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HANDBOOK OF RESEARCH ON VENTURE CAPITAL

Handbook of Research on Venture


Capital

Edited by

Hans Landström
Institute of Economic Research, Lund University, Sweden

Edward Elgar
Cheltenham, UK • Northampton, MA, USA
© Hans Landström 2007

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

Published by
Edward Elgar Publishing Limited
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Montpellier Parade
Cheltenham
Glos GL50 1UA
UK

Edward Elgar Publishing, Inc.


William Pratt House
9 Dewey Court
Northampton
Massachusetts 01060
USA

A catalogue record for this book


is available from the British Library

Library of Congress Control Number: 2007921138

ISBN 978 1 84542 312 4 (cased)

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

List of contributors vii


Foreword ix
Acknowledgements x

PART I VENTURE CAPITAL AS A RESEARCH FIELD

1 Pioneers in venture capital research 3


Hans Landström
2 Conceptual and theoretical reflections on venture capital research 66
Harry J. Sapienza and Jaume Villanueva
3 Venture capital: A geographical perspective 86
Colin Mason
4 Venture capital and government policy 113
Gordon C. Murray

PART II INSTITUTIONAL VENTURE CAPITAL

5 The structure of venture capital funds 155


Douglas Cumming, Grant Fleming and Armin Schwienbacher
6 The pre-investment process: Venture capitalists’ decision policies 177
Andrew Zacharakis and Dean A. Shepherd
7 The venture capital post-investment phase: Opening the
black box of involvement 193
Dirk De Clercq and Sophie Manigart
8 Innovation and performance implications of venture capital involvement in
the ventures they fund 219
Lowell W. Busenitz
9 The performance of venture capital investments 236
Benoit F. Leleux
10 An overview of research on early stage venture capital: Current status and
future directions 253
Annaleena Parhankangas
11 Private equity and management buy-outs 281
Mike Wright

PART III INFORMAL VENTURE CAPITAL

12 Business angel research: The road traveled and the journey ahead 315
Peter Kelly
13 Investment decision making by business angels 332
Allan L. Riding, Judith J. Madill and George H. Haines, Jr

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vi Handbook of research on venture capital

14 The organization of the informal venture capital market 347


Jeffrey E. Sohl

PART IV CORPORATE VENTURE CAPITAL

15 Corporate venture capital as a strategic tool for corporations 371


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

PART V IMPLICATIONS

17 Implications for practice, policy-making and research 415


Hans Landström

Index 427
Contributors

Stephen A. Allen, Babson College, USA


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

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viii Handbook of research on venture capital

Mike Wright, Nottingham University Business School, UK


Andrew Zacharakis, Babson College, USA
Shaker A. Zahra, Center for Entrepreneurial Studies, Carlson School of Management,
University of Minnesota, USA
Foreword

In today’s modern economy a country’s or region’s competitiveness lies in its capability to


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

Anders Lundström
Swedish Foundation of Small Business Research (FSF)

Sune Halvarsson
Swedish Agency for Economic and Regional Growth (NUTEK)

ix
Acknowledgements

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

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Acknowledgements xi

comments on my chapters. In addition, I am grateful to Professor Olle Persson at Umeå


University for helping me with the bibliographical analysis of the research field.
Finally, a special thanks to Francine O’Sullivan at Edward Elgar Publishing for inviting
me to be the editor of the handbook, and for her excellent support throughout the process.

Hans Landström
Institute of Economic Research School of Economics and Management
Lund University, Sweden
PART I

VENTURE CAPITAL AS A
RESEARCH FIELD
1 Pioneers in venture capital research
Hans Landström

Introduction

The importance of venture capital


We need growth-oriented entrepreneurial ventures in society. These ventures represent an
important power in an economy – they create innovations and dynamics, new jobs, income
and, not least, wealth. Although growth-oriented entrepreneurial ventures, or what Birch
(1987) calls ‘gazelles’, can be found in all industry sectors and locations (urban as well as
rural), there are some indications that the ventures with the highest growth potential are
often characterized as knowledge-based and technologically driven – primarily based on
intangible assets, operating in rapidly developing fields and with no documented history.
One of the main problems facing these growth-oriented entrepreneurial ventures is raising
capital for the growth of the business and gaining access to the competence, experience and
networks necessary for growth which most entrepreneurs lack (Brophy, 1997). It is in this
domain of growth-oriented entrepreneurial activities that we need an efficient venture
capital market that can provide adequate capital and management skills. For example, it has
often been argued that the scope and sophistication of the US venture capital industry is
one reason for the exceptional ability of the US economy to turn innovative ideas from 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 it
essential to understand the way the venture capital market operates, and how business
angels and venture capitalists manage their investments. In this book we will summarize
and synthesize the knowledge in the area of venture capital: what do we know? what do
we not know? And what can we learn from existing knowledge (or lack of knowledge)?

The aims of the book


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

3
4 Handbook of research on venture capital

80
70
60
50
40
30
20
10
0
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

Figure 1.1 Number of articles on venture capital

In this state-of-the-art book we will try to summarize and synthesize 25 years of venture
capital research. In addition, our aim is to communicate new and future directions of our
knowledge to scholars, venture capitalists, entrepreneurs and policy-makers, in order to
increase the understanding of the venture capital phenomenon.
Some comments regarding the content of the book will first be made to help the reader.
If we look at our knowledge on venture capital, we can conclude that most venture
capital research concerns the supply side of the market (from the investor perspective)
whereas little work can be found on the demand side – related to the decision-making
processes of ventures seeking venture capital. Obviously, this state-of-the-art book –
which attempts to summarize and synthesize existing knowledge within the field – reflects
this bias.
Second, in a citation analysis performed by Cornelius and Persson (2004; 2006) it
was revealed that the venture capital research community was divided into two sepa-
rate clusters of researchers. With the exception of some very important core authors
within the field who are generally cited (such as William Sahlman, Paul Gompers and
William Bygrave), there seems to be surprisingly little intellectual cross-fertilization
between the two clusters. One cluster of researchers has a background in finance and
economics and mainly analyses venture capital on a macro level, using, for example,
agency theory, capital market theory, and so on as theoretical frameworks in their
studies, which are published in financial and economics journals. Another cluster of
researchers has its roots in management and entrepreneurship research and thus has a
stronger managerial focus on venture capital with more heterogeneity in the research
paradigms employed. These researchers publish their works in entrepreneurship man-
agement journals. The present book focuses on the managerial aspects of venture
capital – although several chapters in the book also cover more aggregated discussions
concerning the development of the market, regional aspects of venture capital, and
policy implications.
Finally, there is a geographical bias in our knowledge about venture capital. Since the
emergence of the research field in the 1980s, venture capital has been regarded as a US
phenomenon dominated by Anglo-Saxon (mainly US) researchers – and this has contin-
ued, in spite of increased interest on the part of scholars all over the world since the 1990s.
Pioneers in venture capital research 5

As a consequence, our knowledge is heavily influenced by the US context and model of


venture capital. However, not only is US research dominant; as venture capital has a 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 derived
from dynamic regions such as Silicon Valley and Boston. As this is a state-of-the-art book,
these geographical biases will be reflected. However, we have tried to select authors from
different parts of the world and have asked them to consider venture capital as a global
phenomenon.

Venture capital – what are we talking about?


Venture capital is a specific form of industrial finance – part of a more broadly based
private equity market, that is investments (with private equity) made by institutions, firms
and wealthy individuals in ventures that are not quoted on a stock market, and which have
the potential to grow and become significant players on the international market (Mason
and Harrison, 1999a; Isaksson, 2006). The private equity market can be divided into two
different parts (although the distinction is not always easy to make):

1. Venture capital, which is primarily devoted to equity or equity-linked investments in


young 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 exit
rather than by means of dividend income.
The venture capital market consists of different submarkets, and in this book we will
focus on three of them: institutional venture capital, corporate venture capital, and
informal venture capital.

Institutional venture capital It is not an easy task to provide a generally accepted defin-
ition of institutional venture capital (also called ‘formal venture capital’) – the number
of definitions is almost as great as the number of authors writing articles on the subject.
Institutional venture capital firms act as intermediaries between financial institutions
(such as large companies, pension funds, wealthy families, and so on) and unquoted
companies, raising finance from the former to invest in the latter (Lumme et al., 1998).
Wright and Robbie (1998) defined institutional venture capital as professional invest-
ments of long-term, unquoted, risk equity finance in new firms where the primary
reward is eventual capital gain supplemented by dividends. Elaborating on this defin-
ition, Mason and Harrison (1999a, p. 16) stated that ‘the institutional VC industry
comprises 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 independent
limited partnerships.’
6 Handbook of research on venture capital

As indicated in the definition by Mason and Harrison, an institutional venture capital


firm can take different organizational forms, depending on the ownership structure, but
usually consists of:

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

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

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

INVESTOR
Returns Fundraising

VENTURE
CAPITALIST

Equity Cash
VENTURE

Figure 1.2 The venture capital process


Pioneers in venture capital research 7

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

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

Corporate venture capital One distinguishable part of the institutional venture capital
markets is ‘corporate venture capital’ as a ‘captive’ venture capital organization. Maula
(2001) defines corporate venture capital as ‘equity or equity-linked investments in young,
privately held companies, where the investor is a financial intermediary of a non-financial
corporation’ (p. 9). Thus, the main difference between institutional venture capital and
corporate venture capital is the fund sponsor – in corporate venture capital the only
limited partner is a corporation, or a subsidiary of a corporation.
Corporate venture capital should be seen as a specific strategic tool in the corporate
venture toolbox. There are many other tools that can be used in order to develop new busi-
ness, and Maula (2001) distinguishes between (i) internal corporate venture, in which
innovations and new businesses are developed at various levels within the boundaries of
the firm, and (ii) external corporate venture, which results in the creation of 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 used
as a tool for strategic considerations and business development, together with other tools
such as venture alliances and acquisitions.
Following this reasoning and using a rather broad definition, McNally (1994) states
that corporate venture capital can take two main forms: externally managed investments,

Table 1.1 Corporate venture capital

Corporate Venture Capital


Type of investment 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’ from
company

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


8 Handbook of research on venture capital

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

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

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

Informal Comprised of private individuals who invest risk


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

Informal Defined as any investments made in start-ups other


investors, than the investors’ own businesses, i.e. including
including family investments, investments by friends,
Broad family and colleagues, etc., but excluding investments in stocks
definition friends and mutual funds (Reynolds et al., 2003).

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


Pioneers in venture capital research 9

connections’ (p. 137). This definition of informal investors includes not only investments
by business angels but also those made by private investors who are less active in the ven-
tures in which they invest as well as private investors who invest smaller amounts of
capital in unlisted companies. On the other hand, the definition excludes investments
made by ‘family and friends’, and this perspective is not uncontroversial. For example, in
the large international research project Global Entrepreneurship Monitor, investments
made by ‘family and friends’ are included in the study of informal investments in different
countries (Reynolds et al., 2003). However, a central argument in the definition by Mason
and Harrison (2000a) is that investments made by close relatives and friends are based on
other considerations and investment criteria than those of external investors and, 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) the
broader definition of ‘informal investors’, and (iii) also including investments made by
family and friends. In empirical studies, the terms ‘business angels’ and ‘informal investors’
are sometimes used to distinguish one from the other, but more often are interchangeable.
Needless to say, this lack of rigour makes empirical studies on informal venture capital
difficult to interpret and compare. Business angels and other types of informal investors
differ significantly – in the way they make decisions, their ability to add value, and so on,
and there is a need to divide the informal venture capital market into relevant segments.

A comparison between three sources of venture capital An overview of the similarities and
differences between institutional venture capital, business angels and corporate venture
capital is an appropriate way in which to conclude this discussion about the definition and
different sources of venture capital. The overview (Table 1.2) shows that different sources
of venture capital seem to represent partially complementary and partially overlapping
sources of finance: complementary in the sense of investment in different venture devel-
opment phases and the amount of capital provided; overlapping in that each category of
investors makes investments in a broad range of ventures.
As can be seen in Table 1.2, institutional venture capital, business angels and corporate
venture capital seem to have some distinctive characteristics. Obviously, the source of
funds and legal status differ, as do the investment motives – all venture capitalists have
some form of financial motive (and even if intrinsic rewards are evident among business
angels, there are also financial reasons for the investment), although corporate venture
capitalists place greater emphasis on strategic considerations. Investment and monitoring
differ, and especially it is the business angels that distinguish themselves in that their
investment capacity and time for due diligence are much more limited; also they have a
much more informal control process compared to institutional and corporate venture
capitalists.
A final comment needs to be made regarding the definitions of venture capital. The field
of venture capital is characterized by vague definitions and a great deal of confusion
regarding central concepts. Of course, unclear definitions make knowledge accumulation
more difficult, and many authors who contributed chapters to the handbook call for
clearer and consistent definitions within the field. However, we do not consider it the aim
of this book – which outlines past and present research on venture capital – to provide
such authoritative recommendations on definitional issues, although in order to develop
10 Handbook of research on venture capital

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

Institutional venture Corporate venture


capital Business angels capital
Source of funds Primarily institutional Investing their own Investing corporate
investors who act as money funds
limited 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 within
industry/technology
Large investment Limited investment Large investment
capacity capacity capacity
Extensive due Limited time for due Extensive due
diligence diligence diligence
Monitoring Formal control Informal control Corporate control

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

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

Reality and research


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

The birth of venture capital


Venture capital as a phenomenon is a very ancient activity. Private individuals have always
had a tendency to invest in high-risk projects. Examples of entrepreneurs raising capital
from private financiers can be found in the Babylonian era as well as in early medieval
Europe. One extraordinary example is the decision by Queen Isabella of Spain to finance
the voyage of Christopher Columbus, which can be regarded as a highly profitable (for the
Spanish) venture capital investment. It could also be argued that in many countries the
investments by private individuals were influential in the development of the industrial
revolution during the nineteenth and the early twentieth century. For example, in the US,
Pioneers in venture capital research 11

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

The development of venture capital in the US


Although the venture capital phenomenon can be regarded as a very ancient activity,
the venture capital industry grew slowly. The market was fragmented and geographically
12 Handbook of research on venture capital

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

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

The tremendous growth of the venture capital industry in the 1980s caused fundamental
changes in the structure and function of the industry. Venture capital firms increased both
in number and size and, as a consequence, the market showed increased heterogeneity
Pioneers in venture capital research 13

across firms, and greater specialization in investment stage, industry and region. Venture
capitalists changed their strategy – and moved towards later stage and larger investments
(Bygrave and Timmons, 1992; Timmons and Sapienza, 1992).
After this period of growth in the US venture capital industry, the development during
the 1980s and 1990s was characterized by ‘ups’ and ‘downs’. In the mid-1980s, the returns
on venture capital funds started to decrease, basically due to over-investment in various
industries and the entry of inexperienced venture capitalists, thus investors became
disappointed with lower returns and fund raising as a consequence. The end of the
1980s was characterized by a drop in venture capital and a ‘shake-out’ in the industry, and
the number of venture capital firms declined. Venture capitalists tended to invest in later
stages, and specialization and differentiation of investment strategies continued (Timmons
and Bygrave, 1997).
There was renewed interest at the beginning of the 1990s – due to new possibilities on
the initial public offerings (IPO) market and the exit of many experienced venture cap-
italists (Gompers and Lerner, 2003). The industry ‘shake-out’ consolidated and stabilized
the market. Returns had improved – mainly due to a robust IPO market. However, we
must bear in mind that the venture capital industry was still heavily concentrated in a few
geographical areas in the US and could be regarded as fairly limited. Despite an overall
improvement in the US venture capital industry, the total investment made by venture
capitalists never exceeded $6 billion until 1996, and it was the end of the 1990s before the
market really showed exceptional growth. In the year 2000 the total investment spending
reached an astonishing $102 billion, and the average investment was about $18 million per
company. Since then, the venture capital market in the US has declined due to the dot.com
crash (Megginson and Smart, 2006), where the drop was more significant than in many
other countries.

The diffusion of venture capital to Europe


For a long time, venture capital was more or less regarded as an American phenomenon.
Even though an emerging venture capital industry in Europe could be found already in
the late 1970s – much earlier we could find individual companies that provided equity
capital to unquoted firms, for example, 3i in the UK, Investco in Belgium and SVETAB
in Sweden. But these companies were rather isolated initiatives, and in general venture
capital was virtually non-existing outside the US during the 1970s. The development of a
European venture capital market mainly took place in the UK, which had just over 20
venture capital funds at the end of the 1970s with a total investment of £20 million. A
little more than a decade later, in 1992, the venture capital industry in the UK had grown
significantly, investing in a total of £1326 million in 1297 ventures (Murray, 1995).
However, it was not until the late 1980s that a more significant venture capital industry
emerged in Europe, and at that point in time its growth outperformed that of the indus-
try in the US – between 1986 and 1990 venture capital in Europe grew from about $9
billion to $29 billion (Bygrave and Timmons, 1992). This growth was associated with the
introduction of secondary stock markets in many countries, which enabled rapidly
growing ventures to make IPOs and venture capitalists to obtain returns on their invest-
ments. A number of secondary stock markets were created, such as the Alternative
Investment Market in the UK, Nouveau Marché in France, and the Neuer Markt in
Germany, and later on a pan-European secondary stock market (EASDAQ). However,
14 Handbook of research on venture capital

most of these markets were unsuccessful due to low levels of trading and liquidity (Lumme
et al., 1998).
When describing the venture capital markets in different countries, it is important to
emphasize that venture capital can differ from one country to another, depending on the
characteristics of the financial markets. For example, Black and Gilson (1998) distinguish
between bank-centred markets such as in Japan and Germany, and stock-market-oriented
markets as in the US. The authors argue that a well-developed stock market and initial
public offerings as well as a high level of private pension fund investments (Jeng and Wells,
2000) are of significant importance for venture capital financing. Differences in the char-
acteristics of the financial market in various countries make venture capital more or less
important, and venture capital operates in different ways.
Following this line of reasoning, we can find several similarities between the venture
capital industries in the US and Europe (Manigart, 1994; Sapienza et al., 1996; Jeng and
Wells, 2000) but also many important differences. For example: (i) venture capitalists in
Europe seem to rely more heavily on investment from financial institutions (banks and
insurance companies) compared to the US, where a great deal of capital comes from
pension funds; (ii) venture capital firms are organized in different ways, for example, in the
US and the UK firms are usually limited partnerships whereas in other European coun-
tries we can find different organizational structures; (iii) historically, European venture
capital has been less focused on early-stage investments compared to venture capitalists in
the US; (iv) active involvement differs across countries – venture capitalists in Europe are
not always as actively involved in managing their investment as their counterparts in the
US; and (v) due to the lack of liquid stock markets for entrepreneurial ventures in many
European countries, the exit strategies have differed and the returns on investments were
lower compared to the US (Jeng and Wells, 2000; Megginson and Smart, 2006).

Venture capital worldwide


It was not until the end of the 1990s, and the boom in the dot.com industry, that we could
really talk about the growth of the venture capital industry worldwide. The total invest-
ments in the US exceeded $100 billion in the year 2000, and the corresponding figure for
Europe is €35 billion (Megginson and Smart, 2006). In addition, the venture capital indus-
try in Asia grew significantly between 1995 and 2000, although less rapidly than in the US
and Europe – mainly due to the moribund venture capital industry in Japan. The most
promising venture capital market in Asia was in India, and to some extent China,
although the latter seemed to lack the basic legal infrastructure needed to support a
venture capital market, and Chinese stock markets have remained inefficient (ibid.).
The Asian market is highly heterogeneous – at one end of the spectrum there are coun-
tries like Japan and Australia with long-established market economies as well as newly
industrialized countries while, at the other, there are countries such as China, India,
Malaysia and Vietnam with emerging market economies (Lockett and Wright, 2002).
However, a general characteristic of the venture capital market in Asia is that the insti-
tutional framework – regulatory and legal as well as the venture capital culture – is not
yet established to support venture capital. In addition, several NASDAQ-type stock
markets have been established, such as the ‘growth markets’ in Hong Kong, Singapore
and Taiwan, but so far they have shown only limited success in funding fast growth firms.
The lack of an institutional framework on many Asian venture capital markets means
Pioneers in venture capital research 15

that venture capitalists have to place more emphasis on employing personal networks to
carry out venture capital operations – indicating that venture capital practice in emerg-
ing markets in Asia diverges somewhat from the Anglo-Saxon model (Ahlstrom and
Bruton, 2006).
Since the 1990s venture capital markets have emerged all over the world. However, the
growth has not been unproblematic – the bursting of the Internet and dot.com bubble at
the end of the 1990s marked a historical peak in terms of capital volume and valuations,
but the market collapse that followed had a major effect on the venture capital market,
not least in the US. As a consequence, the number of venture capital firms declined and
the amount of capital invested decreased dramatically. The dot.com bubble also affected
the behaviour of venture capitalists, who became ‘entrapped in the psychic prison of the
internet bubble’ (Isaksson, 2006).
The market recovered gradually, and in 2006 the size and activities of the US venture
capital market returned to the pre-dot.com level of 1998. The European market is not
much smaller than the US venture capital market, and there are growing venture capital
markets in many Asian countries. We can conclude that venture capital has emerged from
being a source of finance for high growth ventures in the US to a worldwide 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 a
significant source of finance for entrepreneurs in high growth ventures whereas other
countries have less well developed markets in which venture capital still has to prove their
contributions to entrepreneurial ventures.

The pioneers who created the research field


In all emerging fields of research there are always some researchers who appear to have a
greater influence than others – researchers who make a new phenomenon visible, who ask
the interesting questions, who encourage other researchers to explore new and promising
fields – pioneers who open up new areas of research. These pioneers seem to play a major
role in giving direction to the emerging field of research (Crane, 1972).
Venture capital is an old phenomenon and, as shown earlier in this chapter, the insti-
tutional venture capital market was established by the end of the 1940s. However, it was
not until the growth of the venture capital industry in the 1980s that it aroused interest
among scholars. The reason behind this time lag may be the fact that for many years
venture capital was a relatively small industry and, even at the end of the 1980s, the
venture capital industry in the US never exceeded a couple of billion dollars. By all 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 the
1980s, pioneers within the field of venture capital research appeared, such as William
Bygrave at Babson College, William Sahlman at Harvard Business School, Ian
MacMillan at New York University/Wharton School of Business, and Tyzoon Tyebjee
and Albert Bruno at University of Santa Clara, who took an interest in the institutional
venture capital market. There was also Kenneth Rind with experience as an active cor-
porate venture capitalist in New York, and William Wetzel at the University of New
Hampshire who researched the business angels market, and all these researchers were geo-
graphically located near the dynamic venture capital markets around Silicon Valley/San
Francisco, Boston and New York.
16 Handbook of research on venture capital

The subsequent emergence of the venture capital industry in Europe aroused interest
among scholars during the early 1990s, especially in countries with an early and dynamic
venture capital industry. For example, early research contributions were made by Mike
Wright, Richard Harrison and Colin Mason in the UK, Sophie Manigart in Belgium, and
Christer Olofsson in Sweden.
The exponential growth of venture capital worldwide at the end of the 1990s and 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 of
Entrepreneurial Finance in 1999 – which was mainly dedicated to venture capital research.
There was also an increased number of contributions on venture capital from Asia. In
many cases, these studies were conducted by Anglo-Saxon researchers in collaboration
with domestic partners.
The remainder of the chapter will highlight the contributions of the pioneers within the
field of venture capital. My objective is not only to provide an insight into the key 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, based
on my own subjective view. However, the scope of research on institutional, corporate and
informal venture capital differs, which is reflected in the space each part of the venture
capital market is given regarding the pioneers as well as in the book in general.

Research on institutional venture capital

Some early contributions


In 1981 Jeffry Timmons wrote that research on venture capital by academics was practic-
ally non-existent, which was true at that point in time for rather self-evident reasons – the
venture capital industry was still small and rather insignificant for the majority of high
growth firms as well as for economic development in a more general sense. However, we
can find some pioneering contributions to the research on venture capital as early as the
1950s. The first PhD thesis on the topic of venture capital, entitled ‘Corporate profits and
venture capital in the post-war period’, was written by Hussayni in 1959 and published at
the University of Michigan. However, it was during the 1960s and 1970s that new topics
emerged in venture capital research (Brophy, 1982; 1986; Timmons and Bygrave, 1986).
One of the earliest interests in venture capital in the 1960s came from scholars in the
field of management through works on entrepreneurship who became interested in the
characteristics of new technology-based firms, and the problem of external financing in
these ventures (see for example early contributions by Shapero, 1965; Roberts, 1969;
Cooper, 1971; von Hippel, 1973). In addition, these management scholars stimulated a
series of studies on the financing of growth-oriented companies seen from the 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 as
MS theses at MIT in Boston and can in many cases be regarded as ‘one shot’ studies,
whose authors did not develop a sustained body of work in the field.
Another research strand came from scholars in the field of finance who, especially in
the 1970s, became interested in venture capital. For many years, knowledge of equity
markets in finance theory has been well developed. These theories were typically oriented
Pioneers in venture capital research 17

towards equity finance of large publicly traded companies. However, venture capital was
different in several respects; venture capital invested in young firms with little performance
history, the relationship between investor and investee was characterized by a higher
degree of involvement and the investments were often illiquid in the short term due to the
lack of efficient exit markets. As a consequence, there was an open field for theory devel-
opment – trying to apply financial models to venture capital, and researchers also
addressed 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 decision
to the exit of the investment. Throughout the 1970s attention was devoted to examining the
investment and screening process from the venture capitalist’s point of view – a supply per-
spective (see for example Briskman, 1966; Aggarwal, 1973; Wells, 1974) – and most of the
studies confirmed the general belief that the quality of the entrepreneur/founding team and
the marketability of the idea are central for success. Another issue of interest in venture
capital research was the performance of venture capital investments, and in several studies
the annual rate of returns on these investments was calculated (see for example Faucett,
1971; Wells, 1974; Hoban, 1976; Poindexter, 1976; Dorsey, 1977; Huntsman and Hoban,
1980; DeHudy et al., 1981). The conclusions that can be drawn from these studies were that
it was difficult to find reliable data and the results of the studies were highly varied.
Methodologically, most of the research at this time was based on anecdotal data and/or
survey studies using small samples, and venture capitalists were not always willing to provide
information that could be made public – factors that made the research less reliable.

The emergence of research on institutional venture capital


As the venture capital industry grew in scope and importance during the 1980s, interest
among scholars increased. A main point of departure was that venture capital concerned
‘building businesses’ and no single discipline could claim to possess sufficient knowledge to
provide complete understanding of this process. Therefore, a number of scholars, from
different disciplines – mainly management and entrepreneurship as well as from the field of
finance and economics – ‘rushed’ into this emerging topic – providing different concepts and
methodological approaches in order to understand venture capital finance. Thus, one such
group had a background in management and entrepreneurship and focused their attention
on the venture capital process (from fund raising, pre-investment activities, to exit of the
investment) from a managerial point of view – a micro-level focus – or what we will call
‘managerial-oriented venture capital research’. Several pioneering studies were presented in
the 1980s, and some examples are given in Table 1.3. It should be emphasized that the 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 the
venture capital market – a macro-level focus – trying to analyse and understand the flow
of venture capital, its role in the development of new industries, regional aspects of
venture capital, and so on – or what we will term ‘market-oriented venture capital
research’. Some of the pioneering studies of the 1980s are presented in Table 1.4.
As noted by Sapienza and Villanueva in Chapter 2 of this book, the early contributions
to venture capital research can be characterized as highly descriptive, where the researchers
primarily aimed to document a more or less unknown phenomenon. As such, early research
18 Handbook of research on venture capital

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 of
Business Venturing, 2, 123–37.
Venture capital Robinson (1987), ‘Emerging strategies in the venture capital
investment 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 of
venture capital firms’, Journal of Business Venturing, 3, 137–57.
Governance and Sahlman (1990), ‘The structure and governance of venture-capital
contracting 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 building
entrepreneurial companies: Do the venture capitalist add value?’,
in Brockhaus et al. (eds), Frontiers of Entrepreneurship Research,
Wellesley, MA: Babson College, 245–57.
Success factors, returns Bygrave et al. (1989), ‘Early rates of returns of 131 venture
and performance capital funds started 1978–1984’, Journal of Business Venturing,
4 (2), 93–105.

has been extremely useful in that it has not only contributed to a deep understanding of the
industry and the way in which venture capitalists operate, but also provided a sound base
for further theory building. The ‘descriptive’ period of venture capital research during the
1980s was followed by a growing interest in more theory-driven venture capital research.
Before discussing the development of venture capital research during the 1990s, I will
comment on the importance of databases in this regard. A contributing factor in the
emerging interest in venture capital among researchers was the fact that data on venture
capital became available not least from sources such as Venture Economics. Venture
Economics gathered data from venture capital firms regarding their investment activities,
and the information was published monthly in the Venture Capital Journal. But there were
Pioneers in venture capital research 19

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–lender
financial 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 in
allocation 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 in
capitalism: A case study of the US biotechnology industry’,
Research Policy, 15, 21–31.
Regional aspects of Florida and Kenney (1988), ‘Venture capital and high technology
venture capital entrepreneurship’, Journal of Business Venturing, 3, 301–19.
Martin (1989), ‘The growth and geographical anatomy of venture
capitalism in the United Kingdom’, Regional Studies, 23, 389–403.
Policy-oriented venture Timmons and Bygrave (1986), ‘Venture capital’s role in financing
capital research innovation for economic growth’, Journal of Business Venturing,
1, 161–76.

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

Theoretical background
Management and Finance and
Entrepreneurship Economics
Main focus
Examples: Examples:
Jeffry Timmons, William Paul Gompers, Josh Lerner,
Macro Bygrave, Gordon Murray Raphael Amit, Thomas
Hellman, Bernard Black,
Ronald Gilson, Leslie Jeng,
Philippe Wells
Level of
analysis Main focus
Examples: Examples:
William Bygrave, Harry Paul Gompers, Josh Lerner,
Sapienza, Lowell Busenitz, Mike Wright, Raphael Amit,
Micro Jeffry Timmons, Anil Gupta, James Fiet, Anat Admati, Paul
Andrew Zacharakis, Dean Pfleiderer
Shepherd, Sophie Manigart,
Vance Fried, Robert Hisrich

Figure 1.4 Researchers on institutional venture capital

Many important contributions to venture capital research were made during the 1990s,
and it would be impossible to choose two or three that could be regarded as more impor-
tant than the others. However, in Figure 1.4 I will present some of the leading scholars
within the field during the 1990s – researchers who showed a growing interest in theoret-
ical understanding of the venture capital phenomenon and used more sophisticated
methodological approaches.
One conclusion that can be drawn from the study by Cornelius and Persson (2004; 2006)
is that there are two different clusters that seldom meet or cite each other’s work. In order
to develop our knowledge of institutional venture capital, I believe it is necessary to encour-
age cross-fertilization between these two clusters of researchers. The building of a social
structure among researchers within the field goes hand in hand with the cognitive develop-
ment of the research. For example, it is important to develop a ‘cognitive style’ that includes
a professional language and clear definitions of central concepts within the field of venture
capital. In order to establish this cognitive style, it is essential to develop a ‘social culture’
within the field, which requires regular and intensive forums for discussions, where infor-
mal communication between researchers is of central importance. Informal networks are a
prerequisite 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 informal
international networks – promoting cross-fertilization within venture capital research.

Pioneers of institutional venture capital research


In this section I will present some of the pioneers of institutional venture capital research:
Tyzoon Tyebjee, Ian MacMillan, William Bygrave and William Sahlman. I will provide a
short summary of the seminal articles of each pioneer, followed by an interview with each
Pioneers in venture capital research 21

of them in order to present their reflections on their own contribution to knowledge, as


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

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

BOX 1.1 TYZOON TYEBJEE

Born: 1945
Career
1977 – Leavey School of Business,
Santa Clara University, USA
Professor of Marketing
1975–1977 Wharton School, University of Pennsylvania
Education
1976 PhD in Marketing
University of California, Berkeley
1972 MBA in Marketing
University of California, Berkeley
1969 MS in Chemical Engineering
Illinois Institute of Technology, Chicago
1967 B Tech in Chemical Engineering
Indian Institute of Technology, Bombay

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

comprised a telephone survey of 46 venture capitalists in California, Massachusetts and


Texas, while in the second, Tyebjee and Bruno used Pratt’s directory of venture capital
(1981) to identify 156 venture capital firms, 41 of which participated in the study. The
venture capitalists were sent a questionnaire for the purpose of evaluating deals under
consideration by the firm, and 90 completed evaluations were returned. On the basis of
the studies a venture capital process model was developed, in which the investment
process was described as consisting of five phases: (1) deal origination; (2) screening;
(3) evaluation; (4) deal structuring; and (5) post-investment activities. The authors par-
ticularly focused on the evaluation phase in which venture capitalists assess a new venture
proposal based on a multidimensional set of characteristics.
The venture capitalists who participated in the study were asked to rate deals that had
passed their initial screening according to 23 decision criteria. Based upon a factor analy-
sis Tyebjee and Bruno concluded that venture capitalists evaluate deals in terms of five
basic 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 to
subjective 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 on
the risk associated with the deal – a lack of managerial capabilities significantly increases
the 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 were
rejected. A discriminant analysis was used to examine whether the level of perceived risk
and return could be used as a means of distinguishing between rejected and accepted
deals. According to the results of the study, the decision to invest is determined by the risk
versus return expectations, and venture capitalists seem to be profit oriented and averse
to risk, although they are willing to invest in risky deals if the risk involved is offset by the
profit potential.
As indicated above, this seminal work by Tyzoon Tyebjee and Albert Bruno is one of
the most cited articles within venture capital research and forms the basis for many of the
studies that constituted a strong research stream within venture capital research during
the 1990s on the criteria used by venture capitalists when assessing new deals.

Interview with Tyzoon Tyebjee

What attracted your interest in venture capital and venture capital decision-making?
I studied engineering and came to the US from India in the late 1960s to take my gradu-
ate degree. Following some work as an engineer, I decided to go to business school, and
in pursuing a PhD I specialized in the area of marketing, in particular consumer choice
behaviour. After a brief stay in the faculty at Wharton Business School I joined Santa
Clara University. At Santa Clara University, in the heart of Silicon Valley, my interests in
business, and my former interest in engineering and technology really came together,
because I was now in an environment where the commercialization of technology played
a very significant role. So, it was not a big issue for me to go into the area of venture
capital, but my interest was really sparked by some funding which was made available by
the National Science Foundation in order to carry out research on what was then a
Pioneers in venture capital research 23

relatively young industry. My co-author Albert Bruno and I received a fairly large amount
of funding for the project.
The interest of the National Science Foundation was actually a little different from our
interests. The government wanted to know what happened to ventures that received no
funding . . . in other words, was the venture capital market efficient in terms of recogniz-
ing strong opportunities, or were some commercially viable opportunities ignored by the
venture capital industry, and if so, did these ventures find alternative sources of funding?
My personal interest was to try to introduce consumer choice behaviour and apply choice
behaviour models to how venture capitalists made choices.

Your study was published in Management Science and became one of the truly seminal
articles within the field of venture capital research . . .
At that time there was very little published work on venture capital in mainstream 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. I
think one of our significant contributions was the legitimization of both area and topic
by modelling them in a way that gave them academic credibility and, in this regard, the
aspect of the study that focused on venture capital decision-making and venture capital
choice behaviour was a piece that really lent itself best to serious modelling.

You have followed the development of the venture capital industry for a long time. What
changes in venture capital have taken place since the 1980s?
I think a couple of things have happened in the venture capital market in the US. One is
that there is a much greater number of venture capitalists today who were actually entre-
preneurs themselves . . . people who have been through the start-up process themselves
and, as a result, they are not just financiers, they are people who bring operational exper-
tise. Having said that, the venture capital industry has become more professional with less
reliance on pure instinct, far more analysis, far more financial models applied to valua-
tion, resulting in a significant improvement in technical skills within the venture capital
decision-making process.
In addition, the geographic scope of investments has widened considerably. The focus is
no longer local. There was a saying 25 years ago that people invest so that they can visit the
venture and sleep in their own bed that same night . . . that is not so any more . . . venture
capital has become a global industry and that represents a big change. Globalization is also
apparent if you look at what the venture capital network is composed of . . . in the 1980s,
the members of the venture capital associations were all basically American white males.
Today, the membership is global . . . firms employ the skills of people who have either lived
or were born outside of the US and who have very strong networks over there.
Another big change is that there is a distinction now between funding products and
funding businesses. I think there is a discussion which did not take place 25 years ago that
if an entrepreneur has an innovative product – that is no longer enough . . . the venture
capitalist asks: Is this product the foundation . . . has it got the potential to spin off a wider
range of portfolio products or opportunities? A good example is Google. Google which
basically started out as a search engine, but its business today has far exceeded that . . .
basically, a product has to be a platform for building a wider range of businesses.
24 Handbook of research on venture capital

Looking at the venture capital industry today, is there anything that can be learned from your
study in the early 1980s?
One of the things that I think we contributed to, besides the decision-making criteria
model, was to model a process that identified the stages of the venture capitalists’
decision-making process. A good venture capitalist, today as well as in the past, is strong
in each of these areas, they have good networking in order to be able to locate and iden-
tify deals, they have strong evaluation methodologies to be able to focus on deals to which
they can bring the highest level of added value as a venture capital firm as well as those
which are most likely to succeed. Third, they have strong skills in terms of structuring
these venture capital arrangements, and finally, they are very strong in terms of the 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 the
market would have been something that I would have focused on . . . at that time it was
not much of an issue.

Let us look at venture capital research in a general sense . . . what development can you see
in venture capital research?
I think it has broadened the questions that have been asked. It has drawn on a wider range
of disciplinary interests, which in my opinion has been very useful. For example, the
finance community has become a much stronger discipline for venture capital research,
and they have brought a methodology and line of inquiry that was lacking 25 years ago.
So, questions such as what affects valuation, what affects the value of the firm when it goes
public . . . these were not questions which were really pursued 25 years ago . . . focus was
more on the venture capitalist and less on the venture, and I think that has changed.
However, I still think that there is not enough cross-fertilization between the research
which emerges from traditional entrepreneurship surveys and interviews and the more
secondary financial database oriented research which has been carried out by the finance
community.
The second thing that has changed is that there are much stronger quantitative 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 remained
the same. These questions are: how do you select a deal, what affects its success, and to
what extent does the value added by the venture capitalists influence that success . . . these
are the fundamental questions.

What advice would you give to new PhD students on venture capital?
My advice to them would be to push the issue to another level in terms of trying to bring
new approaches by means of new questions rather than simply doing some incremental
advances on previous studies . . . I think a great deal of the research is based on that. For
example, referring to our own study . . . five criteria became six (or maybe seven), and the
Pioneers in venture capital research 25

labels changed . . . but there has really been no significant advance in terms of looking at
it in a new way.
A second piece of advice is to recognize that this is an area in which obtaining good
data is very difficult, particularly if you are relying on venture capitalists and surveys of
them as the source of such data. So, I think that an advance should come from new
research in the area of methodology concerning how to obtain insightful data on venture
capital.
A third area that I would emphasize, and this is a far narrower observation than the
previous two, is to try to understand the role that the portfolio of the venture capital firm
plays in the success of an individual venture. We have looked a great deal at the 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 spite
of the fact that it would facilitate an understanding of how the network of relationships
within a venture capitalist’s portfolio leverages individual ventures.
Fourth, I think it would have been useful to ask: has the structure of the venture capital
industry changed? For a long time we have talked about two legs: institutional and angel,
and corporate venture capital has been added as a third. But are there other emerging
forms of venture capital? I think it is very useful to look at the context . . . different kinds
of venture capital emerge in different contexts. For example, if we look at the Asian
markets where family business structures are very strong; how does the idea of venture
capital and family business overlap and intersect?
Finally, if we look more specifically at venture capitalists’ decision-making, one area
that requires some improvement is that when we study venture capital decision-making
we pretend that there is a single decision-maker . . . which is rarely the case. In a venture
capital firm there are multi-parties who jointly make a decision, so I think that it is impor-
tant to try to understand how multiple inputs in a multi-decision-maker environment end
up in an investment decision as well as how these decisions flow over the multi rounds of
investment in the same firm. So, a longitudinal decision-making approach over a single
venture . . . that is something that I haven’t seen.

Policy aspects of venture capital are always a ‘hot topic’: what can we learn from the US in
order to improve the venture capital market in other countries, for example in Europe?
About 15–20 years ago I wrote a paper called ‘Venture capital in Western Europe’ in an
attempt to understand what aspects of the US environment differ from Europe. I think
several things have changed. At that time tax policy in Europe was very restrictive, but I
think it is much less restrictive today. There are no strong cultural heroes, and there was
less of a tendency to pursue something outside of the established business institutional
structure by striking out on your own. I think that has also changed . . . not as strongly
as in the US but there has nevertheless been a change.
One of the areas in which US venture capital has been extremely successful is the flow
of knowledge . . . historically, much of that has been due to the US immigration laws. If
you look at many of the venture capital successes you will find that there is an immigrant
somewhere in the venture, and I think Europe has been very restrictive in that regard – in
terms of allowing people to bring knowledge capital. So, an efficient venture capital
market requires not only the free flow of capital, but the free flow of knowledge . . . and
I think that policy-makers will have to encourage that.
26 Handbook of research on venture capital

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

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

BOX 1.2 IAN MACMILLAN

Born: 1940
Career
1986– Wharton School, University of Pennsylvania
1986– Director, Sol C. Snider Entrepreneurial Research
Center
1986–1999 George W.Taylor Professor of Entrepreneurial Studies
1999– Fred R. Sullivan Professor
1984–1986 New York University
Professor and Director of the Center for Entrepreneurship Research
1976–1983 Associate Professor, Columbia University
1975 Visiting Researcher, Northwestern University
1965–1970 Chief Chemical Engineer, Consolidated Oil Products, South Africa
1963–1964 Scientist, Atomic Energy Board, Government Metallurgical Labs,
South Africa
Education
1975 DBA, University of South Africa
1972 MBA, University of South Africa
1963 BS, University of Witwatersrand, South Africa
Pioneers in venture capital research 27

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

1. 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 with
the 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 determines
whether the venture capitalist will place a bet at all’ (p. 128).
However, the fact that venture capitalists use certain criteria does not mean that such
criteria can distinguish between successful and unsuccessful ventures. In a later article, in
1987, entitled ‘Criteria distinguishing successful from unsuccessful ventures in the venture
screening process’, MacMillan and his colleagues tried to determine the extent to which
criteria are useful predictors of performance. A questionnaire was designed in which 220
venture capitalists were asked to rate one of the most successful ventures and one of the
least successful ventures they had funded, based on 25 decision criteria. In addition, the
venture capitalists were asked to rate the venture’s performance on seven performance
variables. In total, 150 evaluations were usable in the study.
The results indicated that the major difference between a winner and a loser seemed to
be some ‘difficult-to-define’ entrepreneurial team characteristics, and MacMillan con-
cluded that ‘. . . it is not surprising that venture evaluation remains an art, a long way from
becoming a science’ (p. 129). Another interesting finding was the identification of two
major criteria as predictors of venture success: (1) the extent to which the venture is ini-
tially insulated from competition; and (2) the degree to which there is demonstrated
market acceptance of the product.
It is interesting to note that these two criteria are market- rather than product- or
entrepreneur-related and neither was considered essential in the 1985 study. The question
was: why were criteria related to the entrepreneurial team and the entrepreneur, which
28 Handbook of research on venture capital

were emphasized in earlier studies, not regarded as predictors of success? In this respect,
MacMillan made a distinction between necessary and sufficient conditions for success.
Venture capitalists will not back ventures with a bad entrepreneurial team. Success or
failure has to do with those ventures that receive funding. The evaluation of the entre-
preneurial team is essential in order to obtain financial backing from venture capitalists
whereas the two criteria – threat of competition and market acceptance of the product –
are predictors of success for firms already financed by venture capitalists.
Another topic in MacMillan’s early contributions on venture capital was the interest in
the added value brought by the venture capitalists to the ventures in which they invest.
The article ‘Venture capital involvement in their investments’ (1988) followed some earlier
studies on venture capitalists’ involvement and value-adding (see for example Gorman
and Sahlman, 1989; Timmons and Bygrave, 1986) indicating that, in addition to 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 asked
to indicate their involvement in each of 20 activities for a specific venture. The results show
that serving as a sounding board for the entrepreneurial team and different financially ori-
ented activities had the highest rating, whereas the lowest degree of involvement occurred
in activities related to ongoing operations. However, the most interesting results concern the
identification of three distinct levels of involvement adopted by venture capitalists:

● Laissez-faire involvement – the venture capitalists exhibited limited involvement.


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

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

Interview with Ian MacMillan

Let’s start with the seminal studies on venture capital decision criteria that you conducted in
the mid-1980s, and which were published in the Journal of Business Venturing in 1985 and
1987. Why did you become interested in this topic?
In 1975 I came from South Africa to the Northwestern University in Boston, but after a
few years I moved to Columbia University in New York. In the early 1980s a decision had
been taken by New York University to launch a Center for Entrepreneurship, and in 1984
I was offered the position as professor and director of the Center for Entrepreneurship
Research. I remained in that position until 1986, when I moved to Wharton School of
Business in Philadelphia.
Pioneers in venture capital research 29

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

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 independent
variables, it should come as no surprise that the relationships are ‘messy’. This is probably
a very complex relationship. It might be a good thing for the entrepreneur to involve a
venture capitalist in the venture, but such involvement also means a host of issues that
could be very harmful . . . it is the mix of good and bad that leads to inconsistencies in
the results of the study, and we were unable to sort that out . . . a problem that researchers
still have.

How would you describe the research on venture capital that followed from your and others’
pioneering studies?
I think what we needed back in the 1980s was to get some scope and terrain identifica-
tion. Much of the early work that I did on entrepreneurship and venture capital was
more in the nature of documentation of phenomena that had not been described before,
and categorizations of phenomena, rather than the development of new theories . . .
going into emergent fields or topics and seeing if we could identify the decisive key vari-
ables, to pass them on to other researchers to explore in greater depth . . . it made further
work possible . . . in that respect I think our early work was important. Once you have
done your explorative work somebody must bring some theory into it, and that is what
I think happened in the 1990s. Researchers started to think about the phenomenon of
venture capital in the context of theory and in particular brought economic concepts
and theories, not least agency theory, into venture capital research . . . that is a natural
progression.
The concern is of course if you let these theories totally dominate the research . . . then
you increasingly have the kind of research that we find in a lot of management research
today. We are not there yet, but there is a danger that it will happen – an incredibly sophis-
ticated analysis of basically trivial problems . . . and less emphasis on what we can learn
that provides us with insights for people operating in the ‘real world’ – we need to develop
meaningful knowledge.

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

You are a very experienced mentor and supervisor of doctoral students. What advice would
you give to a new doctoral student who wants to start research on venture capital?
This is perhaps one of the most difficult questions to answer. I have spent many years
trying to tell my doctoral students to think in terms of relevance . . . the research must be
relevant and important to society, and you need a great deal of confidence and intellec-
Pioneers in venture capital research 31

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

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

BOX 1.3 WILLIAM BYGRAVE

Born: 1937
Career
1985– Babson College
1991– Frederic C. Hamilton Chair for Free Enterprise Studies
1993–1999 Director, Arthur M. Blank Center for Entrepreneurship
1982–1985 Associate Professor, Bryant College
1984 Associate Professor, Boston University
1979–1982 Associate Professor, Southeastern Massachusetts University
1970–1978 Deltaray Corporation
1963–1978 High Voltage Engineering Corporation
32 Handbook of research on venture capital

Education
1989 DBA in Management (Policy), Boston University
1979 MBA (Executive Program), Northeastern University
1963 D.Phil. in Physics, Oxford University
1963 MA (Physics), Oxford University
1959 BA (Physics), Oxford University

Seminal articles
One of the most influential pioneers of venture capital research, and a researcher who has
dedicated his life to our knowledge of venture capital, is William Bygrave. During the
1980s Bygrave presented several pioneering contributions in venture capital research. One
study that deserves mention is ‘Venture capital’s role in financing innovation for economic
growth’ together with Jeffry Timmons (1986). The aims of the study were to (i) determine
the characteristics of technology-oriented venture capitalists and entrepreneurs in these
high-tech firms, (ii) examine the factors that influence the supply of venture capital for the
development of small high-tech companies, and (iii) elaborate on whether or not public-
policy instruments could be used effectively in this process. In the study, the authors used
the Venture Economics database and classified 464 venture capital firms according to
their investments in ‘highly innovative technological ventures’ (HITV) and ‘least innova-
tive technological ventures’ (LITV).
The study shed new light on the flow of venture capital to highly innovative ventures
at that point in time. The reduction of the capital gains tax at the end of the 1970s
had led to an unprecedented growth in the venture capital industry, and not least in
HITV investments. However, HITV investment requires less capital than initial invest-
ments in LITV – what is required is quite specialized management, not capital, and there
was a core group of highly skilled and experienced venture capitalists that accounted for
a disproportionate share of HITV investments. In terms of policy implications, the
general view in the article was that government should take a ‘hands-off’ approach to
the venture capital market – active government involvement could well do more harm
than good.
A second study that received a great deal of attention was on the subject of the
co-investment networks of venture capital firms, and Bygrave elaborated on this issue in
several seminal articles. The first article that appeared in the Journal of Business
Venturing (1987), ‘Syndicated investments by venture capital firms’, is an examination
of linkages of venture capital firms through syndication investments. In this article
Bygrave posed the following questions: why do venture capitalists network? Do the
reasons differ for various types of venture firms? Bygrave used a sample of 1501 port-
folio firms for the period from 1966 to 1982 and analysed the joint investments of 464
venture capital firms.
The results show that co-investments were more common among venture capitalists in
high than low innovative technology ventures, and in early-stage compared to later-stage
investments. Thus, the innovativeness and technology of the portfolio companies were
crucial in explaining networking among venture capital firms. Bygrave argues that more
co-investments are made where there is greater uncertainty and that the primary reason for
Pioneers in venture capital research 33

co-investing is the sharing of knowledge rather than the spreading of financial risk –
venture capital firms gain access to the network by having knowledge that other firms need.
The second article on venture capitalists’ co-investment networks, ‘The structure of
investment networks of venture capital firms’ (1988), builds on his previous work and uses
his classification of ‘high innovative’ (HIVC) and ‘low innovative’ (LIVC) venture cap-
italists, depending on their investment profile. He employed this categorization to analyse
the differences between HIVC and LIVC, but also to identify regional differences in
network patterns. The venture capital firms from the Venture Economics database were
classified into three groups: (i) the top 61 firms – in terms of most investment in portfolio
firms; (ii) the top 21 HIVCs – subset of the 61 firms that mainly invested in high-tech com-
panies; and (iii) the top 21 LIVCs – venture capital firms among the top 61 that mainly
invested in low innovative firms.
The conclusion was that the venture capital industry in general could be regarded as a
rather ‘loosely coupled system’, but the coupling of HIVCs, and especially those in
California, was quite tight. In this kind of tight system, external influence can affect the
entire system, as information can flow through many channels and make the behaviour in
these systems more uniform – which may also explain why herds of HIVCs stampede into
or out of new industries.
Finally, in another seminal work by Bygrave, together with some collaborators at
Venture Economics, ‘Early rates of return of 131 venture capital funds started
1978–1984’, published in the Journal of Business Venturing (1989), the authors noted the
lack of reliable data and systematic analysis of the rates of return on venture capital
investments. On the other hand, there was no shortage of anecdotal accounts and folk-
lore about the rate of return in the venture capital industry – often indicating returns of
30 per cent or more. Bygrave compiled a database of 131 venture capital funds reporting
their rate of return on investments – covering about 50 per cent of the new capital 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 first
time ever it was possible to analyse the rates of return in the venture capital industry in
a systematic way – although the analysis reported in the article was rather premature
and it was too early to draw any clear conclusions (for example the oldest fund in the
database was 7 years old and the youngest not more than 15 months old). However, the
preliminary analysis of the annual compound rates of return in the period 1978 to 1985
was disappointing compared to the myths that flourished about them in the industry,
which, in general, declined at the beginning of the 1980s, although the oldest funds in
the database showed a great performance – far in excess of the oft-quoted expectation
of 25–30 per cent.

Interview with William Bygrave

You have an interesting background with a PhD in physics and many years as a manager.
Can you give a short summary of your career?
Yes, I did my PhD in Physics at Oxford in 1963. But I always had an interest in the 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 American
firm, the High Voltage Engineering Company. I was employed as sales manager for three
34 Handbook of research on venture capital

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 the
New York Stock Exchange, and it turned out to be the first ever venture capital backed
company, funded by Georg Doriot and his venture capital company American Research
and Development back in the 1940s.
After a couple of years I became more and more frustrated by the fact that the company
didn’t put enough resources into products that I thought had huge potential, and I left
in a friendly fashion. In 1969, together with an MIT professor, I started the Deltaray
Corporation, a high tech company that manufactured ultra-stable, high voltage power sup-
plies. We raised money from venture capitalists – at that time the venture capital market was
very small and the market almost unknown, but we succeeded. In 1974 we sold the company
to the High Voltage Engineering Company . . . my former employer . . . and I stayed with
them for a couple of years and became marketing manager – but I didn’t enjoy it.
I took an executive MBA at Northeastern University in 1979. Jeff Timmons was the
leader of the programme. I met Jeff and it turned out that we had many things in common.
At one meeting Jeff said to me ‘I think you are a pretty good teacher. Have you ever
thought about an academic career?’ I said ‘why not?’ . . . my family wasn’t keen on me
starting another business. So, I became a teacher and I enjoyed it. However, I soon real-
ized that I couldn’t go further than teaching at a rather average university without doing
research within the field. I went to Boston University and started on their doctoral 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 funding
from the National Science Foundation.
At that time, the beginning of the 1980s, there were many myths about the venture
capital industry, for example, that the rate of return was at least 40 per cent, the most crit-
ical factor for the flow of capital was a reduction in the capital gains tax, and venture
capital was more than money – venture capitalist brought value-added. But very little was
really known about the industry. Some work had been carried out in the 1960s, mainly
from a financial perspective, and there were some studies done at MIT . . . mostly as
master theses . . . but that was all. Very few knew about the industry, about the flow of
capital, and where the industry was going.
We obtained funding for the project, and the National Science Foundation wanted to
know a great deal, but primarily to understand the flow of venture capital to innovative
companies. I started to look at this issue together with Venture Economics . . . which was
a company just a mile from Babson College, and they had a database with about 450
venture capital firms and 4000 portfolio firms. At that time everything was stored in a
mini-computer with 20 Mbyte, and it was a real limitation in terms of the amount of data
that could be stored electronically as opposed to physically.
The first thing we did was to characterize the industry based upon technological
innovativeness, the flow of capital in the market and, most especially, capital for
high-tech companies. We developed a scale for classifying the portfolio firms depend-
ing on their degree of innovativeness. Some rather interesting results came out of the
study, and it became my first paper for the Babson Conference in 1983, after which
some of the results were presented in my Journal of Business Venturing article with Jeff
Timmons in 1986.
Pioneers in venture capital research 35

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 networks
among 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 contrasted
the high-tech firms with the low-tech firms, and what we found was that there were
differences between venture capitalist networks on the east coast and the west coast – the
California network was much tighter than its counterpart on the east coast, which also
influenced the flow of information. But, what we couldn’t disclose in the articles that were
published in the Journal of Business Venturing in 1987 and 1988 were the names of the
most central venture capital firms in the network – the most central one being Kleiner
Perkins.

You also performed a study on the rate of returns in the venture capital industry?
Shortly after the first study, Venture Economics called me up and asked me to put a data-
base together, which included the rates of return in the venture capital industry. That must
have been in 1985. The problem was that the venture capital funds wouldn’t let us have
the information, but we could obtain it from the limited partners. Most of the limited
partners, such as pension funds, didn’t even know about their rate of return from their
venture capital investments because they didn’t have any software to measure it . . . but
we said that we could put together a data set if they only allowed us access to their records.
In that way we put together a data set including the rate of return for more than 200 funds
in America.
I’ll never forget the first time that we printed out the results. It took about 20 minutes
to run . . . we could see it printing, but after a couple of minutes it stopped. In order to
make the programme run efficiently, I designed the rate of return algorithm to have a
maximum 84 per cent rate of return . . . I never dreamt that anyone could achieve that, so
that wouldn’t be a problem . . . but, the printer stopped, and finally, I had to double the
upper limit in my algorithm, and the printer started to run again. So, guess what . . . it
was Kleiner Perkins once again, not only were they the most central in the venture capital
network, their rate of return was so high that it broke my algorithm. That is wonderful . . .
seeing something nobody else knows on your computer screen.
However, Kleiner Perkins was one of the few winners. Looking at the industry in
general, the average rate of return was only 15 per cent in 1985, not the 40 per cent that
everyone was talking about. Venture Economics wouldn’t publish the figures, but the
results leaked out to journalists. The reactions from industry were mixed – some venture
capitalists were furious, others more grateful that correct figures now had been made
public. But I couldn’t use the results in my research because the information was bound
to secrecy until 1988 when Venture Economics agreed that we could publish it, and it
became a Babson Conference paper in 1988 and then an article in the Journal of Business
Venturing in 1989.
I was also doing my dissertation, and all these studies were included in my doctoral
thesis entitled ‘Venture capital investing: a resource exchange perspective’, which I pre-
sented in 1989 at Boston University.
36 Handbook of research on venture capital

How would you characterize the development of the research field since your pioneering
studies in the 1980s?
In the 1980s the venture capital industry was shrouded in mystery . . . it was an industry
full of myths, but it is fair to say that, by the beginning of the 1990s, venture capital was
an ‘open book’ and the research very much from a practitioner’s point of view . . . such
as venture capitalists, policy-makers, and entrepreneurs. Today, a great deal of research
on venture capital is more rooted in the theory of sociology, psychology and economics.
Nothing wrong with theory, but research doesn’t have much impact on practice anymore.
Frankly, I think there is too much research being done on venture capital. If venture
capital disappeared tomorrow in America, we wouldn’t see any effects on entrepreneur-
ship . . . a few years down the road there would be consequences because the growth of
technological innovations would be slower, but venture capital does not develop new ven-
tures, it merely takes existing ventures and accelerates their growth. I have realized more
and more that venture capital is so rare in start-ups that it is negligible – only 1 in 10 000
start-ups will have venture capital when they start their business – and in fact, when I
lecture my MBA students, I say; ‘forget about venture capital . . . try to get informal
investors instead’.

So, that is your advice to your MBA students, but what would your advice be to a new PhD
student interested in venture capital?
Don’t research venture capital! Since I started my research in the 1980s the proportion of
money going to early stage ventures has just kept declining, but if we look at the informal
investors market – it is enormous. When we did the GEM study, the biggest surprise for
me was to see the amounts of money from informal investors, in a broader sense than
‘business angels’. I estimated that about 100 billion dollars a year comes from informal
investors in America, and a great deal goes into early stage ventures. And from the entre-
preneurs’ perspective the action is in the informal investors’ market, and it is there that we
as researchers should make an effort.
The risk is that we are doing ‘easy’ research . . . where we can obtain easy data, as
opposed to research that is relevant to policy-makers and entrepreneurs. If we study the
informal investors’ market, it isn’t easy to obtain data, we have to work with messy data
and less elegant databases, and we have to give credit to young researchers who are willing
to work with this kind of data. Such research will be far more influential in terms of advice
to entrepreneurs and policy-makers.

Finally, if we look at policy implications, what should government do to promote an active


venture capital market?
Looking back, we can conclude that the changes in the pension fund rules at the end of
the 1970s were most influential for the flow of venture capital in America. However, the
changes in capital gains tax only seem to have had minor effects. Capital gains tax only
affects individuals and over the years the proportion of individuals investing in the
venture capital industry has dropped. A majority of the money for venture capital is sup-
plied by non-taxable sources such as pension funds, endowments and foreign investors. In
addition, I have also learned that there is only one thing that really affects the flow of
venture capital and that is the strengths of the public offering market – forget anything
else – you need to have a strong second tier market.
Pioneers in venture capital research 37

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


School, USA

BOX 1.4 WILLIAM SAHLMAN

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

Seminal articles
With his roots in financial economics, William Sahlman has been extremely influential
in venture capital research. His early studies are still among the most cited works
within the field. His article ‘Capital market myopia’ in 1985 was the lead article in the
first issue of the Journal of Business Venturing. In the article, William Sahlman and
Howard Stevenson focused their attention on a phenomenon that they call ‘capital
market myopia’ in which participants in the capital market ignore the logical 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 this
phenomenon.
38 Handbook of research on venture capital

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 introduced
by IBM in 1973, and many new entrants followed, resulting in an inexorable increase in
the performance of computers as well as disk drives. The expectations of the industry
were high, and there were many spin-offs where executives in firms that were active in the
data storage industry decided to go after a share of the growing market and started their
own companies.
Finding venture capital for start-ups in the disk drive industry was easy. The industry
was perceived as attractive, there was a large group of high quality management, and the
equity capital market was increasing. The late 1970s and early 1980s were characterized
by a rapid growth in the venture capital industry in the US as well as robust stock market
performance. Many of the firms in the disk drive industry received money from venture
capitalists – from 1977 to 1983 just over $300 million was invested in the industry by
venture capitalists – and a number of firms began to raise capital through the public stock
market rather than continuing to rely on venture capital funding.
However, something began to happen in the industry and many companies ran into
difficulties; new technologies were introduced and competition increased, many compa-
nies were unable to produce acceptable quality drives, and the market for computers (the
customers of the disk drive companies) showed a significant downturn in the rate of
growth. Sahlman and Stevenson argued that the venture capitalists could have been aware
of these changes if they had used available information on the market, the technology and
competition – ‘the data necessary to anticipate the problem were readily available before
the industry shakeout began and stock prices collapsed’ (p. 7).
In another seminal article, ‘The structure and governance of venture-capital organiza-
tions’ (1990), William Sahlman was one of the first to describe and analyse the structure
of venture capital organizations. In the article Sahlman provides an analysis of the rela-
tionship between the venture capital firm and its fund providers as well as between the
venture capitalist and their portfolio firms. The article provides an in-depth 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 that
venture capitalists have many opportunities to take advantage of the fund providers and
that agency problems are exacerbated by the legal structure of the limited partnerships in
which limited partners are prevented from playing a role in the management of the
venture capital firms. In order to protect the limited partners the contract needs to be
designed in such a way that the venture capitalists will not make decisions against the
interests of the limited partners, for example, by the inclusion of a limitation on the life
of the venture capital fund, a compensation system that gives the venture capitalists
appropriate incentives, and a contract that addresses obvious areas of conflict between
the venture capitalist and the limited partner.
The article also includes a discussion about the relationship between the venture cap-
italist and his/her portfolio firms. Sahlman drew particular attention to the information
asymmetry between the venture capitalist and entrepreneur, which may cause monitoring
problems. In this respect, Sahlman provided a rationale for venture capitalists to stage
their commitment of capital, devise compensation schemes that provide the entrepreneur
Pioneers in venture capital research 39

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 and
William Sahlman shed some light on how venture capitalists spend their time. Based on
the results derived from 49 responses to a questionnaire distributed to venture capitalists
in 1984 they concluded that:

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

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

Interview with William Sahlman

In the 1980s you wrote several seminal articles on the venture capital industry. What
awakened your interest in venture capital and the venture capital industry?
My background was that I had a degree in economics from Princeton, and for a short
period I worked in the area of finance in New York. I came to Harvard Business School
(HBS) in 1973. As I was graduating from the MBA programme I applied to the PhD pro-
gramme in Business Economics at HBS . . . I was accepted for the programme, but spent
a year in Europe writing cases for Harvard Business School. I wrote my thesis in eco-
nomics on the interaction between investment and financial decisions in companies and
joined the faculty of the Department of Finance at HBS in 1980.
In 1982 we started to plan for a conference on entrepreneurship at HBS, for which I
wrote a paper ‘The financial perspective: what should entrepreneurs know’. In the paper
I tried to understand entrepreneurship, what financial decisions were like for 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 a
very interesting conference, which included a number of practitioners, including quite a
few from the venture capital industry as well as some entrepreneurs. The purpose was to
set an agenda for HBS – what should HBS do to understand these kinds of activities? You
have to remember that ten years after graduation just under 50 per cent of all HBS grad-
uates describe themselves as ‘entrepreneurs’, a large proportion of all venture capitalists
have their roots at the Harvard Business School, and the group of people who started the
venture capital industry in the US . . . Doriot, Perkins, to mention a few . . . all came from
HBS. So, the school is deeply rooted in entrepreneurship and the venture capital industry.
I began to write cases about entrepreneurship and about people in the venture capital
industry – in total I have written almost 160 cases for HBS. In the mid-1980s I decided to
40 Handbook of research on venture capital

launch a new course in ‘Entrepreneurial Finance’ which was introduced in the spring of
1985. I also decided to write all my own material and cases for the course . . . as I developed
course materials, I observed several interesting questions in the venture capital industry, like
why did they use securities that seem inappropriate for risky ventures; why did they stage
the commitment of capital; what decision rights do they retain; what happens down the
road depending on the performance of the venture, etc.? So, there were many interesting
questions to be explored.
Based on this experience I wrote a note called ‘Note on financial contracting’ that resulted
in an article entitled ‘Aspects of financial contracting in venture capital’ in the Journal of
Applied Corporate Finance, in 1988, which then evolved into the article ‘The structure and
governance of venture-capital organizations’ in the Journal of Financial Economics, in 1990.

Yes, the article ‘The structure and governance of venture capital organisations’ is probably
your most cited article in venture capital research. What do you see as its major findings?
At that point in time, no-one had really laid out the main issues in the venture capital indus-
try – there was not much written about the venture capital industry – and the article was
an attempt to take a financial economist’s lens and apply it to a field-based research project.
I think the most important part of the article was to show the interconnectedness
between the governance of the funds and the investments in individual ventures – the
interconnectedness of those two systems. Researchers often study one system but not the
other, but you cannot understand why venture capitalists make bets and how they struc-
ture the deals with individual entrepreneurs, without understanding how the funds are
structured. Another important contribution in my opinion was to provide some rationale
for staged capital commitment, and I also tried to compare that with how capital is allo-
cated in larger companies.

Does fund structure matter?


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

Looking at performance it seems as if US funds always outperform European VC funds . . .?


Yes, historically you are correct . . . due to a stronger ‘right hand tail’ of successful com-
panies in the US as well as a more active exit market – most exits have been IPOs in the
US, as opposed to mergers, and IPOs yield higher returns. But as the economy becomes
more global, we will see more successful ventures all over the world and stronger exit
markets – and the differences between countries or continents will level out.

This leads us to some policy issues. What do you think policy-makers can do in order to create
an efficient venture capital market?
Well, I think there is essentially very little that governments can do to encourage
venture capital. My view is that venture capital follows people and ideas . . . venture
Pioneers in venture capital research 41

capital doesn’t lead them . . . in many cases policies are based on the notion
that money attracts entrepreneurs, but I think it has a tendency to attract the wrong
entrepreneurs and the wrong ideas. So, what you have to do is to encourage
entrepreneurship.
However, one thing has to do with failures and bankruptcies. In many countries, it
is a dishonour to fail, and if you go bankrupt there are a host of personal legal
implications as well as high costs – that context is damaging to entrepreneurship and
you will have fewer people starting new ventures. But it is not only a question of the
downside of failures, the question is also: what is the upside of entrepreneurship – the
right hand tail . . . to be successful – is far less attractive in many countries than it is in
the US.

In another early article that you wrote together with Howard Stevenson, ‘Capital market
myopia’, you were very critical of the venture capital industry.
Yes, I noticed that all venture capitalists seemed to rush into the same industry at the same
time. Why did that happen, and what can be learned?
Historically, it turns out that every industry ever created seems to have the same course
of development. In the beginning, you start with a large number of entrants and many
players – it is the same if you look at the railroad industry, the telephone industry, or 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, many
firms will be over-valued and some will disappear from the market, and there will be many
losers. So, this is not a new phenomenon. What was new in the Winchester Disk Drive
industry in the 1970s and 1980s was the new class of professional investors and a new tech-
nology that very few people understood. The entrepreneurs within the industry all had
the same origin in companies like IBM, Memorex, etc. and they were all desperately
searching for faster, cheaper, smaller products . . . in this case disk drives. Every single
venture capitalist who invested in the industry believed that his team and their 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 there
were 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 assuming
that their company would win?’

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

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

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

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

Have you seen any changes in the way venture capitalists work today compared to your study
in the 1980s?
Yes, there is a change in the sense that venture capitalists today have much more capital
to allocate per partner – they are involved in more ventures and spend less time with each
company, and accordingly, they are not as helpful as they were before.
I think of venture capital as an art in which judgement and wisdom play a critical role.
So, therefore, it is not a single attribute that makes a successful venture capitalist. For
example, we have seen venture capitalists with quite different backgrounds who have been
successful . . . venture capitalists with a financial background, in other cases former top
managers, etc. . . . and they are not always experts in the industries in which they invest –
in this respect the venture capitalist hasn’t changed.

Finally, if we look at venture capital research in the future, what are the questions that ought
to be asked?
I would say that there are some important questions that have not yet been addressed.
First, venture capitalists allocate a great deal of money to projects and new ventures, but
so do large corporations . . . and, how do we compare the relative efficiency of these two
models? Thus, I would very much like to see comparative studies of different models of
venture capital investments. Second, I don’t think researchers have done an adequate job
in understanding the dynamics of venture capitalists’ portfolios. Looking at the port-
folio of investments as opposed to individual investment I would liked to ask a series of
questions, for example; what was the proportion of failures, what was the proportion that
recouped more than ten times the money invested, what was the likelihood of obtaining
a second round of financing, what was the pay-off structure for the investments, etc.? A
third area of importance in which we haven’t seen a great deal of research is the board
of directors in venture capital-backed firms. What is an effective and ineffective board
structure?
One problem with these kinds of questions is that they require information from inside
the firms, not from databases . . . this is not an industry you can study without inside
knowledge that current databases do not provide. So, there is much hard work to be done.
Pioneers in venture capital research 43

Research on corporate venture capital

A history of corporate venture capital investments and research on corporate venture


capital
Probably the first corporate venture capital investor was DuPont back in 1919 when one
of its important customers ran out of funds, and DuPont purchased 38 per cent equity
interest in the company – General Motors. They brought in a new president, Alfred Sloan,
and General Motors grew substantially over the years. After World War I, American
Telephone, General Electric and Westinghouse made several investments. Soon after
World War II a small company, Haloid Corporation, funded the commercialization of a
new technology developed by Chester Carlson and the Battelle Memorial Institute – later
the company changed its name to Xerox Corporation (Rind, 1986). In the late 1950s
several larger corporations became interested in venture capital activities, and venture
capital firms funded by larger corporations or a subsidiary of a corporation, emerged in
the mid-1960s, pioneered by companies such as Xerox and AT&T. Since then corporate
venture capital has gone through several cycles (Rind, 1981; Gompers and Lerner, 1999;
Birkinshaw et al., 2002).
The initial wave of corporate venture capital occurred at the end of the 1960s. More
and more companies established divisions that acted as venture capitalists and in the early
1970s more than 25 per cent of the Fortune 500 firms implemented corporate venture
capital programmes. However, the market diminished dramatically in 1973, following the
oil price crisis, the abrupt decline in the market for new public offerings, and the ensuing
recession.
The second wave, beginning in the late 1970s and early 1980s, was fuelled by the growth
of the computer and electronic sector and reached a peak in 1986 when corporate venture
capital funds managed $2 billion, or almost 12 per cent of the total pool of venture capital
in the US. However, when the stock market crashed in 1987 and the market for new IPOs
dropped, larger corporations scaled down their venture capital investment commitments.
Finally, the third wave emerged in the 1990s linked to the technology boom and the
dot.com era, and in 1997 corporate investors accounted for about 30 per cent of the com-
mitments to new funds compared to an average of 5 per cent in the period from 1990 to
1992. As in the earlier waves of corporate venture capital, the interest was stimulated by
the success of the venture capital industry in general – rapid growth of funds and attrac-
tive rates of return. The market peaked in 2000 before the great crash (the collapse of
high-technology stocks, the loss of faith in internet-based businesses, and a number of
high-profile corporate failures). The conclusion arrived at by Gompers and Lerner (1999)
is that, over time, corporate involvement in venture capital has mirrored the cyclical
nature of the entire venture capital industry.
The emergence of the industry during the 1980s led to some pioneering scholarly work
on corporate venture capital, and in Table 1.5 some of the early contributions will be 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 and
discussing its advantages and limitations, that is corporate venture capital was considered
in the frame of strategic management and the corporate venture process.
However, after these pioneering works, the research on corporate venture capital was rel-
atively scarce with a few exceptions (for example, Gompers and Lerner, 1996; McNally, 1994)
44 Handbook of research on venture capital

Table 1.5 Early contributions on corporate venture capital

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

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

Pioneers of corporate venture capital research


As can be seen in Table 1.5, there were several early research contributions on corporate
venture capital in the 1980s. One of the pioneers in this respect was Kenneth Rind, who
in 1981 published an early article on corporate venture capital in the Strategic
Management Journal. Rind can be regarded as an active advocate of venture capital, not
only in the US but internationally, being a mentor for new venture capitalists, the author
of several articles and a notable speaker on venture capital. He is also regarded as one
of the pioneers in introducing venture capital to countries such as Japan, Singapore,
Israel, and Russia. In this section I will summarize his SMJ article and present an
interview in which he looks back on four decades as an active international venture
capitalist.

Seminal article
Kenneth Rind was one of the first to recognize corporate venture capital as a tool in the
corporate development toolbox. His observations were based on his experience of being
responsible for acquisitions and venture capital investments at Xerox Development
Corporation, but were also influenced by the second wave of corporate venture capital
that emerged in the late 1970s as a result of the growth of the computer and electronics
sector. In his article ‘The role of venture capital in corporate development’ (an extended
version was later published in the Handbook of Strategic Planning in 1986 entitled
‘Venture capital planning’), corporate venture capital is mainly seen as a strategic tool,
and in the introduction to the article Rind states (p. 169):
Pioneers in venture capital research 45

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

BOX 1.5 KENNETH RIND

Born: 1935
Career
1961–1962 Post-doctoral Argonne National Laboratory
1963–1964 Assistant Professor of Physics, City University of New York
1964 Founder, Quantum Science Manager, Samson Fund
1968–1969 Associate, Rockefeller Family & Associates
1970–1976 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 Corporation
1981 Co-founder of Oxford Partners – venture capital company
1993 Co-founder of the Nitzanim-AVX/Kyocera Venture Capital Fund in
Israel
1998 Co-founder of the Israel Infinity Venture Capital Fund
Education
1956 BA in Chemistry at Cornell University
1961 PhD in Nuclear Chemistry at Columbia University

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

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

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

● Lack of people with appropriate skills;


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

As a consequence, many corporate investors changed their investment approach and


started to make investments through venture partnerships. A venture capital partnership
provides the opportunity to attract good people, problem investments become less visible,
management time is saved, long-term commitment is assured and many legal liabilities are
eliminated.
Rind formulated his conclusion in the following way (p. 179): ‘venture capital is a useful
tool for corporate development. It is difficult but possible to do internally, and an outside
partnership investment can be either an alternative first step or a beneficial supplement to
a direct corporate venture capital programme.’

Interview with Kenneth Rind

You had a long career as a venture capitalist. Could you say something about your
background?
I obtained my PhD in nuclear chemistry at Columbia University, and after a couple of
years as a post-doc at Argonne National Laboratory I returned to New York in 1963 as
an Assistant Professor at the City University of New York teaching nuclear physics.
However, the promises made to me were not kept, and although I was offered tenure, I
Pioneers in venture capital research 47

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

But you have also been very active as an international venture capitalist and regarded as one
of the pioneering venture capitalists in Japan and Israel, and now you are actively working
to introduce venture capital in Russia . . .
Yes, I first became involved in international venture capital when I was at Oppenheimer.
My senior partner called me up and said that there was a Japanese company that would
like to learn about venture capital. I hosted them for a summer, and I introduced them to
venture capital situations and showed them what was happening in US technology . . . but
on condition that they invite me to Japan and allowed me to look at venture investments
in Japan . . . that must have been 1973 or 1974 . . . I went over and lectured about venture
capital, but I was turned down by MITI for making investments in Japan. However, at
Oppenheimer I hosted a number of people from Japan who had come to learn about
venture capital.
In 1986 I was asked by the Israeli government to come over and consider starting a
venture capital fund in Israel. I went over, but realized rather quickly that it was impossi-
ble to make money – the best engineers were working for the military, the government did
not like business, the inflation rate was 100 per cent per annum, etc. – and I concluded
that there was nothing for me to invest in. However, a few years later I received a phone
call from a friend of mine, who had a factory in Jerusalem, and he told me that the Israeli
government wanted to increase a venture capital activity and asked if I would be willing
to help set up a fund in Israel. Based on my earlier experience, I was doubtful, but he con-
vinced me that things had changed a lot in Israel by the early 1990s. So, in 1993 I founded
my first fund in Israel – Nitzanim-AVX/Kyocera Venture Fund – which was a part of the
government-supported Yozma programme.
In 1997 I was asked to join the board of an organization set up by the US Congress to
find useful work for Russian weapon scientists – the United States Civilian Research and
Development Foundation – and I became interested in technology developments in
Russia. I started to visit Russia, I held speeches on why venture capital should be encour-
aged, and tutored people to understand venture capital. However, progress has been very
slow . . . there is no tradition and no entrepreneurial spirit, and as I see it, it will take time
to foster venture capital in Russia.

You have been involved in introducing venture capital in many emerging venture capital
markets. What is your advice to policy-makers who want to encourage venture capital in a
country?
Over the years, foreign governments have learned more about venture capital . . . they
recognize that venture capital is a good thing . . . and when I make my presentations,
which are based on my experience from several different countries, I always say that
venture capitalists want to have (1) partners with an entrepreneurial spirit – drives and
visions; (2) a financial and scientific infrastructure; (3) world-class products and 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 to
repatriate funds.
I usually advise governments on what has been done elsewhere to promote an active
venture capital market (see Table 1.6). I am not suggesting that all these initiatives work
in every country, but government should know what possibilities exist, and what has been
successful in other countries.
Pioneers in venture capital research 49

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

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 finance
entity 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 raising
small firms, qualified (training) – create exchanges
venture capital funds, – lessen listing requirements
and R&D activities 5. Fund incubators/companies
in incubators 3. Allow investors to control
3. Waive corporate income investees
taxes, sales taxes, and 6. Make grants for generic – no cap limit on ownership
property taxes for R&D programmes
qualified 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 income
8. Finance training abroad for 5. Permit immigration of
5. Lower taxes on venture capitalists skilled talent
management fees/bonus
9. Establish agencies to provide 6. Allow LLCs
6. 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 acquire
7. 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 failures
investments

As I see it, the most important way of encouraging venture capital is to promote an
entrepreneurial spirit in the country – people must feel it is a good thing to be an 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 winners
and losers by themselves – it is always a disaster – anything they do to encourage the
50 Handbook of research on venture capital

industry should be alongside experienced venture capitalists . . . and/or if the venture


capitalists select the companies, the government could say that they will leverage and
invest alongside the venture capitalists, but the venture capitalists are responsible for
making the company a success.

You have been active as a venture capitalist for four decades, you have been a mentor for
new venture capitalists, writing articles, making speeches about venture capital . . . what is
necessary to be a successful venture capitalist?
This is a very difficult question to answer . . . a venture capitalist succeeds by making good
investment, but you never know in advance which investments will be good – many com-
panies fail and venture capitalists lose money on most of their investments. But at least
you should, as a venture capitalist, have the skills to help the companies in which you
invest. The difference between venture capital and predicting stock market prices is that
venture capitalists can help to change the odds. In this respect, I strongly believe that
venture capital is a business that requires an apprenticeship . . . you can’t teach it, one has
to experience venture capital situations and learn from them . . . and we need a trained
cadre of people who know how to operate in the world of venture capital.
And I can see a problem . . . the people who founded the venture capital industry in the
US are now retiring, and new people who are coming in should apprentice . . . but a whole
bunch of people came in during the dot.com boom who didn’t know what they were doing.
Thus, venture capitalists must have the experience to help the companies in which they
invest. One of the most important decisions to make is replacing the founding entrepre-
neur at the right time and bringing in someone who is capable of running a growing
company. At the same time it is important to keep the founder on board, so that he/she
can continue to contribute from a technical point of view, as a spokesperson, etc. Unless
they have done that several times . . . people can’t learn that – they have to experience it
by themselves.
I also teach entrepreneurs how to make exits and always tell them not to make the
company dependent on having an IPO, but to run the company at all times as if either an
IPO or takeover is imminent and to make contact with corporate venture capitalists who
could be potential acquirers – even if they have no interest in investing in your company
at that point in time they should get to know you.
It is also important to emphasize that venture capital is a rather heterogeneous 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 developed
business 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 market
goes through cycles and will always go through cycles – for the same reasons as the stock
market – people are greedy and will invest when the market goes up, and that is good for
venture capital. However, when a lot of money goes into the venture capital market,
venture capitalists invest in too many companies that are doing the same things, so many
go out of business. Thus, investors lose money, then there will be too little money, and we
will start all over again . . .
Pioneers in venture capital research 51

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

Finally, some advice for the research community. What would you say will be the most 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 venture
capital activity going. For example: how do you offer incentives to people in a way that it
doesn’t make corporate management and the internal people working with the corporate
venture capital group jealous?
In addition, I have given advice to many governments about what is needed to encour-
age venture capital in a country, and of course, I would be very happy to see research that
could confirm and sort out the initiatives that are successful – probably certain initiatives
would be more or less successful in different cultures and contexts.

Research on informal venture capital

Some early contributions


The interest in the informal venture capital market among policy-makers and researchers
started in the 1950s and 1960s. In particular, the financial problems experienced by many
young technology-based firms provided a starting point for studies on informal venture
capital. For example, in the late 1950s the Federal Reserve performed a couple of investi-
gations regarding the initial financing of new technology-based firms – studies that preceded
the Small Business Investment Act of 1958, which led to the creation of the Small Business
Investment Company (SBIC) programme in the US. The interest in early financing of young
technology-based firms originated in an emerging interest in business angels as an 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 of
New Hampshire in the US that led to an increasing interest in the informal venture capital

Table 1.7 Early contributions on informal venture capital

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

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 role
in solving this problem. Little was known about the characteristics of business angels and
the flow of informal venture capital and in his study Wetzel wanted to ‘put some bound-
aries on our ignorance’.

Some central themes in informal venture capital research


Following Wetzel’s seminal study in the early 1980s, interest in the informal venture
capital market grew among researchers in the US and around the world. Researchers felt
a need to quantify and describe the informal venture capital market, thus the research has
been fairly descriptive and focused on three main questions:

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

The market scale Estimating the size of the informal venture capital market is a difficult
task. In one of his first research articles on informal venture capital, William Wetzel (1983)
concluded that the informal venture capital market is ‘unknown and probably unknowable’
(p. 26). Despite conceptual and methodological problems in researching the informal
venture capital market, a large number of scholars have been trying to estimate its size –
mainly defined as business angel investments. The result varies significantly between coun-
tries – from about 2.75 per millage of the GDP in the US to about 0.78 per millage in
Sweden – partly due to the different methodological approaches used to measure the scope
of the informal venture capital market (Mason and Harrison, 2000a; Avdeitchikova, 2005).
The conclusion that can be drawn from earlier studies is that the estimations of the
informal venture capital market are problematic in various ways (Mason and Harrison,
2000a) due to the private and unreported nature of the investment activity and the desire
of most informal investors to preserve their privacy. In addition, as indicated earlier, there
are severe problems of definition, for example, in some estimations investments by ‘family
and friends’ are included, whereas they are excluded in others, while some estimations
concentrate on the group of investors known as ‘business angels’. Most of the studies
relied on convenience sampling, and it remains unclear whether these samples are repre-
sentative of the underlying population of informal investors (Riding, 2005). Finally, many
earlier studies had very small samples and low response rates (Mason and Harrison,
2000a). Thus, the estimates made in the various studies must be considered very crude 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
Pioneers in venture capital research 53

different parts of the US in order to describe the ABC of angels in different regions.
However, at the end of the 1980s and early 1990s, academic and public policy interest in
the informal venture capital markets started to grow internationally and continued to do
so throughout the 1990s (for a review of the characteristics of angels, see Chapter 12 by
Peter Kelly).
Although the conditions for an active business angel market differ from region to
region and country to country, it is worth emphasizing that there seem to be many 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 income
and net worth and previous start-up experience, who makes about one investment a year,
usually close to home. The primary method of finding new investment opportunities is
through friends and business associates, and they prefer high-technology and manufac-
turing ventures, with an expectation to sell out in three to five years (Mason and
Harrison, 1992).
However, despite many common characteristics, early research has repeatedly indicated
that the informal venture capital market is highly heterogeneous – almost individualistic
in character – and in the research we can find various attempts to develop categories of
investors that describe the market in more nuanced ways (see for example Gaston, 1989;
Coveney and Moore, 1998; Sørheim and Landström, 2001; Avdeitchikova, 2005). One
conclusion that can be drawn from these attempts is that there does not appear to be much
agreement with respect to the categorization schema developed in the various studies, and
the usefulness of the categorizations can be questioned: (i) informal investments are
unlikely to be mutually exclusive – informal investors may invest in a variety of different
ventures, including both ‘love money’ and ‘business angel investments’, and (ii) their
investment profile may change over time (Riding, 2005).
Thus, the conclusion that can be drawn is that we know a great deal more today about
informal investors and business angels but, despite 25 years of research, much more
remains to be learned about the characteristics of the investors and the dynamics of the
informal venture capital market.

Policies and information networks Wetzel’s pioneering work in the early 1980s addressed
the fact that the informal venture capital market experienced severe inefficiency problems,
making policy interventions necessary. In many countries there seem to be two major
problems associated with the informal venture capital market: (i) there are too few infor-
mal investors active on the market, and (ii) there are market inefficiencies that make it
difficult for investors and entrepreneurs to find each other (Mason and Harrison, 1997).
Tax incentives for private individuals who invest in unquoted companies have been the
main strategy for increasing the pool of informal investors on the market. The UK has
been the leading exponent of this kind of measure. Since the early 1980s, several strategies
that provide investors with different kinds of tax relief for informal investments have been
introduced. A study by Mason and Harrison (1999b; see also Mason and Harrison, 2000b;
2002) shows that the tax relief available to UK business angels has had a positive impact
on informal venture capital investment activity. The availability of tax relief on informal
investments – which reduces the risks involved – seems to be the most important encour-
agement for informal investors to invest more, whereas reducing the rate of capital gains
54 Handbook of research on venture capital

tax – increasing the reward – seems to be less influential than front-end tax relief, although
both have an impact on promoting informal venture capital activity. However, Lerner
(1998) argues that new ventures are inherently risky, and there is considerable uncertainty
regarding their survival and growth. Thus, there is always a risk that attempts by govern-
ment to stimulate the informal venture capital market may ‘encourage amateur individual
investors’ which will be counterproductive for society. Lerner concludes that encouraging
informal investments could be ill-advised – some investors may lack the skills necessary to
protect themselves and to accurately value the opportunity in which they invest.
A conclusion that can be drawn is that tax incentives need to be complemented by
micro-level initiatives – one such initiative is ‘business introduction services’. One initia-
tive was the Venture Capital Network (VCN), introduced by William Wetzel in New
Hampshire in 1984 as a business introduction service to provide an efficient channel of
communication between business angels and entrepreneurs. This idea of business angel
networks or matching services was later introduced in several places in the US as well as
in other countries. In this respect the UK has also been at the forefront in encouraging the
establishment of such communication channels. According to Mason and Harrison
(1999b), the performance of business angel networks (BANs) has been varied but, in
general, evidence suggests that on an aggregate level their impact on informal venture
capital activities has been both positive and significant (different kinds of business angel
networks are discussed by Jeffrey Sohl in Chapter 14).

Pioneers of informal venture capital research


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

Seminal article
Until the end of the 1970s the number of studies on the informal venture capital market
was rather limited. However, at the beginning of the 1980s, Professor William Wetzel at
the University of New Hampshire put informal venture capital on the ‘research map’. In
1978 Wetzel conducted a pilot study, based on a questionnaire distributed to 100 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 total
potential pool of venture capital represented by the respondents exceeded $1 million per
year, the required rates of return were lower than those typically required by professional
venture capitalists, and so on. Wetzel came to the conclusion that ‘business angels’ prob-
ably represent the largest pool of risk capital for entrepreneurial ventures and that the
informal venture capital market plays an essential role in the growth of the high-tech
sector.
Based upon the analysis presented in the pilot study, the Office of Economic Research
of the US Small Business Administration funded an expanded study of the availability
of informal risk capital in New England, USA, in the autumn of 1979. Wetzel and his
colleagues undertook a nine-month search for business angels, resulting in a sample of
133 investors. The results of the study were presented in one of the most cited articles on
Pioneers in venture capital research 55

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

BOX 1.6 WILLIAM WETZEL

Born: 1928
Career
1993– Professor of Management Emeritus University of New Hampshire
1967–1993 Whittemore School of Business and Economics, University of New
Hampshire
1983 Founder of the Center for Venture Research
1983–1993 Director of the Center for Venture Research
1984 Founder of the Venture Capital Network Inc (VCN)
1987–1993 Forbes Professor of Management Chair
1987–1988 Paul T. Babson Visiting Professor of Entrepreneurial Studies,
Babson College
Education
1967 MBA (Finance and Accounting), University of Chicago
1950 BA (Mathematics), Wesleyan University

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

● Business angels are accustomed to sharing investment opportunities with friends


and business associates, and make investments together with others.
● Informal risk capital is an important source of external seed capital. Forty-four per
cent of business angel investments were start-ups, and 80 per cent involved ventures
less than five years old. In addition, one third of the respondents expressed a ‘strong
interest’ in financing technology-based ventures.
56 Handbook of research on venture capital

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

The conclusions from the study by William Wetzel were that business angels seem to
represent a substantial pool of funds for entrepreneurial ventures and to have some
unique characteristics as well as being highly influenced by non-financial incentives to
make investments, but that the market was relatively inefficient in bringing entrepreneurs
and investors together.
William Wetzel made the informal venture capital market visible and revealed its
importance. The study awoke interest among policy-makers as well as scholars and has
been replicated in many different contexts (within the US as well as internationally).

Interview with William Wetzel

Your studies on ‘business angels’ in the late 1970s are truly regarded as a pioneering piece of
work in the area of venture capital research. What aroused your interest in the informal
venture capital market?
I think . . . earlier in my career I worked as a commercial banker in Philadelphia, and in
that position I managed a large commercial office, and many of my clients were family
businesses that needed capital. They often went outside of family and friends to search
for money, and I started to recognize people out there making investments in ventures
with growth potential, which really sparked my interest: how many of these people were
there, what kind of ventures do they look for?, etc.
Later on, as professor at the University of New Hampshire in the mid-1970s, I was
involved in an organization called New England Industrial Resource Development
(NEIRD). NEIRD was often approached by inventors who wanted to commercialize
their ideas, but had no one to back them. Over a number of years NEIRD had informally
assembled names of people with money and experience who could assist the inventors . . .
So, I knew that these people existed.
In 1979 I approached Milton Stewart, the first Chief Counsel for the Office of
Advocacy in the US Small Business Administration and a former venture capitalist, and
applied for a research grant to explore the role played by these invisible private investors
in entrepreneurial ventures. I was successful and received a grant of $55–60 000.

What were the most interesting results of the study?


It goes without saying that there were many interesting results, but one thing that
intrigued me greatly was the list of non-financial rewards that the private investors
Pioneers in venture capital research 57

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

The study was later published in the Sloan Management Review . . .


I had many problems getting it published. The paper was rejected by the Harvard Business
Review and California Management Review, but I gave it one more try . . . I had sabbati-
cal leave, and I sat down and tried to respond to the criticism in the reviews. Most of it
had to do with the problem of convenience sampling and sample bias. In my response I
acknowledged that this was a descriptive study without hypotheses to be tested. In add-
ition, my style of writing was rather conversational . . . I didn’t use ‘academic jargon’ in
the article . . . because I was not really writing for an academic audience, I wanted to get
visibility out there for the phenomenon . . . but, at last the paper was published.
The article in the Sloan Management Review is definitely the most influential article
that I have published in my career. The study was recognized by scholars interested in
entrepreneurship, saying that ‘the informal investors market is certainly something
that deserves a lot more attention’, but the study also caught the interest of public
policy-makers.
I remember that there was an article in Inc Magazine about the study . . . ‘Business
angels myths and reality’. The reporter came to my office with a bundle of dollar bills and
spread them out on my desk. It made a great picture for the Magazine, but it was not
exactly the message that I wanted to give . . . however, the popular press began to pick up
on my work . . . and I preached the role of business angels in the first round of outside
equity finance – taking the venture beyond the family and friend stage.

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

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

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 deal
more work to be done in the area of informal venture capital research – questions that
will end up with important outcomes and make ‘the world a better place to live in’.

It was also a pioneering achievement to introduce the first match-making service on the 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 the
part of investors to see a flow of new deals . . . to see a broader range of investment
opportunities, not only based on random situations, for example, that you mention 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 their
ventures. Even at that time, the venture capital industry was not really interested in small
amounts of money.
We founded the Venture Capital Network (VCN) in 1984 in order to create a more
effective market for angel finance. In addition to matching entrepreneurs with potential
investors, VCN offered seminars in pricing, structuring, and exiting venture investments.
VCN was initially sponsored by leading accounting firms, banks, and by Digital
Equipment.
However, I think we were mistaken in our belief that we could make this process work
in a more orderly and less random fashion. After five years of no home-run performance
we were unable to obtain additional sponsorship. So, we decided to find another home for
it, a home that would have a higher probability of success. We opened up a discussion
with MIT in Boston, and in 1990 VCN became the Technology Capital Network (TCN)
at MIT.
The VCN was used as a model for more than 20 other networks around the US and
even in Canada. We designed the software for the matching services and sold it to the net-
works. We installed the programme, and trained them how to use it. One of the obstacles
faced by these networks, as with the VCN, was locating a critical mass of investors as well
as entrepreneurs . . . and it is not a question of a static critical mass, because these are
people who come in and go out of their entrepreneurial activities.

In many countries it is important to stimulate an active informal venture capital market.


What policy implication can be drawn from your research?
I am very sorry, but I don’t really believe that there is much of a role for public policy in
this field, because the market is very individual and personal. Maybe there might be
potential for tax incentives. In these kinds of investment there is always a risk/reward
ratio, and if you could reduce the risk and/or increase the reward, that would certainly
have a positive impact . . . but as to how big the effect would be, I cannot say.
However, we know that business angels invest close to home, and unless they have a
strong attraction to a specific technology or market, they will typically not invest much
more than a few hours’ drive away from where they live. This indicates that policy instru-
ments should be anchored locally or regionally. I also believe that there is a need for some
form of learning . . . both for the actors involved as well as with regard to the instruments
used . . . we have a great deal of experience of different measures, and new initiatives don’t
need to start from scratch all the time.
Pioneers in venture capital research 59

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

State-of-the-art venture capital research


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

produce overall negative effects by their involvement in the venture capital market as they
are to engineer a lasting improvement in market conditions. In this chapter Murray will
seek to summarize what consensus may be found in seeking an appropriate role and mode
of action for government in the light of the evidence of both academic studies and policy
experience.
Part II of the book focuses on the institutional venture capital market. It is within insti-
tutional venture capital that we find the longest tradition of scholarly work and the most
extensive research volume. As research on informal venture capital and corporate venture
capital in many cases takes the institutional venture capital market as a point of reference,
it seems reasonable to start our ‘journey’ in this area. In this part of the book, we will follow
the ‘venture capital cycle’ from fund raising to the exit of venture capitalists’ investments.
We start in Chapter 5, in which Douglas Cumming, Grant Fleming and Armin
Schwienbacher discuss how venture capital funds are structured and governed. They not
only look at the typical US market fund structure but show how it varies across geo-
graphical markets. Their conclusion is that the way the venture capital fund is structured
will have an important influence on the way venture capitalists manage their operations,
the strategy and type of firms that receive finance, the willingness to add value, and so on.
After this focus on the structure of the venture capital fund, a couple of chapters serve
to elaborate on our knowledge of the investment process used by institutional venture
capitalists, that is the process from the pre-investment phase to post-investment activities
and exit as well as the financial performance of the ventures. In Chapter 6 we look at the
‘pre-investment phase’, in which Andrew Zacharakis and Dean Shepherd elaborate on the
evaluation process – and especially the decision criteria and process applied when venture
capitalists make investments in new venture proposals. Zacharakis and Shepherd take an
information processing perspective to increase understanding of the process of selecting
new investments. In particular, they examine how biases and heuristics impact on the
investment process. In the following chapter (Chapter 7), Dirk De Clercq and Sophie
Manigart focus on the ‘post-investment phase’ and provide an overview of the knowledge
of venture capitalists’ involvement in monitoring activities vis-à-vis entrepreneurs and
value-adding for their investees. De Clercq and Manigart open the ‘black box’ by dis-
cussing the question of how value-added is created in the venture capitalist–entrepreneur
relationship. In Chapter 8, Lowell Busenitz follows up on this discussion by suggesting
new research directions for venture capitalists’ value-adding activities. Busenitz argues
that research needs to go beyond the broad questions that have been studied so far – and
that in many cases have produced very mixed results – and press forward in looking at
governance arrangements, compensation systems and obtaining follow-on rounds of
funding as well as exploring the broader impact of venture capital investments on innov-
ation and the development of new industries. The chapter ends with a discussion on what
measures to use when evaluating venture capitalists’ performance. In Chapter 9, Benoit
Leleux elaborates further on the performance aspect of venture capital, and raises the
issue of the drivers behind venture capital performance on different levels of analysis. The
key message is that the nature of the industry makes it very difficult to measure value cre-
ation and hence performance over time, and Leleux provides an in-depth discussion on
how to measure financial performance in the venture capital context. In this way the
chapter provides the reader with a solid basis for his/her interpretation of the data pre-
sented on and by the venture capital industry.
Pioneers in venture capital research 61

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

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 to
take on, and he synthesizes the literature on corporate venture capital with particular
emphasis on research examining corporate venture capital from the corporate investors’
perspective. In Chapter 16 we change perspective, and Shaker Zahra and Stephen Allen
look at corporate venture capital from the entrepreneurs’ perspective. Zahra and Allen’s
point of departure is that many new ventures need to assemble and use resources fairly
quickly in order to develop capabilities that can create and protect a competitive advan-
tage, and corporate venture capital enables them to obtain the financial resources and
business contacts necessary for development and growth. The authors discuss the poten-
tial financial and non-financial benefits that new ventures can gain from corporate venture
capital investments.
Finally, in Part V (Chapter 17), Hans Landström presents a summary and synthesis of
the discussions in the Handbook by elaborating on the question: what advice can be given
based on the knowledge developed in the book? The chapter provides some implications
for venture capitalists, entrepreneurs and policy-makers as well as a discussion about the
future direction of venture capital research.

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

Introduction

Entrepreneurship and early venture capital literature


As indicated in Chapter 1 the research on venture capital1 dates back at least to the late
1960s (for example Briskman, 1966; Aggarwal, 1973; Wells, 1974; Poindexter, 1976) when
the industry itself was in its infancy. Whereas these early studies in venture capital tended
to focus on the efficiency of venture capital as an investment vehicle or on the decision
criteria used by venture capitalists to assess entrepreneurs and opportunities, other areas
of the more general entrepreneurship literature focused on the nature of the entrepreneur
and on conditions of founding. Thus, early on, venture capital research contributed pri-
marily in the areas of economic implications of this ‘new’ organizational entity (venture
capital) as a financing tool. In truth, the entire field of management or business ‘science’
itself was just forming. Whereas the field of economics was comparatively well-developed,
the examination and study of business organizations as atomistic entities worthy of study
in their own right was just emerging.
Through the 1980s and into the early 1990s, interest in venture capital and its unique
problems and contributions expanded. For entrepreneurship research in general, the
decade began with a focus on the entrepreneur and ended with a focus on the entrepre-
neurial process of new venture creation. Venture capital research complemented this
development by beginning to unravel the mysteries of the venture capitalist–entrepreneur
dyad in this process of venture creation (Sapienza, 1989; Fried and Hisrich, 1995;
Landström et al., 1998). Although venture capital research focused solely on 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 of
people working diligently in the area were attentive to theory development. Into the
twenty-first century, research on venture capital has remained a vibrant and critical part
of the more general entrepreneurship literature.

Purpose and overview of this chapter


In this chapter we share our reflections on the past, present, and, especially, the possible
future of managerial venture capital research. What we mean by managerial is that we
consider work with a disciplinary focus on management, work produced by management
scholars and published in management journals, rather than on other perspectives such
as finance or economics. We reflect on (without reviewing in depth) the historical pattern
of this domain, considering especially the extent to which this research has contributed
to the understanding of the venture capital phenomenon and to the broader entrepre-
neurship literature. We then turn our attention to suggesting how we would like to see

66
Reflections on venture capital research 67

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

In short, the most important question we raise in this chapter is: where should we go
as a field? At one extreme, we could become a clinical field, with proliferation of 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) in
which research enriches practice and vice versa. We believe that theory that is not
informed by practice is neither useful nor interesting; similarly, practice without theory
is particularized and uninformative. Rigorous research with a solid theoretical and
methodological base is essential to advance the field. For us, the best research will also
be meaningful to practitioners. It will not be done ‘for’ practitioners; it will be done
‘with’ them. Perhaps the term ‘practitioner’ is too narrow, for it invokes an incomplete
image of those affected by our research. We suggest that stakeholders (beyond
researchers and their students themselves) include investors, entrepreneurs, policy
makers and broad societal elements such as local communities and regional and
national economies.
The chapter proceeds as follows: first, we analyze the focus of research in venture
capital over time. We identify and discuss the dimensions that have been studied exten-
sively, and we note the ones that have been relatively neglected. We present a stylized figure
that depicts key dimensions of past managerial venture capital research: the stage in the
venture capital cycle, the perspective of the key focal actor (for example venture capital-
ist or entrepreneur), the type of venture capital (institutional, angel, corporate), the level
of analysis used, and the theoretical framework through which works are designed and
interpreted. We also discuss the causes and consequences of the chosen perspectives.
Next, we introduce the concept of ‘engaged scholarship’ (Van de Ven and Johnson, 2006),
examining its applicability to venture capital research. In the penultimate section, we
introduce Ghoshal’s (2005) ‘positive organizational scholarship’ argument and consider
its implications for our field. Finally, we use our stylized model and these two perspectives
to consider avenues for future research.

Causes and consequences of dominant areas of venture capital research


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

Early contributions
Much early literature focused on what exactly venture capitalists do (Tyebjee and Bruno,
1984; MacMillan et al., 1985; Gorman and Sahlman, 1989). These highly descriptive
works have proven extremely useful for three reasons. First, they helped everyone under-
stand the mechanics of the industry and illuminated the significant ways in which venture
capital differs from other sources of capital for entrepreneurial start-ups and from one
another (for example Elango et al., 1995). This contribution is in line with the engaged
scholar view discussed later.
Reflections on venture capital research 69

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 highly
complex, and, without a deep understanding of the mechanics of the industry, theorists
would be likely to create incorrect or incomplete theoretical frameworks. That is, a deep
understanding of the issues and practices involved in the phenomenon improves the valid-
ity, sophistication and power of theoretical models developed. Finance theory work such
as Sahlman’s (1990) on the structure of the venture capital industry served to highlight the
agency issues and financial structure challenges faced by venture capital firms. This type
of study paved the way for managerial work such as Gifford’s (1997) that pointed to the
serious issue of the venture capitalist as agent and for Cable and Shane’s (1997) work that
elucidated the powerful forces for collaboration in venture capitalist–entrepreneur pairs.
Third, empirical descriptions chronicle venture capital at various points in time and at
various economic epochs in a manner that allows us to understand the phenomenon and
to see how types of financing interact over time. For example, the chronicling of corpor-
ate venture capital in the aftermath of the economic booms of the late 1980s (for example
Block and MacMillan, 1993) and around the turn of the twenty-first century (for example
Maula, 2001) has added understanding not only of corporate venture capitalists but also
of institutional venture capitalists and business angels. Thus, theory has been aided
because the chronicles allow us to derive the meaning of variation (or non-variation) in
practice in different times and places. As we move into the twenty-first century, we can
build sophisticated portraits that look at the entire ecosystem of venture capital and that
will provide more complete pictures than are currently available.

Expansion of venture capital research along several dimensions


After the early ‘descriptive’ period, managerial venture capital research grew more theory-
driven and developed along several different paths. Figure 2.1 represents the dimensions
by which the most common examples of past venture capital research might be viewed
and classified. The outer circle surrounding the central dimensions in Figure 2.1 repre-
sents the lenses (or theories) that researchers bring to bear on the questions or dimensions
being studied. Think of this diagram as a metaphorical kaleidoscope, one whose internal
dimensions and external circumference can be rotated, bringing various theoretical views
and elements into different juxtapositions and focuses. Imagine each theoretical 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 of
the inner circles as also being capable of being rotated; they represent levels of analysis,
for example, individual, group, venture, community, region, country, and so on.3
In the interior of the kaleidoscope, we see three overlapping dimensions: type of
venture capital (for example institutional venture capital – VCF, business angels – BA, or
corporate venture capital – CVC), the interests or perspectives being investigated (for
example investor4 vs. entrepreneur), and the stage of the venture capital process (for
example fund raising, selection). Although each dimension is composed of several ele-
ments, most studies center on one element within each dimension. For example, Shepherd
and Ettenson (2000) examined how an investor type (the institutional venture capital
firm) attempts to maximize returns (investor’s perspective) via decisions made during the
selection stage of the venture capital cycle.
70 Handbook of research on venture capital

Theoretical frameworks Levels of analysis

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

Focal perspective VC type


Entrepreneur BAVC
Investor CVC
PFVC

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

Figure 2.1 Kaleidoscope of research in managerial venture capital

We have chosen the metaphor of the kaleidoscope to convey the idea that changing
levels of analysis and/or theoretical lens provides very different views of the phenomena.
For the Shepherd and Ettenson article, the level of analysis is the venture capital firm and
the theoretical framework is the industrial organization perspective. Had they chosen the
entrepreneur’s perspective, different theoretical questions may have arisen such as how to
position their venture to attract capital or how to select venture capitalists if given
options. Other choices of frameworks or levels of analysis would also have resulted in
quite different questions, data and interpretations.
The choice of framework affects the likely questions asked, the levels viewed, and the
data examined. Conceiving of possibilities in this manner may lead researchers to a
variety of questions, some previously studied and some not. Examples of questions sug-
gested if we consider different levels of analysis include: at the individual level, why do
entrepreneurs seek venture capital, and how are their outcomes affected? At the dyadic
level, how do governance structures and mechanisms affect returns, and how do venture
capitalist–entrepreneur interactions moderate these? At the firm level, why do venture
capital firms exist, and why do some venture capital firms outperform others? At the
regional/national levels, how may venture capital activity be fostered, and what is the
appropriate role of government in the venture capital process? The appropriateness of
Reflections on venture capital research 71

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

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

Dominant focuses
Given the focus on the investor’s perspective, it is unsurprising that the rational economic
framework has been the prominent theoretical lens used. In particular, although its
efficacy in this context has increasingly been called into question (for example Landström,
1993; Cable and Shane, 1997), agency theory has been the dominant approach to 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 institutional
venture capital type and on the investor’s perspective. First of all, among venture capital
types, institutional venture capital is the one in which economic return is most 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 venture
capital industry and doubtless influenced the emerging research on venture capital. From
an agency perspective the key issue is how outside investors can minimize agency costs
emanating from adverse selection and opportunism.
Seeking both practical solutions and tests of a dominant theory, researchers devoted
special attention to applying agency theory to the selection (MacMillan et al., 1985;
Harvey and Lusch, 1995; Muzyka and Birley, 1996; Smart, 1999) and monitoring phases
(MacMillan et al., 1989; Sapienza and Gupta, 1994; Mitchell et al., 1997) of the venture
capital process. While not all of these studies relied fully on agency theory, they all shared
with it the assumptions inherent in rational economic models. Most importantly, many
prominent researchers, especially within the domain of financial venture capital research,
have demonstrated the potency of agency theory in predicting the structure of venture
capital firms, the development and employment of financial instruments for investing, the
terms of formal agreement, and the nature of syndication among institutional venture
capitalists.5
We can speculate on two additional factors that may have played a role in the predom-
inance of this theoretical framework: (1) as an emerging topic, venture capital researchers
sought to rely on basic and popular theories within the mainstream disciplines; and (2)
because most of the initial venture capital research was developed in the United States, it
may be that governance, conflict and control of agency problems were more relevant in
that context than in other contexts such as those of Western Europe or Japan.6
In short, the dominant elements studied within our metaphorical kaleidoscope (insti-
tutional venture capital firm, investor perspective, selection/monitoring) are logically
coherent, 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
Reflections on venture capital research 73

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

Contributions of venture capital research to entrepreneurship literature


Venture capital research directly addresses many of the fundamental issues of interest to
entrepreneurship scholars. For example, much of the research has been devoted to how
investors assess opportunity (MacMillan et al., 1985; Shepherd, 1999; Smart, 1999). The
74 Handbook of research on venture capital

most common approach has been to look at the criteria that venture capitalists use to
make investment decisions. Smart (1999) takes the central conclusion from this literature
(that is the conclusion that venture capitalists focus most strongly on the quality of the
entrepreneurs themselves) and delves into how venture capitalists assess the entrepreneurs
and whether some assessment methods are more effective than others. Some work, such
as Fiet’s (1995) comparison of institutional venture capitalists and business angels,
assesses how investors attempt to deal with risk in entrepreneurial settings; Fiet argues
that institutional venture capitalists possess potent remedies against agency risks and thus
focus on market risk whereas business angels, lacking such potent contractual leverage,
focus on agency problems. Some have even looked at business angels as entrepreneurs
themselves (Landström, 1998); such work draws an essential but little recognized parallel
between the challenges and issues facing both entrepreneurs and their investors.
In some ways contributions of venture capital research to the field of entrepreneurship
have been indirect. For example, venture capital portfolio companies are usually consid-
ered ‘high potential’ ventures. As such, venture capital provides a convenient sampling
space for studying ‘entrepreneurial’ firms. The venture capital setting provides an easy-to-
identify, comparable and convenient sampling of high-potential firms. Another benefit of
studying in the venture capital setting is that it helps researchers address a common
problem plaguing users of survey designs. Here, the issue of common source bias – the
validity problem of deriving measures of independent variables from the same source as
dependent variables – may be addressed more readily than in other settings. The presence
of two sets of individuals (investors and entrepreneurs) highly knowledgeable about one
another and about the venture in question provides venture capital researchers with a
means to overcome some common source and common method problems that typically
plague entrepreneurship research. For example, using venture capitalists’ rating of
venture outcomes along with entrepreneurs’ rating of venture activities creates valid
ratings and avoids spuriously related measures.
The high profile nature of the institutional venture capital industry and the stream of
good descriptive early studies have made the industry understandable and accessible to
the broader management field. This matters because it makes entrepreneurship itself
accessible to other areas of business scholarship. We can also be proud of the fact that a
very high percentage of the entrepreneurship studies published in the widely distributed,
highly regarded management journals (for example Academy of Management Journal,
Academy of Management Review and Journal of Management Studies) have been about
venture capital. Clearly, venture capital researchers have been able to execute worthy
empirical work and contribute to entrepreneurship and management theory. And,
whereas entrepreneurship research in general has been plagued by lack of replication,
incomparable samples, variations in measures and constructs, and the like, venture capital
researchers have created several relatively coherent streams of inquiry such as venture
valuation, investment decision making, partner interaction and governance.
Yet, we can do more to advance entrepreneurship literature. Given that venture capital
is a multi-stage, multi-actor process, its study can help us understand whether, or in what
ways, the ‘myth’ of the solo, heroic entrepreneur is indeed a myth (Aldrich, 1999; Van de
Ven et al., 1999). The venture capital setting offers a plethora of circumstances in which
teamwork and inter-organizational relations may be carefully studied. We have the oppor-
tunity to view how teams of entrepreneurs work together over a long period of time with
Reflections on venture capital research 75

customers, suppliers, government entities, as well as with various sources of informal and
formal financing. Further, we have the opportunity to learn how and when venture cap-
italists operate as lone wolves or as parts of investment syndicates and venture ecosystems
that reach far beyond their own organizations (for example Lerner, 1994; Lockett and
Wright, 1999). As yet, however, we understand little about the interconnections across the
ecological landscape of the entrepreneurial process.
To date, we have but begun to mine the potential in this setting to study the value cre-
ation and organization creation processes. We can come to understand more not only
about value appropriation (as would be a focus of rational economic perspectives) but also
about the elusive areas of value creation. For example, how do the roles of the investor and
investee complement, aid, or thwart one another? Are our current approaches to studying
the phenomenon the appropriate ones, or should we approach the field in new ways? Are
the lenses and attitudes we have adopted the most useful, or are we being blinded by our
own perspectives? We take up in the next two sections recent critiques of the larger field of
management scholarship itself to consider their implications for future research in venture
capital.

Implications of the ‘engaged scholar’ view for future venture capital work
Rather than simply enumerate under-researched topics and gaps in the literature, we
center our suggestions on adopting the ideas laid out by Van de Ven and Johnson (2006)
in this section and by Ghoshal (2005) in the following section. Our view is that lack of
prior study in a given area, by itself, is woefully inadequate justification for its future study.
To warrant study, the understanding of the topic must also be important either to the phe-
nomenon itself or to theory, or to both. In this section, we focus on how future research
in venture capital should be conducted so as to ensure these aims.
What is appealing for venture capital researchers about Van de Ven and Johnson’s
(2006) exhortation for engaged scholarship is that it draws on existing strengths in venture
capital research and promises ways to build where we most need work: enhancing our
scholarly rigor and legitimacy. At the same time, this approach asks not that we become
remote arm-chair theorists but that we become fuller scholars by growing closer to the
phenomenon itself. In short, Van de Ven and Johnson offer five guidelines for engaged
scholarship: (1) design work to study big problems grounded in reality; (2) design research
projects to draw on and create a collaborative learning community; (3) design studies to
examine an extended duration of time; (4) employ multiple models and methods; and (5)
re-examine assumptions about scholarship and the roles of researchers. The implications
of these suggestions for future research in venture capital are the following:7

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

and foster innovation?). Of course, such issues are likely to be complex and thus are
typically not amenable to being studied using a single lens or perspective. Thus, 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 about
specific theoretical approaches or even disciplines will be set aside. Research should
not be a hammer searching for a nail.
2. Design the research project to be a collaborative learning community. Engaging
venture capitalists and entrepreneurs (as well as community leaders and the like) in
real world research settings requires time to develop trust and reciprocal knowledge.
Such long-term cooperation is unlikely to occur unless all sides are truly participants
in the research process. The process of arbitrage between other stakeholders and
scholars, which ensures that the questions asked are both of theoretical importance
and grounded in reality, requires collaboration. Collaboration between researchers of
different disciplinary backgrounds or ‘research circles’ (Landström, 2005) would also
increase the plurality of perspectives from which important questions can be ana-
lyzed. Some obvious risks and concerns in such collaborative research efforts include
issues of academic objectivity, scientific methodological requirements, and issues sur-
rounding the proprietary use of research findings. Van de Ven and Johnson argue that
with clear rules of engagement between research partners, these problems can be
managed and the benefits will outweigh the risks. In the venture capital setting, such
rules might include ways to minimize effort required on the part of entrepreneurs and
investors, ways to ensure that proprietary knowledge is protected, and ways to
provide broad access to researchers. Put simply, researchers must help their partners
deal with their specific, idiosyncratic problems, and their partners must be willing to
help researchers gain insights into broader issues that may not be of immediate
concern to them.
A practical issue worthy of explicit mention here is that access to the venture capital
community is extremely limited. An engaged scholar would have to be aware that s/he
may face extraordinary challenges both in ‘getting inside’ or getting access to
investors and their limited partners, but also in convincing them of the value of par-
ticipating in the research process and of the trustworthiness of the researcher to fully
protect 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 we
depend to advance our research. Time is thus a necessary condition to achieve the
previously stated objectives of arbitrage and cooperation. Fortunately, studies con-
ducted over an extended period of time also offer the extremely important advantage
of allowing researchers the possibility to make a deeper and more valid assessment
of causality than is possible with cross-sectional studies or snapshots taken at
different points in time. Day-to-day, immersed involvement over a long period of time
and across many ventures is necessary to understand, for example, whether the
problem is bad leadership leading to bad performance or bad performance leading to
bad leadership.
Reflections on venture capital research 77

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

or ‘artificial’ observations or outcomes renders this suggestion highly controversial.


That is, the danger exists that by imposing themselves amidst the phenomenon of
interest, researchers may alter the phenomenon itself. Nevertheless, engaged 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 worthwhile
ideal, but we should not be afraid to roll up our sleeves and dig into the subject when
necessary. Moreover, many might argue that the ‘pretense’ of objectivity is just that,
a pretense and an ideal.

In sum, we believe that researchers adopting the engaged scholarship approach will
produce innovative insights unavailable through more detached approaches. For example,
venture capital governance occurs largely through the mechanism of the board of direc-
tors, yet little work has explored how these boards actually make decisions because of the
difficulty of gaining access to board meetings (Sapienza et al., 2000). A truly engaged
scholar may be able to develop the level of trust with the entrepreneur and the investors
that allows the kind of access and understanding not previously possible. In terms of the
metaphorical kaleidoscope that we introduced in Figure 2.1, such an approach would
place the scholar amidst the entrepreneur–investor–process triangle in the center of the
figure. A social exchange theory approach would suggest focusing on variations in board
behavior depending on the development of reciprocity (or lack thereof), whereas an
agency perspective might suggest examining the role of the board as a supplement to or
substitute for bonding costs. The vantage from within would result in more intimate views
than would the ordinary position of the scholar on the outer rim of the lens looking in,
and, theoretically, would lead to more valid interpretation of observed behavior.
Besides the time, effort and cost hurdles that ultimately must be dealt with as an
‘engaged scholar’ in any research setting, the venture capital context poses an additional
barrier that must be noted. Venture capitalists have been literally besieged by researchers
seeking their aid in conducting research. The presumption that they would want to
‘engage’ with us is a strong one. We can only note that succeeding in gaining their trust
and attention is a significant challenge.9

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


capital work10
A posthumous publication of the views of Sumantra Ghoshal (2005) regarding trends in
the theoretical content of management literature sheds another light upon the issues and
challenges facing business scholars in the twenty-first century. Ghoshal expresses dismay
over several trends in research which he claims are traceable to two common sources: (1)
Attempts by many to treat the social science of business as an exact science; and (2)
Acceptance by the majority of the assumption of rational economic self-interest as the
sole explainer of behavior. Ghoshal’s article expresses a view similar to that stated at
various times over the years by William Bygrave, that is, that business researchers suffer
from ‘physics envy’, a condition in which scholars seek to emulate the physical sciences in
their theorizing, testing and interpretation by assuming that variables interact with a sort
of law-like consistency. Such assumptions have the attractiveness for those seeking ‘pure’
science of making investigations mathematically tractable and parsimonious. Further, the
Reflections on venture capital research 79

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

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

advantage to do so. In this world, promises and integrity are only as meaningful as
the conditions that mandate them – cooperation becomes synonymous with coercion.
As Bhide and Stevenson (1990) astutely point out, in reality people act with integrity
and goodwill a great deal more than can be explained by enlightened self-interest.
Why is that so, and what should it mean for our theorizing and hypothesis testing?
3. Keep human choice and ethics within the equation of organizational decision-
making. According to Ghoshal, the upshot of accepting economic self-interest as the
sole driving force for human endeavor is that we remove individual responsibility and
ethical norms from theoretical consideration. The assumption of economic self-
interest as the sole motivation for action trivializes human choice as a subject for
study. Many venture capital researchers have already explicitly noted that the applic-
ability of assumptions varies with settings and/or with the subjects considered. For
example, Van Osnabrugge (1998) has found that business angels explicitly consider a
range of motives in ‘developing’ or ‘mentoring’ entrepreneurs. Arthurs and Busenitz
(2003) discuss the limitations of explaining investor/investee decisions using either
only agency theory (which assumes self-interest and opportunism on the part of man-
agers) or only stewardship theory (which assumes good faith stewardship on the part
of managers). In short, researchers must avoid succumbing to the temptation to
adopt simple, mathematically tractable assumptions that make hypothesis testing
neat but inaccurate. Expanding our conceptualization of the drivers of human 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 theorists
teach students to expect opportunism and self-serving dishonesty, they give such
behavior currency and unintended legitimacy as industry norms. We argue here that
although malfeasance and dishonesty do indeed occur, they are not necessarily the
normal or expected behavior in practice. This suggestion to keep in mind that 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 small
part 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 deal
with their absence or betrayal. Although it is perhaps human nature to experience fear
of the negative more strongly than joy in the positive, as researchers of venture capital
we should, like our subjects, seek paths to create or realize the upside potential of our
work. Critical elements of the venture capital process include such positive concepts
as inspiration and innovation, for example. Where do these come from? How may
they be stimulated and enhanced? The rational economic perspective is silent on such
issues, providing little guidance for understanding the sources of inspiration, let alone
such responses as magnanimity. Even in commonly investigated phenomena, such as
the post-investment activities of venture capitalists, too little has been done to 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 when
in fact realizing the upside of investments is paramount in many cases. Creating gains
is not the same as avoiding losses.
Reflections on venture capital research 81

We can relate the above reflections to our ‘kaleidoscope’ of venture capital research by
employing yet another metaphor. Ghoshal’s portrayal of the modern, cynical researcher
can be understood by comparing this researcher with the title character in Nathaniel
Hawthorne’s short story ‘The minister’s black veil’. In this story, the minister in a small
New England town emerged one morning to face his parishioners wearing for the first
time a black veil through which he now viewed the congregation, and through which they
now viewed him. He now saw everything a bit more darkly, and they too imagined that he
harbored dark secrets and dark thoughts too unpleasant to reveal. Not only were those
on both sides of the veil affected by its darkness, but the dark veil seemed to invest the
minister with a certain power over others. By analogy, this story illustrates two problems
in contemporary management research in general and venture capital research in particu-
lar. First, the assumption of self-interest with guile as the true nature of the human actor
affects both those adopting the view and those glimpsed through it. Further, the 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 portrayed
as seeing the world through ‘rose-colored glasses’. Ghoshal challenges us to do more than
view venture capital activity solely through the dark veil of unbridled opportunism and
self-interest – to see other views of actual and possible realities. Consider, for example, the
meaning of the ‘game’ in Cable and Shane’s (1997) analysis: if reputation and reciprocity
are seen not just as self-serving mechanisms to be calculated about and gambled upon,
but rather as desirable human status to aspire to and uphold, then, collaboration is indeed
collaboration, and coercion is recognized for what it is.
If we indeed let go of our arrogant air of certainty, adopt a balanced view of human
nature, keep ethics and responsibility in the picture, remember that what we teach has
effects, and take up the challenge of unearthing antecedents of positive outcomes we will
complete the circle of theorizing. We believe that the spirit of these two works is not to
repudiate and abandon all that has come before but rather to dig in deeply, questioningly,
and with renewed vigor. Like Ghoshal, our call is not for naïve denial of ill-will but for
balanced recognition of the multiplexity of human choice and action.

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

Based on what venture capital researchers have already accomplished, we are optimistic
about the future. Venture capital research (like entrepreneurship research in general) has
benefited from its multidisciplinary roots and its connection to practice. Our exhortation
to take the ‘engaged scholarship’ approach seriously, implies that these roots and this con-
nection should be preserved and enhanced. If we go a step farther and foster the kind of
increased stakeholder cooperation, immersion in the field, and long-term research designs
suggested by the engaged scholar view, we will face significant obstacles in terms of time,
money, access and effort. However, as a relatively unified subfield within the area of 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 of
inquiry but rather approaches to the study of venture capital that might yield significant
insight. These general suggestions may be summarized as follows:

● Stay close to the phenomenon and study ‘big’ issues.


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

Our practical side recognizes the difficulty and burdens of adopting such approaches. We
have suggested, therefore, that efforts to achieve what we have laid out may need to be
accomplished in teams and that these teams might best be led by senior scholars whose
career ‘clocks’ are not ticking quite so loudly. We heartily recommend that junior schol-
ars participate and engage, but we also are cognizant of the fact that they may also need
to nurture parallel conventional studies that have shorter time frames to completion.
In terms of the current dominant rational thinking paradigm, we are suggesting that
future research should neither abandon these roots altogether nor ignore the rational
actor approach in future studies. We do suggest, however, that efforts to look beyond the
narrow confines of rational economic thinking will allow us to discover and conjure some
important, new questions that may have been obscured by the current view. Furthermore,
the broader set of stakeholders (such as local communities, individual entrepreneurs,
institutional representatives and the like) have legitimate interests that have little to do
with profit taking. To provide insights for these interests, we will have to delve deeply into
issues of the processes and mechanisms of value creation unconstrained by assumptions
regarding rent appropriation. In short, we will have to consider societal outcomes beyond
profit generation.
Returning briefly to our kaleidoscope, we can identify several specific suggestions for
future research. Research in the business angel domain would be especially suited to
exploration of the processes of venture and value creation. Furthermore, the role of
emotion and affect is especially amenable to study in the business angel context because
business angels, more so than institutional venture capitalists or corporate venture cap-
italists, have ‘skin in the game’ but are unconstrained by having to justify their decisions
to outside third parties. The corporate venture capital context, on the other hand,
Reflections on venture capital research 83

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 investment
decisions, including both the impact of early investment decisions on the development of
the venture as well as on the nature of later decision making. Our positive organizational
scholarship and engaged scholar views suggests that such studies might be viewed from
alternative lenses, over time, via a multiplicity of instruments. We are reminded, too, that
these issues can and should be viewed from the perspectives not only of the venture 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 to
reveal all that it might, not only about its own complex workings, but also about entre-
preneurship itself.

Acknowledgements
The authors are indebted to Hans Landström, Gordon Murray and Andy Van de Ven for
comments on early versions of this chapter.

Notes
1. Broadly construed, ‘venture capital’ refers to provision of outside equity for a claim against increases in
value of an independent entity. We, however, use the term in this chapter not to refer to the broader set of
all private equity, but primarily to refer more closely to what Bygrave and Timmons (1992) call ‘classic
venture capital’, the provision of equity into earlier stage, high potential ventures (see Chapter 1).
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 the
researcher is on the outside looking in at the phenomenon. As we discuss later, the ‘engaged scholar’ view
places the researcher within the phenomenon as an observer/participant. We are indebted to Andy Van de
Ven for this observation.
4. In this chapter when we use the term ‘investor’ we are referring to the venture capitalist, even though in
the institutional venture capital context the limited partner may be the actual source of the funds invested.
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 the
present, these two have produced (singly and/or in combination with one another) the most significant
stream of work on the financial processes and structures in the institutional venture capital industry.
6. This latter reflection on the possibility that agency theory is less appropriate in some contexts outside the
US is not necessarily shared by all venture capital researchers. We thank Gordon Murray for this comment.
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 scholarly
work in entrepreneurship beginning in 1982 with The Encyclopedia of Entrepreneurship and continuing with
The Art and Science of Entrepreneurship, The State of the Art of Entrepreneurship, Entrepreneurship 2000
and Handbook of Entrepreneurship Research.
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 future
research on the industry. Gordon sees the presence of industry databases as a two-edged sword, one that
provides significant quantitative information that may help researchers overcome the common method
issues that plague primary research but that also may tempt researchers to conduct studies without 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 areas
requiring greater study is not unwarranted. Gordon Murray suggested the following to us in providing
84 Handbook of research on venture capital

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

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3 Venture capital: A geographical perspective
Colin Mason

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

86
Venture capital: A geographical perspective 87

concerned exclusively with the geography of venture capital investing within individual
countries. There is a separate literature on the internationalization of venture capital (see
Wright et al. (2005) for a review).
The next section reviews what can be gleaned from the literature on the role of geog-
raphy of the informal venture capital market (section 2). The chapter then moves on to
consider the formal, or institutional, venture capital market, initially by considering 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 backwards
to explanations, attributing this uneven geography of investing to the combination of the
localized distribution of the venture capital industry and the localized nature of invest-
ing. The role of long distance flows of venture capital in reinforcing the clustering of
venture capital investments is also discussed. Section 4 brings some of these earlier themes
together in the form of a short case study of Ottawa, Canada, a thriving technology
cluster. The intention is to show how economic activity is initially funded in emerging
high-tech clusters by a combination of ‘old economy’ business angels and the importing
of institutional venture capital from elsewhere, but over time, as it develops successful
technology companies so a technology angel community emerges and it also develops its
own indigenous supply of institutional venture capital funds. Section 5 draws the chapter
to a conclusion with some thoughts on future research directions and a brief consider-
ation of the implications for policy. A fuller discussion of policy issues can be found by
Murray in Chapter 4 of this volume.

Geographical aspects of the informal venture capital market


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

The location of business angels


The only study which has looked at the geographical distribution of business angels is by
Avdeitchikova and Landström (2005). Based on a ‘large’ (n = 277) sample of informal
investors in Sweden (defined as anyone who has made a non-collateral investment in private
companies in which they did not have any family connections) they suggest that both
investments (52 per cent) and the amounts invested (77 per cent) are disproportionately
88 Handbook of research on venture capital

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. For
example, a study that was based on a large sample of Canadian business angels (n = 299)
(Riding et al., 1993) noted that business angels in Canada’s Maritime Provinces (Nova
Scotia, Prince Edward Island and New Brunswick) are distinctive in terms of the typical
size of their investments, sectoral preferences, rate of return expectations and expected
time to achieve an exit (Feeney et al., 1998). Investors in Atlantic Canada and Quebec are
also the most parochial (63 per cent and 58 per cent of investments within 50 miles of
home compared with a national average of 53 per cent) (Riding et al., 1993). Johnstone
(2001) makes an important contribution, suggesting that remote and declining industrial
regions are likely to suffer from a mismatch between the supply of angel finance and the
demand for this form of funding. He demonstrates that in the case of Cape Breton, in the
province of Nova Scotia in Canada, the main source of demand for early stage venture
capital is from knowledge-based businesses started by well-educated entrepreneurs
(mostly graduates) with formal technical education and training who are seeking value-
added investors with industry- and technology-relevant marketing and management skills
and industrial contacts. However, the business angels in the region have typically made
their money in the service economy (retail, transport, and so on), have little formal edu-
cation or training, are reluctant to invest in early stage businesses and are not comfortable
with the IT sector. Moreover, their value-added contributions are confined to finance,
planning and operations. This suggests that the informal venture capital market in
‘depleted communities’ is characterized by stage, sector and knowledge mismatches.
There is rather more evidence on the role of geography – specifically the distance
between the investor’s location and that of the investee company – in the business angel’s
investment decision. This literature has looked at three issues: (1) the locational prefer-
ences of business angels; (2) how location is handled in the investment decision; and
(3) the locations of actual investments.

Locational preferences
Various survey-based studies in several countries have asked business angels if they have
any geographical preferences concerning where they invest. These studies reveal that some
angels have a strong preference to make their investments close to home while others
impose no geographical limitations on where they will invest. In the USA Gaston (1989)
reported that 72 per cent of business angels wished to invest within 50 miles of home and
only 7 per cent had no geographical preferences. However, other US studies – based on
smaller sample sizes and confined to specific regions – report that well under half of all
business angels will limit their investing to within 50 miles of home (Table 3.1). Studies in
other countries are equally inconsistent in their findings. For example, in Canada, a study
of Ottawa angels reported that 36 per cent imposed no geographical limits on their
investments (Short and Riding, 1989). In the UK, Coveney and Moore (1997) reported
that 44 per cent of angels would consider investing more than 200 miles or three hours’
travelling time from home, compared with only 15 per cent whose maximum investment
threshold was 50 miles or one hour. Scottish business angels are rather more parochial,
but even here 22 per cent would consider investing more than 200 miles or three hours
Venture capital: A geographical perspective 89

Table 3.1 Locational preferences by business angels: selected studies

Connecticut and
Massachusetts
(Freear et al., 1992; 1994)
New California
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 25
50–300 miles 17 – 10* 20 25
Over 300 miles – – – 19 12
Outside USA – – – 5 0
Other geographical 7 13 11 – –
restriction
No geographical 40 33 7 24 38
preference
100 87 100 100 100

Note: * 50–150 miles

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

The role of location in the investment decision


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

Locations of actual investments


Studies which have focused on the actual location of investments made by business angels
reveals a much more parochial pattern of investing (Table 3.2). The proportion of invest-
ments located within 50 miles of the investor’s home or office ranges from 85 per cent
amongst business angels in Ottawa to 37 per cent amongst business angels in Connecticut
and Massachusetts. In the UK, Mason and Harrison (1994) found that two-thirds of
investments by UK business angels were made within 100 miles of home. In other words,
the actual proportion of long distance investments that are made is much smaller than
might be anticipated in the light of the proportion of investors who report a preference
for or willingness to consider long distance investments.
90 Handbook of research on venture capital

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

Connecticut and
New 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 53
50–300 miles 20 28 4 17
Over 300 miles/ 22 36 (28+8) 11 29
different country
Total 100 100 100 100

Reasons for the dominance of short distance investments This dominance of local
investing reflects several factors. First, it arises because of the effect of distance on an
investor’s awareness of potential investment opportunities. Information flows are
subject to ‘distance decay’, hence, as Wetzel (1983, p. 27) observed, ‘the likelihood of an
investment opportunity coming to an individual’s attention increases, probably
exponentially, the shorter the distance between the two parties.’ Indeed, in the absence
of an extensive proactive search for investment opportunities, combined with the lack
of systematic channels of communication between investors and entrepreneurs, most
business angels derive their information on investment opportunities from informal 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 investment
appraisal – to a much greater extent than venture capital funds do (Fiet, 1995; Mason and
Stark, 2004). Their knowledge of the local business community means that by investing
locally they can limit their investments to entrepreneurs that they either know themselves
or who are known to their associates and so can be trusted. This point is illustrated by one
Philadelphia-based angel quoted by Shane (2005, p. 22): ‘we have more contacts in the
Philadelphia area. More of the people we trust are here in the Philadelphia area. So there-
fore we are more likely to come to some level of comfort or trust with investments that are
closer.’
A third reason is the tendency for business angels to be hands-on investors in order to
minimize agency risk (Landström, 1992). Maintaining close working relationships
with their investee businesses is facilitated by geographical proximity (Wetzel, 1983).
Landström’s (1992) research demonstrates that distance is the most influential factor in
determining contacts between investors and is more influential than the required level of
contact. This, in turn, suggests that the level of involvement is driven by the feasibility of
contact rather than need. Furthermore, active investors give greater emphasis to proxim-
ity than passive investors (Sørheim and Landström, 2001). Proximity is particularly
important in crisis situations where the investor needs to get involved in problem-solving.
As one of the investors in the study by Paul et al. (2003, p. 323) commented ‘if there’s a
problem I want to be able to get into my car and be there in the hour. I don’t want to be
going to the airport to catch a plane.’
Venture capital: A geographical perspective 91

Finally, angels need to monitor their investments. This is often done by serving on the
board of directors. It is desirable that the angel can travel to, attend and return in a day
in order to minimize their travel costs. Some angels prefer to monitor their investments by
making frequent visits to the businesses in which they invest, described by one angel in
Shane’s study as ‘seeing them sweat’ (Shane, 2005, p. 22). This is much easier to do if the
investment is local. Avdeitchikova and Landström (2005) provide statistical support for
these explanations. In their study of Swedish informal investors, they found that investors
who rely on personal social and business networks as their primary method for sourcing
deals, and active investors who provide hands-on support to their investee businesses, are
the most likely to invest close to their home/office.
Some studies have further observed that experienced angels have the greatest awareness
of the benefits of investing close to home. Freear et al. (1992; 1994) noted that whereas
38 per cent of virgin angels had no geographical restrictions on where they would be pre-
pared to invest, this fell to 24 per cent amongst active angels (see Table 3.1). In a study of
UK investors, Lengyel and Gulliford (1997, p. 10) noted that whereas the majority (67 per
cent) of investors gave preference to investee companies which were located within an
hour’s drive, actual investors placed an even bigger emphasis on distance in their future
investments, with 83 per cent indicating that they would prefer their future investments to
be within 100 miles of where they lived.

The characteristics of long distance investments Nevertheless, long distance investments


do occur. In studies of New England (Wetzel, 1981; Freear et al., 1992) and Canada
(Riding et al., 1993) between 22 per cent and 36 per cent of investments were over 300
miles from the investor’s home or office (see Table 3.2). In the UK, Mason and Harrison
(1994) found that one-third of investments were in businesses located more than 100 miles
from the investor’s home. Even in studies that have reported very high levels of local
investing, at least 1 in 10 investments were over a long distance. For example, 11 per cent
of investments made by Ottawa-based business angels were over 300 miles away (Short
and Riding, 1989), while in Finland, 14 per cent of investments were over 300 miles away
from the investor’s home (Lumme et al., 1998).
Long distance investing is distinctive in several respects. First, in terms of investors,
those who have industry-specific investment preferences (including technology prefer-
ences) are more willing to make long distance investments, and the pattern of their actual
investments supports this preference (Lengyel and Gulliford, 1997). Paul et al. (2003)
suggest that the willingness of angels to make non-local investments is related to the funds
that they have available to invest and the number of investments that they have made.
They note, for example, that distance is not an issue for ‘super-angels’ with more than
£500 000 available to invest. Such investors are also more likely to be well-known and so
more likely to be approached by entrepreneurs in distant locations. The ‘personal activity
space’ of angels is also relevant. Investors with other interests elsewhere in the country
will look for additional investments in these locations in order to reduce the opportunity
costs of travelling. Second, certain deal characteristics are associated with long distance
investing. Size of investment is important, with angels willing to invest further afield when
making a £100 000 investment than a £10 000 investment (Innovation Partnership, 1993).
The amount of involvement required is also relevant, with one angel observing that an
investment requiring ‘a one day a week involvement is going to be closer than [one which
92 Handbook of research on venture capital

requires] a one day a month involvement’ (Innovation Partnership, 1993). Third, angels
will make long distance investments if someone from the location in which the business
is based that they know and trust is co-investing with them.
From this fragmentary literature it can be concluded that there is not a national infor-
mal venture capital market. Rather, in view of the dominance of short distance investing
it is best described as comprising a series of overlapping local/regional markets. Localities
and regions differ in terms of both the numbers of business angels and their investment
capabilities. There are also more subtle, but equally significant, differences in terms of the
characteristics of investors, their investment preferences and the nature of the hands-on
support which they can provide to investee companies. It follows from this that informal
venture capital is not equally available in all locations. Nevertheless, some long distance
investing does occur. However, there is little support from the available evidence to suggest
that regions with a deficiency of informal venture capital can import their capital needs
from elsewhere. Indeed, in their exploratory study of long distance investing by business
angels in the UK Harrison et al. (2003) suggest that investors in the South East of
England – the most economically dynamic and most entrepreneurial region in the UK –
are the least likely to make long distance investments, and long distance investments in
technology businesses are most likely to flow from economically less dynamic regions and
into the South East region (which contains the major technology clusters).

Institutional venture capital: a geographical analysis

Definitions
Whereas the informal venture capital market comprises high net worth individuals invest-
ing their own money in unquoted companies, the formal, or institutional, venture capital
market consists of venture capital firms – in other words, professional fund managers who
are investing other people’s money. Most venture capital firms are ‘independents’ who
raise their finance from financial institutions (for example banks, insurance companies,
pension funds) and other investors (for example wealthy families, endowment funds, 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 class
but lack the resources and expertise to invest directly in companies themselves. Moreover,
as they are only allocating a small proportion of their investments to this asset class (typ-
ically a maximum of 1–2 per cent) it is more convenient to invest in funds managed by
venture capital firms (who are termed the ‘general partners’) who have specialist abilities
in deal selection, deal structuring and monitoring. This enables venture capital firms to
deal more efficiently with asymmetric information than other types of investor. Venture
capital firms also have skills in providing value-adding services to their investee businesses
and securing an exit for the investment which maximizes returns. The other, much smaller
category of venture capital firm is ‘captives’. These are venture capital firms that are sub-
sidiaries of financial institutions (especially banks) or non-financial corporations and
who raise their investment funds from their parent organization. (See Cumming, Fleming
and Schwienbacher in Chapter 5 for a more detailed discussion).
Three smaller types of institutional investors are also of note. First, some non-financial
corporations make venture capital investments for strategic reasons associated with R&D
or market considerations, an activity which is termed corporate venturing. Second, some
Venture capital: A geographical perspective 93

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 Capital
Trusts and Canada’s Labor-Sponsored Venture Capital Funds (Ayayi, 2004). Third, in
many countries there are government-funded venture capital funds which have been estab-
lished for economic development reasons usually in regions which lack private sector
venture capital funds (Hood, 2000).

Location of investments
The availability of information on the geographical distribution of venture capital invest-
ing is rather poor. The main source of information is in the form of highly aggregated
statistics produced annually by national venture capital associations or by organizations
acting on their behalf. However, this simply records the location of investments by region,
offers limited disaggregation by type of investment and provides no information on
investment source. A further concern relates to the comprehensiveness of the coverage
(Karaomerlioglu and Jacobsson, 2000). Members of national venture capital associations
tend to be skewed towards larger investors, including those which might not be regarded
as belonging to the venture capital industry,1 whereas many small-scale local investors are
not members and so are excluded. Investments by most corporate investors (that is non-
financial companies making strategic minority investments in small firms) and business
angels, including business angel syndicates, are also not covered. There are some com-
mercial sources of data which do provide deal-specific information (including locations
of investor and investee business). However, these suffer from a lack of comprehensive
coverage, being biased towards larger deals.
In the USA venture capital investments are highly concentrated at all spatial scales:
regional, state and metropolitan area. The pattern at the regional scale is bi-coastal,
with venture capital investing concentrated in California, New England and New York
(Table 3.3). Within individual states venture capital is concentrated in cities. At the 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 venture
capital investing closely relates to the locations of high-tech clusters (Florida and Kenney,
1988a; 1988b; Florida and Smith, 1991; 1992).
In Canada venture capital investments are concentrated in Ontario and Quebec at the
provincial scale, with the Atlantic and Prairie provinces having the smallest amounts of
activity (Table 3.4). At the metropolitan area scale venture capital is concentrated in The
Greater Toronto Area (24 per cent), Montreal (20 per cent) and Ottawa (16 per cent) (2004
figures) which together account for just 28 per cent of total population. Indeed, underly-
ing the metropolitan focus of venture capital investing, just nine cities2 accounted for
82 per cent of all venture capital investments in Canada by value.
Turning to Europe, it should first be noted that the definition of venture capital is rather
broader than is the case in North America, and includes private equity firms which invest
in corporate restructuring situations such as management buy-outs, institution-led buy-
outs and public-to-private deals. These deals are typically very large, usually well in excess
of £10m. The geographical distribution of venture capital investing in the UK favours
London and the South East (Table 3.5) (Mason and Harrison, 2002). These regions have
94 Handbook of research on venture capital

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

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

the largest location quotients – a simple statistical measure to show whether a region has
more, or less, than its ‘expected’ share of venture capital investments by dividing this
figure with some measure of the region’s share of national economic activity (in this case
the business stock). The only other regions with more than their expected shares of
venture capital investments by amount invested (indicated by a location quotient greater
than unity) are the East Midlands and West Midlands. Regions with the lowest location
quotients are in the ‘north’, notably Wales, Northern Ireland, Yorkshire and The Humber,
the North West and North East. Because of the dominance of MBO investments in the
UK there is a much weaker relationship between venture capital investing and high-tech
clusters (Martin et al., 2002). However, early stage investments continue to be dispropor-
tionately concentrated in London, the South East and Eastern regions and are more
closely linked to high-tech clusters (such as Cambridge) and more generally to the loca-
tional distribution of high-tech firms (Mason and Harrison, 2002).
A number of other West European countries, notably France, also exhibit high levels
of geographical concentration of venture capital investments in just one or two regions
(Martin et al., 2002). In Germany, 65 per cent of total investment in 2003 and 2004 was
concentrated in just three of the 15 federal states – Bavaria, Baden-Wurttemberg
and North Rhine-Westphalia (Fritsch and Schilder, 2006). Nevertheless, venture capital
investments are less geographically concentrated in Germany than in other countries, with
five states having location quotients greater than unity (Martin et al., 2005).
Venture capital: A geographical perspective 95

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

Companies Total
Amount invested financed Financings* investments
Province $m % No. % No. % No. %
British Columbia 225.7 12.3 58 9.8 69 10.8 198 12.9
Alberta 64.3 3.5 22 3.7 23 3.6 41 2.7
Saskatchewan 30.9 1.7 17 2.9 18 2.3 32 2.1
Manitoba 10.9 0.6 18 3.0 18 2.3 39 2.5
Ontario 751.0 41.1 156 2.6 170 26.6 510 33.3
Quebec 709.8 38.8 297 49.7 313 49.0 675 42.9
New Brunswick 15.6 0.9 13 2.2 16 2.5 30 2.0
Nova Scotia 17.2 1.0 6 1.0 8 1.3 16 1.0
Prince Edward 2.8 0.1 2 0.3 2 0.3 6 0.4
Island
Newfoundland 0.2 0.0 1 0.2 1 0.2 1 0.1
Territories 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 exceeds
the number of companies raising finance

Source: Thomson Macdonald (www.canadavc.com)

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

Explaining the geographical concentration of venture capital investments


This uneven geographical distribution of venture capital investments arises from the com-
bination of the clustering of the venture capital industry in a relatively small number of
cities, and the localized nature of venture capital investing.
96 Handbook of research on venture capital

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

Early stage
All 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 1.64
London 830 22.0 1.38 4031 30.3 1.91 229 24.9 1.56
South West 210 5.6 0.60 664 5.0 0.54 26 3.9 0.42
Eastern 413 10.9 1.08 827 6.2 0.62 216 23.5 2.32
West Midlands 262 6.9 0.84 1374 10.3 1.24 17 1.8 0.22
East Midlands 147 3.9 0.47 1147 8.6 1.27 22 2.4 0.35
Yorkshire and The Humber 191 5.1 0.72 319 2.4 0.34 10 1.1 0.16
North West 304 8.0 0.84 641 4.8 0.50 54 5.9 0.61
North East 117 3.1 1.24 194 1.5 0.58 6 0.7 0.26
Scotland 301 8.0 1.14 820 6.2 0.88 64 6.9 0.99
Wales 116 3.1 0.71 126 0.9 0.22 31 3.4 0.78
N. 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 of
the total population of businesses registered for VAT. A value of greater than one indicates that venture
capital investments are over-represented in that region. A value of less than one indicates that venture capital
is under-represented in that region

Source: British Venture Capital Association, Report on Investment Activity

The spatial clustering of venture capital firms Venture capital firms are clustered in just
a small number of cities, typically major financial centres and cities in high-tech regions.
Since most venture capital firms have only a single office, including branch offices has only
a minor effect in reducing this high level of spatial clustering. In the USA venture capital
offices are concentrated in San Francisco, Boston and New York. In Canada the main
centre for venture capital firms is Toronto (59 per cent), with smaller concentrations in
Calgary, Montreal (both 9 per cent) and Vancouver (8 per cent). In the UK 71 per cent of
venture capital firms have their head offices in Greater London. There is greater dispersal
in Germany. Munich is the biggest single host to venture capital firms but accounts for
less than 20 per cent of the total (Fritsch and Schilder, 2006). In total, six cities account
for 65 per cent of venture capital firms: nevertheless, all of them are major banking and
financial centres (Martin et al., 2005).
The concentration of venture capital firms in financial centres reflects the origins of
many of them as offshoots of other financial institutions (notably banks). It also offers
access to the pools of knowledge and expertise that venture capital firms require to find
deals, organize investments and support their portfolio companies. Hence a location in a
financial centre enables appropriately qualified staff to be recruited and provides 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
Venture capital: A geographical perspective 97

proportion of venture capital firms located in Silicon Valley, a high-tech region. In


contrast to the venture capital firms in financial centres, these firms have typically been
started by successful technology entrepreneurs and raised a lot of their funding from local
high net worth individuals (particularly wealthy cashed-out entrepreneurs). Technology
regions in other countries – such as Cambridge in the UK and Ottawa in Canada –
typically have only a handful of local venture capital firms, and ‘import’ much of their
funding from venture capital firms based in the major financial centres (London, Toronto,
and so on). However, these local venture capital firms have often been established by suc-
cessful local technology entrepreneurs (for example Amadeus in Cambridge, started by
Hermann Hauser, and Celtic House in Ottawa, started and initially funded by Terry
Matthews), and illustrates how technology clusters benefit from the institution-building
activities of such individuals.

The localized nature of venture capital investing The clustering of venture capital offices
need not necessarily lead to the uneven geographical distribution of venture capital invest-
ments – the money could be invested in distant regions. But in practice venture capital
investing is characterized by spatial biases which favour businesses located close to where
the venture capitalists themselves are located. Florida and Smith (1991; 1992) have
observed that venture capital firms located in high-tech clusters tend to restrict their
investing to the cluster. Powell et al. (2002) report that just over half of all biotech firms
in the USA attracted venture capital investment from local sources. This proportion was
even higher amongst smaller, younger, more science-focused firms and amongst firms in
the main biotech clusters (Boston, San Francisco and San Diego). Moreover, the tendency
for venture capital firms to invest locally increased during the 1990s. In the case of
Internet investing, Zook (2005) points to a strong statistically-significant correlation
between the offices of venture capital firms and the number of investments at all spatial
scales from five-digit zip code to metropolitan statistical area, with the strongest correl-
ation for early stage investments. Martin et al. (2005) similarly report a strong tendency
for German venture capital firms to invest locally, with most Länder dependent on local
venture capital firms for investment. On average nearly half of all firms raising venture
capital have been funded by local investors, with this proportion rising to 68 per cent in
the case of the Bayern region which is centred on Munich.
This strong spatial proximity effect arises because of the absence of publicly available
information on new and young businesses. Their unproven business models, untested
management teams, new technologies and inchoate markets all represent key sources of
risk and uncertainty for investors (Sorenson and Stuart, 2001). Venture capitalists seek to
overcome this uncertainty about the future prospects of potential investee businesses by
information sharing with other investors, consultants, accountants and a wide range of
other actors. Information sharing of this type is built on mutual trust that has been earned
through repeated interaction, while the nature of this information flow tends to be per-
sonal and informal and therefore hard to conduct over distance. As a consequence, less
information is available about businesses in distant locations. Making local investments
is therefore one of the ways in which venture capital firms can reduce uncertainty, 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
98 Handbook of research on venture capital

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 inundated
with business plans and have to develop systems which allow them to quickly identify
and focus on those which have the best prospects for success. There are two sources of
deal flow: deals which come in cold and those which are referred by the venture capital-
ist firm’s network – for example, law firms, accountancy firms, other venture capitalists
and entrepreneurs. Venture capitalists are unable to rely on the information provided by
the entrepreneur in deals which come in without an introduction. Instead, they rely on
their networks – which tend to be local – as a means of receiving deal flow which has
already been screened for relevance and quality. As one venture capitalist quoted by
Zook (2005, p. 83) explained, ‘I depend on someone I know to alert me to good deals. If
I don’t know this person at all and if they’re coming in totally cold, they have to say some-
thing really compelling to get me to look at it.’ Moreover, venture capitalists can place a
high level of trust in the quality of these referrals because these organizations and indiv-
iduals concerned are putting their reputation on the line when they refer deals to venture
capitalists.
Deal evaluation. The outcome of the initial screening is a much smaller number of
opportunities which the investor thinks have potential. These undergo a detailed evalu-
ation. As Banatao and Fong (2000, p. 302) observe, ‘at this stage the venture capitalist’s
contacts in his Palm Pilot are his best friend.’ Venture capitalists use their extensive con-
tacts to research the background of the entrepreneurs, the viability of the market, likely
competition already in place or on the horizon and protection of the intellectual property.
At the start-up and early stages of investing, considerable emphasis is placed on the
people. What have they done? Are they credible? Do they have the right integrity and
ethics? This is particularly the case in situations where the investor believes in the 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 to
bet on the entrepreneurs presenting the business plan’ (von Burg and Kenney, 2000,
p. 1152). It is easier and quicker for a venture capitalist to check an entrepreneur’s résumé
if he or she is local, by using their own knowledge and local connections. The quality of
information is also likely to be better (Zook, 2004). Several Ottawa-based venture 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 and
I can find out everything . . . For the most part, you are dealing with teams and at least some of
the team members come from the Ottawa community . . . Because I have six or seven investments
in semiconductors, there are not many people in the Ottawa area in the semiconductor industry
that I don’t already know or know someone who knows them, or who has worked with them in
the past and so on.

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

I look at where they worked . . . If they’ve worked at half a dozen places there’s got to be one of
those places where I know somebody.
Venture capital: A geographical perspective 99

So, as Zook (2005, p. 81) notes, ‘limiting investments to nearby firms produces easier
and faster access to an entrepreneur’s references, which can often be double-checked by a
venture capitalist’s own personal connections and knowledge.’
Post-investment relationships. The local focus becomes even more important once an
investment is made. Venture capitalists not only provide finance; they also monitor the
performance of their investee companies to safeguard their investment, usually by taking
a seat on the board of directors, setting goals and metrics for the companies to meet and
supporting their portfolio companies with advice and mentoring in an effort to enhance
their performance. They may even play a role in managing the company in the case of
scientist-led young technology businesses. Supporting and monitoring their investments –
which is an important part of managing the risk and accounts for a significant propor-
tion of a venture capitalist’s time – also emphasizes the importance of proximity. Even
though some forms of support do not require close contact there will nevertheless be
many occasions when face-to-face contact is required and the venture capital firm will
incur high costs each time a non-local firm is visited. It is undoubtedly the case that geo-
graphical proximity plays an important role in both the level and quality of support that
businesses are able to obtain from their venture capital investors (Zook, 2004; 2005). First,
venture capitalists can work more closely with their investee companies in their support
and advisory roles when they are located nearby. Second, venture capitalists have abun-
dant contacts and deep knowledge of particular industries: providing referrals to these
sources of expertise is an important value-added contribution that venture capitalists
make. This social network is more readily tapped when investee businesses are geograph-
ically proximate to the venture capitalist (Powell et al., 2002; Zook, 2005). Third, a further
benefit which accrues when the venture capitalists and investee businesses are 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 soccer
matches, or news about a seminar or presentation all happen routinely . . .’ (Powell et al.,
2002, p. 294). In short, it is precisely because venture capital is more than just the 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 a
heavy reliance on their network of contacts to source quality deals, evaluate these deals,
provide timely assistance to their portfolio companies and monitor their performance.
This favours local investing because all of these activities become increasingly difficult to
undertake over long distances (Zook, 2005).

Venture capital as a location factor


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

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

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

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

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

Long distance investing


The discussion thus far has emphasized the localized nature of venture capital investing.
However, it is important to recognize that long distance investing also occurs.
Venture capital: A geographical perspective 101

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

Venture capital clusters and technology clusters: the case of Ottawa


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

The Ottawa technology cluster: an overview


This process is illustrated by Ottawa, Canada’s capital city, which is one of the main
regions for venture capital investing in Canada. (See Shavinina, 2004 for an overview of
Ottawa’s technology cluster.) It currently has around 1500 technology companies which
employ around 70 000 workers (down from a peak of 85 000 at the peak of the technology
boom in 2000). Over 75 per cent of Canada’s telecoms R&D is undertaken in Ottawa. It
is the location for several of the federal government’s R&D facilities and is also the home
of many leading private sector technology companies, including Nortel Networks,
Newbridge Networks (acquired by Alcatel in 2000), Corel Corporation, JDS-Uniphase
and Mitel Corporation – although many of these companies underwent substantial
retrenchment during the post-2000 technology downturn. Nortel undertakes a large share
of its worldwide research in Ottawa. Recognition of Ottawa as a centre for telecoms tech-
nology has led to global companies such as Cisco Systems, Nokia, Cadence Design
Systems and Premisys Telecommunications seeking a presence in the region during the late
1990s either through greenfield site development or the acquisition of local companies.
Ottawa’s emergence as a high technology cluster is largely attributable to the start-up
and growth of entrepreneurial companies over the past 40–50 years. Its origins date back
to the early post-war period with the founding of Computing Devices of Canada Ltd in
1948 as a spin-out from the government’s National Research Council (NRC) Laboratories
to produce military computer hardware. Both NRC and other Government research labs
have been the origin of many other spin-outs since then. A further significant building
block was the decision of Northern Telecom (the forerunner of Bell Northern Research
and later Nortel Networks) to move its R&D facilities from Montreal to Ottawa in the
1950s. This facility has gone on to become one of the largest and most innovative telecom-
munications research centres in the world, although it has contracted since 2000. It has
also been a significant source of spin-outs over the years. A further boost to the cluster
occurred in the mid-1970s with the closure of Microsystems International – a subsidiary
of Northern Telecom – one of the earliest developers of semiconductor technology fol-
lowing a temporary downturn in the chip business. The company had attracted a large
number of highly skilled IT engineers and scientists to Ottawa. Following the closure
some of the redundant workers started their own companies. More than 20 start-ups can
be attributed to former Microsystems employees.
Venture capital: A geographical perspective 103

Venture capital in the early stages of cluster development


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

The recent boom in venture capital investing


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

This growth in venture capital investing has two sources. First, there has been an
increase in the number of Ottawa-based venture capital funds, including several local
funds (in many cases started by ex-Newbridge staff who had been involved in the affiliates
programme) and branch offices of Canadian venture capital funds. In addition, other
Canadian and US venture capital firms put people on the ground to act as their ‘eyes and
ears’. Second, a number of investors based elsewhere in Canada and the US – notably in
Toronto and Boston – started investing in Ottawa-based businesses. In most cases – and
especially in the case of US investors – these investors have been brought in by the ori-
ginal investors to provide second or third round funding.
Accompanying this growth in venture capital investing has a significant expansion
in the population of business angels. This has been a direct consequence of the many
successful, cashed-out entrepreneurs since the mid-1990s and the large number of
senior executives from the large company sector (for example Nortel, Newbridge,
JDS-Uniphase) who have made significant money from stock options, Moreover, these
angels – unlike those who funded earlier generations of technology start-ups such as Mitel
and Lumonics – are technologically savvy and are investing in areas that they understand
so that they are able to bring commercial know-how to support the entrepreneurs that
they are funding. One of the value-added contributions that business angels can provide
is to make introductions to venture capital funds. Indeed, Madill et al. (2005) noted that
57 per cent of technology-based firms which raised angel financing went on to raise
finance from venture capital funds; in comparison, only 10 per cent of firms that had not
secured angel funding obtained venture capital. This reflects the role of business angels in
building up start-up companies to the point where they become ‘investor ready’. The 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 the
quality of their angels’ (quoted in Mason et al., 2002, p. 267).
There are four interrelated factors which account for this recent interest amongst venture
capitalists in investing in Ottawa (Mason et al., 2002). First, several contextual factors
favoured Ottawa. The venture capital industry experienced a boom in fund raising in the
second half of the 1990s, fuelled by a ‘hot’ IPO market and an active takeover market for
young technology companies. Thus, there was plenty of money looking for profitable
opportunities. In particular, US venture capitalists were finding that the money they had to
invest was outstripping the investment opportunities available locally, so they began to look
further afield (cf. Green, 2004). One of the key sectors in which venture capitalists were
interested in was communications – voice, data, telephony and infrastructure businesses.
These were precisely the sectors in which Ottawa was strong. Venture capital firms which
specialized in communications technology recognized that Ottawa has an international rep-
utation for world class technology in this area and knew that they could not overlook the
region as a source of potential opportunities. Two of Ottawa’s own venture capital funds –
Celtic House and Skypoint Capital – also specialize in communications technology.
Second, the sale of three young venture capital-backed companies in 1997 and 1998 for
what at the time were extremely high valuations demonstrated to the venture capital 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 and
staff in these companies (through stock options) had a dramatic effect on the attitude of
engineers in the large companies, making them much more positive about starting, or
Venture capital: A geographical perspective 105

working in, a young technology company. Hence, it became much easier for venture
capitalists to attract people from major local companies to build strong start-up teams.
Third, the success of global companies based in Ottawa, such as Nortel, JDS-Uniphase
and Newbridge Networks, gave the region high visibility for the quality of its technology
and engineers. This attracted the attention of US venture capitalists in particular, giving
Ottawa-based entrepreneurs the credibility to get a hearing from venture capitalists. One
former local economic development official responsible for Ottawa’s Venture Capital Fair
noted that ‘when [entrepreneurs] call and say, “we’re from Ottawa and we’re working in
this area”, they get attention . . . because Ottawa is now really on their map.’ He went on
to quote from a US venture capitalist who told him that ‘if you see a deal involving 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 their
ideas.’ Interestingly, Boston-based venture capitalists have invested in Ottawa despite
having no physical presence there. However, the flight time is only an hour and a half –
and because of Ottawa’s small size could quickly get plugged into the local networks.
Finally, Toronto-based venture capitalists also invested in Ottawa from a distance.
Ottawa is an hour’s flying time from Toronto, close enough for Toronto-based venture
capitalists to do a day’s business. However, by the late 1990s many Toronto-based venture
capitalists were finding this model of investing to be problematic. They were unable to
match the valuations paid by US venture capitalists for young technology companies.
Moreover, the large size of many US funds meant that they did not need to syndicate the
deal, thus excluding Canadian venture capital funds from the investment. This prompted
the recognition amongst Toronto venture capitalists that they needed to invest at an
earlier stage, ahead of the US investors, and therefore to already be an investor in 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 previously
established 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 generating
leading edge ideas, with an entrepreneurial culture and which can support the emergence
and growth of world class companies that will generate high returns for investors. But
once venture capitalists recognize this they will be attracted to invest.

Conclusion

Summary
This chapter has drawn attention to the strong geographical effects that characterize
venture capital investing, contradicting the economist’s concept of perfectly mobile
capital markets (Florida and Smith, 1991). Although venture capital firms can, and do,
raise their investment funds from anywhere, there are strong geographical constraints on
where they make their investments. First, investing locally is a way of minimizing uncer-
tainty and reducing risk in identifying and evaluating investment opportunities and sup-
porting their investee companies. In particular, the hands-on involvement of venture
capitalists encourages local investing. These considerations may also encourage the
relocation of new firms seeking finance from other regions which lack venture capital.
106 Handbook of research on 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 distance
venture 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 to
reinforce the geographical concentration of venture capital investing. It is for these same
reasons that regions which lack local venture capitalists will encounter difficulties in
accessing venture capital from afar. Third, the concentration of venture capital investing
creates a virtuous circle in which knowledge and learning about venture capital spreads
to local entrepreneurs and intermediaries, resulting in increased demand for venture
capital. The exact opposite occurs in venture capital deficient regions where knowledge
and understanding of this type of finance in the business community will be weak, so
entrepreneurs will be less inclined to seek it and intermediaries will be less competent in
getting their client’s investment ready.
Given the positive effect that venture capitalists have on new firm formation and
growth, as both capitalist and catalyst, the effect of the geographical clustering of their
investments, in turn, contributes to uneven regional economic development. In the case
of Silicon Valley, for example, proximity to abundant sources of venture capital enables
firms to raise finance at a younger age, complete more funding rounds and raise more
money at each round. This translates into better performance: faster growth, profitabil-
ity, greater employment and a high likelihood of achieving an IPO.5 By having early access
to venture capital this gives start-ups substantial first-mover advantages, enabling pioneer
firms to transform ideas quickly into marketable products and become industry leaders
(Zhang, 2006).

Future research directions


The geographies of venture capital have been largely ignored by those scholars who have
approached the topic from entrepreneurial and finance perspectives. The subject has also
attracted surprisingly limited attention from economic geographers despite the growing
interest in the geography of money (Martin, 1999; Pollard, 2003). Hence, many significant
research questions need to be addressed. It is inevitable that any research agenda is per-
sonal and idiosyncratic. Based on the material that has been reviewed in this chapter, five
topics are identified as priorities for further research.
First, considering business angels, there is a need for research which can ‘put 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 business
angels 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 locational
challenges. These are fairly straightforward questions but pose considerable challenges
simply because of the difficulties in obtaining comprehensive statistical information on
business angels and their investment activity.
Second, most geographical analyses of venture capital investing have used highly aggre-
gate data. Future studies need to make use of databases, such as Thomson Financial’s
Venture Expert Database, which contains a range of information on companies which
Venture capital: A geographical perspective 107

have received venture capital, and their investors, thereby permitting a much greater range
of geographical questions to be explored.
Third, moving from the macro scale, and quantitative data, to the micro-scale and
qualitative data, there is a need for greater insights into the way in which both business
angels and venture capital firms factor location and distance into their investment 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 investee
is a compensatory factor, waived if other aspects of the investment are particularly
favourable. This is likely to require ‘real time’ research methodologies. More generally,
there is a need to explore the spatial biases of investors which influence their attitudes to
investment opportunities in different locations.
Fourth, there is a need to tease out the connections between venture capital and tech-
nology clusters. There are two particular issues. The first concerns the popular view that
venture capital is a pre-condition for the emergence of technology clusters. This chapter
has highlighted the case of Ottawa, and cited several other studies, which clearly 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 capitalists
located in other regions who make and monitor their investments on a fly-in, fly-out basis.
Local sources of venture capital only emerge when a critical mass of entrepreneurial
activity is reached, the cluster develops an identity of its own, entrepreneurial success
stories begin to emerge and the quality of the region’s technology is recognized. More
research is needed to explore these processes.
The second concerns the process of knowledge spillovers in clusters. Firms that are
located in clusters derive competitive advantages by gaining rapid access to knowledge on
innovation, production techniques and competitive strategies of other firms. This know-
ledge, which is tacit and therefore difficult to transfer, circulates mainly by inter-personal
contact. Research has tended to focus on three main processes: the mobility of 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 of
cooperative behaviour between firms in the cluster (for example suppliers, sub-contractors,
strategic alliances). It has not considered the role of venture capitalists as either a 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 other
investors, entrepreneurs, corporate financiers, head-hunters, consultants and experts. This
provides 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 what
not to invest in, and supporting their portfolio of investee companies. How this shapes the
trajectory of technology clusters is an important issue for research.
Finally, the venture capital industry is dynamic and as it has matured it has become
more heterogeneous. Research therefore needs to avoid extrapolating from what happens
in Silicon Valley, or even the USA and to examine venture capital investing practices in
different regions. There is also a need to recognize that investment processes and practices
change over the course of the investment cycle and that this produces different geogra-
phies (as Green, 2004, demonstrated). Research must also distinguish between ‘venture
108 Handbook of research on venture capital

capital’ – which can be defined as investing in new and growing entrepreneurial


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

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

Researchers also need to be alert to the changing nature of the venture capital 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 that
funds have substantially larger amounts of money under management. This, in turn, has
driven up both the minimum and average size of investments and led to an increasing
emphasis on later stage investments in established businesses which have larger capital
needs than start-ups. Second, there has been a shift from generalist to specialist investors
who focus on specific industry ‘spaces’ (either vertical or horizontal). Both trends can be
expected to have geographical consequences, notably a weakening in the significance of
local investing (Mason et al., 2002).

Policy implications
The evidence concerning the catalytic effect which venture capital has on business 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 venture
capital available will not magically generate the conditions under which high technology
entrepreneurship will flourish.’ In similar vein, Zook (2005) comments that ‘simply
pumping additional capital into a region will not necessarily produce the dynamism of
established venture capital centres.’ First, as Venkataraman (2004) notes, venture capital
needs to be combined with talented individuals – typically business executives who can
generate and develop novel ideas, start companies, make the prototype, obtain the first
customer, develop products and markets and compete in the rough and tumble of com-
petitive markets. This, in turn, will generate some successes which provide the role models
Venture capital: A geographical perspective 109

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

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

Notes
1. Notably private equity firms which invest in large companies to facilitate their restructuring.
2. Vancouver, Victoria, Kitchener-Waterloo, Calgary, Edmonton, Ottawa, Greater Toronto Area, Montréal
and Québec City. These cities accounted for 45 per cent of Canada’s population at the 2001 Census of
Population.
3. For example, Mitel was started with seed money from local lawyers while Lumonics raised its money from
local businessmen (‘retailers, lawyers and car lot owners’: Mittelstaedt, 1980).
4. Noranda Enterprises – the only Ottawa-based venture capital company listed in the 1992 CVCA directory –
was closed down in the early 1990s following acquisition of the parent company in the late 1980s. Its new
owners saw it as a resources company and so in 1992 closed its investment activities (despite having achieved
a 38 per cent compound rate of return to shareholders: Doyle, 1991; 1993).
5. However, venture capital-backed firms in Silicon Valley also have lower survival rates. Zhang (2006) sug-
gests this may reflect the lack of prudent screening. A more plausible explanation may be the competition
between venture capital firms for investment opportunities leading to over-investment in specific markets.

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(2006), ‘Venture capitalists’ decision to syndicate’, Entrepreneurship: Theory & Practice, 30, 131–53.
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4 Venture capital and government policy
Gordon C. Murray

Introduction

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

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

113
114 Handbook of research on venture capital

prescriptions are more anonymously concerned with removing market barriers that
impede individual agents (for example business angels, venture capital firms or entrepre-
neurs) from pursuing their own commercial interests. But the involvement of government
in risk capital markets presumes some form of serious and persistent market failure.
Determining the importance or even existence of market failures will, in turn, require a
view of both demand and supply-side efficiencies. The difficulty of determining market
failure, despite its widespread presumption in entrepreneurship finance policy initiatives,
is noted below.
Academic and policy interests closely reflect the rapidly growing importance of venture
capital activity at both national and international levels over the last 25 years.
Governments’ recent endorsement of venture capital’s status as an important instrument
of entrepreneurial and innovation policy has been particularly noteworthy in Europe
(EC, 1998; 2001; 2003a; 2003b; 2005b; 2006a; 2006b; Murray, 1998; Martin et al., 2003).3
A profusion of contemporary public schemes is also indicative of governments’ contin-
gent response to the rapid reduction in supply of early-stage risk capital after the year
2000 collapse in technology markets (Sohl, 2003). High potential young firms were among
the first casualties of the changing market conditions at the start of the present century.
In several European markets, publicly supported funds were quickly to become one of the
most important and continuing sources of risk capital for new enterprises in the hiatus
of privately-funded, institutional and informal venture finance following the dot.com
collapse (Auerswald and Branscomb, 2003; EC, 2004; NEFI, 2005; Small Business
Service/Almeida Capital, 2005).
It would be incorrect to assume that venture capital is exclusively Anglo-Saxon in its
nature or distribution although a strong association exists between countries in the
former British Empire and the international centers of venture capital activity. Nascent
or growing venture capital industries now exist in virtually all developed economies in
the world. They are frequently encouraged by government action. Similarly, policy
makers in the emerging economies of China, Russia, and Brazil are also now exploring
the development potential of risk capital.4 India already has an established venture
capital community.5
Despite the assumption that venture capital is a suitable subject for policy action,
surveys of SME finance repeatedly show that entrepreneurs’ receipt of risk capital from
professional investors is an extremely rare event. Reynolds et al. (2003) ‘guesstimate’ that
less than half a per cent of all nascent entrepreneurs receive either venture capital or busi-
ness angel finance at start-up. A 2004 survey of UK SMEs showed that less than 2 per
cent of respondents had ever raised institutional venture capital (Small Business Service,
2005). A similar percentage has been recorded in Europe (see European Commission,
2005a). Given that the UK has the largest and most advanced venture capital/private
equity industry in Europe, it is probable that other countries are unlikely to register sig-
nificantly greater risk capital activity among their young firms. European studies confirm
this reality of the scarcity of venture capital receipt (European Venture Capital
Association, 2005).
Early-stage (‘classic’) venture capitalists primarily target technology-based young firms
because of their potential for very rapid growth in attractive and immature markets. Yet,
in a 1997 survey of 600 high-tech start-ups in Germany and the UK (that is conducted at
the start of the technology bull market), Bürgel et al. (2004) found that only around 1 in
Venture capital and government policy 115

10 of UK firms had received venture capital. In Germany, this ratio went down to 1 in 14.
Even in the US, Auerswald and Branscomb (2003) note that the supply of institutional
venture capital finance for technology development trails significantly behind business
angels, corporations and the Federal Government. It is salutary to note that in 2005, the
US and UK venture capital industries invested collectively in only 412 seed and start-up
deals (BVCA, 2006;6 PricewaterhouseCoopers/National Venture Capital Association,
2006). This is from two major world economies where, collectively, over one million new
businesses are started every year. Thus, institutional venture capital still remains a spe-
cialist financing instrument of relevance only to a tiny percentage of the population of
new and growing enterprises in any economy. This continues to be the case even during a
bullish, new technology market.
This chapter will seek to summarize what consensus may be found in seeking an 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 so
interested in venture capital will be addressed while also noting the considerable influence
of US experience. The circumstances under which government itself becomes involved in
either influencing or participating directly in risk capital investment will be explained. The
nature of policy instruments at governments’ disposal are subsequently catalogued
including the growing interest in ‘equity-enhancement’ programs that incentivize private
venture capital agents. The chapter will also seek to address why governments have also
become involved in the ‘alternative’ policy direction of supporting informal investors or
business angels. The chapter will conclude by suggesting future research questions of both
academic and policy import.

Why are governments so interested in venture capital?


The attraction of an established venture capital industry lies in its putative ability both to
help finance the creation of new industries and, in so doing, to transform and reinvigo-
rate mature and established economies (Apax Partners, 2006; European Commission,
2006a; 2006b). The joint application of risk capital and high levels of managerial and
entrepreneurial experience is seen as a particularly attractive resource combination
(Sapienza, 1992) which possibly explains venture capitalists’ popularly perceived ability
to both identify and nurture exceptional new and innovative enterprises.
It is evident that the venture capital experience of the United States in the second half
of the twentieth century has exerted a huge influence on the entrepreneurship policy
ambitions of the majority of developed and emerging economies alike. Above all, it
was America’s unique ability to generate a stream of new companies of enormous vigor
and global span from the nation’s advanced science and technology research centers.
American venture capital clusters, pre-eminently Silicon Valley and Route 128, are per-
ceived as the ‘gold standard’ of early-stage innovation finance systems (Bygrave and
Timmons, 1992). Venture capital – both in its institutional and informal variants – is seen
as part of the very fabric of the USA’s ability to remain at the forefront of knowledge pro-
duction and commercialization (Edwards, 1999) through risk capital’s contribution to the
entrepreneurship/economic growth link (Audretsch and Keilbach, 2004). Multi-country
findings from the Global Entrepreneurship Monitor (GEM) further validate venture
capital ‘as playing a central role in facilitating high growth entrepreneurship’ (Reynolds
et al., 2000).
116 Handbook of research on venture capital

Accordingly, policy goals are often crudely framed as ‘How does country X or region Y
create the necessary conditions to replicate a Silicon Valley’ (Armour and Cumming,
2006). As the emerging BIC economies7 grow their global share of the production of
manufactured goods of increasing sophistication, high value, knowledge-based goods
and services are seen to be of growing importance for the continued prosperity of 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 Western
economies as traditional markets erode (Archibugi and Iammarino, 1999). In Europe,
these concerns about regional competitiveness are exemplified by the Lisbon Agenda
which sought by 2010 to make Europe the most competitive world region in which to
establish and grow a new business (EC, 2004; Kok, 2004).
Despite the absence of a resolution of the question of how to create a new Palo Alto
in Bavaria or a Route 128 around Helsinki, governments’ concerns for the continued
support of the domestic science base (including the commercialization of intellectual
property from laboratory to successful enterprise) remain intertwined with a strong faith
in the value of venture capital finance. Venture capital is as much an instrument of innov-
ation policy as enterprise policy. That many governments recognize the importance of
venture capital finance is, of course, no argument that they should directly engage in such
commercial actions. Most free-market oriented, public administrations have considerable
reservations about direct state involvement in specialist financing activities. They would
prefer to remove themselves completely from this commercial role. None the less, gov-
ernments reserve the right to intervene if there is clear evidence that: 1) the supply of
appropriate finance is insufficient; 2) as a consequence, material economic and other bene-
fits from entrepreneurial actions are being lost to the domestic economy; and 3) no private
investors will independently increase the supply of risk capital. Thus, public intervention
is predicated on an ‘insufficient’ response from private capital markets.

Market failure
We have argued that, given the evolution of the venture capital industry, the competen-
cies and dynamism of its professional managers and the weight of institutional money
now at their disposal, there appears little direct role for the state. Yet, there exists a 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 state
has 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 default
been obliged to assume responsibilities for early-stage enterprise financing activities that
many academic and industry observers believe should better be left to efficient capital
markets. Their involvement in the investment process is recognition that the institutional
venture capital industry increasingly believes that early stage investments are not
sufficiently attractive.
A market failure can be said to have occurred when the price mechanism fails to produce
a socially optimal outcome. In effect, rent-seeking investors8 being unable to capture the
full economic and social value of their investments provide less finance (venture capital)
than could effectively and profitably be employed in existing opportunities. In these cir-
cumstances, public intervention is one possible contingent response to private market
shortcomings (European Commission, 2001). At best, the public involvement is seen as
Venture capital and government policy 117

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

The longevity of the ‘equity gap’


The term ‘equity gap’ has entered the policy vocabulary. It was first used in an official British
governmental report in 1931 that looked at the availability and access of small and medium
sized businesses to sources of external finance. The Macmillan Report concluded that firms
were facing impediments in the search for capital that were not a function of their 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
118 Handbook of research on venture capital

providers of business finance. Thus, the equity gap was conceived as a supply-side market
failure. Successive official reports in the UK (Bolton, 1971; Wilson, 1980; National
Economic Development Office, 1986; Williams, 1998; Pickering, 2002; HM Treasury and
Small Business Service, 2003) over the three-quarters of a century since the Macmillan
Report have broadly echoed its findings that the capital markets are frequently 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 continuing
notoriety. That the gap remains an issue of substantive debate (HM Treasury and Small
Business Service, 2003) is in large part because of the changing nature of the enterprises
affected by capital constraints. The financing problems experienced by firms which could
be classified as ‘high-tech’ or ‘R&D intensive’ (Butchart, 1987; OECD, 1997) only gained
visibility in the latter quarter of the twentieth century. The use of the term ‘knowledge
economy’ with its implication of intangible (and thus un-bankable) intellectual assets is
similarly recent (Sweeney, 1977).
Murray (1995) and latterly Sohl (1999) have both argued that the use of the term ‘equity
gap’ in the singular is a misrepresentation of the harsher realities faced by the young and
growing firm in its vulnerable years prior to the accumulation of sufficient 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 additional
providers 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-on
rounds 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 be
within the equity gap problem. The UK government believes that the gap exists for small
firms seeking investments broadly between £500 000 to £2 million (HM Treasury and
Small Business Service, 2003). Yet, its exact quantification remains vague and inconclu-
sive. The term, and its estimation, is frequently anecdotal. More than one gap has been
identified for more than one reason (Lawton, 2002; Sohl, 2003). The institutional venture
capital industry largely denies the import of the gap arguing that there are few supply-side
constraints. Rather, they counter that the (demand-side) failure is in the quality of the
entrepreneurs seeking risk capital (Queen, 2002).

Causes of market failure when investing in knowledge-based industries


The term equity gap nicely describes a financing constraint affecting high potential but as
yet immature and vulnerable businesses. The actual reasons causing investors to provide
insufficient finance are embedded in the investment process and the risks and reward that
such investment decisions will incur. Further, there is an operational question of 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 benefits
of the investment. In these circumstances, a rational and informed decision not to invest
in an early stage venture cannot be seen as a market failure. On the contrary, it is the market
working effectively. None the less, there are genuine sources of market failure affecting new
knowledge-based firms. Two are particularly pernicious: information asymmetries and
R&D spillovers.
Venture capital and government policy 119

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


business managers.
● Project assessment and due diligence are highly problematic in areas
concerning ‘leading edge’ technologies.
● Uncertainty is compounded by the need to analyze both technological
feasibility and the existence of a sufficiently large and attractive market
(often for a product which does not yet exist).
● The speed of the change and the threat of technological redundancy often
require an extremely rapid rate of commercial exploitation.
● Competitive response and the availability of alternative products/services
are likely to be rapid in dynamic and attractive new technology markets.
● Successful NTBFs need to grow, internationalize and develop second 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 markets
increases the uncertainty of the future financing of the investee firm and
the profitable ‘exit’ of the venture capital investor.
120 Handbook of research on venture capital

Risk is a computable state based on estimated probabilities. Thus, seed, start-up and
other early-stage investments in unique enterprises where no prior history exists are
particularly problematic. Without reference benchmarks, investors also face 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 and
volatile environment. The main implication of this situation is that the presence of non-
quantifiable uncertainty affects commercial decisions by amplifying their perceived
risk components (Einhorn and Hogarth, 1985; Kahn and Sarin, 1988; Ghosh and
Ray, 1997). As a result, early-stage venture capital investments may offer investors the
prospect of little confidence of higher returns but with a considerable likelihood of
project failure. In such circumstances, the abandonment of seed investments in favor of
later stage deals by commercial investors can be viewed as highly rational (Dimov and
Murray, 2006).

R&D spillovers
Audretsch (2004) also observes that it cannot be assumed that desirable spillover effects,
that is whereby society at large gains access to and benefits from the availability of a 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 of
investments in a portfolio will either fail or return (at best) a negligible net present value
when the time cost of money and an appropriate risk premium are computed (Fenn et al.,
1995; Murray and Marriott, 1998; Rosa and Raade, 2006). Where attractive net returns
are made by the fund, it is likely to result from the realization of a small minority of excep-
tional investments within the portfolio (Huntsman and Hoban, 1980; Bürgel, 2000).
Given these uncertainties, the venture capital investors will seek to ensure contractually
that when abnormal rents are generated they are owned by the investors (van Osnabrugge,
1999). Hence, the attention given by technology investors to ensure that they have strong
patent protection (Salhman, 1990; Kortum and Lerner, 2000). Indeed, the investors’
ability to appropriate the commercial benefits of their actions is likely to affect their 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 the
investors. Competitors may emulate and copy key attributes, both legally and illegally.
The bargaining power of suppliers or customers may also erode the innovator’s surplus
rents (Griliches, 1992). In a study of 600 high-tech start-ups in Germany and the UK,
Bürgel et al. (2004) found that the high-tech young firms experienced their first serious
competitive threat after a median period of 16 months of sales.
In these circumstances, both entrepreneurs and investors may well feel that the 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 result
in an undersupply of investment regardless of the fact that the existence of the innovation
has benefits to a wide range of parties. Griliches estimates that the gap between the private
and the social rate of return spans 50–100 per cent of the private rate of return. Small
firms because of their lesser market power and inability to finance the aggressive defense
of intellectual ownership infringements are particularly likely to see an erosion of their
returns (Mansfield et al., 1977).
Venture capital and government policy 121

Policy challenges in the venture capital arena


Based on a near universal admiration as to the vigor of the US innovation financing
system, several governments have sought to emulate elements of the American venture
capital system. The assumption is made, often implicitly, that elements of a system may
be isolated and applied within other different contexts. This raises a set of issues of both
theoretical and operational complexity that policy makers ignore at their peril.

The influence of a US exemplar


Given the noted hegemony of the USA innovation finance system, it is legitimate to ques-
tion what can be learned from the American experience of venture capital activity and
readily applied to other national economies both in the developed and developing world.
Yet the simplicity of the question betrays an ignorance of both ‘path dependency’
(Kenney and von Burg, 1998) or what it is that can actually be made transferable even
assuming that the environmental and institutional conditions (for example tax regimes,
legal and corporate governance structures, and so on) exist for such a transfer to be pos-
sible.10 Gilson (2003) is explicit in his assertion that others cannot follow USA experience
in order to reach ‘the holy grail’ of a flourishing venture capital market modeled on
Silicon Valley. He notes that because of the US industry’s highly idiosyncratic history, ‘the
manner in which the US venture capital market developed is not duplicable elsewhere’
(p. 3). He goes on to argue that other countries might be obliged to use public policy mea-
sures given the inability to copy another country’s history.11
State interest in entrepreneurial action has moved from exhortation to involvement
as many commercial investors have abandoned early-stage equity finance (Sohl, 2003;
Cumming et al., 2005; Coller Capital, 2006). General and limited partners’ actions are an
articulate judgment of the economic attractiveness of the early-stage market. Their deser-
tion has left a financing (equity) gap that governments have felt obliged to try and fill. This
move from early to later stage deals (‘style drift’) is most evident in European venture
capital markets. However, it is not an exclusively European phenomenon. Gompers (1998)
shows that US investors also moved to later stage deals as the size of the finance under
management by venture capital general partnerships increased rapidly in the late 1990s.
This same phenomenon was earlier described by Bygrave and Timmons (1992) and more
recently by Branscomb and Auerswald (2003).

The specific problem of minimum fund scale


‘Ask an LP what he thinks of investing in European venture tech and he is likely
to respond “what is European venture tech”?’ (European Venture Capital Journal,
November 2004).
The single biggest problem – facing both governments keen to encourage early-stage
investment in new technology-based firms as well as for general and limited partnerships
prepared to consider early-stage risk capital investment activity – is simply put. With very
few exceptions, the investment record of early-stage funds worldwide has been very poor
(European Venture Capital Association, 2005). The general exceptions to this rule over
the long term have been from the upper quartile of US technology investors. The consist-
ency of poor venture capital returns in Europe has been so uniform as to make a number
of institutions question whether Europe actually has a viable, early-stage technology
investment activity (Ernst and Young, 2004).
122 Handbook of research on venture capital

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 Quarter
Stage IRR Quartile IRR*
Early stage 0.1 2.3 13.6
Development 9.2 9.0 18.8
Balanced 8.3 8.5 23.7
All venture 6.3 6.2 17.1
Buyouts 13.7 17.8 31.8
Generalist 8.6 8.8 10.3
All 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)

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

● Industry specialization (knowledge effects);


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

Collectively, these firm-level influences can be interpreted as the positive application of


‘scale and scope economies’ to the risk capital investment process.
Murray and Marriott (1998), in a simulation of early-stage venture capital fund 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 supply
determinants of seed capital in their investigation of seed capital fund activities from
1962 to 2002. They showed that the most active seed investors over time were almost
exclusively large and well established US funds. The top five venture capital
investors active in seed capital which were all US based12 had, on average, made 92 seed
investments from total funds under management of nearly $4 billion per venture
capital firm.
Venture capital and government policy 123

50

40

30 Limited
I
R 20 Partners’ IRR
R Management
% 10 IRR

0
7.5 10 15 20 25 30 35 40 45 50
–10

–20
Fund size £ million

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

Small is not beautiful


The most conspicuous outcome of these studies is to challenge the apparent willingness
of policy makers to create and to support programs which encourage the formation of
sub-optimal, and ultimately non-viable, seed capital funds. Here, the state can be seen as
both part of the problem as well as a possible solution to financing constraints. In the
state’s absence, few private investors would have participated in such funds. Small, 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 their
management (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. These
investors including pension funds, insurance companies and other money managers
become 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 the
multi-billion dollar global reach of these institutional investors, asset allocation has to be
material in order to have any effect on the performance of their investment portfolio. In
these circumstances, a minority position for a limited partner demands involvement in a
fund of sufficient scale in order to influence the institution’s overall performance. For all
but the smallest institutional investors, a minority position in a closed venture capital fund
of under US$100 million is likely to be irrelevant.
Thus, a small seed fund’s circumstances often describe the worst of all worlds. It has
modest funds to invest and little income with which to execute a strategy of finding and
evaluating potential investee firms. It is unlikely to be fully diversified. Investee firms, par-
ticularly at start-up, are costly in their urgent need for advice, and the fund has little
money to provide follow-on finance for the most attractive prospects in its portfolio. The
lack of finance results in either impeding the portfolio firm’s growth plans and/or in the
rapid dilution of the fund’s ownership share as syndication finance is arranged. These
conditions are very likely to lead to a sustained poor investment record which will severely
124 Handbook of research on venture capital

BOX 4.2 NEGATIVE CONSEQUENCES OF SMALL VENTURE


CAPITAL FUND SIZE

Small, early-stage venture capital funds bear disproportionately the following


dis-economies:

● The high costs of reducing information asymmetries in immature, complex


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

reduce the fund’s ability to survive by attracting subsequent follow-on funds from private
sector investors. In these circumstances, policy makers outside the elite technology 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 obliged
to come to a view as to their own response to such a withdrawal of private, early-stage
funding sources to priority (new technology) young enterprises. Almost universally, they
have considered the reduction (or absence) of support for such firms to be strategically
and politically unacceptable.

Government instruments to promote institutional venture capital finance


Government’s influences on the entrepreneurial vigor of a national economy are mani-
fold. For example, the institutional legal and fiscal frameworks (Fenn et al., 1995; La
Porta et al., 1997; 1998), the incentive structure of personal and corporate tax systems,
the regulatory regime’s impact on business, and the efficiency of the market for corporate
control will each have profound (albeit not easily predicted) effects on the incentives for
entrepreneurial risk taking. As such, these influences also affect the demand for venture
capital as an important source of entrepreneurial finance.
The eclectic nature of popular policy recommendations (see Box 4.3) reflects the wide spec-
trum of important influences on venture capital activity. Further, such conditions in order to
be effective will in turn have to be embedded in, and legitimized by, a culture of opportunity
recognition and entrepreneurial endeavor (Shane, 2003). However, given the dynamic and
linked nature of investment activities to both micro- and macro-economic variables, it is not
Venture capital and government policy 125

BOX 4.3 VENTURE CAPITAL POLICY RECOMMENDATIONS


Investment regulations:
● Ease quantitative restrictions on institutional investors to diversify sources
of venture funds
● Support the development of a private equity culture among institutional
investment managers
● Facilitate creation of alternative investment pooling vehicles, such as
funds-of-funds
● Improve accounting standards and performance benchmarks to reduce
opacity of venture capital funds and protect investors
● Remove barriers to inflows of foreign venture capital finance
Taxation
● Reduce complexity in tax treatment of capital from different sources and
types of investments
● Decrease high capital gains tax rates and wealth taxes which can deter
venture capital investments and entrepreneurs
● Evaluate targeted tax incentives for venture capital investment and 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 to
national 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 through
mergers, e.g. at pan-European level
● Enhance alternative exit routes such as mergers and acquisitions (M&As)
126 Handbook of research on venture capital

necessarily easy to determine what factors are most important at any one time. Factors that
constrain entrepreneurial activity (for example legal and regulatory compliance) may not by
their removal necessarily act as an accelerator for greater entrepreneurial endeavor.
A full treatment of environmental conditions conducive to venture capital finance is
inappropriate in this chapter. Accordingly, we will focus specifically on what measures the
state may employ directly to support the actions and effectiveness of both the institutional
and informal venture capital industries.

The growing status of entrepreneurial activity


The late twentieth century saw a coming together of two related trends of 1) an increas-
ing awareness of the importance of small and young firms to the wider economy after
Birch’s seminal MIT study (1979), and 2) an appreciation of the changing nature of 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). Incumbent
large 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 it
was highly unlikely that governments could envisage not supporting entrepreneurial
young firms. The ‘political stock’ of small firms increased throughout the 1980s and
1990s. The technology and Internet-related bull markets of the latter part of the 1990s,
with their focus on young knowledge-based firms, further fueled public and government
interest in entrepreneurial activity. Accordingly, the specific financial constraints faced by
young firms in their attempts to grow, and particularly the appropriateness of risk capital
finance to high potential, new enterprises, became an increasing focus of policy interest.
Despite setbacks, there is also evidence that governments can and do learn over time.
The environmental preconditions to effective entrepreneurial action including its financ-
ing are increasingly being recognized in policy circles (OECD, 2004; Small Business
Service, 2005; US Department of Commerce and European Commission Directorate
General for Enterprise and Industry, 2005). Thurik (2003) summarizes Europe’s eclectic
policy needs in order to stimulate greater entrepreneurial activity (Box 4.4).
Thurik’s span of policy prescriptions reflects closely both the EC’s 2003 document
Green Paper: Entrepreneurship in Europe and similarly the UK government’s own 2004
policy roadmap for a more entrepreneurial Britain (Figure 4.2). These enabling environ-
mental conditions set a context in which venture capital programs can operate. The UK
model is interesting for its belief in entrepreneurial activity and its comprehensive linking
to government departments with both a commercial (for example DTI, Treasury and
Inland Revenue) as well as a social mandate (Home Office). The encouragement of new
enterprises in economically disadvantaged communities borrows from earlier experiences
of immigration into both the British and US economies.
The two above illustrations raise an important issue of policy priorities and focus.
Venture capital is an important instrument for promoting enterprise.13 But as the US
experience has also shown us, risk capital has played a critical role in the emergence of
technology hubs on the East and West coasts. Thus, venture capital is additionally seen
Venture capital and government policy 127

BOX 4.4 FIVE AVENUES TO STIMULATE


ENTREPRENEURSHIP

1. Demand side intervention


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

Drivers of Policy Government Vision 7 National Strategies


Many more people
have the desire
Building an Enterprise Culture
skills and
Encouraging a more dynamic
opportunity to start
start-up market
Productivity a business
Building the capability for small
Everyone with the
business growth
ambition to grow
Improving access to finance for
their business is
small businesses
helped and
Encouraging more enterprise in
supported
disadvantaged communities
A supportive
Enterprise Improving small businesses’
business
for all experience of government
environment makes
services
it easy for all small
Developing better regulation and
businesses to
policy
respond to
government and
access to its services

Source: Small Business Service (2004a)

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

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

Venture capital intervention typologies


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

1. Direct intervention – government as venture capitalist. Government may elect to


become its own venture capitalist and undertakes all the roles that would otherwise be
the responsibility of a rent-seeking, market intermediary. Here, the government run,
venture capital firm has to undertake all the selection and due diligence, governance
and nurturing duties incumbent on an early-stage risk capital investor. Given that the
government is investing public finance in order to fulfill its role, the state assumes
simultaneously both the roles of general and limited partner in the public fund.
2. Indirect intervention – private venture capital firms as agent of government.
Alternatively, government can delegate executive responsibility to a private venture
capitalist fund manager. This is often done on the assumption that the state has neither
the professional skills nor the experience to be a ‘direct’ risk capital investor. Once
operational responsibility has been assumed by a private general partner agent, the
position of the state becomes analogous to that of a limited partner in a traditional
limited liability partnership (LLP) fund. Limited partners are not able to intervene in
the operations of the fund manager at the risk of losing tax status privileges. Similarly,
the government’s operational involvement ceases once the focus and mode of opera-
tion of the fund has been agreed and public monies committed. Indirect intervention
via equity enhancement schemes is becoming the dominant contemporary mode of
Venture capital and government policy 129

public involvement as the importance of highly skilled, and properly incentivized,


investment managers is recognized (Gilson, 2003; OECD, 2004).

Government uses multiple incentives with which to encourage the involvement of


private venture capital agents. It will exploit the power of the state to provide additional
and cheaper finance to the fund thereby allowing a leverage affect to increase ‘up-side
returns’. Government may further reduce the costs of the venture capital fund by con-
tributing to a proportion of the operating costs of the fund. However, such operating
subsidies are less common than alternative measures with a direct incentivizing effect on
the fund’s performance. Finally, the state may change the risk/reward profile of the fund
by underwriting part or all of the risk of financial loss to the limited and general
partners.

Direct public involvement


The state as a direct investor creates some challenging issues. First, there is the question
as to whether government has appropriate personnel capable of carrying out such com-
mercially sophisticated activities as equity investment in early-stage firms. It is unlikely
that such persons are widely available as civil servants. Secondly, the state by its size and
influence inevitably will create an impact – for good or ill. Thirdly, that the state has to
assume the role of a direct investor may be seen as a consequence of its failure to incen-
tivize a private market to take on this largely commercial role. A number of countries
do have direct investment via public bodies. The Finnish Investment Industry program
with civil servants investing public money directly into young enterprises primarily to
fulfill government policy goals would meet this definition (Maula and Murray, 2003).
Similarly, the Danish government financed VaekstFonden (Business Development
Finance) also has a direct venture capital investment activity.15 Yet these programs
raise some very considerable issues regarding the conflict between policy and commer-
cial goals.
As noted, direct involvement in new venture investment by government agencies carries
a material risk of market disruption through the potential misallocation of capital and
the possible ‘crowding out’ of private investors (Leleux and Surlemont, 2003). These
undesired effects can be due to both the commercial involvement of inexperienced public
service personnel, who may often control substantial levels of finance relative to the total
supply of early-stage venture finance in a market. In addition, there may be differing
return requirements of public investors (OECD, 1997; Manigart et al., 2002; Armour and
Cumming, 2006). Government funding can further distort private markets by offering
finance which does not fully reflect the appropriate risk premium (Maula and Murray,
2003; 2007). Venture capital is a ‘learned’ activity (Bergemann and Hege, 1998; Shepherd et
al., 2000; De Clercq and Sapienza, 2005). General partnerships often need the experience
of managing and investing multiple funds before they have accumulated sufficient tech-
nical and market knowledge to provide their investors with acceptable returns (Gompers
and Lerner, 1998). Many public programs have recognized the possible adverse effects of
government inexperience on market outcomes. None the less, government’s direct inter-
vention in the supply of venture capital has frequently been defended on market failure
arguments without reference to the efficacy of such actions. It is perhaps inevitable that
criticisms of market distortion have been leveled at such public programs. For example,
130 Handbook of research on venture capital

the Canadian Labor-Sponsored Venture Capital Corporations – a program with both


commercial and social goals and made attractive to individual investors via substantial
federal tax breaks – have been accused of crowding out private venture capital activities
(Cumming and MacIntosh, 2003).

Indirect or ‘hybrid’ public/private venture capital models


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

Private Loan or
Private investors Investment Equity Government

‘Uncapped’ Early-stage ‘Capped’


Profit share fund Profit share

Start-up &
growing SMEs

Source: Small Business Service (2004b)

Figure 4.3 Generic ‘hybrid’ venture capital model


Venture capital and government policy 131

In discussing the evolution of different incentive structures in government’s support of


venture capital, it is important to acknowledge the contribution of the Small Business
Investment Company program created by the US Government’s Small Business
Administration.18 The basic model of an ‘equity enhancement’ program by which the
state’s involvement (either by direct investment or acting as a guarantor to other fund
providers) enables additional and cheaper funds to be raised – thereby creating a leverage
advantage to private investors – has been reflected in venture capital programs worldwide.
It should be stressed that the full value of the Small Business Investment Company
program in its various forms (that is bank owned, debenture and participating securities
funds) was not restricted to the net returns generated by the funds. Indeed, the investment
performance of these funds has been highly variable over time (Small Business
Administration, 2002; 2004). Rather, the value of the program has been in the espousing
of novel public–private experiments used to address the problem of the inadequate 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 via
government supported funds. There is an ‘infant industry’ argument for interceding in
immature markets (Baldwin, 1969; Irwin and Klenow, 1994). In the UK, the government-
conceived venture capital firm, 3i plc and its predecessor ICFC, performed a similar
industry development role from 1946 until the late 1980s (Coopey and Clarke, 1995).

Public-funded incentives in hybrid funds


Hybrid funds illustrate the imperative of government action in strategically important
investment categories where consistently poor returns have precipitated a major reduction
in private finance for young enterprises. Such structures also acknowledge that good
investment managers will rarely tolerate the state having an executive role in their funds.
This impasse is resolved by the use of government finance to incentivize private managers
to engage in more risky, early-stage funds. It is the ‘hands-off’ provision of government
leverage finance that has appealed to professional investment managers mindful of the
need to increase fund scale in the challenging early-stage markets and frequently faced
with private investor indifference.
The term ‘equity enhancement’ is accurate. The state needs to incentivize the general
and limited partners to be prepared to engage in a fund that includes public welfare goals
as part of its raison d’être. In the absence of explicit economic incentives, there is little
logic for profit maximizing, private agents to become involved. Pari passu funding,
whereby the state and private investors provide investment finance on equal terms, only
works where the returns to private investors are attractive enough without needing to skew
the return distributions to private limited partners’ advantage. The state is obliged to
enhance the returns to the general partner and to the other commercially motivated
limited partners in order to attract private investors’ commitment to the co-investment
model. Essentially, the public investor forgoes some of its rights to a pro rata share in the
economic returns of the fund. Given that the state is often the largest single investor in
the fund, a reduction of its share of any net capital gain can leverage a material increase
to the other parties’ returns in the event of a moderately successful fund. In all cases, the
state as a ‘special’ limited partner does not influence the commercial and executive deci-
sions of the fund managers once the investment criteria of the fund are determined.
132 Handbook of research on venture capital

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

A list of a number of existing government-supported venture capital structures that


have adopted one or more of the four described incentives programs is given in Table 4.2.
Despite the increasing popularity of government involvement in hybrid, venture capital
funds, rigorous evaluation of their effects is limited. Evaluations have been undertaken on
such schemes in the UK, New Zealand and Australia.22 However, unabridged evaluations
are rarely available in the public domain.23 Thus, while we may assume that subsequent
program rounds have learned from policy experience, our overall knowledge of 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 each
urgently required in an area of government interest and action of increasing scale
(Lundström and Stevenson, 2005).
Venture capital and government policy 133

Table 4.2 Publicly financed venture capital ‘equity enhancement’ schemes

Examples (present
Feature 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/EIF
co-investing investments by fund to benefit from economies Finland/FII
with private private investors of scale Israel/Yozma
investors However, investing in pari passu 50% of the fund:
with private investors does not Australia/IIF and
have direct incentive effects i.e. it Pre-seed Fund
does not improve the expected USA/SBIC and
returns for private investors in SSBIC UK/regional
market failure segments such venture capital funds
as early stage
Capped After all the Capped return for the UK/regional venture
return for investors (including government increases the capital funds
public the public investor) expected IRR for private Australia/IIF and
investors have received certain investors. The incentive effect is Pre-seed fund
IRR (e.g. interest such that it increases the
rate  perhaps some compensation for good Chile/CORFU
risk premium) the performance. This in turn creates
rest of the cash flows a strong incentive for the private
are distributed to investors to incentivize the
private investors only general partners to make
successful investments and add
value to portfolio companies
Buy–out Private investors are The effect of buy-out option on Israel/Yozma
option for given the option to the IRR of private investors is New Zealand/New
private buy the share of the quite similar as the effect of Zealand Venture
investors government at (or ‘capped return’ of public Investment Fund
until) a specific point investor. However, there are two
of time at additional benefits:
predetermined price 1) The buy-out option gives
(typically nominal both the public investor and the
price  interest rate) private investors an opportunity
to demonstrate success earlier
and more visibly than in the
capped return alternative
2) In the case of success,
government gets a quick exit
from the fund and can put the
money to work again instead of
waiting for the returns on fund
termination
Downside Downside protection Downside protection has a Germany/WFG
protection means the negative effect from the incentive Germany/tbg &
government perspective. While downside KfW France/
134 Handbook of research on venture capital

Table 4.2 (continued)

Examples (present
Feature 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 lower
impact on the performance of
the fund
Fund Government gives a The fund operating costs are Europe/European
operating subsidy for the neutral from the perspective of Seed Capital Scheme
costs management incentives to fund management
company to cover or LPs while increasing the IRR
some of the costs of the fund
from running the
fund
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 the
money in first and attractiveness of the fund
gets the money
out last

Government’s role in venture capital ‘funds of funds’


The hybrid venture capital fund structure assumes that government is the co-partner and
limited partner to an individual fund. In the ‘fund of funds’ option, the government does
not signal preference for any one fund but supports investments in a range of funds that
are sanctioned by the general partner management. The fund of funds manager, acting as
an allocator of limited partners’ commitments, allocates finance to specific venture capital
funds, not to individual investments. While several such fund of funds exist, governments
tend to invest only in such groupings that specifically target young and high potential
firms of policy interest. In France, the Fund for the Promotion of Venture capital (Fonds
de Promotion pour le Capital Risque – FPCR) was set up in 2001. With €150 million,
including European Investment Bank support, at its disposal, the FPCR has invested in
10 French venture capital funds. Investments are geared towards innovating companies
less than 7 years old in sectors where it is difficult to mobilize private funding, that is life
sciences, ICT, electronics, new materials and environment and sustainable development.
The UK equivalent is the UK High Technology Fund. This fund of funds, set up by gov-
ernment in 2000 and managed by a commercial investment company, has raised £126
million, of which £20 million only came from government. It invests exclusively in spe-
cialist technology venture capital funds located in the UK. This fund of funds also
Venture capital and government policy 135

attracted EC assistance via the co-investment of the European Investment Fund. It is as


yet too early to appraise the performance of either of these programs.

Government policy and informal investors (business angels)


So far in this chapter, discussions have focused on policy actions in the institutional market
for risk capital. Thus, the unit of analysis has been the established, and often very visible,
venture capital firms or general partnerships. Yet, advocates of the importance of business
angels have repeatedly noted that the scale of the informal supply is likely to dwarf that of
the institutional venture capital in all developed risk capital markets. There is clear evi-
dence of this disparity in the US and the UK where both types of investor co-exist. This
argument regarding the scale, and thus potential for economic transformation via business
angels, is strongly made and mutually re-enforced by authors Mason, Kelly, Riding,
Madill, Haines and Sohl writing in this book. Accordingly, governments concerned at the
effective supply of financial and business-related support to young and growing companies
have increasingly become interested in informal investors or business angels.24 As Kelly
rightly notes, government interest in these ‘publicly hidden’ investors was materially 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 angel
research and practice, this author will not repeat the analysis of acknowledged experts in
the field. Rather this section will remain exclusively within the policy focus of the chapter
and will look at how governments have sought to promote a vigorous and successful busi-
ness angel sector.

Investors of first resort


Van Osnabrugge (1999) ‘guesstimates’ that business angels provide between 2–5 times the
amount of finance to entrepreneurial firms in the US and possibly invest in up to 40 times
the number of portfolio companies compared to institutional venture capital firms.
Bygrave et al. (2003), using GEM data on 15 nations, subsequently offer more modest
differences in business angels’ favor of 1:1.6 in respect of funds allocated. Sohl (1999)
argues that the ratio of understanding of business angels compared to their impact on the
economy is lower than just about any other major contributor. Bygrave et al. (2003)
support this view noting that entrepreneurs – and policy makers – should pay far less
attention to institutional venture capital activities. They observe that new enterprises,
including those involved in the commercialization of revolutionary research, are much
more likely to be self-financed or gain support from business angels rather than from
classic venture capital firms. In an international venture capital and private equity indus-
try which is becoming increasingly dominated by scale, those parochial investors that are
prepared 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 of
venture capital funds, that continues to militate strongly against small investments.25

A complement to institutional investors


In an ideal policy maker’s world, one might envisage informed and highly experienced
business angels being the predominant seed capital providers to nascent businesses.
Through their own commercial experience in allied sectors or activity, they would be able
to offer the new enterprise valuable practical experience of running a young company. Of
136 Handbook of research on venture capital

equal value, they can provide a ‘certification effect’ allowing fledgling entrepreneurs access
to valuable commercial networks (Birley, 1985; Stuart et al., 1999; Steier and Greenwood,
2000), as well as offering timely and pertinent advice on markets, production and so on.
As the investee firm starts to grow and to demonstrate a major economic opportunity, the
business angel could be the conduit to institutional venture capital. With firm growth
accelerating, the influence of the business angel would give way to the more structured
and ‘enterprise nurturing’ skills of the venture capital firm (Harrison and Mason, 2000).
However, as with formal investing, practice is likely to fall short of idealized expect-
ations. The business angel invests his/her own money and thus does not need to meet
external regulatory standards. The venture capital firms are handling investors’ monies
and must therefore be registered with the appropriate financial regulators. The former can
act as idiosyncratically as they wish. Hunch, gut feel and subjective stimuli are all found
to be important investment decision criteria. The institutional venture capital manager is
much more likely to undertake industry-specific training and to have clear guidelines from
both the general partners of the fund as well as industry guidance from the national
venture capital industry association on due diligence, deal pricing, use of share structures,
legal contracts and so on. Accordingly, unless well known and trusted by the venture
capital investor, the idiosyncratic and untrained business angel is likely to be viewed with
mistrust as an investment syndicate partner. As Kelly wisely notes: ‘complementarity’
does not presume ‘compatibility’.

Business angels as a policy focus


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

Targeting business angels as individuals


Government has generally adopted a two-pronged strategy to facilitate the supply of
informal investors in the national and local market. Firstly, they have had to address the
‘indirect measures’ (OECD, 2004) of taxation in order to ensure that the incentives avail-
able to private investors are commensurate with the level of (undiversified) risk that they
Venture capital and government policy 137

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

BOX 4.5 ENTERPRISE INVESTMENT SCHEME (UK):


INVESTOR TAX BENEFITS

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

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 criteria
evident in most programs, namely:

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

Based on several countries’ experiences, a European-wide program, the Young


Innovative Company Scheme is currently evolving (EuropaBio, 2006). It is proposed that,
for eligible investments, no tax is levied on capital gains realized or stocks that have been
held for a minimum of three years. The French equivalent of the Young Innovative
Company program (that is Jeune Entreprise Innovante) was adopted by the French
Parliament in the 2004 Budget Bill. A similar bill, HR 5198, the Access to Capital for
Entrepreneurs Act of 2006, was presented to the US Congress in April of this year.

Targeting business angels as co-investors


These above schemes are directed at incentivizing the individual to invest directly or via a
tax efficient, trust fund structure. Government has also increasingly seen the business
angel community as an entity that may be incentivized collectively at the fund level in a
potentially similar fashion to institutional venture capital businesses. To date, the tax
transparency attractions of the Limited Liability Partnership structure have largely been
irrelevant to the private investor. Yet, a syndicate of business angels investing co-
operatively on projects where the due diligence and other investment costs has been
shared, as well as any eventual capital gains, is broadly equivalent to the established 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. Such
leverage initiatives have had to address and accommodate the legal issue that the business
angel is a personal investor rather than an institutional investor. However, as business
angel networks or bespoke syndicates start to manage external funds, these differences
begin to blur.
A number of recent developments are noteworthy. Governments may invest as a public
limited partner in a fund specifically made up of business angels investors. The UK’s 2004
scheme, the Enterprise Capital Fund, is designed in such a manner as to accommodate
both institutional and informal investor groups. The bringing of business angel investors
into a legal identity as a group or fund is relatively novel. It addresses the common
problem of business angel investors being severely curtailed in the size of personal 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 primarily
institutional venture capital context in Germany via the BTU program. An informal
Venture capital and government policy 139

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

● State acts as a co-investor increasing scale of investment available;


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

Networks, portals, match-makers and information asymmetries


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

In these circumstances, the involvement of government in activities which increase the


information available to investors and/or investees is likely to be productive at modest
cost. Similarly, the powerful national venture capital associations also have an interest in
ensuring that informal investors looking for early-stage deals that might lead on to insti-
tutional venture capital activity are also sensibly advised, financed and structured. The
policy 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 been
supported by both government and institutional venture capital associations. Sohl uses
the generic term ‘portal’ to describe this interface between investors and entrepreneurs.
Public transfers have also allowed the networks to be sufficiently well financed to ensure
the recruitment of appropriate management and training resources.

A dissenting voice
Lerner (1998) turns a refreshingly skeptical eye on business angel activity. This is a useful
antidote as the business angel literature is often highly evangelical in its arguments. Lerner
asks two questions that he contends are too often assumed rather than posed: 1) do private
capital markets provide insufficient capital to new firms; and 2) can governments better
identify future winning businesses in which to invest? In the absence of robust empirical
examination31 of both the contribution of angels and the value-added role of govern-
ment, Lerner remains a skeptic. Picking up a major theme of this chapter, he notes that
the importance of scale is clear, but business angels, with very few exceptions, are com-
monly characterized by their modest investment resources. Even when bandied together
in investment syndicates, they are seldom likely to create an aggregate fund size of >$50
million. In classic venture capital terms, such a small fund size would now widely be seen
as uneconomic. Lerner’s concern is that new enterprises of insufficient potential to be
financed by institutional venture capital firms are then taken up by sub-optimally sized
business angel networks where the range and level of investment skills and experience are
highly variable. In effect, the informal investor network is both ‘second best’ in its
resources and in the potential assistance that it can offer entrepreneurial firms. Business
angels are also far less regulated for minimum quality practices than their institutional
equivalents. In Lerner’s arguments, there is an implied ‘trickle down’ process with classic
venture capitalists first reviewing prospects and the huge majority they reject becoming
part of the raw material of informal investors. Accordingly, he argues that we have at
present little proof that fiscal incentive programs funded by the state are necessary to
increase business angel activity, nor do we have a clear understanding as to how such pro-
grams may best be structured in order to realize policy goals (Lerner, 2002). While
Lerner’s argument remains cogent, the assumption that business angels are second best to
institutional venture capitalists when appraised by early-stage investment performance
remains hotly debated.
Lerner is supporting those academics who argue that there exists a failure in quality
demand (‘investment readiness’ argument) rather than a lack of available risk capital for
nascent enterprises (the ‘equity gap’ argument). Yet, in practice, the minimum size thresh-
olds for new investments imposed by the majority of professional venture capitalists are
now so high that it is highly unlikely that they would consider investing in a seed or start-
up investment other than for the most interesting opportunity in a new technology. Such
Venture capital and government policy 141

speculative and exploratory investment could be viewed as placing a ‘put’ option on


potentially important future developments (McGrath and MacMillan, 2000; Miller and
Arikan, 2004). Yet, as Dimov and Murray (2006) demonstrate, such an integrated, market
intelligence strategy is rarely undertaken by professional venture capital investors outside
the largest US firms.

Business angels – future policy interest


Business angels by their very scale and ubiquity remain a focus of considerable interest to
governments. Ironically, it is their lack of activity that makes them so enticing. A modest
increase in informal investment activity is likely to have a much larger impact than an
equivalent increase in institutional venture capital given the business angels’ predominant
focus on early-stage investment. Accordingly, it is likely that business angels will increas-
ingly feature in the enterprise policy activities of developed economies. Countries that
facilitate and incentivize personal investment activity via generous fiscal incentives are
likely to have an important head start. A number of trends will reinforce the growing
policy interest in business angels. As the maturing, venture capital industry gets larger in
terms of funds managed (rather than the numbers of venture capital general partner-
ships), a number of traditional venture capital funds will continue to withdraw from the
earliest stage activities as partners experience the need to invest large amounts of fund
monies quickly. The relative performance advantages of later stage funds, including
private equity investments, will exacerbate this long term trend in Europe. In order to
support this rational trend by their venture capital firm members, national venture capital
industry associations will increasingly work with government to ensure that business
angels receive public support.
Such a cooperative industry stance supports the supply of potentially attractive 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 national
innovation and entrepreneurship programs. Business Angel Networks will be able to
exploit this opportunity to argue successfully for greater support (operating grants, co-
investment schemes, and so on) for individual investors and (increasingly) legally defined
angel groups. Programs supporting networks’ development, information exchange and
investor training, are likely to continue to attract public support at regional, national and
international levels. Yet, few public-supported programs are likely to invite independent
academic evaluation and scrutiny de novo. Hence the importance of Sohl’s call for more
support for empirical research into a major financing activity that, in comparison to its
institutional venture capital equivalent, can still reasonably be viewed as terra nullis.

What have we learned from public involvement in private venture capital activity?
One can argue with some authority that the evidence of government learning in the arena
of early-stage risk capital finance is rather poor. Detractors of government’s role could
repeatedly point to unviable small fund sizes in public supported programs; the 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 supported
funds. The vigorous growth over the last quarter of a century when venture capital has
142 Handbook of research on venture capital

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 imperfections
or to realign incentives in a manner congruent with their policy goals. They have to decide
how attractive a flourishing venture capital industry would be to the domestic economy,
and what can sensibly be done to promote its realization. Yet, while there is considerable
and growing governmental activity in the arena of early-stage risk capital investment, the
body of knowledge on which this activity is based remains sparse. Lerner (1999) has com-
mented on the absence of theory in guiding public venture capital activity. Similarly, Jeng
and Wells (2000) note that just as later and early-stage venture capital investment behav-
iors are different and not necessarily influenced by the same factors, so likewise are public
and private venture capital activities different. These authors note that we are still 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 a
diversity of exemplar programs from which we can benchmark progress.
Gilson (2003) takes a similar view that governments often undertake programs without
a clear understanding as to the full consequences of their actions. In addition, political
cycles and investment cycles are rarely likely to be synchronized. There appears a growing
academic consensus that sanctioning government intervention is a decision that should
only be taken with considerable caution, and perhaps only when private venture capital
markets are patently failing. Circumstantial evidence of the large number of sub-optimal,
publicly supported venture capital programs operating across the world including the US
would suggest that academics’ concerns with the logic of public intervention have 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 learning
is inevitable. There is a burgeoning corpus of research knowledge from scholars based in the
entrepreneurship, innovation, management and economics subject areas.33 However, the
communication and accommodation of research lessons into contemporary policy actions
at national level is still capable of considerable improvement (Söderblom and Murray, 2006).
Further, and of equal importance, government usually works in the least attractive
areas of a financial market. The public exchequer becomes involved because of the
absence of private investors. Accordingly, the situation of difficult investment choices and
poor returns is virtually guaranteed. Governments should not be criticized for poor
returns per se. Rather, a more apposite question is whether they should rationally hazard
public monies by attempting to undertake investment activities in areas so commonly
abandoned by informed, experienced and profit-seeking commercial interests.
These comments should not be seen as an apologia for harassed policy makers. There is
regrettably little evidence that robust research findings are acted upon in new policy 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 research
programs, government may too readily accept the convenient results of management
consultants or venture capital industry association.34
Venture capital and government policy 143

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

● Institutional or informal venture capital programs should harness private investors’


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

Future academic research opportunities


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

● Does the equity gap actually exist? If so, at what levels of finance, who is affected,
and are the adverse consequences material?
144 Handbook of research on venture capital

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

While academic scholars have much to offer their policy colleagues, it cannot be
assumed that the potential complementarity of their interests will guarantee research
access or funding. Scholars will have to earn policy makers’ respect and active support.
Experience shows that this is not an easy task. Similarly, while academics are often tribal
in their disciplinary interests (see Sapienza and Villanueva’s chapter), policy clients fre-
quently prefer inter-disciplinary teams that will address big issues with strong evaluation
and execution recommendations. The skill for the academic is to be able to meet 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 will
require a level of trust building and mutual understanding between academics and policy
makers that is still largely in its infancy. Entrepreneurship and venture capital scholars are
going to have to be equally as entrepreneurial in the crafting of venture capital policy
Venture capital and government policy 145

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

Notes
1. 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 should
be 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 capital
actions 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 venture
capital and private equity firms. However, these commercial interests are rarely at the level of new
enterprises.
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 direct
support; 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 more
positive returns and that performance is not affected by location once fund structural characteristics are
controlled (Lindstrom, 2006).
15. Over the last 25 years, Northern European countries have arguably had a stronger tradition of direct
investment activity via public agencies than the more market-driven Anglo-Saxon models of the US and
the UK.
16. Despite Rocha and Ghoshal’s (2006) concern with the adversarial presumption of agency theory, it is a
powerful concept that has considerable salience to venture capital studies.
17. The managers of a venture capital fund which is structured in the industry standard format of a Limited
Liability Partnership are called ‘general partners or GPs. Similarly, the investors into such a fund are called
the ‘limited partners’ or LPs. Both parties have a range of specific rights and responsibilities which are the
subject of considerable, and complex, legal documentation.
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 performance
comparison between funds.
21. Communication with Yigal Erlich, the Government Chief Scientist of Israel at the time of the program’s
inception and now CEO of the Yozma Group, Tel Aviv. The seven emulating countries cited by Mr Erlich
are: Australia, Czechoslovakia, Denmark, Korea, New Zealand, South Africa and Taiwan.
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) for
non-family enterprises.
146 Handbook of research on venture capital

25. In Europe in 2006, a private equity fund, Permira, launched an international fund of approximately €10
billion. At least four venture capital funds of over $10 billion are scheduled for launch in 2007.
26. University endowment programs and investment trusts for high net worth family dynasties have played an
important early role in the development of the US venture capital industry (Bygrave and Timmons, 1992).
27. See http://www.lse.co.uk/financeglossary.asp?searchTerm&iArticleID1646&definitionbusiness_exp
ansion_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 and
known 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 on
comparable 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 UK
and 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 benefits
of venture capital activities albeit from a clearly articulated position of interest.

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PART II

INSTITUTIONAL VENTURE
CAPITAL
5 The structure of venture capital funds
Douglas Cumming, Grant Fleming and
Armin Schwienbacher

Introduction
Venture capital funds perform a vital intermediary role in the financing of entrepreneur-
ial firms and the spurning of new technology and knowledge in an economy. These funds
can take a variety of different organizational and legal forms, including limited 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 capital
market has developed over the last forty years, becoming increasingly institutionalized
and internationally active. Academic research has followed these market developments in
a quest to analyse and explain how institutional markets emerge, what structures 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 the
heart of the way in which the institutional venture capital market works. The institutional
market involves professional venture capitalists investing on behalf of their investors in
entrepreneurial firms. The structure of these relationships is a combination of explicit and
implicit contracts that regulate and guide how venture capital finance, skills and expertise
is delivered to entrepreneurs. In some cases, venture capitalists are loosely governed by
covenants through limited partnerships, and ‘live or die’ by their investment success. In
other cases, more formal bureaucratic structures impinge on the delivery of venture
capital. Our review of the research on the structure of venture capital funds brings
together theoretical and empirical studies in analysing and explaining how these 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 funds
were structured as limited partnerships. The focus in this work was on the USA and was
driven by empirical observations. Only later have we witnessed the literature deepen
through empirical work on markets outside the USA, and through research on the
economic–theoretic foundations of the structure of venture capital funds. The literature
on contract design as it pertains to venture capital fund structure now makes an 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 about
their 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 of
venture capital funds leads to different behaviour by rational venture capitalists? Is there
more or less risk taking, willingness to add value to companies, or indeed, investment
success? Important policy and economic lessons can be gleaned from studying how
venture capital fund structures vary within a country and between countries, and the
implications for the delivery of finance to entrepreneurial firms.

155
156 Handbook of research on venture capital

This chapter reviews literature on the structure and governance of different types of
venture capital funds with a focus on the institutional structures designed to alleviate
agency problems associated with financial intermediation in venture capital finance. As
venture capital limited partnerships (VCLPs) are the most common type of venture
capital fund in many developed economies, our analysis uses the VCLP structure as a
benchmark upon which other types of venture capital funds are compared. It is 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 venture
capitalists as financial intermediaries between investors and entrepreneurial firms. As
investors do not have the time and skills to structure venture capital contracts, screen
potential investees, and add value to investees so that they are brought to fruition in an
initial public offering (IPO) or acquisition exit, investors contract with venture capitalists
such that venture capitalists act on their behalf in carrying out the process of entrepre-
neurial investment. We examine research on this process and contrast VCLPs with other
structures. We then turn to review literature and evidence on why fund structure matters.
As discussed above, fund structure may impact strategy, types of firms receiving finance,
incentives for venture capitalists, the venture capitalist’s behaviour in the investment selec-
tion and management process, and investment returns. The variation in structural forms
observed in the market are due, in our view, to the way in which contracting parties solve
agency problems given differentiated objective functions. The relationship between the
structure of venture capital funds and behaviour of venture capitalists is fundamental to
our understanding of the nature of the venture capital market.
This chapter is organized as follows. The next section provides a short history of the
development of institutional venture capital markets, with particular attention to the
change in fund structures. Next, we will review research surrounding the structure and
governance of venture capital funds, and then our attempt is to show evidence on why
venture capital fund structure matters, in terms of the types of investments made and the
returns to such investments. Finally, we will present our conclusions and offer some areas
of future research.

The development of institutional venture capital markets


Research on the structure of venture capital funds has always been motivated by the
empirical observations that venture capital markets around the world were using various
organizational forms to finance entrepreneurial firms. The growth in the body of litera-
ture on the subject can best be understood in the context of how markets themselves
developed. Research did not emerge due to a paradigmatic shift in economics and finance,
the development of new research techniques, or cross-fertilization of ideas from related
disciplines. Rather, it was impetus to understand the increasing importance of profes-
sional venture capital firms in the economy, and the way in which parties contract between
each other to create new businesses that characterized the seminal articles.
The history of institutional venture capital markets has been well documented by Fenn
et al. (1997) and Gompers and Lerner (2001a). The literature focuses on the emergence of
venture financing in the post-second world war period in the USA through American
Research and Development (ARD), listed closed-end funds spawned by the ARD, the
first limited partnerships in the late 1950s, and federally supported Small Business
Investment Companies (SBICs). Even today, the historiography provides few insights into
The structure of venture capital funds 157

the institutional developments in non-US markets, or of the experiments in corporate


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

110 000
100 000 USA Europe Asia-Pacific
90 000
80 000
70 000
US$m

60 000
50 000
40 000
30 000
20 000
10 000
0
1968

1974

1980

1986

1992

1998

2004

Figure 5.1a Total venture capital commitments 1968–2005: USA, Europe and
Asia-Pacific
158 Handbook of research on venture capital

0.60
Europe Asia-Pacific
0.50

0.40

0.30

0.20

0.10

0.00
1980

1985

1990

1995

2000

2005
Source: Thomson Venture Economics; Authors’ calculations

Figure 5.1b Relative venture capital market development 1980–2005: Europe and
Asia-Pacific vs USA

Asia-Pacific as a percentage of US capital raisings. The European market grew rapidly in


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

United States All European Countries All Asia-Pacific Countries


Vintage Year
(Aggregated All IND CORP FIN All IND CORP FIN All IND CORP FIN
in Periods) Funds Funds Funds Funds Funds Funds Funds Funds Funds Funds Funds Funds
Total Number of New VC Funds by Period:
1980–1989 957 661 76 91 236 135 3 43 112 85 – 12
1990–1996 718 543 30 51 274 170 8 32 391 279 8 54
1997–2001 1804 1342 120 94 1152 703 80 134 856 595 54 116
2002–2004 376 317 13 12 225 150 8 29 150 90 12 27
Relative Importance of Different VC Fund Types (in Per cent of all New VC Funds) by Period:
1980–1989 1.000 0.691 0.079 0.095 1.000 0.572 0.013 0.182 1.000 0.759 – 0.107

159
1990–1996 1.000 0.756 0.042 0.071 1.000 0.620 0.029 0.117 1.000 0.714 0.020 0.138
1997–2001 1.000 0.744 0.067 0.052 1.000 0.610 0.069 0.116 1.000 0.695 0.063 0.136
2002–2004 1.000 0.843 0.035 0.032 1.000 0.667 0.036 0.129 1.000 0.600 0.080 0.180
Average Number of New VC Funds per year by Period:
1980–1989 96 66 8 9 24 14 2 4 14 11 – 2
1990–1996 103 78 4 9 39 24 2 5 56 40 2 8
1997–2001 361 268 24 19 230 141 16 27 171 119 11 23
2002–2004 125 106 4 4 75 50 8 10 50 30 4 9

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

Source: Thomson Venture Economics; Authors’ calculations


160 Handbook of research on venture capital

number of venture capital funds in the category increased between 400–600 per cent. Now
researchers were faced with a new structural form whereby venture capital was provided
to firms through more bureaucratic structures. Thirdly, the internationalization of
venture capital has prompted research on the ways in which legal systems, culture and
institutions impact structure. While the USA continued to be the home of the most new
funds raised each year, Europe and Asia has increased in importance. Indeed, there are
now more funds raised outside the USA than inside the USA, providing impetus to 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 market
trends described above have meant that research covers three major types of venture
capital fund structure: VCLPs, captive funds (financial institutions and corporate venture
capital funds), and government funds (under the guise of government venture capital
support programmes). We will examine each of these structures in turn.

The structure of venture capital funds


The development of institutional venture capital markets and the rise of venture capital
as an important form of finance provided researchers with a fertile topic of analysis. Of
particular importance was the way in which parties contracted to solve agency problems
in the investment management process. In this section we review the work that pioneered
our understanding of fund structures. We first discuss research examining venture capital
limited partnerships. We then turn to more recent work on captive venture funds and 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 contractual
outcome of negotiations between the general partner (the venture capital firm run by
investment professionals) and the limited partners (investors). Two features of the for-
mation of a VCLP have been documented – fund raising and contract negotiation. In
terms of fund raising, limited partners are institutional investors that invest in a range of
assets across the risk spectrum (depending upon their asset–liability structure). Venture
capital and private equity forms a relatively small part of institutional investors’ asset
portfolio. Investors (typically) aim to have up to 10 per cent of their capital to the venture
capital (funds focused on early stage investments) and private equity (funds focused on
late stage, turnaround and buy-out investments) asset class, depending on economic and
institutional conditions (Gompers and Lerner, 1998; Jeng and Wells, 2000; Mayer et al.,
2005). Endowments and foundations (long term, intergenerational asset pools) have trad-
itionally allocated much higher proportions of their assets (often above 25 per cent) to
venture capital and private equity. Gompers and Lerner (1998) and Jeng and Wells (2000)
show that pension funds are dominant investors, while other investors include life 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
Table 5.2 Key features of the structure of venture capital funds

Type of VC fund & Typical ownership of


structure the firm Source of funds Objectives Contract features
Independent VC firm Individual partners Third party investors Financial returns Limited life; multiple fund
(VCLP) through a private company including pension funds, (return on investment, raisings; contract
endowments, fund-of- IRR) covenants; limited liability
funds, life insurance
companies, individuals
Captive (division/business Publicly owned Balance sheet funds; Strategic goals including Unlimited life; formal
unit) corporation business development or access to new technologies administrative control and
R&D budgets and/or products; limiting informal control through

161
competitive threats; corporate culture
financial returns
Government sponsored Individual partners Government finances (and Public policy goals Limited life; single fund
fund (various structures) through a private sometimes matching including development of raising; contract
company, endorsed private sector capital from the local venture capital covenants often with
by a government third party investors) industry; accelerating geographic, company type
programme economic growth and and investment stage
employment; restrictions
commercialization of
technology
162 Handbook of research on venture capital

major source of funds in all considered countries, but particularly in Germany and Japan.
Pension funds are more important in the UK than elsewhere.
The motivation for limited partners to invest in VCLPs derives from portfolio theory.
Gompers and Lerner (2001a) and Lerner et al. (2005) found that investors can increase
overall portfolio return through a justifiable increase in associated risks so long as they
select venture capitalists that perform, over their life time, above the observable median
fund return. Obtaining the required allocation and exposure, however, is not a simple
matter. While institutional investors desire a set exposure to venture capital, this exposure
is not achieved immediately upon committing capital to a venture capital fund (Cumming
et al., 2005). Capital commitments are drawn down over time through capital calls when
the fund managers have selected entrepreneurial firms to invest in, and as such, it typically
takes a number of years before an institutional investor has reached their targeted expo-
sure to venture capital and private equity. Once exposure is achieved the investor must
continue to commit new capital to venture capital in order to maintain a ‘steady state’
exposure position. Institutions with long term, steady state programmes have been shown
to outperform other investors in achieving returns (Lerner et al., 2005).
The second feature of the formation of a VCLP is the negotiation of covenants in the
partnership agreement. This area was first studied by Sahlman (1990) and Gompers and
Lerner (1996; 1999). The structure of VCLPs is designed to mitigate information 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 a
contractual 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 companies
need to be exited). This contractual arrangement is efficient, as it facilitates the time
required to select entrepreneurial firms in which the VCLP will invest and bring that
investment to fruition (either in the form of an IPO or an acquisition). The time of first
investment until exit in an entrepreneurial firm can take between 2–7 years. Venture
capital fund managers start fund raising for subsequent funds in the later part of the life
of their existing fund(s), and may operate more than one VCLP simultaneously (subject
to covenants, as discussed below). In industry practice, the collection of funds that 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 under
conditions of hidden information and hidden action. Venture capital fund managers are
compensated in a way that provides them with a fixed management fee (1–3 per cent of
committed capital per year) and a carried interest performance fee (20–30 per cent of
profits over return of capital). The fixed management fee is designed to provide enough
capital to run the fund and pay the fund manager prior to any exit. The performance fee
is designed to align the incentives of the VCLP managers with their institutional investors.
Gompers and Lerner (1999) show younger inexperienced fund managers typically 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 from
the ‘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).
The structure of venture capital funds 163

VCLPs have three key legal advantages. First, they avoid (or at least mitigate) double
taxation of profits as would take place if the structure were a corporation. Second, they
allow for unlimited liability of the fund managers (the general partner), while allowing for
limited liability of the institutional investors (the limited partners). The fund manager is
involved in the day-to-day operation of the fund, and can make decisions without inter-
ference from the institutional investors (or otherwise the institutional investors risk losing
their limited liability status). This autonomy is a marked advantage over corporate
venture capital funds, as discussed below. Third, unlike a corporation (where covenants
are imposed by statute), VCLPs are structured by contract, which is completely flexible
and negotiated to specifically suit the best interests of the parties.

Covenants governing the VCLPs The covenants contained in VCLP set out the ‘rules of
behaviour’ for long term relationships. Theory on the design of these covenants is in its
infancy. Lerner and Schoar (2004) examine the extent to which venture capital managers
may want to include specific covenants in the LP agreements in order to screen better
investors for their fund (that is more ‘liquid’ investors that are long term oriented, with
secure sources of capital). The central hypothesis is that the manager benefits from having
their investors participate in follow-up funds, since it provides a signal to other investors
that LPs are happy with the manager. Therefore, the latter may prefer to keep out liquidity-
constrained investors in early funds, since these investors may not participate in follow-up
rounds for reasons other than how well the fund performed. Their study leads to empirical
predictions with respect to the particular design of partnership agreements.
In terms of empirical studies on covenants, the seminal work was undertaken by
Gompers and Lerner (1996; 1999), who analyse the covenants used to govern VCLPs in
the US. Subsequent work (Schmidt and Wahrenburg, 2003; Cumming and Johan, 2005)
considers similar evidence in an international context. One type of covenant among
VCLPs is the restriction on the fund manager regarding investment decisions. First, fund
managers are restricted on the size of investment in any one portfolio company. Without
such a restriction, a fund manager might lower his or her effort costs associated with diver-
sifying the institutional investors’ capital across a number of different entrepreneurial
firms. It also limits excessive risk-taking by venture capital managers as it forces them to
diversify. Second, fund managers are typically restricted from borrowing in the form of
bank debt, as it would increase the leverage of the fund and impose extra risks on insti-
tutional investors. Third, there are restrictions on co-investment by another fund
managed by the same fund manager, as well as restrictions on co-investment by the fund
investors, which limit conflicts of interest managing the fund. Fourth, there are restric-
tions on the re-investment of capital gains obtained from investments brought to fruition
to ensure realized capital gains are returned to institutional investors.
A second category of covenants relates to types of investment and ensures that the insti-
tutional investors’ capital is invested in a way that is consistent with their desired
risk/return profile. Restrictions include investments in other venture funds, follow-on
investments in portfolio companies of other funds of the fund manager, public securities,
leveraged buy-outs, foreign securities, and bridge financing. Without such restrictions, the
fund manager could pursue investment strategies that better suit the interests of the fund
managers regardless of the interests of the institutional investors. In practice, covenants
tend to be defined in relatively broad language in order to give flexibility to venture capital
164 Handbook of research on venture capital

managers. However, private equity offering memoranda used by venture capital firms to
raise funds typically include more detailed investment objectives in terms of stage of
development, industry focus and geographical scope. Any deviation from these invest-
ment objectives is traditionally called ‘style drift’. Cumming et al. (2004) study such style
drifts in a sample of US data, and show drifts are related to fund age (first-time fund man-
agers are less likely to drift due to potential reputation costs), and to changes in market
conditions between the time funds were raised and funds are invested. Other forms of
covenants are discussed in Gompers and Lerner (1996; 1999), Litvak (2004b), Lerner and
Schoar (2004) for US evidence, and Schmidt and Wahrenburg (2003) and Cumming and
Johan (2005) for international evidence.
Overall, the flexible nature of contractual covenants used to govern VCLPs, and the
autonomy of VCLP managers vis-à-vis their institutional investors, are viewed to be a
major reason behind the successful development of the US venture capital market
(Gompers and Lerner, 1996; 1999). Lerner and Schoar (2004) show that an effective way
to punish venture capital managers is to not participate in follow-on funds of a venture
capital firm. This provides an adverse signal to other fund providers about the quality of
the venture capital firm. The manager then faces a ‘lemons’ problem when he has to raise
funds for a subsequent fund from outside investors. New investors cannot determine
whether the manager is of poor quality. Where prior institutional investors no longer par-
ticipate in follow-on funds of the venture capital firm, other potential institutional
investors of the fund may infer that the existing investors believe that the venture capital
fund managers are of low quality. Thus, VCLP covenants bind the behaviour of the
venture capitalist but it is rare for the sanctions involved in VCLPs to be invoked by
investors. Punishment is more likely to take place through the investor exiting the rela-
tionship when the next fund is offered for investment.

Captive venture capital funds


Captive venture capital funds are funds that are partly or wholly owned by parties other
than the venture capital professionals. Captives may be affiliated to banks, securities firms,
larger diversified financial institutions or a division/unit of a corporation. The ownership
structure of the captive venture capital fund means that its legal and organizational struc-
ture differ from VCLPs in several crucial ways. First, captive funds primarily derive capital
from their parent and invest on behalf of the parent. There is no limited life fund struc-
ture in the agency relationship. Second, governance of venture capitalists within the
captive fund is materially different from governance as contracted through the covenants
in the VCLP. Rather, the company acts as a large (and often sole) shareholder controlling
the fund. Third, venture capitalists invest in entrepreneurial firms in order to satisfy objec-
tive functions that may contain financial and non-financial goals. Finally, the behaviour
of venture capitalists is influenced by the structure of the fund in terms of risk investing,
portfolio construction and effort (we examine this last difference later on in this chapter).
Research on bank venture capital funds is still in infancy. Banks supply their venture
capital divisions with capital from the balance sheet of the bank, allocating a notional
commitment amount (for example capital per year to be invested). Thus, fund raising is
different in process to professional venture capital firms under the VCLP structure
(Gompers and Lerner, 1999; Cumming et al., 2005; Dushnitsky and Lenox, 2005;
Cumming and MacIntosh, 2006). Banks intermediate between depositors and private
The structure of venture capital funds 165

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

Government venture capital funds

Government venture capital programmes Government-backed venture capital company


programmes have been popular around the world as governments support the development
166 Handbook of research on venture capital

of national venture capital markets servicing all stages in the entrepreneurial investment
process (see for example programmes operating in the USA (SBIC), the UK, Israel
(Yozma), Scandinavia, Belgium (SRIW and GIMV), Australia (Innovation Investment
Fund), and New Zealand (Venture Investment Fund)). Typically, these programmes
provide government funding alongside private sector funding (sometimes with an option
to ‘buy out’ the government at a lower rate of return, providing a leverage effect). The
investment objective is usually to alleviate perceived market failure in the supply of
seed/early stage venture capital, where information asymmetries are highest and sub-
optimal capital is allocated by private sector investors (Jaaskelainen et al., 2004).
Government venture capital funds are often driven by policy objectives associated with
welfare outcomes to enhance the market structure, improve financing options to younger
firms, increase employment, foster innovation and support economic growth (Kortum and
Lerner, 2000; Jaaskelainen et al., 2004). From a theoretical perspective, government pro-
grammes have been shown to be Pareto improvements, leading to net positive economic
benefits to an economy (Keuschnigg, 2003; Kanniainen and Keuschnigg, 2004). The struc-
ture of government funds involves covenants on the sector/stage geographic conditions, on
investment behaviour (for example regional, state or country limitations, technology focus,
stage focus), a commitment to wider policy goals such as knowledge transfer, 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 venture
capital come in one of two primary forms: (1) law, and (2) direct government investment
schemes. Capital gains taxes are widely recognized as being one of the most important
legal instruments for stimulating venture capital markets (Poterba, 1989a; 1989b;
Gompers and Lerner, 1998; Jeng and Wells, 2000) (but there are other legal instruments
for venture capital markets; see Armour and Cumming, 2005). Poterba (1989a; 1989b)
shows US venture capital fund raising increased from $68.2 million in 1977 to $2.1 billion
in 1982 as there was a reduction in the capital gains tax rate from 35 per cent in 1977 to
20 per cent in 1982. Venture capitalists invest with a view to exit. As entrepreneurial firms
typically do not have cash flows to pay interest on debt and dividends on equity, venture
capitalists invariably invest with a view towards an exit and the ensuing capital gains. The
most profitable forms of exit for high quality entrepreneurial firms are typically IPO and
acquisitions (Gompers and Lerner, 1999; Cumming and MacIntosh, 2003b; Cochrane,
2005). Therefore, tax policy in the area of capital gains taxation is particularly important
for venture capital finance (for theoretical work on tax policy, venture capital and entre-
preneurship, see Keuschnigg and Nielsen, 2001; 2003a; 2003b; 2004a; 2004b; Kanniainen
and Keuschnigg, 2004; Keuschnigg, 2003; 2004). Da Rin et al. (2005) and Armour and
Cumming (2005) examine the effectiveness of several public policy measures. As conjec-
tured by Black and Gilson (1998), the creation of active IPO markets in Europe appears
to be an important measure for fostering an effective venture capital market. Other mea-
sures that increase the extent to which venture capital flows to high-tech and early-stage
investment opportunities are tax benefits and reduced labour and bankruptcy regulation.
A second form of government support is via direct government created venture capital
funds. Lerner (1999; 2002) discusses the ways in which government funds can be success-
fully implemented to work alongside private venture capitalists. One of the most important
The structure of venture capital funds 167

items identified by Lerner (2002) is the need for government funds to partner with, and
not compete with, private venture capital funds. It is also important for government funds
to work towards areas in the market where there exists a clear and identifiable market
failure in the financing of companies due to, for example, structural impediments in the
market that have given rise to a comparative dearth of capital. Further, Lerner (2002) sug-
gests it is useful for government funds to be structured in ways that minimize agency costs
associated with the financing of small and high-tech firms. For example, it is useful for
fund managers to have covenants controlling investment mandates and compensation
incentives to add value to all of their investee companies; such covenants and compensa-
tion mechanisms have worked extremely well in mitigating agency problems among
private limited partnership venture capital funds (Gompers and Lerner, 1996; 1999).

Government programmes around the world Countries around the world have adopted
different forms of direct government investment programmes in venture capital and
private equity. For example, the US has adopted the Small Business Innovation Research
(SBIR) Programme, administered by the US Small Business Administration (SBA). The
SBIR programme is the largest government support programme for venture capital in the
world. SBIRs have invested over $21 billion in nearly 120 000 financings to US small busi-
nesses since the 1960s. Investee companies include such successes as Intel Corporation,
Apple Computer, Federal Express and America Online. SBIRs are operated like private
venture capital funds and are operated by private investment managers. The difference
between a private venture capital fund and an SBIR is that the SBIR is subject to statu-
tory terms and conditions in respect of the types of investments and the manner in which
the investments are carried out. For example, there is a minimum period of investment for
one year, and a maximum period of seven years for which the SBIR can indirectly or
directly control the investee company. The SBIR does not distinguish between types of
businesses, although investments in buy-outs, real estate, and oil exploration are prohib-
ited. Investee companies are required to be small (as defined by the SBA) which generally
speaking is smaller than those firms that would be considered for private venture capital
financing. SBIRs also face restrictions as to the types of investment in which they may
invest. Capital is provided by the SBA to an SBIR at a lower required rate of return than
typical institutional investors in private venture capital funds. Excess returns to the SBIR
flows to the private investors and fund managers, thereby increasing or leveraging their
returns. Lerner (1999) shows early stage companies financed by the SBIR have substan-
tially higher growth rates than non-SBIR financed companies. This programme has been
quite effective in spurring venture capital investment and creating sustainable companies
(Lerner, 1999). A key feature of this programme is that it complements and partners with,
and does not compete with, private sector venture capital investment.
Similarly, the Government of Australia adopted the Innovation Investment Fund (IIF)
Programme in 1997. As in the US SBIR programme, a key feature of the Australian IIF
programme is that it operates like a private venture capital fund. There have been nine
IIFs created in Australia, for which the ratio of government to privately sourced capital
must not exceed 2:1. Investments will generally be in the form of equity and must only be
in small, new-technology companies. At least 60 per cent of each fund’s committed capital
must be invested within five years. Unless specifically approved by the Industry Research
and Development Board of the Government of Australia, an investee company must not
168 Handbook of research on venture capital

receive funds in excess of $4 million or 10 per cent of the fund’s committed capital,
whichever is the smaller. Prior to the introduction of the IIF programme in 1997, there
was scant start-up and early stage venture capital investment in Australia. Cumming
(2006a) finds that IIFs are fostering the development of the Australian venture capital and
private equity industry in a statistically and economically significant way. In short, the US
SBIR and Australian IIF are indicative that there is tremendous potential for govern-
ments to foster innovation and economic development through public subsidization of
venture capital.
Policy makers in Canada have adopted a unique form of government venture capital
fund known as the Labour Sponsored Venture Capital Corporation, or LSVCC
(Cumming and MacIntosh, 2006). The UK has adopted a similar type of fund known as
the Venture Capital Trust (VCT) (Cumming, 2003). Both the Canadian LSVCC and the
UK VCT are mutual funds listed on stock exchanges, and not operated like private
venture capital funds as in the case of US SBIRs and Australian IIFs. The LSVCC and
VCT investors are individuals, and they receive substantial tax incentives to contribute
capital to this class of funds (by contrast, a mix of government and private funds are used
in partnership to support Australian IIFs and US SBIRs). In exchange for the tax subsidy,
LSVCC and VCT managers agree to adhere to a set of statutory covenants that constrain
their investment decisions and activities. The dominant presence of government subsi-
dized LSVCC funds in Canada is in sharp contrast to the US venture capital market. Prior
work has shown that LSVCCs distort efficient venture capital investment duration
(Cumming and MacIntosh, 2001) and efficient exit strategies (Cumming and MacIntosh,
2003a; 2003b) in Canada relative to the US. Further, LSVCCs crowd out private venture
capital funds (Cumming and MacIntosh, 2006). LSVCCs have much larger portfolios of
investee companies per fund manager than private independent venture capitalists in
Canada (Cumming, 2006b), and distort the selected security in Canada (Cumming,
2005a; 2005b).
Overall, government support programmes for venture capital have had mixed success.
In countries where the government venture capital fund competes with private venture
capital funds (as in Canada), the policy objectives of the government programme has not
been met. Where the government programme complements the private market and fills a
gap in the private provision of capital (as in the US and Australia, for example), the pro-
grammes have been quite successful.

Summary
Research on the structure of venture capital funds is consistent with the view that VCLPs
are the most appropriate structure for the financing of entrepreneurship and innovation in
most areas of venture capital (Gompers and Lerner, 1996; 1999; Schmidt and Wahrenburg,
2003; Cumming and Johan, 2005). As we showed in Table 5.2, these venture capital funds
are owned by the individual investment professionals and make contracts (VCLPs) with
third party investors. The delineation of activities between the parties is well laid out, and
the goals are clear. Entrepreneurial firms receive finance from venture capitalists who are
motivated to help the company to grow in order to maximize shareholder value and invest-
ment returns. Indeed, the continuation of the venture capitalist’s franchise depends upon
successful support of entrepreneurial companies. The structure of the VCLP facilitates long
term autonomous investment structures and appropriate compensation arrangements.
The structure of venture capital funds 169

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 provides
venture capitalists with little autonomy and the organizations are much less stable. Goals
may be unclear, conflict, and include the potential negative effects of limiting entrepre-
neurial company growth to protect the competitive position of the corporation. Finally, the
ownership of the venture capital fund by a corporation means that while its structure is
open-ended (which is more suitable than a VCLP for long term risk capital), there may be
less certainty over the life of the fund as the corporation changes strategy or faces financial
pressures in other areas of the business. Government venture capital funds have had mixed
success depending on the design of the programme, which varies significantly across coun-
tries. Successful government programmes take the best structural characteristics from
VCLPs and complement this with specific features to minimize market distortions.

Why venture capital fund structure matters


We have seen that venture capital fund structures vary within a market, and across geo-
graphies. In this section we review the theoretical literature on why venture capital fund
structure matters for the value-added provided by venture capitalists to investee firms, as
well as for generating returns. We then examine empirical evidence.

Theoretical research on venture capital fund structure and venture capital behaviour
The main strand of theoretical research focuses on micro-level analysis and uses agency
theories and mechanism design to produce insights into the functioning of venture capital
markets. Venture capital-specific theories are relatively new, and the first ones certainly
were written after empirical research on venture capital started. The functioning of the
venture capital market has been used as motivation ground for many analyses in incom-
plete contracting and control theories (for example Hellmann, 1998). The theoretical
research in venture capital has largely focused on the relationship between the venture
capital fund manager and the entrepreneur, taking a single investment perspective. Only
recently has there been attention directed to the relationship between limited partners
(LPs) and the venture capital fund manager (general partner, GP). A small number of the-
oretical works have contributed to a better understanding of tradeoffs that a venture
capital fund manager faces, and how these are resolved in order to align the manager’s
incentives with LPs’ interests. This is particularly important for venture capital funds since
LPs cannot easily liquidate their positions once they have invested (or only at very high
costs). This reason, and the fact that LPs by definition cannot interfere in the day-to-day
process of the fund, makes the contract design of partnership agreements a crucial aspect
of a well-functioning fund.
When examining decisions made by venture capital managers, a number of papers
utilize information economics theories such as the signalling and learning hypotheses.
These are especially useful when examining the decisions made by venture capitalists
when approaching the fund raising process for their next fund (for example Gompers,
1996; Cumming et al., 2005). The signalling hypothesis refers to fund manager actions
that seek to demonstrate to institutional investors that they are of high quality. A central
variable along these lines is the degree to which the manager (or the firm she runs) is
already well-established or still young. In the latter case, it is assumed that fund providers
170 Handbook of research on venture capital

have little information about the true quality of the manager and try to infer her quality
from information signals. Two possible signals that have been investigated are exit 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 and
Lerner (1999) find evidence in favour of learning. However, other evidence shows sig-
nalling is important for both exits (Gompers, 1996) and investment decisions (Cumming
et al., 2004).
Investment decisions are also closely tied to the structure of a venture capitalist’s port-
folio. Recent papers have therefore moved from a single investor model to take a portfolio
perspective of venture capital investments. Kanniainen and Keuschnigg (2003; 2004) and
Keuschnigg (2004) examine the tradeoff between the number of portfolio companies (that
is portfolio size) and the amount of effort each investment receives. Clearly, a manager
that needs to monitor more companies has less time for each of them. Their resulting com-
parative static analysis provides a clear departure from earlier papers (for example
Gompers and Lerner, 1999) that did not consider the number of portfolio companies.
Similarly, examination of the interaction between portfolio companies within a venture
capital fund shows that venture capital managers do not choose each company 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 early
stages, and stop the less promising one afterwards so that resources and human capital
can be redeployed to the most promising one. Under certain conditions, this provides
better incentives to entrepreneurs and venture capital fund managers. Their work has
empirical implications for size and focus on venture capital funds. Along similar lines,
Kandel et al. (2004) study the inefficiency arising due to the limited duration of funds.
This forces the venture capital fund manager to liquidate the fund’s asset at a given time
in the future. Given that LPs cannot observe the quality of the venture capital manager’s
investments, they may not reward the manager appropriately at liquidation time of the
fund. This in turn provides incentives to the GP to favour short-term projects at the
expense of value maximization of the fund.
Other papers have expanded the standard principal–agent framework to two-side
moral hazard. This strand of the literature recognizes the fact that both players, 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 has
led to a better understanding of the widespread use of convertible securities in venture
capital finance.
In sum, theoretical work is consistent with the view that venture capital fund structure
is important for the screening of new potential investments and the governance provided
by venture capitalists to the investee firms. The next subsection describes empirical evi-
dence consistent with this view.

Empirical research
Empirical research has found that the structure of venture capital funds and the contracts
that govern the relationship with suppliers of capital influence the behaviour of profes-
sionals and their investment strategy and style. While the next chapters of this book focus
on investment decisions by venture capital companies, we emphasize here some research
The structure of venture capital funds 171

findings specific to differences in the structure of venture capital funds. Research on how
structure influences behaviour has been organized into a small number of themes, as
detailed below.

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

capital suppliers and the venture capital means that both grandstanding and style drift
act as a signalling device.

Fund structure and financial returns (direct and indirect) The financial returns to venture
capital investing have been most commonly linked with the state of finance markets and
the legal conditions underpinning the structure of VCLPs. The stronger public finance
markets and legal protection for investors are in the VCLP, the higher are financial returns
to investment. Black and Gilson (1998) argue that there is a strong link between active
stock markets and active venture capital markets, as the former allow investors to divest
their most successful deals. An international study of venture capital in the Asia-Pacific
region by Cumming et al. (2006) provides evidence that a more important factor than
active stock markets is the quality of a country’s legal system, which is a central mech-
anism to mitigate agency problems between outside shareholders and entrepreneurs.
Legality affects exits because legality affects the new owners’ ability to resolve problems
resulting from information asymmetries in the sale of the firm (consistent with La Porta
et al., 1997; 1998; Shleifer and Wolfenzon, 2002). The venture capitalist’s goal is to maxi-
mize capital gains upon sale of the entrepreneurial firm. All else being equal, the new
investor(s) will pay the most when information asymmetries are lowest. IPOs are less
costly exit routes relative to private exits (acquisitions, secondary sales and buybacks)
among countries with a higher legality index and stronger investor protections, and should
therefore be observed more frequently in countries with higher legality indices (Cumming
et al., 2006). Hege et al. (2003) find a significant performance gap (measured by IRR of
individual investments) between Europe and the United States. US venture capital funds
outperform their European counterpart in the financing of entrepreneurial firms funded
at the early stage. Their analysis is consistent with the idea that either European ventures
are of lower quality or US venture capitalists are better at screening business plans.
Indirect financial benefits to venture capital funds are more important in non-VCLP
structures. Studies have shown that, for instance, large corporations set up their own funds
for strategic reasons (Siegel et al., 1988; Winters and Murfin, 1988; Yost and Devlin, 1993;
Chesbrough, 2002; Santhanakrishnan, 2002) so that the companies financed by the cor-
porate venture capital fund fit within the corporation’s objectives. Some studies document
that the use of corporate venture funds is most likely when complementarity gains are
highest (Lemelin, 1982; Dushnitsky and Lenox, 2005; Dushnitsky, 2004). Gompers and
Lerner (1998) find that corporate venture capital fund investments in companies with
‘strategic fit’ to the mother company perform at least as well as investments by 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 up
corporate venture capital funds in order to generate demand for their own products. The
article also mentions a number of real cases where this indeed took place. Given these posi-
tive externalities for corporate investors, they need to be taken into account in investment
decisions of corporate funds. Hellmann (2002) analyses the strategic role of venture
investing, that is either a corporate venture financing or an independent venture financ-
ing. The use of corporate venture capital mitigates the potential hold-up problem at the
R&D stage. In contrast, Riyanto and Schwienbacher (2005) take another perspective.
They focus on the corporate investor’s active role in utilizing corporate venture financing
strategically as a commitment to compensate the entrepreneur for potential opportunistic
The structure of venture capital funds 173

behaviour in the product market. It therefore helps to avoid a potential ex post hold-up
problem in the product market (instead of at R&D stage).

Future research directions


This chapter has examined the structure and governance of different types of venture
capital organizations, including limited partnerships, captive venture capitalists and gov-
ernment venture capital programmes. This chapter has also examined the relation
between organization structure and governance provided by venture capitalists to investee
firms, and has shown that prior research is consistent with the view that returns are
affected by venture capital fund structures. Agency relationships between capital 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. We
offer here our views on future research directions.

1. Internationalization of venture capital


The past ten years has witnessed the increased internationalization of the venture capital
industry, especially given the presence of large institutional investors (see Megginson,
2004, for a review of work on non-US markets). Work on Europe and the Asia-Pacific
(Lockett and Wright, 2002) show the potential provided by analysis of the international
aspects of venture capital. The internationalization phenomenon raises a number of new
research questions, listed below:

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

2. Single VCLPs versus fund-of-funds


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

● How do venture capital fund-of-funds invest?


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

3. Listed venture capital funds


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

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

● Are venture capital outcomes different when the vehicle is listed?


● What is the impact of listed structures on the types of venture capital investments,
venture capital behaviour and investment returns?

4. Business culture and venture capital fund structure


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

● How does organizational culture impact venture capitalist behaviour?


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

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

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

177
178 Handbook of research on venture capital

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 minimize
the 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 due
diligence and negotiation. As such, there is room to explore how venture capital decisions
influence these phases.
Venture capitalists differ in the screening criteria they use to select ventures including
type of industry, company stage of development, geographic location, and size of invest-
ment required. For example, venture capitalists often specialize by industry (Sorenson and
Stuart, 2001). A venture capitalist interested in biotechnology will look at criteria
differently than venture capitalists interested in retail; proprietary protection may be of
more importance for instance. Likewise, venture capitalists focused on early stage deals
may place more emphasis on the team – can the entrepreneur execute on the opportunity –
since there is little past history of the venture to evaluate. Later stage venture capitalists
can assess the team’s capabilities based upon what the venture has achieved in its earlier
stages. While venture capitalists with different objectives emphasize different criteria, the
basic categories still hold (the entrepreneur, the market size and growth, the product, the
competition, and so on), but how the criteria are used or weighted differs.
The primary goal of this chapter is to review the progression of venture capital research
on investment selection in the screening phase and primarily takes an information pro-
cessing perspective to do so. It is our belief that the field is becoming more sophisticated
in both its methods and questions asked. We have moved beyond simple surveys and inter-
views asking venture capitalists how they select which ventures to back, to tests of how
venture capitalists actually make decisions and how contextual and process factors 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 capital
decision making followed by an overview of how verbal protocols and conjoint analysis
have helped us answer basic questions, such as what criteria do venture capitalists use in
the decision and how do they use those criteria. The following section looks at context of
the decision. Industrial organization economics, the resource based view and institutional
theory suggest how context might influence the decision. Next, we examine how biases
and heuristics impact the venture capital process. The basic question underlying process
is whether biases and heuristics are efficient means for boundedly rational decision makers
to pick the best ventures, or whether they lead to sub-optimal decisions. Much of the
research to date assumes that venture capital decision making is relatively homogeneous,
but more recently researchers are looking at factors that lead to heterogeneity in the deci-
sion process. At the end of each of the major sections of our review, we raise several new
research questions and avenues to explore them.

The evolution of research on pre-investment venture capital


Venture capital research has progressed and become more sophisticated. This section
highlights the move from simple surveys and interviews which rely on accurate 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 allow
researchers to track what and when information is used in the decision. Conjoint analysis
The pre-investment process 179

moves beyond verbal protocols to a controlled experiment which allows researchers to


capture the relative importance of different decision criteria.

Venture capitalists’ espoused decisions


Venture capitalists are conspicuously successful at predicting new venture success (Hall
and Hofer, 1993; Sandberg, 1986) and numerous studies have investigated their decision
making. The majority of research on venture capitalists’ decision making has produced
empirically derived lists of venture capitalists’ ‘espoused’ criteria which are the criteria
venture capitalists report they use when evaluating new venture proposals, including early
seminal articles by Tyebjee and Bruno (1984) and MacMillan and colleagues (MacMillan
et al., 1985; 1987). Tyebjee and Bruno (1984) articulated four categories – market 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 and
venture team. This early research consistently finds that the entrepreneur and team are the
most important decision criteria in distinguishing between successful and failed ventures.
For example, MacMillan et al. (1985) find that 6 of the top 10 criteria relate to the entre-
preneur and team. The findings of these early studies fit the mantra espoused by Georges
Doriot, the father of venture capital and founder of the first modern venture capital firm
ARD, that he’d rather ‘invest in an “A” team with a “B” idea than a “B” team with an “A”
idea’ (as noted in Timmons and Spinelli, 2003). This early research provided a context in
which to understand and evaluate venture capitalists’ decision making, but it was prone
to recall and post hoc rationalization biases (Zacharakis and Meyer, 1995). Zacharakis
and Meyer (1998) find that venture capitalists aren’t accurate in self-introspection. In
other words, post hoc studies may not truly capture how venture capitalists use decision
criteria.

Verbal protocol analysis of venture capitalists’ decisions


Next there were studies by Sandberg et al. (1988), Hall and Hofer (1993), and Zacharakis
and Meyer (1995) that attempted to overcome prior post hoc study flaws by using verbal
protocols. Verbal protocols are real time experiments where venture capitalists ‘think
aloud’ as they are screening a business plan (Ericsson and Crutcher, 1991). Thus, venture
capitalists aren’t required to introspect about their thought processes which removes recall
and post hoc rationalization biases (Sandberg et al., 1988). Moreover, the verbal protocol
approach provides richer understanding of the decision process whereas post hoc
methods focus on the decision outcome (Hall and Hofer, 1993). Verbal protocols, for
instance, not only allow the research to capture what criteria venture capitalists use, but
in which order they consider different criteria and how much time they spend evaluating
each criterion, which gives us a relative sense of the importance of different criteria.
Results from verbal protocol studies suggest that venture capitalists’ insight into their
decision processes may be less than perfect. For example, Hall and Hofer (1993) find that
the venture capitalist pays relatively little attention to entrepreneur/team characteristics
and even less attention to strategic issues of the new venture proposal. Instead, the most
important factor centred on the market and product attributes, which is congruent with
the findings of Zacharakis and Meyer (1995). Such findings appear to contradict most
post hoc studies which find that the entrepreneur is typically the most important factor.
180 Handbook of research on venture capital

Zacharakis and Meyer (1995) suggest that the discrepancy may be attributable to the
screening stage on which verbal protocol research has focused. Specifically, venture capi-
talists may assess whether the entrepreneur meets minimum qualifications during the
screening stage, and reserve final judgment for later evaluation (see Smart’s, 1999 study on
how venture capitalists evaluate the entrepreneur during due diligence).
While verbal protocols are rich in the amount of data collected from each venture cap-
italist, they are time consuming as the researcher needs to observe each venture capitalist
as he actually reviews a plan. As such, these studies are limited by the small sample sizes
that can be easily accommodated. Nonetheless, the discrepancy between verbal protocols
and earlier post hoc studies spurred a new wave of real time experiments that can more
efficiently manage larger samples.

Conjoint analysis and policy capturing of venture capitalists’ decision policies


Conjoint analysis and policy capturing move beyond survey methods used to identify deci-
sion criteria and verbal protocols used to assess how and when criteria are used. Conjoint
analysis is a ‘technique that requires respondents to make a series of judgments, assessments
or preference choices, based on profiles from which their “captured” decision processes can
be decomposed into its underlying structure’ (Shepherd and Zacharakis, 1997, p. 207).
Policy capturing is a type of conjoint analysis. The research supports the notion that venture
capitalists aren’t very good at introspecting about their decision process (Zacharakis and
Meyer, 1998). Conjoint studies (Zacharakis and Meyer, 1998) support verbal protocol
research (Hall and Hofer, 1993; Zacharakis and Meyer, 1995) indicating that market issues
might be more important than entrepreneur characteristics. In general, real time studies find
that venture capitalists tend to overweight less important factors and underweight more
important factors when they ‘espouse’ lists of decision criteria they say they use in their
assessments (Zacharakis and Meyer, 1998; Shepherd, 1999). Furthermore, the accuracy of
introspection decreases the more information that the decision maker faces (Zacharakis and
Meyer, 1998). This leads venture capitalists to remember more salient information as being
more important than it actually was. The finding is particularly pertinent to the venture
capital process as information inundates the venture capital decision context. For example,
there is information about the entrepreneur (for example entrepreneur’s industry and 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 the
chemistry is not right. Such intuitive, or ‘gut feel’ (MacMillan et al., 1987; Khan, 1987),
decision making is difficult to quantify or objectively analyse. The added complexity from
subjective information further clouds the decision making process and invites decision
makers toward more biases that impede their ability to introspect accurately. Due to the
complexity of the decision and the venture capitalists’ intuitive approach, venture 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 of
how they make the decision. This lack of understanding may lead to sub-optimal decision
strategies and subject venture capitalists to biases that may lead to sub-optimal decisions.
Conjoint analysis and policy capturing allows us to gain a deeper understanding of the
venture capital decision process (Shepherd and Zacharakis, 1999). Not only can researchers
The pre-investment process 181

capture how important each decision criterion is to the decision relative to other decision
criteria (Zacharakis and Meyer, 1998), but it also allows for examining contingent deci-
sion processes (Zacharakis and Shepherd, 2005). Thus, the research in venture capital
decision making has followed a natural progression from identifying decision criteria
through post hoc surveys (for example Tyebjee and Bruno, 1984; MacMillan et al., 1985)
to understanding how that information is utilized during the actual decision via verbal 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 example
Muzyka et al., 1996) and more complex, contingent decision policies (Shepherd et al., 2000;
Zacharakis and Shepherd, 2005). The following sections will elaborate on how the venture
capital decision making research has used experiments to test theory on both the content
venture capitalists’ decision policies and the decision process.

Theory development and experiments for empirical testing


In this section we continue our review of conjoint analysis and focus on the theory 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 experiments


Riquelme and Rickards (1992) pioneered conjoint analysis in the study of venture capital
decision making. They ran a series of pilot tests on 14 venture capitalists and concluded
that conjoint analysis is an effective means of studying the venture capital process. Shortly
thereafter, Muzyka et al. (1996) used conjoint experiments to explore the importance of
a long list of criteria (35 investment criteria) that venture capitalists had identified as being
important when making their decisions. They used a conjoint experiment that required 73
venture capitalists to each make 53 pair-wise trade-offs with multiple levels. The criteria
fell into seven groupings: (1) financial; (2) product-market; (3) strategic-competitive; (4)
fund; (5) management team; (6) management competence; and (7) deal. They found that
venture capitalists ranked in the top seven criteria all five management team attributes,
product market criteria appeared to be only moderately important, and fund and deal 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 financial
and product-market characteristics, even if the opportunity does not meet the overall fund and
deal requirements. It appears, quite logically, that without the correct management team and a
reasonable idea, good financials are generally meaningless because they will never be achieved.

While pair-wise conjoint studies identify which criteria might be more important than
other criteria, it still suffers post hoc recall biases as the venture capitalists are not making
real time investment decisions, but thinking about how they believe they used the criteria
listed on past decisions.
More recently, experimental methods such as metric conjoint analysis and policy 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 colleagues
used an industrial organization economics (IO) perspective of strategy to investigate the
182 Handbook of research on venture capital

types of information venture capitalists utilize when evaluating new ventures (including its
strategy and experience) and how venture capitalists use this information to assess new
venture survival (Shepherd, 1999) and profitability (Shepherd et al., 2000). Specifically,
Shepherd (1999) used the IO strategy and population ecology literatures to develop a model
of new venture survival that centred on the importance of uncertainty. This study found
that in assessing the probability of survival venture capitalists consider the new venture’s
timing, lead time, educational capability, industry related competence and the nature of the
environment in terms of stability of the key success factors and competitive rivalry. These
results suggested considerable consistency between the proposed theoretical framework and
the decision policies of venture capitalists. In investigating venture capitalists’ assessments
of profitability, the theory development work of Shepherd et al. (2000) suggested contin-
gent relationships between the criteria that were previously used to explain the probability
of survival. Specifically, they found that the relationship between timing of entry and
venture capitalists’ assessment of profitability is moderated by key success factor stability
(environmental stability), lead time and educational capability.
Zacharakis and Shepherd (2005) used theory from the resource-based view (RBV) of
strategy to hypothesize that venture capitalists use non-additive decision policies when
making their investment decision – interactions between leadership experience and other
internal resources, and between leadership experience and environmental munificence are
reflected in venture capitalists’ decision policy. A policy capturing experiment found that
although venture capitalists always prefer greater general experience in leadership, they
value it more highly in large markets, when there are many competitors, and when
the competitors are relatively weak. It also found that previous start-up experience of the
venture’s management team may substitute for leadership experience in venture capital-
ists’ decision policy.
The above research has used theory to hypothesize content that is then tested using
experiments to understand whether venture capitalists’ decision policies are consistent
with theory, or if they deviate, what the nature of that deviation is. These studies are 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 ask
not 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 for
the sample as a whole yet there are theoretical reasons that under certain circumstances
venture capitalists should differ in their decision policies. The next level of sophistication
moves beyond building base models that describe the general venture capital decision, to
when venture capitalists might deviate from this base model. In other words, newer
research needs to examine the heterogeneity of venture capital decision making.
Recent experimental research on the content of venture capitalists has focused on
explaining variance in the decision policies across venture capitalists. Based on institu-
tional theory that various economic institutions structure the incentives of human
exchange differently, Zacharakis et al. (2007) proposed that venture capitalists from
different countries (US – mature market economy, South Korea – emerging economy, and
China – transitional economy) would use different information when formulating their
decisions. Using policy capturing experiments on 119 venture capitalists across these three
countries, they found that venture capitalists in rules-based market economies rely upon
market information to a greater extent than venture capitalists in emerging economies,
The pre-investment process 183

and also found that Chinese venture capitalists more heavily weigh human capital factors
than either US or Korean venture capitalists. We expect that more research will use theory
to explain variance in decision policies across venture capitalists.

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

Theory development in process and experiments


Using information processing theory (Anderson, 1990; Lord and Maher, 1990) has helped
the venture capital decision making stream to develop by allowing us to predict and
understand how venture capitalists make decisions, and when those decisions may be sub-
optimal, biased and contain errors. The following sections delineate why we need to
184 Handbook of research on venture capital

understand the ‘process’, how information processing theory helps us understand the
process, especially as it pertains to mean for managing all the information, potential biases
to the process and so on.

Why understanding process is important While understanding the content of the venture
capitalist’s decision is crucial to improving those decisions, it is also critical to understand
the process by which venture capitalists make decisions. Decision makers are not perfectly
rational, but boundedly rational (Simon, 1955; Cyert and March, 1963). It is impossible
for venture capitalists to evaluate all information fully as their decision environment is 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 environmental
level (industry trends, economic conditions, and so forth), the business model level (can
the venture capital financing enable the company to grow to a point where the venture
capital can extract a return on investment), and the team level (can the entrepreneur team
execute). Information richness, or as Zacharakis and Meyer (1998) call it, ‘information
noise’, leads venture capitalists to economize on their decision process in order to manage
the sheer volume of information. Thus, venture capitalists will use heuristics, both 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 pay
attention 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 venture
capital decision process. Barr et al. (1992) delineate a simple information processing
model that describes decisions as a function of what information attracts the manager’s
attention, how that information is interpreted, and what actions follow from that inter-
pretation. The expert decision making model (Lord and Maher, 1990) best fits the venture
capital environment (Shepherd et al., 2003). Expert models can be characterized as fitting
between a truly rational decision model where all information and alternatives are con-
sidered and evaluated to a limited capacity model which recognizes the cognitive limits of
decision makers (Cyert and March, 1963). Experts learn which factors best distinguish
between successful and unsuccessful ventures (Shepherd et al., 2003), although this is
often on an unconscious level (Zacharakis and Meyer, 1998).
Venture capitalists possess a multitude of mental models which can be called into action
depending upon the situation (that is based on past experience with industry, or past
experience with lead entrepreneur, and so on (Zacharakis and Shepherd, 2001)). Thus,
when the venture capitalist perceives a somewhat familiar situation which requires action,
an appropriate mental model is summoned from long term memory (Moesel et al., 2001).
In unfamiliar situations, the venture capitalist uses an evaluation strategy (a mental model
of how to approach new situations) to formulate the information into a mental model
which is then manipulated to make a decision. However, the venture capitalist’s mental
model of the situation influences what and how the information surrounding the situation
is perceived; the mental model acts as a filter which preserves limited cognitive processing
capacity (Moesel et al., 2001; Zacharakis and Shepherd, 2001). An example might better
illustrate the mental model concept. Imagine two venture capitalists examining the same
proposal. The first venture capitalist is very familiar with the industry and, in fact, also
The pre-investment process 185

has extensive knowledge of the team. As such, the venture capitalist is likely to base her/his
judgment on these two chunks of information. Other important information that doesn’t
fit neatly within this configuration receives limited consideration. The second venture cap-
italist, on the other hand, is not familiar with the industry or the entrepreneurial team. In
this case, the venture capitalist doesn’t possess a mental model based on the larger chunks
of information. The venture capitalist assesses the entire array of information and uses
various decision strategies to make her/his decision. For example, s/he may use a satisfic-
ing strategy (Simon, 1955) and assess whether the proposal meets the minimum criteria on
each decision factor.
With information processing theory as a theoretical lens, a number of pertinent issues
have been studied in the venture capitalist decision process. Primarily, what heuristics do
venture capitalists employ to make decisions in an information rich environment? And,
what factors might bias venture capitalist decision making? It is our estimation that we
have only begun to scratch the surface on these issues.

Heuristics Heuristics, or ‘rules of thumb’, are sub-optimal decision strategies in that the
decision maker does not fully utilize all available information (Tversky and Khaneman,
1974; Simon and Houghton, 2002). Since decision makers have limited cognitive capacity,
they rely on heuristics to conserve cognitive resources (Simon, 1981). Whereas biases
impact decision effectiveness by directing the decision maker’s attention to salient infor-
mation, heuristics provide a ‘road map’ on how and which information is used to make a
decision. Eisenhardt (1989) suggests that heuristics allow decision makers to derive 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 certain
information factors more salient than others. Therefore, while heuristics ‘are always
efficient, and at times valid, these heuristics can lead to biases that are persistent, and
serious in their implications’ (Slovic et al., 1977, p. 4). Hitt and Tyler (1991) add that
although heuristics ease cognitive strain, they often lead to systematic biases.
The new venture environment encourages heuristic use as entrepreneurs and venture
capitalists face information overload, high uncertainty regarding success, novel situations,
and time pressure (Baron, 1998). Baron (1998) points out that under certain contextual
factors, such as time constraints, heuristic strategies may lead to better decisions than
would occur under the rational model. Busenitz (1999) adds that speed may be critical in
an entrepreneurial environment where a new venture needs to launch while the ‘window
of opportunity’ is open. Although heuristic research has focused mostly on entrepreneur
decision making, much of it is relevant to venture capitalists as they participate in a
similar environment (Moesel et al., 2001). The underlying principle is that heuristic
effectiveness is a question of cost versus benefit (Fiske and Taylor, 1991). Is the time spent
reaching an optimal decision more valuable than the approximate decision reached by
using a time saving heuristic? Part of the answer depends on which heuristic the decision
maker is using.
Based upon Payne et al.’s (1988) categories, it is likely that venture capitalists use non-
compensatory strategies (that is they don’t evaluate all the information surrounding an
alternative when making a decision); they do not have the time, or the cognitive capacity
to use all information surrounding a proposal (Moesel and Fiet, 2001). Venture capitalists
are also likely to use an alternative versus an attribute-based approach (Payne et al., 1988)
186 Handbook of research on venture capital

as they typically review ventures as they are presented to them. Under an alternative
approach, the venture capitalist evaluates each proposal in isolation, typically looking to
reject the venture idea because it fails on one or more of the attributes. Since each proposal
is evaluated in isolation, the venture capitalist may be inclined to compare it to past 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 the
venture capitalists’ case, they tend to compare current ventures under consideration to
deals that they have made (or passed on) in the past (Zacharakis and Meyer, 2000). While
using a representative heuristic saves time, it can lead to sub-optimal decisions in that the
decision maker generalizes from a small, non-random sample and thereby is likely to
underestimate the risk of failure (Busenitz, 1999; Keh et al., 2002). The underestimation
risk is heightened in conjunction with the recall bias in that people tend to recall past 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 as
most venture capitalists are inundated with entrepreneurs seeking funding. Quickly
screening out deals allows venture capitalists to spend more time on other activities that
can increase returns, such as post-investment work with portfolio companies. Thus, con-
sidering the time constraints that venture capitalists face, satisficing is both efficient and
effective by enabling venture capitalists to focus their time on those ventures that have the
greatest perceived potential. The downside of satisficing and representative heuristics is
that they may lead to a ‘herding’ phenomenon (Gompers et al., 1998). Venture capitalists
may chose to invest in those ventures which are most like the ventures that other venture
capitalists have funded, such as was the case in the dot.com boom and bust. This can lead
to overcrowding in the market space with lots of ‘me-too’ competitors that damage the
overall sector dynamics and increase the failure rate within that space.

Biases Biases are those salient factors that cause the venture capitalist to evaluate 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 an
industry may cause the venture capitalist to evaluate available industry information more
rigorously because s/he knows the industry well (that is industry indicators and bench-
marks); an availability bias. On the other hand, it may cause the venture capitalist to
evaluate the other aspects of the proposal less rigorously such as product and entrepre-
neur attributes. The point is that such knowledge biases the venture capitalist; the venture
capitalist evaluates or uses different mental models for this proposal than a venture capi-
talist who is unfamiliar with the industry. In other words, the venture capitalist deviates
from his/her base decision model.
Just because mental models bias decisions does not mean that they result in errors (Barr
et al., 1992). However, these biases most likely prevent decision makers from reaching
optimal solutions (in the rational model sense) because they may reduce the amount of 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 of
the listed biases have received attention in the venture capital literature. The others provide
an opportunity to research their impact, if any, on venture capitalist decision making.
The pre-investment process 187

Table 6.1 Biases to decision making

Bias Description
Availability Easy recall of well-publicized or chance events which means that
decision maker focuses more on available events in the decision
process, and neglects unavailable information
Selective perception Problems structured by an individual’s prior experience
Frequency Absolute cue frequency is used versus the relative occurrence
Concrete information Concrete data dominates abstract data
Illusory correlation Belief that two variables covary when in fact they do not covary
Data presentation Evaluation biased by sequence, presentation mode, qualitative
versus quantitative mixture, perceived display ‘logic’, and context
Inconsistency Inability to apply judgments consistently
Conservatism Failure to revise decisions when presented with new evidence
Non-linear extrapolation Underestimation of joint probabilities and growth rate
Habit Previously successful alternatives are applied to solve a problem
Anchoring/adjustment Prediction results from upward or downward adjustment of a cue
value
Representativeness Evaluation based upon a similar class of events
Law of small numbers Small samples are believed representative
Justifiability A rule can be used if it can be ‘justified’
Regression bias Predictions fail to recognize regression toward the mean
Best guess strategy Simplification and ignoring data
Complex environment Information overload and time pressures reduce consistency
Overconfidence Belief that your decisions are correct more often than is actually
the case
Emotional stress Induces panic judgments or reduced attention
Social pressures Conformity or distortion of judgments
Consistent data sources Increase decision confidence but not accuracy
Question format Judgment process requirements or choice affects outcome
Scale effects Measurement scale affects response perceptions
Wishful thinking Preferences affect the assessment of events
Illusion of control Perceived control resulting from activity concerning the outcome
Outcome irrelevant Observed outcomes provide incomplete feedback for correction
‘Gambler’s fallacy’ Higher probability of event following unexpected similar chance
outcomes
Success/failure attributions Success is attributed to skill; failure to chance
Recall fallacies Failure to recall past details leads to logical reconstruction
Hindsight bias Plausible explanations can be found for past surprises

Source: Adapted from Hogarth and Makridakis, 1981.

Overconfidence is one bias that has received attention in the venture capitalist realm.
Using a conjoint experiment, Zacharakis and Shepherd (2001) find that venture 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). The
experiment controlled for the amount of information each venture capitalist reviewed and
188 Handbook of research on venture capital

the type of information reviewed. The study finds that more information leads to
increased 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 and
their overall decision accuracy is lower. Likewise, venture capitalists’ confidence increases
when they view information criteria with which they are more familiar and comfortable.
Finally venture capitalists are more overconfident in their failure predictions than success
predictions. As such, Zacharakis and Shepherd (2001) posit that overconfident venture
capitalists may limit their information search (although they believe that they are fully
considering all relevant information) and focus on salient factors (for example how similar
this deal is to a past successful deal) despite other information factors that would suggest
this deal might fail. Unlike Busenitz and Barney (1997) who suggest that overconfidence
can have positive ramifications for entrepreneurs – they will launch the venture in the
first place and then work harder to make sure the venture succeeds – overconfidence in
venture capitalists is likely to be mostly a negative in that it is overconfidence in decision
making ability and it may not lead to increased effort to help failing ventures succeed,
especially when venture capitalists often attribute failure to outside, uncontrollable events
(Zacharakis et al., 1999).

Future research opportunities on the venture capital decision process Beyond the above
studies, there does not appear to be much other work on heuristics and biases that impact
the venture capital decision process. Research on heuristics in the entrepreneurship liter-
ature, however, has focused on those used by entrepreneurs, and has relatively ignored
venture capitalists’ decision making. Although only a small number of heuristics have
received the attention of entrepreneurship scholars, there are others that may be pertinent.
We suggest these as a source of future research. Finally, heuristics can have both positive
and negative outcomes. Much more research, along the lines of Baron (1998) and
Busenitz (1999), can shed light under which conditions heuristics are better or worse.
The topic of biases has received more attention when looking at entrepreneurs’ deci-
sion making. As noted above, Baron (1998) asserts that the new venture context creates
an environment ripe for decision biases. Baron (1998) suggests that entrepreneurs are
prone to counterfactual thinking; the tendency to think about ‘what might have been’. He
proposes that entrepreneurs are more likely to regret actions not taken (for example a
missed opportunity), rather than the mistakes they may have actually made. A counter-
factual bias may also have a strong impact on venture capitalists. Anecdotally, we read
about venture capitalists who bemoan passing up investments in big winners, such as
Amazon or Google. This regret may increase the tendency to take bigger risks without
fully evaluating all the information around a venture decision because the venture 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 or
lose out (for example the dot.com bubble). This counterfactual thinking and any number
of the biases listed in Table 6.1 provide fertile ground for extending our knowledge of
venture capital decision making.

Future research opportunities to examine heterogeneity in venture capital decision policies


Now that the field has a strong grasp of the core venture capital decision making process,
it is time to dig into aspects that lead to variance from that core process, such as heuristics
The pre-investment process 189

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

1. Information from the environment which is not clean; environmental noise disguises
information 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; and
8. judgments which, at times, must be made under pressure.

All of these factors are prevalent in the venture capital decision domain and create an
opportunity to assess how they impact the venture capitalist decision. For example, are
venture capitalists differently susceptible to these conditions? Are these conditions
stronger in certain industries than others? Do they differ across countries?

Conclusion
This chapter focuses on venture capitalists’ pre-investment activities, namely, their assess-
ment and investment decisions. The implications from the research to date are many. For
example, we have learned that venture capitalists are poor at introspecting about their own
decision processes (Zacharakis and Meyer, 1998). This lack of insight makes it difficult
for venture capitalists to learn from past decisions and to improve future decisions.
Moreover, it is difficult to articulate and train junior associates if the venture capitalist
doesn’t understand his own decision process. Shepherd and Zacharakis (2002) suggest
that modeling a venture capitalist’s decision process can help him gain this insight and can
190 Handbook of research on venture capital

also be used as a training tool. Zacharakis and Meyer (2000) find that models of the
venture capital process, or actuarial aids, improve the venture capitalist’s decision 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 efficient
and effective especially for time constrained venture capitalists. Yet, venture capitalists
need to understand which heuristics they use and when different heuristics are most
effective. While a satisficing heuristic allows venture capitalists to screen proposals
quickly, strictly following the heuristic may mean that venture capitalists reject potentially
attractive deals because they fail to pass a hurdle on a relatively minor attribute. Creating
a venture ‘scorecard’ where the venture capitalist rates and records each proposal on the
attributes that they believe to be most pertinent helps ensure that venture capitalists don’t
overweight the importance of a negative evaluation on a relatively minor attribute or
underweight a positive evaluation on a relatively more important attribute. The scorecard
also creates a history that minimizes post hoc recall and rationalization biases and thereby
provides a feedback source that can help venture capitalists learn and improve their deci-
sion process (Zacharakis and Meyer, 1998).
While some research has investigated potential biases and their impact (Zacharakis and
Shepherd, 2001), more research into biases will further benefit venture capitalists. The key
implication is that venture capitalists should be aware that they, as is true for all decision
makers, are prone to biases that might lead to sub-optimal decisions. Venture capitalists
can take steps to minimize the potentially negative impact of biases. Some methods, such
as the weekly partners meeting, are built into the venture capital process (Shepherd et al.,
2003). During such meetings, a venture capitalist should articulate why they like a 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 as
overweighting a salient attribute like the entrepreneur. Unfortunately, this meeting only
helps venture capitalists avoid biases that might incline them to back a venture that isn’t
as attractive as it seems. Venture capitalists should consider also presenting a deal that
they didn’t like and to articulate why. While it is true that venture capitalists reject far too
many deals to present all of them to the partner’s meeting, picking an occasional rejec-
tion will help them learn if they have any biases that are causing them to reject potentially
promising ventures prematurely.
In conclusion, this chapter has presented a historical perspective of research in the area
with pioneering works interviewing and surveying venture capitalists to gain deeper
insights into their reported decision policies. With more sophisticated methods, more
recent research has focused on real time methods of data collection from which decision
policies can be composed (for example verbal protocol analysis) or decomposed (for
example conjoint analysis and policy capturing). Along with the use of experiments to
decompose venture capitalists’ decisions into their underlying structure, research has been
more theory driven. Theory has been used to hypothesize which attributes are used in
venture capitalists’ decision policy and how they are used, to hypothesize differences in
decision policies across venture capitalists; and to better explain the process of 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 forward
to reading future research on this important topic.
The pre-investment process 191

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

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

193
194 Handbook of research on venture capital

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


The early research on the post-investment relationship between venture capitalist and
entrepreneur has pointed to the undertaking of monitoring and value adding activities by
The venture capital post-investment phase 195

Monitoring

Venture capitalist Entrepreneur


Value added

Content: Process:
– VC experience – Trust
– Knowledge – Social interaction
exchange between – Goal congruence
VCs – Commitment
– Knowledge
exchange between
VC and entrepreneur

Figure 7.1 Conceptual framework

venture capitalists. Whereas these two broad types of activities overlap with one another,
and in fact may represent complementary roles, the assumption underlying these 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 on
value added relates to venture capitalists’ attempt to increase the upside potential of their
investments. In the following paragraphs, we provide an overview of the literature on
monitoring and value added.

Monitoring and information asymmetry


Prior research has indicated that an important aspect of the venture capitalist–entrepre-
neur relationship pertains to the former’s monitoring of the latter’s actions. Monitoring
pertains to the procedures that are used by the venture capitalist to evaluate the 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 capitalists
therefore receive strong control levers, sometimes disproportionate to the size of their
equity 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 had
already been converted into common stock (Gompers, 1997), or they receive a relatively
great board representation in order to allow the replacement of the entrepreneur as chief
executive officer if performance lags (Lerner, 1995).
The venture capitalists’ involvement in monitoring activities stems from the presence of
goal incongruencies coupled with information asymmetry between the two parties. First,
196 Handbook of research on venture capital

venture capitalists and entrepreneurs may not always have the same goals. For example,
firm survival or generating a personal income, rather than value creation, may be of
primary importance for the entrepreneur, but not for the venture capitalist. Alternatively,
venture capitalists aim for early exit, while entrepreneurs may have more long term 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. For
example, entrepreneurs often have a better insight into their own capabilities and the level
of effort they want to put in the venture, compared to external investors. Also, entrepre-
neurs often have a good insight into the nature of technological developments. Venture
capitalists, on the other hand, may have a better insight into the potential market accept-
ance and competition, given that they invest in a portfolio of companies (Cable and
Shane, 1997).
Goal incongruencies, together with unequal distribution of information, may lead to
agency problems of adverse selection or moral hazard (see hereafter). They are thus
important when both parties negotiate about establishing an investment agreement (see
Chapter 8), as well as after the investment decision has been made (Sapienza and Gupta,
1994). The presence of information asymmetry may be particularly high in the case of
high-tech investment deals in which the entrepreneur has an in-depth knowledge about
the specifics of an innovative technology. Given the information opaqueness surrounding
technological ventures and the intangibility of most of their investments, close monitor-
ing by venture capitalists is, albeit not easy, essential in order to understand the actions
of the entrepreneur (Sapienza and De Clercq, 2000).
In order to explain the impact of information asymmetry on venture capital behavior,
agency theory has been used by many early researchers as their central framework to
explain venture capitalist behavior (for example Sapienza and Gupta, 1994; Lerner, 1995;
Sapienza et al., 1996). The center of agency theory is the agency relationship in which one
party (the principal) delegates work to another party (the agent), who performs that job
as defined in a contract (Eisenhardt, 1989). Interestingly, recently researchers have argued
that both the entrepreneur and venture capitalist can play the role of ‘agent’. In the fol-
lowing paragraphs we provide an overview of this research.

Entrepreneur as agent Most early research on venture capitalist behavior has depicted the
venture capitalist as the principal and the entrepreneur as the agent (Eisenhardt, 1989;
Sapienza and Gupta, 1994). That is, from the venture capitalist’s perspective, an important
question may evolve from the question of how to ensure that entrepreneurs do not take
actions that jeopardize the venture capitalists’ chances to generate maximum financial
returns. According to agency theory, two types of agency problems may arise, that is
‘adverse selection’ and ‘moral hazard’. First, the term ‘adverse selection’ pertains to the
uncertainty the venture capitalist faces with respect to the entrepreneurs’ capabilities to
meet pre-set expectations (Eisenhardt, 1989), and therefore is an important issue in the
venture capital selection process (see Chapter 6). For instance, an entrepreneur may end
up not having the required competencies to grow her venture successfully (Wright and
Robbie, 1998). Second, and more importantly in terms of the post-investment relationship,
‘moral hazard’ problems pertain to a party’s potential shirking behavior and unwillingness
to make sufficient efforts, even if it has the capability to meet pre-set expectations
(Eisenhardt, 1989). For instance, from the venture capitalist’s perspective, there is a danger
The venture capital post-investment phase 197

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

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

Venture capitalist as agent Alternatively, some researchers have suggested that venture
capitalists can be the agents of entrepreneurs. For instance, Cable and Shane (1997) crit-
icized the representation of the venture capitalist–entrepreneur dyad as an agency
problem, in that this framework ‘does not incorporate the possibility of opportunistic
behavior by the principal’ (Cable and Shane, 1997, p. 147). Also, Sahlman (1990) reported
that a venture capitalist is often responsible for almost nine investments and sits on five
boards of directors. Therefore, post-investment activities – such as the search for further
financing, or assistance in strategic decision making – that venture capitalists undertake
The venture capital post-investment phase 199

for one portfolio company, cannot necessarily be undertaken for all portfolio companies,
such that venture capitalists are often not able to allocate an optimal amount of time to
each entrepreneur (Gifford, 1997).
It has furthermore been suggested that venture capitalists are sometimes inclined to
‘under-invest’ in their portfolio companies. That is, venture capitalists often prefer to stage
their investments because this reduces the amount of money invested at the earliest stages
of venture development when investment risk is highest. This practice may not necessar-
ily be bad for entrepreneurs as it enables them to retain a higher fractional ownership. It
nevertheless poses the risk that if their venture does not develop as planned, entrepreneurs
may run out of money and be in a poor negotiation position to raise additional money
(De Clercq et al., 2006), thereby potentially facing high levels of dilution. Furthermore,
it has been argued that venture capitalists may sometimes be inclined to distribute a firm’s
profits rather than to reinvest these profits in the company as limited partners have the
right to get returns on their investments before venture capitalists can secure a profit
(Sahlman, 1990). This venture capitalist behavior can prevent an entrepreneur from bring-
ing her company to a next growth stage.
Finally, prior research has shown that some venture capitalists may seek a premature
IPO in their portfolio companies in order to gain reputation and report enhanced
performance when raising new funds. This ‘grandstanding’ behavior is more likely to
happen among young venture capitalists that want to establish a reputation in the venture
capital community (Gompers, 1996). Also, venture capitalists are inclined to take com-
panies public near market peaks, even if this is not necessarily the optimal timing for the
entrepreneurial company (Lerner, 1994).
In short, it has been argued that venture capitalists’ actions can be contradictory
to the best interests of an entrepreneur in terms of their allocation of time and effort,
re-investment decisions, or the timing of a portfolio company going public.

Concluding note Some researchers have suggested that the literature on venture capital
monitoring and its assumptions regarding information asymmetry and opportunism,
should be complemented with research that views the venture capitalist–entrepreneur
relationship from a more positive angle (Sapienza and De Clercq, 2000; Arthurs
and Busenitz, 2003). For instance, it has been suggested that stewardship theory may
provide a framework complementary with agency theory for examining the venture cap-
italist–entrepreneur relationship (Davis et al., 1997; Arthurs and Busenitz, 2003). The
starting point in this alternative approach is the identification of situations in which the
interests of the venture capitalist and the entrepreneur are aligned, and both parties
commit themselves to the development of a trustful relationship. In other words, the
application of agency theory to the venture capitalist–entrepreneur relationship may be
appropriate only when the two parties have diverging goals (Arthurs and Busenitz, 2003).
Furthermore, the fact that both venture capitalist and entrepreneur hold informational
advantages over one another may be related to the very nature of, and difference in, the
activities these parties engage in. That is, venture capitalists and entrepreneurs essentially
specialize in the development and contribution of different types of knowledge (Cable
and Shane, 1997). By virtue of their repeated experience with the monitoring of start-ups
and growing companies, venture capitalists may often have a better idea of their portfo-
lio companies’ value than the entrepreneurs themselves. Alternatively, entrepreneurs are
200 Handbook of research on venture capital

specialized in detecting new opportunities in the environment and combining resources


to exploit these opportunities in an original fashion (Kirzner, 1973). For instance, high-
tech entrepreneurs may possess specialized technical knowledge and skills that are
difficult if not impossible to be replicated.
Although entrepreneurs’ wish to hide negative information from their investors com-
bined with their superior insight into the viability of new technology may make defective
behavior appear to be a likely option, the wisdom of hiding information for 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 (Sapienza
and Korsgaard, 1996; Cable and Shane, 1997). Furthermore, although information asym-
metry may lead to defective behavior, it also includes the potential for benefits to be
derived for both parties. This issue will be discussed later in this chapter.

Value adding
Whereas venture capitalists’ monitoring activities mainly focus on how venture capital-
ists can minimize potentially harmful behavior by entrepreneurs, venture capitalists may
try to increase the value of their portfolio company through value-adding activities after
the investment decision has been made. The literature on the post-investment process
starts from the dominant assumption that venture capitalists do add value and highlights
the question of how they increase the upside potential of their investments. An early
stream of research has emphasized the value-adding activities venture capitalists engage
in with respect to their investment deals. More specifically, this research has discussed the
beneficial role of the value-adding beyond financial capital that is provided by venture
capitalists to their portfolio companies (Sapienza, 1992; Fried and Hisrich, 1995;
Sapienza et al., 1996; Busenitz et al., 2004). From the entrepreneur’s point of view, the
presence of added value beyond pure financial support compensates for the high cost of
venture capitalist money (Manigart et al., 2002). Interestingly, Seppa (2002) and Hsu
(2004) showed that entrepreneurs are willing to accept significantly lower valuations and
thus face higher dilution when they expect that the venture capitalist will contribute more
to the development of their venture, more specifically when the venture capitalist has a
better reputation.
In early research on value added, all venture capitalists were treated homogeneously or,
if differences between venture capitalists were acknowledged, they were not clearly
explained (for example MacMillan et al., 1988). For example, a distinction was made
between three categories of venture capitalists, the ‘inactive’ investors, the ‘active advice
givers’, and the ‘hands-on’ investors (MacMillan et al., 1988; Elango et al., 1995), with the
latter category attaching most importance to value-adding activities. In contrast,
other research has emphasized that ‘not all venture capital is the same’, and has started
to explain the differences in venture capitalist value-adding behavior. It has been sug-
gested that the roles venture capitalists play in their portfolio companies differ depending
on the characteristics of the venture capitalist or venture capital firm itself (for example
reputation – Gompers, 1996) or of the portfolio company (for example its stage of
development – Sapienza, 1992). In the following paragraphs we give a short overview of
what we believe are two important sub-streams in the value added literature, that is
research on the ‘classic’ value-adding roles, and research on how venture capital reputa-
tion may influence venture capitalist involvement.
The venture capital post-investment phase 201

Value-adding roles Providing non-financial assistance to portfolio companies and


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

in this chapter recent research has begun to open this black box by probing the role
of content and process-related issues in fostering the creation of value in venture
capitalist–entrepreneur relationships.

Venture capital and reputation A more indirect but nevertheless important aspect of
venture capitalists’ value-adding potential pertains to their reputation, in that for the
entrepreneur the venture capitalist’s reputation may be a critical point in gaining legiti-
macy in the market place (Gompers, 1996; Black and Gilson, 1998). That is, next to
money, monitoring and value adding, venture capitalists may provide enhanced credibil-
ity to their portfolio companies, especially when they are highly respected players in the
venture capital industry. The venture capitalist’s reputation can have a positive effect on
the entrepreneur because a company backed by a venture capitalist with an outstanding
reputation may be more capable of attracting customers, suppliers and highly-talented
managers (for example Davila et al., 2003) as venture capitalist performance and 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 and
therefore 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 willing
to accept the advice from highly esteemed investors (Busenitz et al., 1997; Hsu, 2004).
Interestingly, it has also been argued that venture capitalist reputation may potentially
have a negative effect for entrepreneurs. More specifically, because of the time constraints
venture capitalists are confronted with (Gifford, 1997), some venture capitalists may be
inclined to treat their own reputation as substitutes for their value-adding services. That
is, all else being equal, some venture capitalists with high reputational capital may devote
less effort to their investments compared to their less well-known rivals because they –
perhaps falsely – assume that their mere reputation will be sufficient to create value,
regardless of their post-investment effort (De Clercq et al., 2003).
For the venture capitalists themselves, reputation may be important because it gives
great market power in their ability to close attractive deals, as entrepreneurs of start-up
companies are more likely to accept a financing offer made by a venture capitalist with a
high reputation, even at lower valuations (Seppa, 2002; Hsu, 2004). Reputation also pro-
vides the venture capitalist with the ability to raise new funds and certify ventures to third
parties (Gompers, 1996). The consequences of losing a good reputation can therefore be
significant. For example, in the aftermath of the market crash in 2001, a number of well-
established venture capitalists damaged their reputation by over-investing in marginal
ventures, and subsequently were unable to raise new funds and were forced out of busi-
ness (Lerner and Gompers, 2001). Furthermore, because venture capitalist reputation is
highly valued by the market, venture capitalists attempt to gain reputations as soon as
possible. A primary vehicle for building reputation is going public with a portfolio
company because an IPO may serve as a visible (if somewhat imperfect) signal of the
venture capitalists’ prowess in selecting, developing, and cashing out of high potential
ventures (Stuart et al., 1999). Another way to build reputation is to syndicate with
respected venture capitalists (Sorenson and Stuart, 2001), which venture capitalists may
seek out of their own interest, rather than in the venture’s best interest.
The venture capital post-investment phase 203

Concluding note Overall, prior empirical studies on venture capitalists’ value added have
shown that both venture capitalists and entrepreneurs perceive value in active venture
capitalist presence in entrepreneurial ventures. The importance of venture capitalists’
value-adding potential has been illustrated by the fact that successful venture capitalists
have been found to use a ‘hands-on’ approach on a discriminating and exceptional basis
rather than in a universal manner, in that successful venture capitalists intervene in areas
where they believe they can make an important economic contribution to their portfolio
companies (for example Murray, 1996). However, and as mentioned earlier, despite the
empirical evidence that venture capitalist value added is an important aspect of the post-
investment relationship, the literature to date has to a great extent considered the venture
capitalist–entrepreneur relationship as a ‘black box’. That is, the notion that value can be
added is expected as ‘a fact of venture capitalist practice’, and no clear explanation is
given of how exactly value is created. In the next section, we highlight some recent
research that has attempted to focus more closely on the type of interactions that take
place between the venture capitalist and entrepreneur. In essence, two categories of issues
arise with respect to the dynamics that occur between the two parties: (1) the content of
the interactions; and (2) the process through which these interactions take place.

The role of content and process in venture capitalist–entrepreneur relationship

Content-related issues
As indicated above, venture capitalists’ active involvement in their portfolio companies
represents an important path through which entrepreneurs can benefit. In the following
section, we focus on research that has looked particularly at the role of knowledge and
learning in venture capital investments. More specifically, we discuss the role of venture
capitalists’ experience and knowledge, the importance of knowledge sharing between
venture capitalists (either within a given venture capital firm or within an investment 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 diversify
their portfolio in order to decrease their financial risk, others prefer to specialize and focus
on developing specific expertise within a given domain (for example in terms of industry
and/or development stage) in order to reduce the uncertainty embedded in their invest-
ments (for example Gupta and Sapienza, 1992; Norton and Tenenbaum, 1993; Lockett
and Wright, 1999; De Clercq et al., 2001). More specifically, it has been argued that while
financial risk management may help reduce a venture capitalist portfolio’s downside,
knowledge management may help increase its upside (Dimov and Shepherd, 2005). De
Clercq and Dimov (2003) found that investors’ specialization in terms of industry and
development stage has a positive effect on their overall portfolio performance. Venture
capitalists’ specialized knowledge may make it more difficult for entrepreneurs to hide
issues of management incompetence, misbehavior or other crucial information regarding
company performance due to the investor’s more in-depth understanding of the
company’s business. Furthermore, a positive relationship between specialization and per-
formance may also suggest that specialized venture capitalists may be more efficient in
detecting and providing adequate resources (for example potential customers, employees
204 Handbook of research on venture capital

or other investors) to portfolio companies depending on their particular industry and


stage of development.
Other research has suggested that the advantages stemming from investment special-
ization may be particularly strong in the case of high-tech investments. As high-tech
investments are characterized by high levels of informational asymmetry and opacity,
specialized venture capitalists may be in a better position to reduce the uncertainty
stemming from this asymmetry (Henderson, 1989). It has even been argued that the high
informational asymmetries typical for high technology investing create a competitive
advantage for venture capitalists if they decide to specialize in these firms (Sapienza and
De Clercq, 2000). Going one step further, Hurry et al. (1992) found that Japanese venture
capital investments often serve as a learning mechanism to carry the venture capitalist to
a new technology, and the success of this learning transition may take precedence over the
success of the portfolio company or the goal to produce immediate financial returns to
the venture capitalist.
In short, prior research suggests that investment specialization may facilitate the acqui-
sition of specific information by the venture capitalist, and this in turn may enable the
investor to become more effectively involved in the key decision-making processes of her
ventures. Experienced venture capitalists may thus be better equipped to detect 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 portfolio
company (De Clercq and Sapienza, 2005). This counter-intuitive finding needs further
investigation in terms of what some of the boundary conditions are for venture 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 communicate
with the entrepreneur or other investors (Prahalad and Bettis, 1986).

Knowledge exchange between venture capitalists In addition to the knowledge held by an


individual venture capitalist, the communication that takes place between venture capital-
ists may also play an influential role in generating positive investment outcomes. First, the
communication between investors working for one and the same venture capital firm may
be important. Venture capital firms indeed consist of several general partners and a staff
of associates who function as apprentices to the general managers (Sahlman, 1990). As the
partners and associates have to some extent varying backgrounds and skills, and each may
hold different ‘chunks’ of knowledge, entrepreneurs may benefit from investors who foster
effective communication routines with their colleagues within the venture capital firm. For
instance, intensive knowledge exchange among individual venture capitalists regarding a
particular portfolio company may give the venture capital firm as a whole broader access
to and deeper insight into knowledge that is important to assist a portfolio company suc-
cessfully (De Clercq and Fried, 2005). As such, in order for a venture capital firm to exploit
its knowledge base optimally, it benefits from combining and integrating knowledge from
among various individuals (that is venture capitalists) within the firm.
Furthermore, there is an increasing body of research that addresses the importance of
knowledge exchange that takes place within venture capital investment syndicates, that is
The venture capital post-investment phase 205

the cooperation between individual venture capitalists working for different venture capital
firms (Lockett and Wright, 2001; De Clercq and Dimov, 2004; Dimov and De Clercq, 2006;
Manigart et al., 2006). At a conceptual level, an important aspect of the beneficial effect
of syndication pertains to the productive interactions that may take place among syndi-
cate partners (for example Bygrave, 1987; 1988; Lerner, 1994; Brander et al., 2002). From
a knowledge perspective, there may be two principal positive outcomes resulting from
venture capitalists’ syndication. First, syndication may help facilitate venture capitalists’
selection process in that venture capital syndicates may find better investment targets than
each individual venture capitalist would find on her own (Lerner, 1994). Second, 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 the
table (Brander et al., 2002) and are heterogeneous with respect to their resources (Lockett
and Wright, 2001). That is, as different syndicate members may have different skills rele-
vant to a particular portfolio company (for example detecting new customers, filling top
management team vacancies, or bringing the entrepreneur in contact with additional
investors), investment syndicates represent a rich variety of knowledge relevant to the
entrepreneur. Interestingly, Dimov and De Clercq (2006) found a positive, rather than neg-
ative, effect of syndication on the proportion of portfolio company defaults in a venture
capitalist’s portfolio. One explanation of this finding is that once a portfolio company loses
its promise of high returns, venture capitalists involved in a syndicate may feel a lower
responsibility vis-à-vis a prior investment decision when this responsibility is shared with
other investors. This may not necessarily be a bad thing as this practice diminishes the 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 with
a disappointing performance, may be attenuated when venture capitalists are being part of
a group of investors (Birmingham et al., 2003).

Knowledge exchange between venture capitalist and entrepreneur Recent research has 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 Clercq
and Sapienza, 2001; Busenitz et al., 2004). More specifically, the potential outcomes from
the relationship between venture capitalist and entrepreneur may be highest when the two
parties hold complementary knowledge that enforces the other party’s expertise and skills
(Murray, 1996). A specific manifestation of the complementarity between the venture 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 (Dyer
and Singh, 1998). Relation-specific investments by the venture capitalist for example may
be to devote considerable time and energy with an entrepreneur to learn the nuances and
potential of a specific technology. Likewise, the entrepreneur may develop and utilize
reporting procedures specifically aimed at fitting the venture capitalist’s timing and report-
ing requirements. De Clercq and Sapienza (2001) argued that both venture capitalist and
entrepreneur can benefit from such relation-specific investments since these investments
enable them to access information and capabilities not widely available in the market. That
is, the complementary skills of venture capitalist and entrepreneur can result in an
extremely potent combination that leads to enhanced learning for both parties.
206 Handbook of research on venture capital

In addition to the nature of the knowledge that is held by venture capitalist and
entrepreneur, effective knowledge sharing routines have to be established between the two
parties. Communication between venture capitalist and entrepreneur may occur in a
variety of formal and informal forms, such as through telephone, email, voice mail,
formal meetings and board meetings (Gorman and Sahlman, 1989; Sahlman, 1990).
When effective board knowledge-sharing routines are in place, the interaction between
venture capitalist and entrepreneur may lead to an improved capacity for both parties to
exchange and process knowledge, and this may then lead to optimal learning outcomes
(De Clercq and Sapienza, 2005). Furthermore, personal contacts outside board meetings
may allow for easier exchange of information, in that such contacts may allow the venture
capitalist and entrepreneur to learn more about the other’s idiosyncrasies and to develop
a mutual understanding of each other’s goals. Also, the employment of frequent interac-
tion routines between venture capitalist and entrepreneur enhances access to each other’s
knowledge base and increases the capability of processing complex knowledge (Sapienza,
1992). More generally, effective communication between venture capitalist and entrepre-
neur stimulates a greater understanding between the two parties, and ultimately enhances
the potential for favorable investment outcomes.

Concluding note An important aspect of how venture capitalists add value to their 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. As
illustrated in the research cited above, the knowledge held by the individual venture cap-
italist, the aggregated knowledge held by multiple venture capitalists belonging to the
same or different venture capital firms, as well as the combined knowledge of investor and
entrepreneur all play an important role in the effectiveness of venture capital investments.
Overall, the literature indicates that the knowledge-based view and learning theory are
appropriate frameworks that help explain why certain venture capitalist–entrepreneur
relationships are more effective than others. However, although the literature mentioned
above suggests that venture capitalists and entrepreneurs should work together in a 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 the
two parties, for example, what are the specific task descriptions outlined for the venture
capitalist during and outside board meetings, or what is the content and frequency of the
feedback that entrepreneurs provide to their investors?

Process-related issues
Whereas the previous section focused on the role of knowledge in venture capital finance,
we now turn our attention to process-related aspects of the relationship between venture
capitalist and entrepreneur. We draw hereby on the increasing body of venture capital
research that recognizes the importance of establishing strong social relationships
between the two parties rather than focusing solely on behavior based on self-interest and
opportunism as advanced by the agency framework.

Various theoretical frameworks In essence, the assumptions underlying agency theory


deny the establishment of a trusting relationship between exchange partners, and the
The venture capital post-investment phase 207

theory is predicated on an extreme form of self-serving behavior (Eisenhardt, 1989).


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

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 of
trust as the first process-related aspect characterizing venture capitalist–entrepreneur
relationships. The presence of ‘trust’ has for long been considered an essential determin-
ant of the performance of exchange relationships since the willingness to interact with
others is often contingent on the prevalence of trust (Ring and Van de Ven, 1992). From
a social exchange perspective, trust involves the presence of positive expectations about
another’s motives in situations entailing risk, that is, ‘to trust another party’ essentially
means to leave oneself vulnerable to the actions of ‘trusted others’ (Boon and Holmes,
1991). Although the early research in the venture capital area did not explicitly focus on
the importance of trust in venture capitalist–entrepreneur relationships, trust has gener-
ally been considered as being an important aspect of relationships between investor and
investee. 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 relationships
with their entrepreneurs.
The potential value of trust in venture capitalist–entrepreneur relationships has been
argued to derive from the more effective knowledge exchange that takes place between the
two parties. For instance, De Clercq and Sapienza (2006) found a positive relationship
between the venture capitalists’ trust in their portfolio companies and their perception of
the companies’ performance. The authors reasoned that the presence of trust between
venture capitalist and entrepreneur creates a context in which both parties are willing to
open themselves to the other since the likelihood that the other will act opportunistically
is diminished.
Interestingly, there is also some evidence that, in some cases, too much trust in venture
capitalist–entrepreneur relationships may potentially have a negative side effect. More
specifically, at extremely high levels of trust there may be less need felt by the two parties
to engage in penetrating discussions and information exchange. In other words, there
may be a danger that they scrutinize the other’s decisions less (De Clercq and Sapienza,
2005). This suggests that venture capitalist and entrepreneur should be wary not to
develop a level of trust that actually reduces the intensity of processing information in
their relationship.

The role of social interaction The level of social interaction that takes place between the
venture capitalist and entrepreneur (or exchange partners in general) pertains to the social
contacts and personal relationships that exist among the parties. The notion of social
interaction is not necessarily synonymous with that of trust in that the venture capitalist
and entrepreneur may have confidence that the other will not engage in opportunistic
behavior, but that they will still interact with one another in a formal rather than infor-
mal manner. Prior research has suggested that strong personal contacts between exchange
partners may be beneficial as these contacts increase their willingness to be involved with
the other for a long period of time (Morgan and Hunt, 1994). Similarly, recent research
in the venture capital area has found empirical evidence for a positive relationship
between the extent to which venture capitalist and entrepreneur interact with one another
in social occasions and the performance of venture capitalist investments (De Clercq and
Sapienza, 2006). The rationale for this positive relationship is that thanks to strong social
The venture capital post-investment phase 209

contacts the investor may become more motivated in assisting the entrepreneur for
reasons different from economical ones (Zaheer et al., 1998). Social interaction between
venture capitalist and entrepreneur can also expand the nature of the knowledge
exchanged in the relationship, in that social interaction increases the transfer of complex,
tacit knowledge (Nonaka, 1994). In the venture capital context, tacit knowledge may
pertain to the venture capitalist’s ability to detect the knowledge needs of her portfolio
companies, or to the entrepreneur’s ability to detect hidden value-adding skills held by the
venture capitalist.
An implication from this stream of research for entrepreneurs is that their willingness
to develop close social relationships with their investors may affect their standing within
the venture capital community. That is, an entrepreneur’s reputation with respect to their
willingness to engage in open relationships with external partners may function as a signal
to the venture capitalist that cooperation with the entrepreneur will be efficient and
effective. Put differently, entrepreneurs may increase their potential access to additional
needed funding by building a track record of strong social relationships with investors
and other exchange partners.

The role of goal congruence Goal congruence refers to the degree to which two exchange
partners hold common beliefs regarding their relationship (Nahapiet and Ghoshal, 1998).
The notion of goal congruence, or goal incongruence, is closely related to the presence of
information asymmetry as described in agency theory (Eisenhardt, 1989). Goal 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 (Davis
et al., 1997). The broader literature on inter-firm relationships has argued for a positive
relationship between goal congruence and relationship outcomes in that higher goal 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 will
potentially help the other in better achieving the common goals.
In the context of venture capital financing, the venture capitalist and entrepreneur may
each have unique skills and capabilities, and therefore, differ in terms of their orientation,
activities and goals (Cable and Shane, 1997). Several types of goal conflict may hamper
the extent of the information exchange between venture capitalist and entrepreneur, and
the resulting poor communication may ultimately reduce the potential of the entrepre-
neur to benefit optimally from the venture capitalist’s input. For instance, a possible goal
conflict between the venture capitalist and entrepreneur pertains to the venture capital-
ist’s expectation that the entrepreneur is willing to give up her absolute independence in
order to maximize the expected shareholder wealth through corporate growth (Brophy
and Shulman, 1992). However, when the entrepreneur’s main objective is not just future
wealth maximization, but also meeting other personal needs, such as approval and 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 phase
because of divergent interpretations, which may then lead to mutual disappointments and
conflict (Parhankangas et al., 2005).
210 Handbook of research on venture capital

From a more positive angle, high levels of goal congruence between venture capitalist
and entrepreneur should stimulate the parties’ ability to interact effectively with one
another. There is indeed empirical evidence for the existence of a positive relationship
between the level of goal similarity between the venture capitalist and entrepreneur and
the performance of the venture capitalist’s investment (De Clercq and Sapienza, 2006).
When the venture capitalist and entrepreneur share the same goals and expectations, it is
more likely that they engage in more effective communication because each party has a
better understanding of which information is important for each, and how this 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 shown
that 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, and
they engage in closer cooperation (Morgan and Hunt, 1994). In the context of venture
capital financing, the commitment of venture capitalist and entrepreneur to their mutual
relationship may manifest itself in specific behaviors that reflect the partners’ willingness
to invest highly in the relationship, that is their commitment may be reflected in their will-
ingness to undertake significant efforts (Gifford, 1997). For instance, venture capitalists
may 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. In
addition, the level of commitment in venture capitalist–entrepreneur relationships may
not only pertain to the actual efforts that are undertaken on behalf of the relationship,
but also to one’s identification with and feelings vis-à-vis the other (De Clercq and
Sapienza, 2006). Commitment therefore also reflects the affective or emotional 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 created
in 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 the
venture capitalist spending more time in executing various value-adding roles (Sapienza
et al., 1994), which may then increase the likelihood that the entrepreneur will benefit from
the venture capitalist’s assistance. Second, prior research has indicated that entrepreneurs
may be resistant to the advice provided by their venture capital providers. This resistance
may be explained by the entrepreneur’s unwillingness to give up control over her company
(Sahlman, 1990). However, when the venture capitalist shows a deep concern about and
interest in the entrepreneur’s well-being, the latter may be more likely to believe in the
loyalty and motives of the venture capitalist, and therefore be less resistant in accepting
the offered advice. It has indeed been shown that entrepreneurs are more receptive
for the venture capitalist’s advice when the venture capitalist is a highly involved member
of the board of directors (Busenitz et al., 1997). Also, De Clercq and Sapienza (2006)
found empirical support for the positive relationship between a venture capitalist’s 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 convincing
entrepreneurs that they are ‘in the game’ for the long run and are willing to function as
committed insiders.
The venture capital post-investment phase 211

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 venture
capitalists face a serious time allocation dilemma with regard to the myriad of activities
they are involved in, that is devoting attention to their existing portfolio companies,
locating and closing new investment deals, and raising new funds. This author argued
that venture capitalists often economize on allocating their effort across these activities
in ways that are optimal for the venture capitalist herself, but not necessarily optimal for
the portfolio companies. More specifically, given that venture capitalists have a tendency
to devote as much time as possible to those deals that generate the majority of their
returns (Sahlman, 1990; Sapienza et al., 1994), entrepreneurs who are in the highest need
for venture capitalist advice may in fact be left in the cold. Ultimately, this conscious
choice of reduced involvement may have gruesome consequences for the individual
entrepreneur.

Concluding note An important aspect of how venture capitalists add value to their
portfolio companies, in addition to the content of the knowledge that is exchanged
between the venture capitalist and entrepreneur, pertains to the social dynamics that
take place in the interactions between the two parties. The literature suggests that
process-related issues, such as trust and commitment, may facilitate venture capitalists’
ability to aid a particular entrepreneur through an improved understanding of the entre-
preneurs’ operations and needs. That is, good relationships between venture capitalist
and entrepreneur may lead to more specific insights into how an investment deal can be
optimized, and therefore enhance the potential that the venture capitalist adds value.
Also, process-related issues may increase venture capitalists’ value-adding potential
because these issues increase the receptivity of the parties vis-à-vis the other’s input and
advice. Finally, whereas the literature cited above appeals to the intuitive notion
that venture capitalists and entrepreneurs will benefit from more trustful, socially ori-
ented, congruent and committed relationships, further examination is needed with
respect to whether in some cases close relationships may actually hurt rather than help.
For instance, it is possible that high-quality relationships may lead to groupthink in
which the scrutiny with which the two parties judge each other’s actions is diminished.
This may then potentially lead to poor decision making (Janis, 1972; De Clercq and
Sapienza, 2005).

Future research
In this chapter we have provided an overview of prior research on the post-investment
phase of venture capital investing. We first discussed the literature on the monitoring
and value-adding activities undertaken by venture capitalists vis-à-vis their portfolio
companies. We then turned our attention to the literature that attempted to better
explain the mechanisms underlying the question of how value is added in venture cap-
italist–entrepreneur relationships. Two types of issues relevant to better understanding
value-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 give
some indications of how future researchers can further extend the literature highlighted
in this chapter.
212 Handbook of research on venture capital

Heterogeneity of monitoring and value-adding activities


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

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

Furthermore, monitoring and value-adding activities may further be influenced by


characteristics of the portfolio company and entrepreneur:

● The business or financial risk of the venture (for example level of innovation; 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 in
the venture capital industry worldwide, specific settings and social norms and behavior in
different parts of the world mean that the US model is not universal. More research is
needed to fully understand the specific behavior of venture capitalists depending on 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.
The venture capital post-investment phase 213

Content and process-related issues


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

● A longitudinal examination of venture capital performance and organizational learn-


ing across a variety of portfolio companies could answer the question of how venture
capitalists are able to transfer knowledge from one venture to another. Furthermore,
a related question that needs further investigation is: at what point does extensive
communication between the venture capitalist and entrepreneur become a burden for
learning given the costs associated with extensive information processing?
● It is well-established that venture capitalists stage their investment across 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 in
terms of the intensity of the interactions that take place between the venture cap-
italist and entrepreneur. It could be examined how the nature of communication
between the two parties differs and evolves across subsequent investment rounds.
● Another topic pertains to how venture capitalists are better able than others to
create conditions and mechanisms that encourage quality interactions with their
portfolio companies. For instance, what is the importance of establishing know-
ledge-sharing routines before the initial investment is made? How can the venture
capitalist motivate the entrepreneur to provide useful inside information in a con-
tinuous and spontaneous manner, especially when the entrepreneur has not been
able to achieve pre-set performance targets?

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

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

Classic venture capitalists versus other investor types


Finally, whereas the primary focus in this chapter was on the classic (or institutional) venture
capitalist, as opposed to the business angel (see Chapters 12 to 14) or corporate venture 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 across
different investor types. In essence, classic (institutional) venture capitalists, business angels
and corporate venture capitalists represent complementary sources of finance for entrepre-
neurs, and each type of investor may have specific characteristics that reflect on the nature
of the relationship between investor and entrepreneur (De Clercq et al., 2006).
First, given that business angels tend to be more willing than institutional venture
capitalists to invest at the very earliest stages (Benjamin and Margulis, 2005), their invest-
ments may be characterized by more uncertainty. Consequently, business angel invest-
ments may provide a higher opportunity for entrepreneurs to benefit from the knowledge
provided by the investor, yet the uncertainty involved in such investments may make the
establishment of stable, trustful relationships more challenging. Furthermore, since busi-
ness angels, compared to institutional venture capitalists, may be more motivated by the
intrinsic reward of their involvement in a portfolio company and often do not have a wide
portfolio of companies, the time allocation dilemma as described above (Gifford, 1997)
may be less relevant for business angels. Also, due to the informal nature of angel financ-
ing, entrepreneurs who have angel financiers may not enjoy as many reputational benefits
as entrepreneurs who have institutional venture capitalists or corporate venture capital
investors on board.
Furthermore, the nature of possible goal incongruence between investor and 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 about
increasing the realizable trade value of their ventures since a substantial portion of their
compensation is based on capital gains. When harvesting is an important short-term
objective, the investor will want to collect as much information as possible that is useful
for presentation to potential buyers of the venture. However, the entrepreneur may not be
willing to provide the institutional venture capitalist with such information if she has
different goals for the company. In contrast, a relevant goal for a corporate venture cap-
italist may be to utilize the portfolio company as an external research and development
resource, or to direct the company’s research towards the mother company’s strategic
goals (Siegel, 1988). In that case, possible goal conflict between the corporate venture cap-
italist and entrepreneur may pertain more to how autonomous the entrepreneur can be in
terms of the strategic direction in which her company is going. This type of goal incon-
gruence is of a very different nature and calls for different action, which in turn presents
a further route for fruitful research.

Acknowledgement
We thank the editor (Hans Landström), Lowell Busenitz and participants of the State-
of-the-Art workshop (Lund) for helpful comments on earlier drafts of this chapter.

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

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

219
220 Handbook of research on venture capital

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 capitalist
investments. While past research has started to probe this area, there is much work that
needs to be done here.
Finally, this chapter addresses performance issues that come with studying venture
capital funding. Given that these ventures are private firms, obtaining legitimate financial
numbers clearly represents unique challenges. Given that investors such as venture cap-
italists look to exit a venture after a season of involvement and, hopefully, growth (venture
capital exits are generally projected at approximately 5–6 years), organizational outcomes
or exit modes represent a viable metric for analyzing performance. Furthermore, venture
capital involvement often involves interactions and relationships with individuals inside
the venture, making the evaluations of both venture capitalists and entrepreneurs import-
ant. The final section explores these various measurement alternatives and addresses the
strengths and limitations of these alternatives.
This chapter will proceed in the following manner. The next section addresses activities
in which venture capitalists typically get involved with a venture and how they may help
or hinder the development of the venture. Second, we discuss the impact that venture cap-
italists have on innovation and the development of new industries. Third, we will explore
performance measurement issues as they relate to venture capital-backed ventures. In so
doing, we will address the types of phenomena being researched and the type of perform-
ance that is likely to be most appropriate as the dependent variable.

Venture capital impact on venture development


Venture capitalists are known for potentially adding value to ventures through their
knowledge and contacts to enhance supplier and customer relationships, through offering
strategic and operational advice, and helping recruit key managers (MacMillan et al.,
1989; Sapienza, 1992; Barney et al., 1996). Furthermore, venture capitalists have often
established relationships with underwriters (Bygrave and Timmons, 1992) and certify the
value of their ventures to those underwriters (Megginson and Weiss, 1991). Thus, venture
capital involvement in ventures may represent an important asset that allows for a
resource advantage in subsequent phases such as acquisitons and IPOs. In sum, the 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. We
now develop research opportunities for addressing the potential impact that venture
capital involvement can have in the form of the governance oversight that they bring to
the venture, the financial accountability, the certification of venture capital backing and
managing positive exits. By addressing these issues, we seek to provide direction to future
research where venture capitalists may add value to the ventures in which they invest
through governance and reputation effects.

Governance
Some venture capital research is addressing internal governance issues in venture capital-
backed ventures (for example Amit et al., 1990; Sahlman, 1990; Bruton et al., 2000). When
the entrepreneur (for example the agent) contracts with the venture capitalist (for example
Innovation and performance implications 221

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

capital-backed firms. More specifically, I suspect that there is more industry experience
and more diversity in venture capital-backed boards. Venture capitalists are adamant
about moving a firm towards commercialization as soon as possible and generally want
as much experience on the board as possible. Non-venture capital-backed ventures tend
to attract ‘likes’ and more family members to their boards whereas venture capitalists in
and of themselves typically represent significant deviations from founder norms and char-
acteristics. Furthermore, an increase in the equity held by one or two members of the
founding team is likely to be associated with insider domination on the board, and the
board may be less diverse (Filatochev and Bishop, 2002). In sum, we believe that the gov-
ernance mechanisms put in place by the boards of venture capital-backed ventures will
significantly differ from those of non-venture capital-backed ventures. More importantly,
stronger governance should lead to better venture performance. These arguments lead to
the following propositions:

Proposition 1: Venture capital-backed ventures will have substantially better governance


mechanisms in place than will non-venture capital-backed ventures.

Proposition 2: Because of the repetition and skill that venture capitalists have in moni-
toring entrepreneurial ventures, there will be significantly less variance in
the governance mechanisms in venture capital-backed ventures than in
ventures with non-venture capital-backed ventures.

Proposition 3: Stronger governance mechanisms in venture firms will lead to better


venture performance.

Venture team compensation


When entrepreneurs start their ventures, compensation and pay-off issues are almost
always assumed to be at some distance into the future. Often little compensation is taken
by the founders from the venture in the early months with the assumption that their
‘sweat’ equity will be rewarded by the long-term success of the venture. Consequently,
near-term compensation tends not to be much of an issue until venture capitalists invest.
A reduction in the equity stake of the venture and the implications of needing to share
the long-term rewards of the venture are projected to create substantial compensation
issues. While it seems that this subject has received at best minimal research attention, it
is an important issue.
I first turn to the research on executive compensation as a platform into this new area
for venture capital research. Research on managerial pay has shown how monitoring and
reward mechanisms can help to align the interests of managers and shareholders (Jensen
and Murphy, 1990; Barkema and Gomez-Mejia, 1998). Furthermore, contingent pay, such
as stock options, may motivate managers differently than non-contingent pay, such as salary
and other annual cash compensations (Daily et al., 1998). The use of contingent pay mech-
anisms more closely aligns managerial incentives with those of investors because managers
have a substantial position in the firm whose value is contingent on firm performance
(Jensen and Murphy, 1990). In addition, as noted above, the presence of venture 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).
Innovation and performance implications 223

Non-contingent pay is also a part of the compensation scheme and may be more
salient with the advent of venture capital investments. Venture capitalists can realign the
entrepreneurial team through greater use of contingent pay mechanisms. Contrary to
contingent pay, non-contingent pay is normally expected to generate managerial inter-
est in the shorter term, although the empirical evidence for the effectiveness of cash
compensation on increasing firm performance tends to be relatively weak (Jensen and
Murphy, 1990; Balkin et al., 2000). Cash compensation provides a stable income stream
and mitigates compensation-based risk or rewards (Daily et al., 1998). Thus the 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 positively
related 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). This
may be a particular problem in entrepreneurial ventures. With the onset of venture
capital funding, non-contingent pay may represent a mechanism through which man-
agers can be rewarded without transferring too much risk. Furthermore, at lower levels
of non-contingent compensation, managers may feel that their income is inequitable
and not commensurate with the amount of effort and time that they expend. As a result,
lower levels of this type of compensation may encourage undesirable behavior (Kidwell
and Bennett, 1993), or the pursuit of excessive perquisites (Jensen and Meckling, 1976)
or other utility-maximizing behavior to the detriment of the firm. On the other hand,
higher levels of non-contingent pay can help soften the impact of having to give up a
significant equity stake in the venture in exchange for venture capital funding. Future
research should explore the use of compensation in venture capital versus non-venture
capital-backed ventures as well as the importance of each with the advent of venture
capital funding.

Proposition 4: Venture firms with venture capital backing will have greater protection
against managerial opportunism compared to those new ventures
without venture capital involvement as evidenced by the greater use of
contingent and non-contingent compensation.

Proposition 5: Entrepreneurs will view the giving up of partial venture equity more
favorably with higher levels of non-contingent pay.

It is also likely that compensation schemes will affect the performance of venture
capital-backed ventures. Greater contingent pay helps to soften the impact of decreased
equity that entrepreneurs are likely to feel with the advent of venture capital funding,
leading them to work harder for the overall well-being of the venture. Contingent pay
in the form of stock options is also likely to increase long-term venture performance.
While the equity portion of entrepreneur ownership contracts with venture capital 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 venture


capital-backed ventures will increase the long term performance of the
venture.
224 Handbook of research on venture capital

Reputation and certification


Since entrepreneurs usually start firms in turbulent environments with an unproven product
market, a great deal of uncertainty typically surrounds these ventures. Furthermore, there
is usually little or no historical information giving a venture little or no ‘track record’ on
which to base future projections. It is in this type of context that venture capitalists have the
potential to add to the stature and credibility of a venture. Megginson and Weiss (1991)
examined venture capital backing in IPO firms and found that their presence lowered both
underpricing and the gross spread paid to underwriters. Dolvin (2005) also found support
for the certification hypothesis with IPO firms, as venture capital-backed firms had lower
issuance costs, increased upward price adjustments, and shorter lock-up periods. Dolvin
also found support for venture capital certification among penny stocks.
While this prior research on certification in the IPO process is helpful, venture capital
certification may also have implications in the earlier days of a venture. Venture capital
involvement and certification may make it easier for the venture to establish a relationship
with critical buyers and suppliers, obtain additional financing, and develop a better
reputation with external constituents. Given the importance of credible commitments
(Williamson, 1983; 1991), we argue that the presence of venture capital investments and
positions on the venture board of directors will serve in this manner. For example, venture
capitalists will not want to harm their reputation in the industry of the new venture (Amit
et al., 1998) and will take steps to improve any difficulties between transacting parties. This
in turn will act to reduce the potential transaction costs (Williamson, 1985) for the parties
involved, and will provide additional benefits for the new venture. Thus, we should expect
to see greater efficiency, especially as it relates to governance costs (Williamson, 1991) in
venture capital-backed firms.

Proposition 7: Venture capital-backed ventures will have higher levels of credible 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-on
investors. Given that venture capitalists typically invest in stages or rounds providing
enough money for venture firms for roughly a year before additional financing is needed,
follow-on investors are critical. The amount of financing needed in subsequent rounds
usually increases and if credible investors have been involved in earlier rounds and they
continue to support the venture in subsequent rounds, this sends a positive signal and par-
tially certifies the venture as a credible investment for follow-on financing. On the other
hand, non-venture capital-backed ventures are likely to have to find a whole new set of
investors. This is almost always a very time consuming process.

Proposition 8: Once venture capitalists have invested in a venture, the entrepreneurs will
spend less time obtaining subsequent rounds of financing than non-
venture capital-backed ventures.

Reputation and certification characteristics are also likely to lead to performance


effects. When quality venture capitalists invest in a venture, this will add to their reputa-
tion in a positive way, thus enabling the venture to develop alliances and relationships with
Innovation and performance implications 225

higher quality firms. The enhanced reputation is also likely to allow the entrepreneurs to
spend more time on their own ventures instead of making and further establishing con-
tacts. These issues should have positive effects on venture performance.

Proposition 9: Venture capital-backed firms will have better reputations leading to


higher venture performance.

Concluding remarks
One of the longest standing assumptions in the research literature on venture capital
involvement is that they add value to the ventures that they invest in. Unfortunately,
empirical findings have been quite mixed thus far. This does not mean that venture cap-
italists do not add value and that researchers should stop examining this area. Rather, the
essence of the above arguments is that we need to focus our research in the areas argued
above. I have developed arguments for more specifically examining governance 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 research
should enable us to better address this critical issue.

Venture capital impact on innovation


With venture capital backing as an alternative becoming more common across the globe,
it is often assumed that the presence of venture capital investments is an important 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 from
smaller and start-up firms, and much of this growth involves technological innovations
(Tyebjee and Bruno, 1984). Venture capital is a common source of funding for these ven-
tures that have high-growth potential (Bygrave and Timmons, 1992). However, we still
know very little about the impact that venture capitalists have on the ventures they back
individually as well as the more collective impact. This section examines exploration and
exploitation at the firm level as well as the development of new industries and how venture
capitalists impact these issues.

Exploration and exploitation


Venture capital funding is often closely linked with the pursuit of innovative technologies,
with this probably being particularly true in the US. Of course innovation can occur in
larger corporations as well as in smaller firms without venture capital funding, but venture
capitalists are almost always associated with the funding of innovative ventures. The
involvement of venture capitalists in such ventures stems at least in part from the issue
that newer technology-based ventures have few funding sources since they do not have an
established financial history nor fixed assets on which to anchor their funding. Venture
capitalists also invest with a relatively limited time frame. Successful exits (IPOs or acqui-
sitions) have to be anticipated within about five years to be considered for venture capital
funding because of the funding cycle of their own limited partners. So while they tend to
prefer innovative ventures, they are also very much concerned about their own returns and
the quick commercialization or exploitation of the innovations that they are funding. By
exploitation, we have reference to implementation, efficiency, production and market
development (March, 1991; He and Wong, 2004).
226 Handbook of research on venture capital

The development of the exploration and exploitation literature has show