual property, realizingthat the best protection lies in causal ambiguity where the CVC provider cannot decipherwhat the new venture is doing (Zahra and Chaples, 1993). Embedding innovations andintellectual property into the new ventures’ systems, internal processes and organization isanother important means to achieving this goal. Overall, our discussion shows that bothtrust and transaction-based monitoring are necessary when uncertainty is high andoutcomes of the relationship are subject to interpretation and change. Transaction andrelational governance therefore could be effective complements, not substitutes.

DiscussionCVC investments offer opportunities for incumbents and new ventures to collaborate andacquire new skills and capabilities. Adopting the perspective of the entrepreneur andher/his new venture, we have highlighted the importance of CVC for gaining access tofinancial resources, complementary assets and market information. CVC investments alsoprovide an important signal of a new venture’s legitimacy and viability. We have arguedthat the congruence of goals of new ventures and incumbents are a crucial requirement fora ‘win–win’ partnership between these parties (Table 16.1). Yet, the stakes are too high forboth parties to assume that good intentions will lead to satisfactory and sustainable results.New ventures have to work to curb incumbent partners’ potential opportunism through


contracting, patenting, licensing, legally binding non-disclosure agreements, selectiveboard membership decisions, syndicated investments, and making credible investments inbuilding and sustaining their relationships with their CVC partners. Our discussionsuggests several implications for entrepreneurs and new ventures, as discussed next.

Implications for managerial practiceOur discussion highlights the importance of several managerial actions that can improvenew ventures’ gains from CVC. Notably, there is a need for due diligence in selecting CVCpartners. We have outlined several criteria that entrepreneurs can apply in this process butit is worth reiterating the need to go beyond numbers. It is important for entrepreneurs toprobe CVC investors’ motives, goals, track records, personnel and overall credibility.Entrepreneurs are busy people who often err by favoring speed over gaining insights intotheir partners. Clouded by the ‘illusion of control’, some entrepreneurs may come tobelieve that they can ‘fix’ problems as they arise. This is not always possible, especiallywhen valuable information about a company’s proprietary technologies, skills, tradesecrets, weaknesses and strategies leaks to outsiders.

Entrepreneurs also need to communicate the goals of their new ventures clearly topotential CVC providers. It is equally important to seek clarifications about their CVCs’partners’ goals related to investing in their new ventures. Even though these goals arelikely to change over time, understanding them initially sets the stage for a clearer andmore congruent alignment of goals. Entrepreneurs therefore need frequently to reassesstheir goals and those of their partners to ensure an effective fit.

Future research directionsWe believe that research opportunities on the various benefits of CVC for new venturesabound. Yet, as we reviewed the literature, we could only find a few studies on the topic –highlighting the need for better theory development and testing in this fertile area. Clearly,we need to move beyond anecdotal evidence and case-based research and apply a moresystematic and theory-grounded approach (Maula, 2001). Thousands of CVC deals havebeen completed in the US and elsewhere, offering a broad basis to theorize about cond-itions under which they can create value for investors and new ventures. Agency, strategiccontingency, institutional and knowledge based theories could offer a foundation forexamining these conditions and delineating the effect of CVC on new ventures andinvestors. Theory building and testing could substitute individual case studies to begin toprovide reliable generalizations that can guide effective managerial practice. Fortunately,recent published research on the topic shows a great deal of attention to careful theorybuilding and empirical testing (Dushnitsky and Lenox, 2005; 2006).

Future researchers would also benefit from examining how new ventures select theirCVC partners. As stated throughout this chapter, there are multiple criteria for newventure managers to consider as they evaluate potential CVC investors and it is useful todetermine the relative importance of these criteria across industries, different stages of theventures’ evolution, and time periods. How do venture managers rank the tangible andintangible attributes of potential CVC investors? How do these rankings relate to indus-try and strategic variables and the preferences and skills of entrepreneurs? Answeringthese questions can improve our understanding of how entrepreneurs choose CVCproviders and how they begin to build their relationship with them.


Throughout this chapter, we have discussed several legal and relational ways that newventures can curb the opportunism of their CVC partners. It would be useful to developtheories that allow us to predict the viability of these approaches under differentindustry and competitive conditions. Empirical studies that identify and clarify theseconditions would also enrich the literature. Are these approaches complementary? Dothey substitute for each other? If so, when and how does this influence the relation-ship between new ventures and incumbents? What are the types of social capital thatdetermine this substitutability? Maula et al. (2005) highlight different roles for socialcapital in the context of CVC, and future researchers would benefit from exploringthese roles.

Recent analyses also suggest that the capabilities of CVC partners have importantimplications for new ventures’ knowledge acquisition and learning (Zahra, 2006a). Forinstance, ventures that obtain funding from well established technological leaders aremore apt to learn a great deal more about technology commercialization than those ven-tures that have technologically weaker partners. These preliminary findings indicate aneed to delve more deeply into CVC partners’ knowledge and capabilities and how theymight influence new ventures’ learning. These results extend and revise the prevailingwisdom by showing that these ventures also learn from their relationships with establishedcompanies. This learning, in turn, depends greatly on the social capital and absorptivecapacity of new ventures and entrepreneurs’ willingness to build trusting relationshipswith their CVC partners (Zahra, 2006a).

Understanding potential partners’ skills and knowledge requires due diligence by newventure managers who have to analyze the capabilities of CVC providers. Therefore, man-agers might seek the feedback of other ventures that received CVC support from a givenprovider, inquire about the ease by which knowledge and skills were transferred, anybarriers that limited such transfers, and the quality of skills and information transferred.Partners’ reliability in keeping their promises regarding skill and resource transfers shouldbe a central issue. New venture managers can also use formal and informal competitiveanalysis techniques to gather and assess information about partners’ reliability in sharingtheir knowledge. New ventures often need help with strategic planning, marketing andmanufacturing capabilities and established companies typically possess competent staffwho perform these activities. New venture managers should openly discuss with potentialCVC providers the extent to which they are willing to share their knowledge and theappropriate forum in which this sharing is likely to occur.

Finally, future research would benefit from applying and testing the relationships sug-gested in Table 16.1 and the applicability of the relational approach we discussed through-out this chapter. Complementarities vs. competition between CVC providers and newventures could influence the potential payoff from exploratory vs. exploitative investmentsthat incumbents make. Several research questions arise from considering Table 16.1 anddeserve attention. For instance, does the timing of investment (late vs. early) influencethe payoff from exploratory vs. exploitative CVC funding? How do new ventures ensurecomplementarity when making CVC decisions? When does complementarity give way tocompetition between the CVC provider and the venture receiving funding? Conversely,when does the relationship between these two groups change from competition to com-plementarity? Empirical studies along these lines can enrich our understanding of thepayoff from CVC for providers and new ventures.


ConclusionEntrepreneurs and their ventures stand to gain a great deal from CVC relationships. Eventhough some CVC relationships provide a setting in which opportunistic behavior couldflourish, others serve as an important means of legitimization and an effective conduit forknowledge sharing and organizational learning. As we have presented throughout thischapter, opportunities for collaboration and learning increase significantly with new ven-tures’ use of legal and trust-based mechanisms to protect their intellectual property andcurb their partners’ potential opportunism. Using the approaches we have outlined in thischapter, CVC investments could evolve into ‘win–win’ relationships for new ventures andtheir established corporate partners.

AcknowledgementsWe acknowledge with appreciation the comments of Hans Landström, Markku Maula,Don Neubaum, Harry Sapienza and Patricia H. Zahra on earlier drafts of this chapter.The first author also expresses his gratitude for financial support of The ResearchProgramme for Advanced Technology Policy (ProACT) of the Ministry of Trade andIndustry and the National Technology Agency, Tekes (Finland) and the Glavin Center forGlobal Management at Babson College. The second author expresses his appreciation forfinancial support as holder of the Paul and Phyllis Fireman Charitable Foundation Chairat Babson College.

Notes1. While CVC activity dates from the 1960s (Rind, 1981), we focus on the previous decade because invest-

ment levels, sectoral focuses of activity, and program characteristics differ significantly from prior periods(Gompers, 2002; Dushnitsky and Lenox, 2005).

2. Estimates of investment are derived from analyses of the Thomson Venture Economics database andexclude indirect and certain direct activity. They may also understate substantial activity by Asian firms(Haemmig, 2003).

3. Allen and Hevert (2007) provide evidence on direct performance of CVC programs.4. Some observers view the possibilities we describe as real options (McGrath, 1997). While option logics are

broadly consistent with our treatment, their underlying assumption of a right but not obligation to take sub-sequent actions is not fully representative. In many instances, exploratory investment does not convey a con-tingent claim to pursue additional strategic benefits. This is often subject to negotiation among the parties.Also, there are numerous examples of renegotiation of alliance agreements by investees (Lerner et al., 2003).

5. This assumes bounded rationality of investors in establishing and applying criteria for strategic relevanceof targets. A Corporate Strategy Board (2000) study indicates that this may be the case for a subset of bestpractice companies. However, it also cites misaligned criteria and inconsistency and lack of rigor in screen-ing and monitoring processes as major challenges for the wider population of CVC programs.

6. Opportunism discourages the flow of information between new ventures and incumbents, thus deprivingestablished companies of a vital source of information about pending technological and other competi-tive changes. When the threat of opportunism is high, new ventures may withhold information or share itselectively with their CVC investors. New ventures can also induce causal ambiguity by omitting key detailsabout their technologies. When their technologies are vastly different from those of the incumbents, ambi-guity becomes real and incumbents cannot ascertain cause–effect relationships. There are serious implica-tions for new ventures’ efforts aimed at reducing incumbents’ potential opportunism.

7. While differences in strength of intellectual property protection regimes (Cohen et al., 2001; Dushnitsky& Lenox, 2005) may influence young firm attitudes in low goal congruence situations, limited evidence isavailable. Kann (2000) finds that industries with stronger intellectual property protection have more CVCprograms with early-stage investment missions; however, his data do not extend to views of investees or tocharacteristics of deals.

8. The broader alliance literature provides evidence of value creation: positive average wealth effects aroundannouncement dates, heterogeneity of results across samples, and wealth creating learning effects for firmswhich make repeated use of R&D joint ventures (Chan et al., 1997; Anand and Khanna, 2000). Whether


these results extend to CVC-based alliances and the issues of division of gains among partners remainempirical questions.

9. CVC investments in low goal congruence situations often may not meet this condition. This is an issue ofadverse selection, which we treat earlier in the chapter. Syndicated investment with venture capitalists orother CVC programs may mitigate risks of hold up or appropriation of intellectual property by a singlecorporate investor (Maula and Murray, 2000), but this does not address how to generate positive strategicbenefits from a relationship.

10. This relates to the role of relational capital in obtaining productive outcomes from alliances. In a surveyof 212 managers who had been involved in alliances in technology intensive industries, Kale et al. (2000)found positive relationships among relational capital, integrative conflict management behavior, organ-izational learning, and protection of proprietary assets. They did not address CVC-based alliances per seor economic significance of outcomes for partners.

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PART V

IMPLICATIONS

17 Implications for practice, policy-making andresearchHans Landström

In this Handbook of Research on Venture Capital we have tried to show the ‘research front’of our knowledge on venture capital – what we know about venture capital – but, thechapters also clearly indicate what we do not know. This final chapter is intended toprovide some suggestions for researchers, doctoral candidates and masters students on thefuture direction of our understanding about venture capital as well as trying to answerthe question: where are we going in venture capital research?

In the previous chapters we have tried to learn from earlier knowledge in the respectthat we try to communicate to reflective entrepreneurs, venture capitalists and policy-makers what conclusions can be drawn from research on venture capital and how ourknowledge can be applicable to their field of activities and the understanding of venturecapital. Therefore, in the second section of this chapter we will try to answer the question:what advice can be given to practitioners and policy-makers?

Where are we going in venture capital research?Although research on venture capital has been in progress for a quarter of a century and wenow have a great deal of knowledge that did not exist 10–15 years ago, many unansweredquestions remain. The authors of the chapters in the book have all tried to pinpoint thesequestions and provide some indications of where venture capital research is going.

Venture capital research in generalBased on the arguments by Van de Ven and Johnson (2006) on ‘engaged scholarship’ andGhosal (2005) on ‘positive organizational scholarship’, Harry Sapienza and JaumeVillanueva (Chapter 2) exhort venture capital researchers to immerse themselves in thephenomenon of venture capital and foster increased stakeholder cooperation in order tobroaden as well as deepen our theoretical knowledge and the methods used in our studies,in addition to addressing important questions that enrich theory and practice in a mean-ingful way. Sapienza and Villanueva make the following recommendations for futurestudies on venture capital:

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

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

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

● In business angel research there is a need to ‘put boundaries on our ignorance’,for example, better quality statistical information on the local distribution ofbusiness angels, the characteristics of business angels in different locations, andso on.

● Make use of databases that enable researchers to explore a greater range ofgeographical questions.

● Move from the macro-scale and quantitative data, to the micro-scale and qualitativedata.

● There is a need to clarify the connection between venture capital and technologicalclusters.

● A very great deal of our knowledge reflects what happens in dynamic regions suchas Silicon Valley and Boston, but we need to recognize venture capital practicesin other regions.

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

● The existence of the equity capital gap. Does an equity capital gap exist and, if so, atwhat levels of finance, who is affected, and are there adverse material consequences?

● The efficiency of government actions. Which government actions are most effectivein stimulating venture capital investments?

● Business angels are seen as an alternative to institutional venture capital. Is thisassumption empirically valid? By what means can business angels succeed in early-stage market conditions? How can business angels and venture capitalists mosteffectively work together to support potential ventures?

● ‘Hybrid’ venture capital programs. By what means should public/private ‘hybrid’venture capital programs be evaluated?

● Internationalization of venture capital. The venture capital industry has becomeglobalized, and more comparative studies are needed. How can emerging economieslearn from current venture capital experience?

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


review – which requires a high level of trust building and mutual understanding betweenacademics and policy-makers, something that is still largely in its infancy.

Institutional venture capitalIn Part II of the handbook several authors elaborated on institutional venture capital. InChapter 5 Douglas Cumming, Grant Fleming and Armin Schwienbacher examined thestructure and governance of different types of venture capital organizations. Regardingfuture research themes they offered the following suggestions:

● Internationalization of venture capital – the internationalization of the industryraises a number of new research questions, such as, how will venture capital marketsevolve around the world, how does internationalization impact on venture capitalfirm structure and management, and will the growth of new markets with differentlegal systems lead to different styles of venture capital investing?

● Business culture and venture capital fund structure. The venture capital model ismainly based on an Anglo-Saxon (especially US) business tradition. As the venturecapital industry becomes more international, venture capital must merge with otherbusiness cultures, which may question existing models and constitute a dynamicbasis for interesting research in the future.

● Emerging fund structures. The professionalization of the venture capital industry hasled to new structures, for example, the venture capital fund-of-funds and listedventure capital funds, but we still need more research on these emerging structures –their development, characteristics and performance.

In Chapter 6, which deals with venture capitalists’ pre-investment process, AndrewZacharakis and Dean Shepherd call for more research on: (1) decision heuristics – heuristicscan be efficient for time constrained venture capitalists, but we need to know more abouthow and when to use it, and (2) biases in venture capitalists’ decision-making – we need togain further insights in order to minimize the potentially negative impact of decision-biases.In addition, despite the fact that the research on venture capitalists’ investment activitieshas been more and more theoretically based – mainly relying on strategy research – there isa need to move beyond theories of strategy and explore other theoretical frameworks,for example, in psychology and sociology, as well as investigating how decision-makingcriteria might differ across both the venture capital process and the venture’s develop-ment stage.

Dirk De Clercq and Sophie Manigart in Chapter 7 reviewed and synthesized ourknowledge of venture capitalists’ activities after the investment has been made. Regardingthe post-investment phase they suggest that future research should further elaborate onhow the heterogeneity of venture capitalists’ monitoring and value-adding activitiesdepends on the combination of (1) venture capitalist characteristics, (2) characteristicsof the entrepreneur and the venture, and (3) the institutional and social environment inwhich both parties are embedded. In addition, research should build further on the liter-ature pertaining to how value is added in the venture capitalist–entrepreneur relationship,and in particular, how the exchanges of specific knowledge and the process of suchexchanges affect investment performance. Finally, our knowledge would benefit fromcomparing how the context and process-related issues of monitoring and value-adding

Implications for practice, policy-making and research 417

activities may differ across different investor types, for example, institutional venturecapitalists, business angels and corporate venture capitalists.

Chapter 8 follows up on this discussion, and Lowell Busenitz argues that researchon venture capitalists’ value-adding has addressed rather broad questions and the studieshave produced mixed results. According to Busenitz, we need to move beyond these broadquestions and he suggests further research into several areas. First, we need to knowmore about (1) the internal governance structures that venture capitalists bring to theventures – not least the activities on the board of directors in the venture capital context,(2) the provision of compensation to founders and top management teams and itsconsequences, and (3) the role of venture capitalists’ reputation and certification in thesubsequent rounds of financing and in the IPO process. Second, research has only startedto probe the question of the relationship between venture capital and the emergence ofnew industries – more work needs to be done – for example, we need to know more aboutquestions such as: does venture capital investment lead to more innovations in society?What role does venture capital play in the emergence of new industries?

A similar argument is offered by Benoit Leleux in Chapter 9, who states that, despiteseveral studies on venture capitalists’ value-adding activities, it is difficult to find consensusin the results, and one important issue in this respect is the problem of measuring financialreturns on venture capital investments in early stage, privately held ventures. Leleux con-cludes that we need a great deal more research on measuring venture capital performance.

In her review of our knowledge on early stage venture capital, Annaleena Parhankangasconcludes in Chapter 10 that after decades of research we still have limited knowledgeabout venture capital investments in early stage ventures. Parhankangas makes thefollowing suggestions for future studies:

● There is a declining trend worldwide in venture capital investments in early stageventures, but we don’t know the reasons behind it. Therefore, we need studies toidentify changes in the incentive systems and governance structures within theventure capital industry that may explain the relative decline in investments in earlystage ventures.

● It could be argued that the financial needs of early stage ventures can be bestaddressed by a combination of different financial sources – public funding, informalinvestors and early stage venture capitalists – and we need research that addresses thecomplementarities and synergies between different sources of early stage financing.

● There seem to be regional differences and different traditions between countries inthe finance of early stage ventures, and we need to explore how venture capitalcould appear in different contexts.

● The greatest challenges for venture capitalists investing in early stage ventures arecognitive in nature – the perception of risks and trying to make sense of the chaoticenvironment surrounding new ventures. Therefore, research on early stage venturecapital benefits from borrowing from research fields such as human cognition andinformation processing mechanisms.

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


The development of private equity and buy-out markets:

● Changes in deal characteristics over time, for example, comparative analyses ofdifferent time periods.

● International aspects of private equity and MBOs, for example, the influenceof contextual factors in the growth of the market as well as focus on the inter-nationalization of private equity firms.

● Source of MBOs – in this respect neglected areas of research are the linkagebetween early stage venture capital funds and buy-out funds as well as buy-outinvestments and the succession problems facing many family firms.

The buy-out life cycle:

● Organizational forms of financiers – private equity firms can take several organi-zational forms, and we need more knowledge on how different organizational formsimpact on the buy-out life-cycle.

● The added value brought about by MBOs.● Exiting MBOs, that is issues concerning the ability of private equity firms to realize

the gains from their investments.

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

● The early funding gap, that is the gap between the funding achieved by the three Fs(founder, family and friends) and business angel finance as well as the role andimpact of public sector funding instruments in this context.

● Following the Global Entrepreneurship Monitor research initiative, we need toundertake business angel demographic studies beyond developed economies.

● The complementary nature of business angels and venture capital funds – are theycomplementary, and if so, in what way?

● Latent angels – individuals who have not yet made their first investment – seem tobe an immense untapped potential in the informal venture capital market, and weneed to know how to encourage them into the market.

Kelly argues that researchers on the informal venture capital market need to broadentheir theoretical frameworks and include fields such as psychology and sociology, andhighlights some methodological issues for future research.

In Chapter 13, Allan Riding, Judith Madill and George Haines provide a review and syn-thesis of our knowledge regarding the decision-making process employed by businessangels when making investments in new proposals – a central and long-standing theme ofinterest for researchers on informal venture capital. The authors suggest that:

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


● We need to know more about how decision criteria used by business angels canchange as the investment process unwinds.

● Business angels are actively involved in the firms in which they invest, and we needto know more about the relationship between the investment process and post-investment involvement.

● Business angels are usually not the only financier of a new venture – it is a mix ofbusiness angels, founders, banks, government money and even institutional venturecapitalists – and we need to know more about how different financiers of newventures interact.

Riding, Madill and Haines also address some methodological issues of research oninformal venture capital, and they argue that we need: (1) more theoretically basedstudies (not least when it comes to modelling the investment decision process); (2) moredemand side research (seen from the entrepreneur’s perspective); and (3) in order to sortout the definitional problems that exist in informal venture capital research, we need todecompose the informal venture capital market into relevant segments, and by elaborat-ing on these segments contribute to the understanding of how different types of infor-mal investors differ in significant ways, including how they make their investmentdecisions.

Jeffrey Sohl focused his chapter (Chapter 14) on a special feature of the business angelinvestment process – business angel portals – that are introduced in order to enhance theefficiency of quality deal flow and increase the availability of capital. Business angelportals have received considerable attention in previous research, but Sohl argues thatmany facets of angel portals remain misunderstood and thus require further research, forwhich he makes the following suggestions:

● It is important to understand why some angel portals may be appropriate for certainregions and not for others as well as the role of angel portals in regional economicdevelopment.

● The relationship between angel portals and institutional venture capitalists – arethere market complementarities or not?

In common with Riding, Madill and Haines in the previous chapter, Sohl suggestslongitudinal methodological approaches in order to track changes in various portalsover time. As seems to be the case for business angel research in general, Sohl advocatesmore theoretically based research on business angel portals and suggests that theoriessuch as the effectiveness of group structures, the interplay of group dynamics,social capital and social networks could provide an interesting basis for such theoreti-cal development.

Corporate venture capitalPart IV of the book concerns the corporate venture capital market, and in Chapter 15Markku Maula demonstrates that both the research and the practice of corporate venturecapital have become increasingly sophisticated and that earlier research has answeredmany previously puzzling questions. However, several avenues for further researchremain, and Maula emphasizes that the following issues need to be addressed:


● Analysis of benefits over costs under different circumstances, such as various firmand industry level determinants and different corporate venture capital strategies.

● The impact of corporate venture capital on the performance of corporations.● The management of corporate venture capital operations, including investment

processes, the use of corporate resources to facilitate corporate venture capitalactivity, knowledge integration from corporate venture capital investments, andinternal performance measurement.

However, as shown by Shaker Zahra and Stephen Allen in Chapter 16, research oncorporate venture capital that adopts the entrepreneur’s perspective has been sparse andfragmented, and the authors highlight the need for better theory development andtesting within the area, that is theory building and testing could substitute for individ-ual case studies in order to provide reliable generalizations that can guide effectivemanagerial practice. Furthermore, the authors suggest the following topics for futureresearch:

● New ventures’ selection of corporate venture capital partners and due diligence bynew venture managers in order to gather and assess information about potentialcorporate venture capital partners.

● Legal and relational ways in which new ventures can curb the opportunities of theircorporate venture capital partners.

● The influence of corporate venture capital partners’ knowledge and capabilities onthe new ventures’ learning.

● The relationship between corporate venture capital investors and new ventures.

What advice can be given to practitioners and policy-makers?

Implications for policy-makersVenture capital has been regarded as an influential factor in the creation of new firms anddynamics in the economy. This positive view has prompted governments around the worldto see venture capital as an essential ingredient in their policies to facilitate entrepreneur-ship, innovation, employment and economic growth. This interest in venture capital hasnot least been shown in lagging regions where venture capital has been seen as a measureto change the prevailing situation into something positive – increasing growth and wealthin the region. However, as argued by Mason in Chapter 3, the mere availability of venturecapital is not the solution, more needs to be done, for example:

● Venture capital must be combined with talented individuals and role models.● Providing capital is not the only role of venture capitalists, and thus creating

venture capital funds staffed by managers who lack the value-added skills ofventure capitalists will be ineffective.

● Trying to artificially create a regional pool of venture capital is likely to be unsuc-cessful – venture capital is only attracted to places with novel ideas and talentedindividuals – thus policy-makers should concentrate on developing their region’stechnology base, encourage venture creation and growth and enhance the businesssupport infrastructure.


Murray devotes the whole of Chapter 4 to venture capital policy issues, and policy-makers can learn a great deal from it. In order to conclude the chapter, Murray arguesthat despite the enormous growth in the amount of venture capital in many countriesin recent decades, we cannot find the same level of success in public involvement innew venture financing. However, we have to remind ourselves that governments do notface an easy or unambiguous task: governments have to determine if they wish to inter-vene in order to correct market imperfections or realign incentives in a manner congru-ent with their policy goals; and government is usually involved in the least attractive areasof a financial market – the public becomes involved due to the absence of privateinvestors. In addition, we still lack knowledge as to the appropriate role of government inventure capital activity, both in terms of theoretical understanding and the diversity ofexemplar programs from which to benchmark progress. However, there seems to begrowing academic consensus that sanctioning government intervention is a decisionthat should be taken with considerable caution and perhaps only when private venturecapital markets are obviously failing. Murray provides some guidelines that policy-makers may consider:

● Institutional or informal venture capital programs should harness private investors’interests and experience as agents of government program goals.

● There are trade-offs between venture capital and business angel program outcomes.Policy makers should be explicit as to the ‘value’ of different objectives when bothlaunching and evaluating programs.

● There are major economies of scale and scope in venture capital fund activities.● The level of unmanageable uncertainty in the very early stages of venture develop-

ment may be such that it may not be sensible to allocate resources by market alone –venture capital should be seen as only one of a range of financing options.

● The premium for managerial and investor experience is high – program designersneed to reflect on how such tacit knowledge may be best harnessed to addressthe challenges of early-stage investments.

● All new venture capital programs involving public funds should have a formalevaluation model built into the program at the design stage.

● The US provides a role model for venture capital worldwide. Much of the stock ofknowledge in the US may be valid and relevant outside North America, althoughcertain aspects will not be usable in other contexts. It is implausible that a globalventure capital industry will, over time, be dependent on one absolute and exclusivemodel of success.

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


It is often assumed that institutional venture capital is an important contributor to theadvancement of innovation and the emergence of new industries. The assumption is thatventure capital is intimately involved in the development of entirely new industries –without venture capital investments these industries would not have been developed.However, in Chapter 8 Busenitz states that we still know very little about the impact ofinstitutional venture capital in this respect, and he argues that, although there is evidencethat venture capitalists invest in technology-based ventures that pursue an innovativestrategy, it does not mean that they prefer to back the exploration of new technologies.On the contrary, most venture capitalists tend to become involved in later stages of devel-opment where capital requirements are larger and the distance to exit and pay-off isshorter. Especially, venture capitalists seem to be particularly helpful in the transitionfrom the exploration of new technologies to their commercialization on the market. Thus,evidence suggests that venture capitalists seem to be reluctant to become involved infunding new ventures that are not part of an industry that is perceived to be developing,and in that respect, one can question the view of venture capitalists as drivers, or creators,of entirely new industries – indeed, this rarely seems to be the case. It would be more accu-rate to say that venture capitalists help to finance newer industries that are on the rise andshow some growth rate.

In Part III (Chapters 12 to 14) we discussed the informal venture capital market. Fromthe survey it was evident that the informal venture capital market is fraught withinefficiencies, causing two kinds of capital gaps (Sohl, 2003): (1) primary seed gap, that isthe difficulty in finding business angels and the lack of ‘investor ready’ quality deals invery early stages of development; and (2) secondary post-seed gap, that is due to the factthat the institutional venture capital industry migrates to later stage and larger sized deals,there is a gap between business angels and the institutional venture industry for venturesin the early stages of growth. However, Sohl (ibid.) indicates that business angels areincreasing their investments in this secondary post-seed gap, redistributing the risk capitalthat exacerbates the primary seed capital.

Sohl argues in Chapter 14 that policy can play a role in enhancing the flow of early stageequity capital and contribute to establishing a more efficient market. In particular, Sohl offersthe following recommendations for policy-makers in the field of informal venture capital:

1. Public policy can play a role in fostering and nurturing the links between innovators,entrepreneurs and business angels.

2. Support research in order to increase understanding of the informal venture capitalmarket.

3. Develop educational programmes targeting the supply (latent and existing businessangels) as well as the demand (entrepreneurs) side.

4. Public policy monetary incentives should focus on enhancing the flow of early stageequity capital to entrepreneurial ventures.

More specifically, looking at the lack of efficiency in the informal venture capitalmarket, different kinds of business angel portals have been established since the mid-1980s. A business angel portal is ‘an organization that provides a structure and approachfor bringing together entrepreneurs seeking capital and business angels searching forinvestment opportunities. The primary goal of angel portals is to increase the efficiency


in the early stage market’ (Sohl, Chapter 14, p. 348). Lessons that can be learned fromearly attempts to develop business angel portals are that they have been important inincreasing the awareness of angel investing and the role played by business angels in theearly stage financing of entrepreneurial ventures. But, on the other hand, in many casesearly business angel portals have experienced difficulties in (1) finding a sufficient numberof investors to join the networks; (2) identifying high quality deals (‘investment ready’deals); (3) finding funding for the operation for the portal; and (4) an inability to createsufficient awareness of the existence and value of the networks.

Adapting to changing market conditions and experiences from earlier attempts toincrease the efficiency of the market have led the informal venture capital market toassume several organizational structures, and in his chapter Sohl examined six types ofbusiness angel portal: matching networks, facilitators, informal angel groups, formalangel alliances, electronic networks and individual angels. According to Sohl, these angelportals should adopt some basic features:

● Angel portals should maintain an informal structure, be based on a regional model,provide a face-to-face interaction between business angels and entrepreneurs andstrive to provide a quality deal flow for their members.

● The three portal types ‘informal angel groups’, ‘individual angels’, and ‘matchingnetworks’ are best suited to investing in the primary seed gap, whereas the ‘formalangel alliances’ and to some extent the ‘matching network’, are best positioned forinvestment in the secondary post-seed gap.

● Portals must remember that they are collections of business angels who make anindividual investment decision and not institutional venture capitalists who managea pool of capital.

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

● Venture capitalists’ specialization in terms of the industry and development stagehas a positive effect on the performance of portfolio firms.

● Knowledge exchange between venture capitalists plays an important role in generat-ing positive investment outcomes, including (1) the aggregated knowledge held by theindividual venture capitalists in one and the same venture capital firm as well as (2)the knowledge exchange that takes place within venture capital investment syndicates.

● Knowledge exchange between the venture capitalist and entrepreneur indicatesthat the potential outcomes from this relationship may be highest when the two partieshold complementary knowledge that enhances each other’s expertise and skills.However, it is necessary for the two parties to establish effective knowledge sharingroutines – both in the form of formal (for example board of directors) and informal(for example by means of the telephone and personal meetings) communication.


In addition, value-adding is a process-related issue, and De Clercq and Manigartrecognize the importance of establishing strong social relationships between the venturecapitalist and entrepreneur:

● There seems to be a positive relationship between venture capitalists’ trust in theirportfolio firms and their perception of the firms’ performance, but too much trustmay potentially have a negative effect on performance.

● In addition, the level of goal congruence between the partners is an importantaspect of the value-adding process, while the commitment of venture capital-ist and entrepreneur to their mutual relationship may increase the value that iscreated.

● Research suggests that process-related issues, such as trust and commitment, mayfacilitate venture capitalists’ ability to add value to their portfolio firms, that is goodrelationships may lead to more specific insights into how an investment can be opti-mized and therefore enhance the potential to add value.

Over the years a great deal of research has investigated the key drivers of performancein venture capital-backed deals. The results are mixed and it is difficult to find consensusregarding venture capitalists’ value-adding activities and their effect on venture perform-ance. However, both Leleux in Chapter 9 and Parhankangas in Chapter 10 reviewearlier findings of factors that seem to influence venture performance, and followingthe reasoning of Leleux we can divide the key drivers of performance into threecategories: (1) venture capital-controlled investment factors; (2) environmental factors;and (3) decision-making processes (see Figure 17.1).

In Part IV of the handbook we turn our attention to corporate venture capital. InChapter 16 Zahra and Allen argue that entrepreneurs and their new ventures could gain


Figure 17.1 Key drivers of performance in venture capital-backed ventures

Venture capital-controlled investment factors– larger funds (up to a point)– high quality deal flow and syndication deals– control mechanisms– specialization strategy– earlier performance of venture capital fund– timing and duration of investment – reputation of fund and general partners– value-added services– multistage investment PERFORMANCE

Environmental factors– availability and status of public markets for IPOs– overall economic cycle– tax, regulatory and legal environment– availability of investors

Venture capitalist decision-making processes– the screening, evaluation and selection of new

venture investments

a great deal from an investment by a corporate venture capital provider. Such an invest-ment offers opportunities for the new venture to collaborate and acquire new skills andcapabilities. Corporate venture capital partners seem to have important implications fornew ventures’ knowledge acquisition and learning, but in order to achieve a ‘win–win’partnership the authors highlight the fact that the congruence of new ventures’ andincumbents’ goals are of crucial importance. The entrepreneur can take several actions toimprove the gain from corporate venture capital, for example:

● Due diligence in selecting corporate venture capital partners (and probe theirmotives, goals, track records, personnel and overall credibility),

● the entrepreneur also needs to communicate the goals of the ventures clearly topotential corporate venture capital investors, and

● as goals and motives change over time, the entrepreneurs need to reassess their goalsand those of their corporate venture capital partners frequently in order to ensurean effective fit.

ReferencesGhosal, S. (2005), ‘Bad management theories are destroying good management practices’, Academy of

Management Learning & Education, 4(1), 75–91.Sohl, J. (2003), ‘The private equity market in the USA: lessons from volatility’, Venture Capital, 5(1), 29–46.Van de Ven, A.H. and P.E. Johnson (2006), ‘Knowledge for theory and practice’, Academy of Management

Review, 31(4), 802–21.


Index

ABC – study of angels (attitudes, behaviors,characteristics) 52–3, 315, 316

absorptive capacity 403 Access to Capital for Entrepreneurs Act 2006

138 accounting measures of financial performance

230, 232 added value 18, 240

activities heterogeneity 212 early stage venture capital 265–7, 270 innovation and performance implications

219 post-investment phase 193–4 private equity and management buy-outs

300–304, 307–8 service 171–2

adverse selection 196–7 corporate venture capital 386, 401 early stage venture capital 262, 263 innovation and performance implications

221 private equity and management buy-outs

296 Africa 281 agency risks 258, 260 agency theory 72–3, 80, 199, 206–7, 321–2

business angels and investment decisionmaking 333, 337, 340

corporate venture capital 401 early stage venture capital 272 innovation and performance implications

221 performance of investments 239 post-investment phase 209 private equity and management buy-outs

306 Ajzen, I. 335 Allen, S. 62, 393–410, 421 alternative assets portfolio 250 altruistic motivation 318 Alvarez, S.A. 401, 402 Amatucci, F.M. 333, 335 Amazon 188 American Research and Development 11, 34,

71, 156 Amess, K. 302 Amit, R. 119, 257–8, 356 angel portals 139–40, 353–61

electronic networks 355, 360–61

facilitators 355, 357–8 formal angel alliance 355, 359–60 individual angels 355, 361 informal angel groups 355, 358–9 matching networks 355–7

Apple Computer 47, 71, 167 Archimedes Fund 364–5 Argentina 323 Arthurs, J.D. 80 Asia 14–15, 16

early stage venture capital 254, 270 government policy 139, 144 informal venture capital market 352 post-investment phase 197, 201 private equity and management buy-outs

281 structure of venture capital funds 160 see also Asia-Pacific

Asia-Pacific 157, 158, 159, 172, 173 Asquith, P. 295, 302 asset-based financing 298 attribution bias 264 Audretsch, D.B. 120 Auerswald, P.E. 115, 121 Australia 14, 352–3

Aussie Opportunities 360 business angels 316, 318 Business Angels Party 356 early stage venture capital 261 Enterprise Angels 352–3 Founders Forum 352, 358 government policy 130, 132 Industry Research and Development Board

167 Innovation Investment Fund Programme

133, 166, 167–8 Pre-seed Fund 134 Private Equity and Entrepreneur Exchange

360 Austria 226, 261, 290, 293 Avdeitchikova, S. 91

Balkin, D.B. 223 Banatao, D.P. 98 bank venture capital funds 164–5 Bannock Consulting Ltd 374 Barney, J. 188, 401, 402 Baron, R. 185, 188 Barr, P. 184

427

Belgium 13, 16, 137, 261, 290, 293 Benjamin, G. 318 Berg, A. 307 Bhide, A. 80 biases 185, 186–8, 189

attribution 264 mental model 186

BIC economies 116 biotech industry 396, 400, 401, 402 Birch, D.J. 3 Birkinshaw, J. 237, 381, 385 Birley, S. 263, 267 birth of venture capital 10–11 Black, B. 14, 166, 172, 241 board of directors 18, 197, 221–2, 405 Bottazzi, L. 259–60 bounded rationality 221 Branscomb, L.M. 115, 121 Brazil 114, 323, 371 Bruining, H. 301 Bruno, A. 15, 21–3, 27, 177, 179, 253–4 Bruton, G. 304 Bürgel, O. 114–15, 120 Busenitz, L. 60, 73, 80, 185, 188, 219–34, 267,

418, 423 business angels 9, 52, 55–8, 59, 71, 315–29

agency theory 321–2 attitudes, behaviours and characteristics

317–19 conceptual and theoretical reflections 73, 74,

77, 80, 82 decision-making process 319 demographic research 323 early stage venture capital 256, 257 experience 325–6 FFFs (family, friends and fools) 323 funds 360 geographical perspective 86, 89, 90–91, 92,

104, 106 government policy 135, 144 individual 355, 361, 362, 424 informal venture capital market 347, 353–4 location 87–8 market scale 317 methodological approaches 327–8 networks 54, 125, 141, 317, 336 post-investment phase 214 public financiers 324 public policy 320 signaling theory 322–3 social capital 322 venture capital funds 67, 324–5 see also angel portals; formal angel alliance;

informal venture capital; investmentdecision making; ‘virgin angels’

business associate referrals 336 business culture 174, 417 Business Development Bank 103 business introduction services 54 business volume measures 230–31 buy-back options 132 buy-in/management buy-outs (BIMBOs) 283 buy-ins 290, 291, 299–301 buy-outs:

worldwide 292 see also leveraged buy-outs; management

buy-outs Bygrave, W. 6–7, 15, 31–6, 78, 121, 135, 323,

332 early stage venture capital 254, 264 innovation and performance implications

226, 227

Cable, D. 69, 79, 81, 198 Canada:

business angels 316, 318, 319, 327, 333, 337,338

early stage venture capital 261 geographical perspective 87, 88, 90, 91, 93,

95, 96 government policy 137 informal venture capital market 349 Labor-Sponsored Venture Capital

Corporation (LSVCC) 93, 130, 168 Opportunities Investment Network (COIN)

349 structure of venture capital funds 165 Venture Capital Association 103 see also Ottawa

Capital Alliances 103 capital gains tax 12, 36

government policy 137 performance of investments 242 structure of venture capital funds 166

capped return for public investors 133 capped returns to the state 132 captive venture capitalists 6, 7, 92, 161, 164–5,

169 Celtic House 97, 103, 104 Center for Research in Securities Prices 19, 315 Center for Venture Research 348 Central and Eastern Europe 144, 281, 284–6 certification 136, 224–5 Chandler, G.N. 230, 233 chemicals industry 396, 398 chief executive officers 201, 221–2, 295, 301, 303 Chile: CORFU 133 China 14, 114, 174, 261

corporate venture capital 371 pre-investment process 182–3


private equity and management buy-outs281

Cisco Systems 102 classical venture capital funds 6, 7, 254

see also institutional venture capitalCochrane, J. 245 cognitive dimensions 207, 322 cognitive processes 272, 273–4 co-investing 18 Compaq 377 compensation 222–3, 265 complementarity 325 complementary technologies 398 Compton, C. 11 computer industry 43 conceptual and theoretical reflections 66–84

dominant focuses 72–3 early contributions 68–9 ‘engaged scholar’ view 75–8 entrepreneurship literature 66, 73–5expansion along several dimensions

69–72 conflict 267, 398 conjoint analysis 71, 178–9, 180–81, 183, 187,

243 consummation 334, 339–41, 343 content-related issues 181–3, 193–4, 203–6,

213 contingent pay 222–3 contingent valuation techniques 248–9 contract repudiation 259 contracting 18, 404 contractual covenants 265 control mechanisms 238–9 convertible securities 197 Cook, D.O. 295 Cornelius, B. 19–20 Corporate Executive Board 381 corporate governance 303 corporate law variations 270 corporate venture capital 6, 7–8, 9–10, 43–51,

67, 165 external 7, 372, 373 fund 159 history and research 43–4 internal 7, 372 Rind, K. 44–51 see also corporate venture capital from

entrepreneurs’ perspective; corporateventure capital as strategic tool

corporate venture capital from entrepreneurs’perspective 393–410

board membership 405 contracting 404 corporate investor perspectives 397–400

entrepreneurial firms’ perspective400–402

importance and growth 396–7 objectives, focus and contribution 393–6 proactive relationship management 405–6 strategic benefits 402–3

corporate venture capital as strategic tool371–89

cyclical history 378 definition 372–3 industry and firm level drivers of investment

378–80 learning motives 375–6 option building motives 376–7 performance 382–6 resource leveraging motives 377–8

co-specialization perspective 393 Cotter, J.F. 298 covenants:

contractual 265 governing venture capital limited

partnerships 163–4 negotiation 162

Coveney, P. 88, 318 cross-national variations 260, 262 cultural factors 269 Cumming, D. 60, 155–74, 267, 303, 417

DalCin, P. 333, 335, 336, 340, 341 De Clercq, D. 60, 193–214, 233, 240, 268,

417–18, 424–5 De Noble, A.F. 336 deal/deals:

appraisal 262–4 characteristics, changes in over time 305 evaluation 98–9, 177 flows 98, 177, 237–8, 353 generation 262, 269, 292–6 -makers 325 opportunities 284 origination 177, 336 resurgence 289 screening 177, 269 sourcing 335–6 structure 177, 339–41

DeAngelo, L. 295, 298 decision:

accuracy 189 aids 244, 264 criteria 181, 183 -making:

criteria 24–5expert 184process 127, 243–4, 319, 425see also investment decision-making

Index 429

-policies see pre-investment process: decisionpolicies

definition of venture capital 5–10 corporate venture capital 7–8, 9–10 informal venture capital 8–10 institutional venture capital 5–7, 9–10

Dell 377 Deltaray Corporation 34 demand 256

enhanced 374, 398 for private equity 285 -side factors 100, 127, 284, 341

demographic research 323 Denmark 261, 290, 293, 350–51

Business Development Finance 129 Business Innovation Center 351 Business Introduction Service 351 Loan Guarantee Scheme 134 National Agency of Industry and Trade

351 Department of Labor 12 Desbrierers, P. 301 development of industries 19 DeVol, R.C. 102 Dibben, M. 338 Digital Equipment Company 11 Diller, C. 268 Dimov, D.P. 122, 141, 233, 260, 268 direct public involvement 129–30 disruptive technologies 398 Dolvin, S. 224 Doriot, G. 11, 34, 179 dot.com boom and bust 15, 114, 186, 188, 289,

360, 443 downside protection 133–4 Draper, Gaither and Andersen 11 due diligence 177–8

business angels and investment decisionmaking 336–7, 339

corporate venture capital 401 early stage venture capital 263 informal venture capital market 366

DuPont 43 Dushnitsky, G. 378–9, 382, 385, 393 Duxbury, L. 333, 339

early stage venture capital 253–74 characteristics 258–60 classification based on development stage

255–7 deals, appraisal of 262–4 exit strategies and performance 267–8 fund raising 260–62institutional context and management

269–71

major risks 257–8 monitoring and adding value 265–7 recent trends 258 structuring of investments and investment

portfolios 264–5 theoretical and methodological

considerations 272–3 EASDAQ 13 economic cycle, overall 242 educational capability 182 educational programs 364 educational seminars 356–7 Einhorn, H. 189 Eisenhardt, K. 185 electronic networks 355, 360–61 electronic sector 43 Elitzur, R. 340 emerging fund structures 417 emerging technologies 398 Employee Share Ownership Plans 302 Employers’ Retirement Investment Security

Act (ERISA) 12 ‘Prudent Man Rule’ 12

endowments 160, 268 ‘engaged scholar’ view 68, 75–8, 82

‘positive organizational scholarship’ view78–81

Engel, D. 238, 239 entrepreneur 179, 212

as agent 196–8 early stage venture capital 262, 264, 267 innovation and performance implications

221 perceived impact 399 practice, policy-making and research

implications 424–6 /venture capital evaluations 231

entrepreneurial activity, growing status of126–7

entrepreneurial knowledge sharing 326 entrepreneurial team quality 263 entrepreneurship 66

conceptual and theoretical reflections74–5

literature 73–5 scholars 272–3

environmental factors 241–3, 425 equity 298

enhancement schemes 131, 133–4 gap 86, 117–18, 140 programs 125 ratchets 300–301see also private equity

Ernst, H. 385 Ettenson, R. 69–70


Europe 6, 7, 10–11, 13–14, 15, 16, 25, 40 Angel Academies 364 business angels 315, 324 corporate venture capital 372, 374, 381 early stage venture capital 254, 258, 259–60,

267, 269 geographical perspective 93–4 government policy 114, 116, 121–2, 126–8,

133, 135, 139, 141, 144 informal venture capital market 357 performance of investments 238–9, 240, 242,

243, 245, 246 post-investment phase 197, 198, 201 private equity and management buy-outs

281, 282, 287, 289–92, 298, 300 Seed Capital Scheme 134 structure of venture capital funds 157, 158,

159, 160, 166, 172, 173 Young Innovative Company Scheme 138 see also Central and Eastern Europe

European Investment Bank 134 European Investment Fund 133, 135 European Private Equity and Venture

Capital Association (EVCA) 248, 250,381

evaluation:business angels and investment decision

making 339 criteria 269–70 early stage venture capital 262 of proposal 334, 343 strategy (mental model) 184–5

exit 334, 343 events 342 private equity and management buy-outs

304, 308 routes 284 strategies 267–8, 270 timing of 270

expected rates of return 342 experience 179, 182, 189, 203–4, 262, 268,

325–6 expert decision-making model 184 exploitation 225–7, 398–9, 400 exploration 225–7, 398–9 exposure 162, 398

facilitators 355, 357–8 Fair Market Value 248 Farrell, A.E. 342 Federal Express 167 Federal Reserve 51

Bank of Boston 11 Feeney, L. 339 female entrepreneurs 322, 323

FFFs (family, friends and fools) 9, 52, 53, 257,306, 323, 328, 329, 342

Fiet, J. 74, 264, 321, 339 financial considerations 179 financial goals 374 financial institutions and investment 14 financial intermediator, venture capital as

19 financial motivation 318 financial objectives 375 financial returns (direct and indirect)

172–3 Finland 91, 261, 290, 293, 351

business angels 316, 318, 324 INTRO Venture Forums 351 Investment Industry program 129 Matching-Palvelu 351, 353, 354 Sitra PreSeed Finance 351

first resort investors 135 first stage financing 255, 256, 257 Fishbein, M. 335 fixed management fee 162 Flanders, R. 11 Fleming, G. 60, 155–74, 268, 417 Florida, R. 97, 101, 108 flow of venture capital 19 Flynn, D.M. 266 Fong, K.A. 98 Ford, H. 315 formal angel alliance 355, 359–60, 362, 424 formal networks 264 formal venture capital 87, 325

see also institutional venture capital France 13

early stage venture capital 261, 270 Fund for the Promotion of Venture Capital

(FPCR) 134 geographical perspective 94 government policy 137 Jeune Entreprise Innovante 138 Nouveau Marché 13, 289 post-investment phase 201 private equity and management buy-outs

290, 291, 292, 293, 301 Second Marché 289 SOFARIS 133–4

Freear, J. 77, 91, 318 Fried, V.H. 273 front end incentives 137 Fulghieri, P. 170 fund:

-level perspective 236, 244–5 -of-funds 173 operating costs 134 performance 270–71

Index 431

raising 260–62reputation 240 returns 232 size 123–4, 260, 268

‘funds of funds’ 134–5

gains, realization of 286 game theory 207 Gaston, R. 88, 318 ‘gatekeepers’ see investment advisors Gavious, A. 340 Genentech 71 General Electric 43 General Motors 43, 47 general partners 92, 169, 170

experience 239 reputation 240

geographical perspective 23, 86–109, 265,268

informal venture capital market 87–92 policy implications 108–9 see also institutional venture capital:

geographical analysis;internationalization

George, G. 403 Germany 13, 14, 353

BTU program 138 Business Angel Network Deutschland

(BAND) 353 business angels 316, 318, 338 corporate venture capital 385, 387 early stage venture capital 261 Euregional Business Angel Network 356 geographical perspective 87, 94, 96, 97,

101 government policy 114–15, 120, 130 innovation and performance implications

226 Neuer Markt 13 private equity and management buy-outs

284–6, 289, 290, 291, 292, 293 structure of venture capital funds 160, 162,

171 Ghoshal, S. 68, 75, 78–80, 415 Gifford, S. 69, 139, 211 Gilson, R.J. 14, 121, 139, 142, 166, 172, 241 Gladwell, M. 328 Global Entrepreneurship Monitor 9, 135, 323 globalization 23 Glofson, C. 16 goal 256

congruence 207, 209–10, 401 financial 374 incongruence 196, 214 strategic 374

Gompers, P. 121, 189, 332, 342, 405 performance of investments 238, 239, 241,

242, 243 structure of venture capital funds 160, 162,

163, 170, 171, 172 Google 23, 188 Gorman, M. 39, 177, 254 Gottschalg, O. 239, 242, 245 governance 18, 220–22 government:

investment schemes 166 sponsored fund 161 venture capital funds 165–9 venture capital organizations 6 see also government policy

government policy 113–46 ‘equity gap’, longevity of 117–18 fund size, insufficient 123–4 information asymmetries 119–20 market failure 116–17, 118 minimum fund scale 121–3 performance of investments 243 public involvement in private venture capital

141–3 R&D spillovers 120 United States exemplar, influence of 121 see also informal investors (business angels);

institutional venture capital grandstanding 170, 172, 189, 199, 239 Greece 261 Grilichese, Z. 120 growth markets, high 263 guaranteed underwriting of investment losses

incurred by limited partners 132 Gulliford, J. 91 gut feeling (intuition) 180, 189, 264, 337

Haines, G. Jr 61, 332–45, 419–20 Hall, J. 179 Halpern, P. 295 Hand, J. 244 hands-on investors 200 Hanks, S. 230, 233 Harris, R. 302 Harrison, R. 5–6, 8–9, 16, 54, 89, 91–2, 136

business angels 317, 319, 320, 322 investment decisions by business angels 336,

337–8, 339, 340, 341, 342 Hatch, J.E. 340 Hatherly, D. 301 Hatton, L. 243 Hauser, H. 97 Hay, M. 318, 321, 340–41 hedge funds 307 Hege, U. 172, 238, 240, 270


Hellmann, T. 172, 399 Henderson, J. 381, 399, 402 herding phenomenon 186 heuristics 185–6, 188, 189, 190

representative 186, 264 satisficing 186, 190, 264

Hewlett Packard 381 hidden action 257 hidden information 257 Higashide, H. 267 High Voltage Engineering Corporation 11, 34 highly innovative technological ventures 31, 33 Hill, C. 302–3 Hill, S. 237, 385 Hisrich, R.D. 273 Hitt, M. 307 Hochberg, Y. 237 Hofer, C. 179 Holthausen, D. 304 Hong Kong 14 Houghton, S. 189 Hsu, D.H. 200 Hunt, S. 332 Hurry, D. 204 Hussayni, H.Y. 16 hybrid venture capital 144

IBM (International Business Machines) 11, 38,47, 377

importance of venture capital 3 inactive investors 200 independent funds 159 independent limited partnership 6 independent venture capital firm 161 India 14, 269, 371 indirect intervention 128–31 industry:

diversity 265 level evidence 245–6 performance and correlation with other

asset classes 250 infant industry argument 131 informal angel groups 355, 358–9, 362, 424 informal investors (business angels) 9,

135–41 business angels as policy focus 136 early stage venture capital 257 first resort investors 135 institutional investors, complement to 135–6 networks, portals, match-makers and

information asymmetries 139–40 targeting business angels as co-investors

138–9 targeting business angels as individuals

136–8

informal networks 264 informal venture capital 8–10, 51–62, 325

ABC of angels 52–3 geographical perspective 86–7 market scale 52 policies and information networks 53–4 Wetzel, W. 54–9 see also informal venture capital market

informal venture capital market 87–92, 347–67 Australia 352–3 business angels, location of 87–8 Canada 349 Denmark 350–51early business angel network 353–4 Finland 351 Germany 353 location, role of in investment decision 89 locational preferences 88–9 locations of actual investments 89–92 policy implications 363–5 Singapore 352 Sweden 350 United Kingdom 349–50 United States 348–9 see also angel portals

information:asymmetry 119–20, 139–40, 195–200

business angels and investment decisionmaking 341

early stage venture capital 257, 260, 262,264, 265, 269, 272

innovation and performance implications221

performance of investments 242post-investment phase 199, 209private equity and management buy-outs

296–7, 306networks 53–4 processing 183–5, 273–4 technology 396, 401, 402

infrastructure to complete deals 284, 285–6 initial market development 288 initial public offerings 13, 14, 40, 43, 50

corporate venture capital 402 early stage venture capital 270 geographical perspective 104 innovation and performance implications

224, 233 performance of investments 249 post-investment phase 199 private equity and management buy-outs

304, 306 public markets 241 structure of venture capital funds 166,

172

Index 433

innovation and performance implications219–34

accounting measures of performance 230 compensation 222–3 exploration and exploitation 225–7 governance 220–22 new industries 227–9 reputation and certification 224–5 subjective measures of performance 230,

233 venture outcomes as measure of

performance 233 institutional venture capital 5–7, 9–10, 16–42,

212, 214, 272 Bygrave, W. on 31–6 conceptual and theoretical reflections 74 early contributions 16–17 early stage venture capital 269–71 geographical analysis 92–105

definitions 92–3demand-side factors 100geographical concentration of investments

95–9location factor, venture capital as

99–100location of investments 93–5long distance investing 100–101

geographical perspective 86 government policy 124–35

direct public involvement 129–30entrepreneurial activity, growing status of

126–7‘equity enhancement’ schemes 133–4‘funds of funds’ 134–5indirect or ‘hybrid’ public/private models

130–31intervention typologies 128–9public-funded incentives in hybrid funds

131–4 Intel 167, 377, 381

Capital 371, 376, 380 internal rate of return 122, 132, 249–50,

263 internationalization 173, 305–6, 417 Internet investing 97 intuition see gut feeling investment:

advisors 12 ‘bubble’ 95 decision-making by business angels

332–45deal sourcing and initial screening

335–6decision criteria 337–9due diligence 336–7

negotiation, consummation and dealstructure 339–41 post-investmentinvolvement 341–3

decisions 170 durations 239–40 portfolios 265–6 readiness arguments 140 regulations 125 risks in new technology-based firms 119 strategies 18 types 171–2

investment factors, venture capital-controlled237–41, 425

investor:availability 243 -led buy-outs (IBOs) 283 membership 353 tax benefits 137

Ireland 137, 261, 290, 293 Israel 44, 48

early stage venture capital 269 Nitzanim-AVX/Kyocera Venture Fund

48 structure of venture capital funds 160,

171 Yozma program 132, 133, 166

Italy 174, 261, 290, 291, 292, 293

Japan 14, 44, 48 business angels 316, 318 early stage venture capital 261 International Angel Investors 357 Nippon Angels Forum 359 post-investment phase 204 private equity and management buy-outs

281, 284–6, 292 structure of venture capital funds 160, 162,

171 JDS-Uniphase 102, 104, 105 Jeng, L. 142, 160, 241, 242, 243 Jensen, M.C. 287, 294 Johnson, P.E. 75–8, 415 Johnstone, H. 88 Jungwirth, C. 226

Kandel, G. 170 Kann, A. 374, 398, 400 Kanniainen, V. 170 Kaplan, S. 197, 270

performance of investments 239, 240, 241,245

private equity and management buy-outs295, 297, 298, 300, 302, 303

Kaserer, C. 268 Katis, N. 404


Keeley, R.H. 177 Keil, T. 80, 372, 374, 381, 383, 385 Keilbach, M. 120 Kelly, P. 61, 135, 136, 315–29, 340–41, 419 Kenney, M. 101, 108, 227 Keuschnigg, C. 170 Kieschnick, R. 295 Kleiner Perkins 35 Knigge, A. 303 knowledge:

-based industries and market failure 118 -based view 394 conversion capability 403 economy 118 exchange 204–6 implicit, tacit 239 inflows 403 spillovers 107

Korea 182, 281, 323, 387 Korsgaard, A.M. 267, 270 Kotha, S. 385

Landström, H. 3–62, 91, 335, 341, 342, 415–26 business angels 318, 319, 321, 322

Larcker, D. 304 leadership experience 182 leadership potential 263 learning motives 375–6 learning new markets and technologies 374 least innovative technological ventures 31, 33 legal protections 271 Lehn, K. 295 Lei, D. 307 Leleux, B. 60, 236–51, 381, 399, 402, 418, 422,

425 Lengyel, Z. 91 Lenox, M.J. 378–9, 382, 385 Lerner, J. 8, 54, 332, 342

corporate venture capital 400, 404, 405 government policy 113, 140, 142 performance of investments 238, 239, 241,

242, 243, 245 structure of venture capital funds 160, 162,

163, 164, 166–7, 170, 172, 173 leveraged build-ups 283–4 Leveraged Buy-Out Associations 300 leveraged buy-outs 239–40, 282–3, 287–8, 295,

297–8, 301–3, 305, 307–8 leveraged recapitalizations 302 leveraging own complementary resources

377–8 leveraging own technologies and platforms 377 Lichtenberg, F.R. 301–2 limited liability partnership fund 128 limited liability partnership structure 138

limited partnerships 92, 160–65, 170, 173 early stage venture capital 269 independent 6 structure of venture capital funds 169 venture capital limited partnerships

Linux 377 Lisbon Agenda 116 listed closed-end funds 156 listed venture capital funds 173–4 ‘living dead’ 233 Ljungqvist, A. 242, 245 local area networking 227 localized nature of investing 97–8 location factor, venture capital as 99–100 location of investments 93–5 location, role of in investment decision

89 locational preferences 88–9 locations of actual investments 89–92 long distance investing 91–2, 100–101 longevity in private equity and management

buy-outs 304 long-run investment returns 122 love money see FFFs Lowenstein, L. 294–5 Lumme, A. 341

McGrath, R. 30 MacIntosh, J.G. 267 MacLean, J. 340 MacMillan, I.C. 15, 26–31, 179, 254 Macmillan Report 117–18 McNally, K. 7, 372, 373–4 macro perspective (industry level) 236 macroeconomic conditions 242 Madill, J. 61, 104, 332–45, 419–20 Malaysia 14 management 179

buy-ins 283, 296, 302, 303 buy-outs 61, 290, 293, 419

geographical perspective 94, 108see also private equity and management

buy-outs early stage venture capital 269–71 -employee buy-out 283

managerial practice and corporate venturecapital 407

‘managerial-oriented venture capital research’17

Manigart, S. 16, 60, 193–214, 240, 268, 340,417–18, 424–5

Marais, L. 302 Margulis, J. 318 market 262

characteristics 179

Index 435

enhancement 374 failure 114, 116–17, 118 growth, rapid 288–9 -level learning 375–6 potential 179 risks 258, 260 scale 52, 317 size hurdles 263

Marriott, R. 122 Martin, R. 97, 100 Mason, C. 5–6, 8–9, 16, 54, 59, 86–109, 136,

415–16, 421 business angels 317, 319, 320, 322 investment decisions by business angels 336,

337–8, 339, 340, 341, 342 Mast, R. 373 match-makers 139–40 matching networks 355–7, 362, 424 Matthews, T. 97, 103 Maula, M. 7, 62, 371–89, 393, 395, 402, 408,

420–21Mayer, C. 160, 162, 171 Megginson, W. 224, 269 mentoring 341, 343 merchant venture capital funds 6–7, 254 Merges, R.P. 400, 404 metaphorical kaleidoscope 69–70, 72, 73, 81,

82 Mexico 323 Meyer, G. 180, 190 mezzanine finance 300 Microsoft 377 Microsystems International 102 Middle East 371 minimum fund scale 121–3 Mitel Corporation 102, 104 Moesel, D.D. 264 monetary incentives 364–5 monitoring 71

corporate venture capital 374 early stage venture capital 265–7, 270 heterogeneity 212 performance of investments 239 post-investment phase 193–4, 197–8,

199 private equity and management buy-outs

300–304 value-added in venture

capitalist-entrepreneur relationships194–203

information asymmetry 195–200value adding 200–203

Moog, P. 226 Moore, K. 88, 318 Moorehead, J. 243

moral hazard 196–7 business angels and investment decision

making 340, 341, 344 corporate venture capital 386, 401 early stage venture capital 264, 272 innovation and performance implications 221

Motorola 381 multistage investment 241 Murfin, D.L. 373 Murray, G. 59–60, 113–46, 260, 306, 402, 416,

422 Muzyka, D. 181

Nahata, R. 240, 241 NASDAQ 14 National Research Council Laboratories 102 National Science Foundation 34 negotiation 334, 343

business angels 339–41 of covenants 162 pre-investment process 178 private equity and management buy-outs

296–7 Netherlands 201, 261, 289, 290, 293 Netscape 100 networks 139–40

ties 322 new industries development guide 227–9 new techologies 12 New Zealand 113

early stage venture capital 261 government policy 130, 132 Mentor Investor Network Events for

Business Angels 359 Seed Co-investment Fund 138–9 Venture Investment Fund 133, 166

Newbridge Affiliates Programme 103 Newbridge Networks 102, 103, 104, 105 Nikoskelainen, E. 303 Nokia 102

Venture Partners 380 non-serial angels 338 Nortel 104, 105

Networks 102 North America 144

see also Canada; United States Northern Telecom 102 Norway 261, 290, 293, 316, 318, 322 Novell 377, 381 Nye, D. 269

operational role 201 operational skills 263 Opler, T.C. 295, 302 Oppenheimer 47, 48


opportunism 199 option:

building motives 376–7 reasoning 30 to acquire companies 376 to enter new markets 376–7 to expand 374

Oracle 377 Organisation for Economic Co-operation and

Development (OECD) 130, 137 organizational forms of financiers 302, 306–7 Orser, B. 344 Ottawa 89, 98, 102–5, 107, 109

Venture Capital Fair 103, 105 overconfidence 187–8, 244, 264

Pareto improvements 166 Parhankangas, A. 61, 253–74, 418, 425 pari passu funding 131 partnership agreement 162 Peck, S.W. 298 pensions funds 12, 14, 36, 160, 162

early stage venture capital 269 performance of investments 243

performance 18 corporate venture capital as strategic tool

382–4 determinants 384–6 early stage venture capital 268 fee 162 gap 238–9 implications see innovation and performance

implications of investments 236–51

fund level perspective – returnperformance 244–5

generic issues with industry performancemeasurement 246–50

industry level evidence 245–6see also value drivers

persistence 239–40 prior 262 subjective measures 230, 233

Perry, S.E. 298 Persson, O. 19–20 Peters, H. 333, 338 Phan, P. 302–3 pharmaceuticals industry 396, 398 pioneers in venture capital research 3–62

birth of venture capital 10–11 definition of venture capital 5–10 Europe 13–14 importance of venture capital 3 state-of-the art venture capital research

59–62

United States 11–13 worldwide venture capital 14–15 see also corporate; informal; institutional

planned behaviour theory 335, 344 policy:

capturing 180–81, 182 implications in informal venture capital

market 363–5 -oriented venture capital research 19

Politis, D. 322 population ecology literatures 182 Porter, M. 307 portfolio:

companies 212, 268, 270 size 171 theory 162

Portugal 290, 293 ‘positive organizational scholarship’ view 67,

78–81 post-investment 177

activities 18 involvement 334, 341–3 phase 193–214

content-related issues 203–6process-related issues 206–11see also monitoring and value-added

relationships 99 potential financial distress costs 295 Poulsen, A. 295 Powell, W.W. 97, 101 practice, policy-making and research

implications 415–26 corporate venture capital 420–21 entrepreneurs 424–6 general research 415–17 informal venture capital 419–20 institutional venture capital 417–19 policy-makers 421–4 venture capitalists 424–6

Prasad, D. 322, 336–7 Pratt, S. 255 pre-investment process: decision policies 18,

177–90 conjoint analysis and policy capturing

180–81espoused decisions of venture capitalists 179 theory development and content tested using

experiments 181–3 theory development in process and

experiments 183–9 verbal protocol analysis 179–80

preferred convertible stock 265 PriceWaterhouseCoopers 250 primary seed gap 347–8, 362, 363, 423, 424 private equity 5, 128

Index 437

early stage venture capital 254, 256geographical perspective 108 government policy 128 performance of investments 239, 245, 250 see also private equity and management

buy-outs private equity and management buy-outs

281–308 adding value 307–8 deal characteristics, changes in over time 305 deal generation and antecedents 292–6 definitions of buy-outs 282–4 Europe 289–92 factors influencing 284–7 international aspects 305–6 life-cycle behaviour and organizational

forms of financiers 306–7 monitoring and adding value 300–304 screening and negotiation 296–7 sources 306 structuring 298–300 United Kingdom 288–9 United States 287–8 valuation 297–8 worldwide buy-outs 292

proactive relationship management 405–6 procedural justice theory 73, 207, 272 process-related issues 193–4, 206–11, 213

commitment 210–11 goal congruence 209–10 social interaction 208–9 trust, role of 208

product:attributes 262 feasibility 179 /service characteristics 179 uniqueness 263

proprietary deal flow 240 proprietary products 263 ‘Prudent Man Rule’ 12 public financiers 324 public investor co-investing with private

investors 133 public involvement in private venture capital

141–3 public markets, availability and status of

241 public policies 166–7, 320 public to private transactions 288, 291, 294,

295, 296, 297, 306 public-funded incentives in hybrid funds

131–4

quasi-debt 298 quasi-equity 298

rational model 186 regional aspects 19 regional gaps 86 regulatory environment 242–3 relational capital perspective 394–5 relational dimension 207, 322 relationship orientation 270 relation-specific investments 205 Renneboog, L. 296, 297 reputation 202, 224–5, 240, 264 research 364

and development 120, 302, 374 see also practice, policy-making and research

implications resource:

-based theory 182, 272 dependence theory 194 endowments 194 leveraging motives 377–8

Reynolds, P.D. 114 Richardson, M. 242, 245 Rickards, T. 181 Riding, A. 61, 319, 332–45, 419–20 Rind, K.W. 15, 44–51 Riquelme, H. 181 risk capital, informal 55 risk reduction 265 risks 256, 258, 260 Riyanto, Y. 172–3 Robbie, K. 300 Robinson, R. 265, 317, 319 Rockefeller family 47 Romain, A. 243 Roure, J.B. 177 Ruhnka, J.C. 255, 265 rules of thumb see heuristics Russia 44, 48, 114

S&P 500 245 Sætre, A. 322 Sahlman, W.A. 15, 37–42, 69, 177, 198, 254,

300 Sapienza, H.J. 19, 59, 66–84, 201, 208, 233,

267, 270, 415 Sarbanes-Oxley Act 288 SBA Dun’s Market Identifier data 317 Scandinavia 166, 327

see also Denmark; Finland; Norway;Sweden

Schatt, A. 301 Schildt, H.A. 383 Schoar, A. 163, 164, 239, 240, 245 scholarship and roles of researchers 77–8

see also engaged; positive organizational Schulze, W. 306


Schwienbacher, A. 60, 155–74, 259–60, 270,417

screening 237–8 business angels 335–6, 338 early stage venture capital 262, 264 pre-investment process 178, 180 private equity and management buy-outs

296–7 second-tier stock markets 125 secondary post-seed gap 347–8, 362, 363,

423–4 Securities and Exchange Commission 249 seed stage 255, 256, 258, 260, 264 self-interest 79–80, 81 self-oriented motivation 318 semiconductor industries 401, 402 Seppa, T. 200 serial investors 318, 325, 338 Severiens, H. 359 Sevilir, M. 170 Shane, S. 69, 79, 81, 198 shareholder rights 259 Shepherd, D. 60, 69–70, 177–90, 233, 244, 263,

417 short distance investments, dominance of

90–91Siegel, D. 301–2 Siegel, R. 373, 384 Siemens 47 signaling theory 322–3

business angels 324, 336–7 corporate venture capital 386 early stage venture capital 272 structure of venture capital funds 169–70

Silicon Valley 11, 97, 102, 106, 107 Band of Angels 359 government policy 116, 121

Silver, D.A. 373 Simon, M. 189 Singapore 14, 44, 261, 316, 318, 352

Business Angel Network Southeast Asia(BANSEA) Mentoring Program 352

Singh, H. 295 Small Business Administration 12 Small Business Investment Companies 12, 51,

131, 156 Smart, G. 74, 180, 183 Smith, A. 298, 302 Smith, D.F. Jr 97, 101 Smith, D.G. 264 snowball sampling 317 social capital 322 social environment 212 social interaction 207, 208–9 Söderblom, A. 122

software companies 398 Sohl, J.E. 61, 347–67, 420, 423–4

business angels 320, 323, 324 government policy 118, 135, 136, 141 investment decisions by business angels 333,

335, 336 Sorenson, O. 101 Sørheim, R. 318 source of funding 256 sourcing of potential deals and first

impressions 334, 343 South Africa 261 South America 144 Spain 261, 290, 291, 292, 293 spatial clustering of firms 96–7 staged capital infusions 241, 265 staged investing 197 Stark, M. 339 start-up stage 255, 256, 257 state-of-the art venture capital research 59–62 Stedler, H. 333, 338 Stein, J.C. 298, 303 Stevenson, H. 37–8, 41, 80, 244–5 stewardship theory 80, 199 stock market 14 strategic goals 374 strategic objectives 374, 375 strategic role 201 strip financing arrangement 282 Strömberg, P. 197, 239, 240, 241, 300 structural dimensions 207, 322 structure of venture capital funds 155–74

financial returns (direct and indirect) 172–3 future research directions 173–4 government venture capital funds 165–9 institutional venture capital markets

development 156–60 investment types and value-added service

171–2 limited partnerships 160–65

structuring of investments and investmentportfolios 264–5

structuring in private equity and managementbuy-outs 298–300

Stuart, T.E. 101, 402 style drift 164, 171–2 ‘super-angels’ 91 supply of opportunities 285 supply side factors 127, 341, 345 Surlemont, B. 243 Sweden 13, 16, 52, 261, 289, 290, 293, 350

business angels 316, 317, 318, 324 geographical perspective 87–8

Sweeting, R. 208, 266 Switzerland 226, 261, 290, 293

Index 439

Sykes, H.B. 373, 384–5 syndication 18, 101, 205, 237–8, 265

business angels 326 early stage venture capital 270

Taiwan 14 tax 125

hypothesis 294 incentives 53–4 law variations 270

technology boom 43 Technology Capital Network 58, 357 technology clusters 102–5, 107 telecommunications industry 396, 399, 402 temporal variations 260, 262 Thompson, S. 302 Thomson Financial: Venture Expert Database

106–7 Thurik, A.R. 126 timing 177, 239–40

of cash flows 134 preferred 399–400

Timmons, J.A. 6–7, 16, 31, 34, 121, 226, 227,254, 264

Titman, S. 295 Toms, S. 289 transaction cost hypothesis 294 transaction-based analyses 395 trust 207, 208, 322

business angels and investment decisionmaking 338, 339, 340

calculative 405 informal venture capital market 358 relational 405–6

Tyebjee, T.T. 15, 21–6, 27, 177, 179, 253–4

uncertainty 269 under-investment 199 undervaluation hypothesis 295 United Kingdom 13, 14, 16, 53, 54

3i 13, 131 Advantage Business Angels 359 Alternative Investment Market 13 business angels 316, 317, 318, 319, 320, 327,

337, 338, 342 Business Enterprise Scheme see Enterprise

Investment Scheme Business Start-Up Scheme see Enterprise

Investment Scheme Cambridge 97, 102 corporate venture capital 373–4 Department of Trade and Industry Informal

Investment Demonstration Projects 350 early stage venture capital 261, 263, 270 Enterprise Capital Fund 138

Enterprise Investment Scheme 137–8 geographical perspective 87, 88–9, 91, 92,

93–4, 95, 96 government policy 114–15, 117–18, 120,

126–7, 130–32, 135, 137 High Technology Fund 134–5 informal venture capital market 349–50 Local Investment Networking Company

349–50, 354 London Business Angels 139, 359 Macmillan Committee on Finance and

Industry 320 post-investment phase 201 private equity and management buy-outs

281, 284–6, 287–90, 292–3, 295–304 regional venture capital funds 134, 135, 136 Scottish Co-Investment Fund 139, 365 Scottish Enterprise Business Growth Fund

365 Small Business Service: Early Growth Fund

139 structure of venture capital funds 160, 162,

166, 171 Venture Capital Trust 93, 168

United Parcel Service 381 United States 3–7, 10–15, 23, 25, 38, 40–41, 43,

46, 50, 52–4 128 Innovation Capital Group 357 Angels Forum 359 BlueTree Allied Angels 359 Boston Chamber of Commerce 11 business angels 315, 317–18, 320, 323–5,

327, 336, 338 Civilian Research and Development

Foundation 48 corporate venture capital 372, 383, 387, 396,

401, 407 early stage venture capital 253–4, 258, 260,

261, 267, 269–70 eCoast Angels 358 Funding Match 360 geographical perspective 87–91, 93–7, 99,

101, 103–5, 108 government policy 115, 122, 124, 126, 128,

130–31, 135, 137, 139, 142–3 informal venture capital market 348–9, 357,

358, 361 innovation and performance implications

221, 225 Mid Atlantic Angel Group 360 National Venture Capital Association 245 New England Industrial Development

Corporation 11 performance of investments 238–9, 241, 246,

247, 249


post-investment phase 197, 198, 201, 212 Power of Angel Investing 364 pre-investment process 182 private equity and management buy-outs

282, 287–8, 295, 297–8, 301–3, 305–6 Robin Hood Ventures 360 SBIC 133, 166 Small Business Administration 131, 167,

316 Small Business Innovation Research

Programme 167, 168 structure of venture capital funds 155, 159,

160, 164, 165, 172 Tech Coast Angels 359 Venture Capital Network 350 Walnut Ventures 358 see also Silicon Valley

university spin-outs 257

valuation 269, 270, 297–8, 340 early stage companies 247–8 methods 263 processes 263

value drivers 237–44 decision making processes 243–4 environmental factors 241–3 venture capital-controlled investment factors

237–41 value-added see added value Van de Ven, A.H. 75–8, 415 Van Osnabrugge, M. 79, 135

business angels 317, 319, 321 investment decisions by business angels 332,

333, 337, 338, 341 Van Pottelsberghe de la Potterie, B. 243 Venkataraman, S. 108–9 venture capital limited partnerships 156, 158,

161, 168, 169, 171, 172 Venture Capital Network 54, 58

informal venture capital market 348–9,356

see also Technology Capital NetworkVenture Economics 18, 31, 33, 35, 250

venture growth 230–31 venture outcomes 231–2, 233 venture team 179 venture-specific learning 376 verbal protocol analysis 178, 179–80, 181 Villanueva, J. 19, 59, 66–84, 415 ‘virgin angels’ 318, 325, 326 von Burg, U. 227

Wadhwa, A. 385 Walz, U. 303 Warga, A. 295 Wassermann, N. 269 wealth transfer from other stakeholders

hypothesis 295 Weir, C. 295–6, 297 Weiss, K. 224 Welch, I. 295 Wells, P. 142, 160, 241, 242, 243 Westinghouse 43 Wetzel, W.E. Jr 8, 15, 51–2, 53, 54–9, 90,

315–17, 327, 341, 356 Wiklund, J. 122 Williams, T. 298 Winchester Disk Drive 37–8, 41 Winters, T.E. 373 Wizman, T. 295, 302 Wong, C.F. 266 worldwide buy-outs 292 worldwide venture capital 14–15 Wright, M. 16, 61, 281–308, 418–19 Wrigley, N. 108 Wu, T.W. 295

Xerox Corporation 43, 44, 47

Yahoo! 100 Young, J.E. 255, 265 Young, S. 404

Zacharakis, A. 60, 177–90, 244, 263, 417 Zahra, S. 62, 301, 393–410, 421 Zook, M.A. 97, 99–100, 108

Index 441

handbook of venture capital

Documents