Introduction

Venture capital has in recent

years become a substantial and
growing area of
1
academic research . This
florescence has emerged from
the pioneering work of
Bygrave, Timmons, Sahlman,
Gompers, Lerner and others
together with the build-up
and final bursting of the stock
market bubble of the 1990s,
regarded by many as
fuelled by venture capital. (See
Gompers and Lerner, 2001).
However, venture capital
research is still a comparatively
young field and several of the
fundamental questions
raised by scholars working
within it remain to be answered.
These fundamental
questions include the following:
Why do venture capital firms
exist (or persist)? In
other words, what is different (if
anything) about venture capital
as compared with
other types of finance that
creates a need for it as a
separate entity? How important
is
venture capital to an economy?
This question raises issues of
the monetary value of
venture capital and the
contribution of enterprises
financed by venture capital to
national product. Who are the
main recipients of venture
capital and why? The
answer to this question involves
an exploration of the types of
firm funded by venture
capital and an examination of
what makes them ‘special’.
What is the nature of and
motivation for the kinds of
contracts governing the
relationship between venture
capital fund providers (e.g.
financial institutions) and fund
disbursers (Venture
Capitalist investors?) The
answer to this question involves
an exploration of the
agency problems engendered by
the venture capital relationships
and their proposed
solution in the contractual
conditions governing them. Do
venture capitalists (VCs)
have superior investment
selection skills and do their
post-investment activities add
Introduction

Venture capital has in recent years become a substantial and growing area of
academic research1. This florescence has emerged from the pioneering work of
Bygrave, Timmons, Sahlman, Gompers, Lerner and others together with the
build-up and final bursting of the stock market bubble of the 1990s, regarded by
many as fuelled by venture capital. (See Gompers and Lerner, 2001). However,
venture capital research is still a comparatively young field and several of the
fundamental questions raised by scholars working within it remain to be
answered. These fundamental questions include the following: Why do venture
capital firms exist (or persist)? In other words, what is different (if anything) about
venture capital as compared with other types of finance that creates a need for it
as a separate entity? How important is venture capital to an economy? This
question raises issues of the monetary value of venture capital and the
contribution of enterprises financed by venture capital to national product. Who
are the main recipients of venture capital and why? The answer to this question
involves an exploration of the types of firm funded by venture capital and an
examination of what makes them ‘special’. What is the nature of and motivation
for the kinds of contracts governing the relationship between venture capital fund
providers (e.g. financial institutions) and fund disbursers (Venture Capitalist
investors?) The answer to this question involves an exploration of the agency
problems engendered by the venture capital relationships and their proposed
solution in the contractual conditions governing them.

Venture capitalists
Measured in terms of personnel
Venture capitalists are
organisations that can range in
size from a single high net
worth individual (the so-called
Angel investor) up to very
large organisations employing
hundreds or even thousands of
staff, e.g. the UK’s 3i or
Apax partners. (See
Denny(2000) for an overview of
the UK industry). Typically
however, the venture capital
partnership (for they are
generally arranged as
partnerships rather than limited
companies – see below) has
only a handful of
investment managers and
support staff. As with most
industries the distribution of
venture organisation size is
almost certainly lognormal
implying a positively skewed
distribution with a small
number of large and a large
number of small firms
2. Venture capitalists

Measured in terms of personnel Venture capitalists are organisations that can

range in size from a single high net worth individual (the so-called Angel investor)
up to very large organisations employing hundreds or even thousands of staff, e.g.
the UK’s 3i or Apax partners. (See Denny(2000) for an overview of the UK
industry). Typically however, the venture capital partnership (for they are
generally arranged as partnerships rather than limited companies – see below)
has only a handful of investment managers and support staff. As with most
industries the distribution of venture organisation size is almost certainly
lognormal implying a positively skewed distribution with a small number of large
and a large number of small firms

2.1 Business Angels

Business angels are high net
worth individuals, usually
successful entrepreneurs
wishing to plough back some of
their wealth into the community
and wishing to help
develop the managerial skills of
young, potentially fast growth
entrepreneurs. They
are much larger in number than
institutional VCs and make
smaller, faster
investments that involve the day
to day involvement of the
investor in strategy and
implementation. Their
investment decisions can be
faster than institutional VCs
because they are less
bureaucratic organisations and
often do not require due
14
diligence to be performed
before ‘taking the plunge’.
However, they also
complement the activities of
VCs acting in tandem with
them, for example, by
providing seed capital (funding
for a prototype or proof of
concept) and leaving any
larger follow-on investments to
the bigger VC firms. The total
contribution of Angel
 2.1 Business AngelsBusiness angels are high net worth individuals,
usually successful entrepreneurs wishing to plough back some of their
wealth into the community and wishing to help develop the managerial
skills of young, potentially fast growth entrepreneurs. They are much larger
in number than institutional VCs and make smaller, faster investments that
involve the day to day involvement of the investor in strategy and
implementation. Their investment decisions can be faster than institutional
VCs because they are less bureaucratic organisations and often do not
require due diligence14 to be performed before ‘taking the plunge’.
However, they also complement the activities of VCs acting in tandem with
them, for example, by providing seed capital (funding for a prototype or
proof of concept) and leaving any larger follow-on investments to the
bigger VC firms. The total contribution of Angel

2.2 Institutional Venture capital Limited partnerships.In the United

States and in the UK institutional venture capital organisations tend to be
Limited Partnerships (Gompers and Lerner, 1999; Smith and Smith, 2004).
Such partnerships involve aspects of both limited liability (for the investors
or fund providers) and of unlimited liability (for the venture capitalists).
There are two kinds of ‘agency’ relationships in venture capital15: one
between the Investors (fund providers) and the VCs and one (or strictly
several16) between the VCs and the investee companies (companies in
which VCs invest the Investors money). These relationships are subject to
various conflicts of interest arising from the fact that one party to the
agreement has privileged information that it can potentially take advantage
of. Investors are invited to participate in a fund e.g. “The Guangdong
Telecomms fund II”, with an obvious sector or stage focus and often will
meet to hear presentations from its organisers (the VCs). The fund size is
normally fixed (e.g. $1bn US). Once this sum has been raised, investments
will be made, usually being completed within three years of the money
being raised. Limited partnerships take the form of a closed end funds
(Gompers and Lerner, 2001) which are investment vehicles quoted on a
stock exchange and allowing the investor to liquidate his investment even if
 the investments made by the VC have not yet been harvested. Dependents,
independents and corporatesInstitutional VCs are divisible into
independents, dependents and corporations. Independents are
partnerships investing their own money. Dependent or Captive VCs are
partnerships that are subsidiaries or affiliates of another financial
institution e.g. a bank. (For example, Barclays Ventures of the UK are a
subsidiary of Barclays Bank plc.) Finally, Corporate venture capitalists are
corporations who invest in the equity of private companies whilst
remaining involved in industrial or commercial activity as their main
business.

Fund providers (‘Investors’)

Firms that do not exclusively
rely on their own retained
profits for investments
periodically raise funds from
Investors, typically big financial
institutions (the banks,
pension funds or insurance
companies), government or the
universities. Pension funds
make up a very large proportion
of quoted equity ownership in
Europe and North
America and it is argued that
despite some of the apparent
problems associated with
venture capital (e.g. illiquidity
and ‘excess’ risk) they offer a
suitable investment
vehicle for them(e.g. British
Venture Capital Association,
2000; henceforth BVCA).
BVCA suggests that the
problems of risk can be
overcome by the use of venture
capital as a small proportion of
a diversified portfolio. This
would, it is claimed,
reduce the ‘excess’ firm-
specific risk associated with it.
Likewise, the problem of the
illiquidity of venture capital
investments could be
circumvented by the use of
quoted
investment vehicles in which
venture capital is embedded,
thus obviating the need to
sell individual shares should the
need arise.
Governments provide assistance
to venture capital investment in
many
European countries e.g. the
UK’s setting up of Regional
Venture Capital funds to plug
the so-called regional equity
gaps or the German
government’s BioRegio
Program
providing incubator
environments for biotech
startups. (Murray, 1994, 1998).
Universities often generate
spinoff companies from their
science departments,
companies that are often based
on patents from university
inventions from which
academics then attempt to make
money (see Shane, 2004; Tang
et al, 2004). For
example, the Scottish Wolfson
Microelectronics company was
a spinoff from
Edinburgh university’s
computing department.
3. Fund providers

(‘Investors’)Firms that do not exclusively rely on their own retained profits for
investments periodically raise funds from Investors, typically big financial
institutions (the banks, pension funds or insurance companies), government or
the universities. Pension funds make up a very large proportion of quoted equity
ownership in Europe and North America and it is argued that despite some of the
apparent problems associated with venture capital (e.g. illiquidity and ‘excess’
risk) they offer a suitable investment vehicle for them(e.g. British Venture Capital
Association, 2000; henceforth BVCA). BVCA suggests that the problems of risk can
be overcome by the use of venture capital as a small proportion of a diversified
portfolio. This would, it is claimed, reduce the ‘excess’ firm-specific risk associated
with it. Likewise, the problem of the illiquidity of venture capital investments
could be circumvented by the use of quoted investment vehicles in which venture
capital is embedded, thus obviating the need to sell individual shares should the
need arise. Governments provide assistance to venture capital investment in
many European countries e.g. the UK’s setting up of Regional Venture Capital
funds to plug the so-called regional equity gaps or the German government’s
BioRegio Program providing incubator environments for biotech startups.
(Murray, 1994, 1998).Universities often generate spinoff companies from their
science departments, companies that are often based on patents from university
inventions from which academics then attempt to make money (see Shane, 2004;
Tang et al, 2004). For example, the Scottish Wolfson Microelectronics company
was a spinoff from Edinburgh university’s computing department.

4. Why do venture capitalists

exist?
What does venture capital offer
that the more conventional
methods of finance do
not? In practical terms the
obvious reasons for the
existence and persistence of
venture capital are the
following.
4.1 Role as financial
intermediary
Venture capitalists act as
financial intermediaries,
institutions that channels funds
between consumers who save
and businesses that need to
invest. They perform the
role of fund agents for the
financial institutions by acting
as investors of their money
in a specific field, namely
private equity investment. The
reason institutions do not go
directly to the stock markets to
buy shares in such companies is
allegedly because
they lack the expertise in
1
picking the winners. Venture
capitalists are thought to be
better at this. More importantly,
VCs play a role not merely as
fund providers and
stock pickers, but also in
nurturing the investee
companies to maturity and
profitability.
4. Why do venture capitalists exist?

What does venture capital offer that the more conventional methods of finance
do not? In practical terms the obvious reasons for the existence and persistence
of venture capital are the following.

4.1 Role as financial intermediaryVenture capitalists act as financial

intermediaries, institutions that channels funds between consumers who
save and businesses that need to invest. They perform the role of fund
agents for the financial institutions by acting as investors of their money in
a specific field, namely private equity investment. The reason institutions
do not go directly to the stock markets to buy shares in such companies is
allegedly because they lack the expertise in picking the winners.1 Venture
capitalists are thought to be better at this. More importantly, VCs play a
role not merely as fund providers and stock pickers, but also in nurturing
the investee companies to maturity and profitability.

The Oxford Handbook of Entrepreneurship, ed. M. Casson, OUP,

2006, Chapter 14certainly possess and offers therefore a unique advantage
to institutional investors that is not available elsewhere.

4.2 Problems with the banksBut what about preferences of the

companies themselves? VCs would seem to have competition, most notably
the banks, and less obviously the finance houses (hire purchase), friends
and relatives (love money) and owner savings. There is plenty of evidence
that the last two options are used by the owner-manager - henceforth OM -
 to some small degree to finance the high tech startup (e.g. Cressy, 1993,
2006; Bhide, 2000). But why not the banks?The main source of external
finance for the typical small firm in the United States and in Europe is the
banking system. Those that do borrow mainly for purposes of working
capital. (Cressy, 1993; 2006). The problem for the young high tech business
is that banks typically require collateral or a track record, together with
business propositions they can understand. Young, high tech firms with
growth potential (we shall refer henceforth to as NTBFs or New Technology
Based Firms) do not fit into this category well, lacking both. Their assets are
intangible – patents and copyrights – and specific – possessing negligible
liquidation value) and they offer products or services at the cutting edge of
technology that often are recondite to the layperson and often generate
positive net cash flows only some years down the line. Nor do these
businesses want the worry of needing to meet regular debt service
payments required by a loan or even an overdraft (line of credit) facility19.
Although most fast growth businesses grow by the use of retained profits
(Bhide, 1999) high tech startups generally do not have this privilege. They
often neeed the first-mover advantage in a highly competitive market that
is conferred by outside equity in large amounts.We can now identify pros
and cons of venture capital to the VC itself and to the company in which it
invests (the investee company).

4.3 Advantages of venture capital

4.3.1 To the investee company As indicated, outside equity has

the advantage that it involves no collateral requirement on the user
Most high tech start-ups have little by way of tangible assets that
banks like to use as security for loans. Secondly, venture capital
offers a large.

4.3.2 To the VC
VCs stand to make considerable
financial gains from investing
their clients (or their
own) money. The VC’s
monetary return consists of two
components: the annual
management fee that the VC
charges investors and which
covers primarily the salaries
of its investment managers, and
its share of the capital gain from
the eventual sale of
the firm’s shares should they be
sold profitably (see Gompers
and Lerner, 1999).
The VC’s management fee
averages at about 2-3% of the
value of the fund,
and is paid annually for the
duration of the fund. Thus a $1
21
billion fund would attract
an average management fee for
the VC firm of $20-30 million
per annum over a 10
year period – the typical
duration of the fund under
which the money is invested.
The
total cost of VC management
over the life of the fund is
therefore of the order of $250
million. It is important to note
that this fee is independent of
the firm’s current
performance, though a poorly
performing fund might find it
difficult to raise money
for future investments thus
exerting some discipline on
performance, but only over
the longer term.
4.3.2 To the VCVCs stand to make considerable financial gains
from investing their clients (or their own) money. The VC’s monetary
return consists of two components: the annual management fee that
the VC charges investors and which covers primarily the salaries of its
investment managers, and its share of the capital gain from the
 eventual sale of the firm’s shares should they be sold profitably (see
Gompers and Lerner, 1999). The VC’s management fee averages at
about 2-3% of the value of the fund, and is paid annually for the
duration of the fund. Thus a $1 billion21 fund would attract an
average management fee for the VC firm of $20-30 million per
annum over a 10 year period – the typical duration of the fund under
which the money is invested. The total cost of VC management over
the life of the fund is therefore of the order of $250 million. It is
important to note that this fee is independent of the firm’s current
performance, though a poorly performing fund might find it difficult
to raise money for future investments thus exerting some discipline
on performance, but only over the longer term.

4.4 Disadvantages of venture

capital
4.4.1 To the investee company
We can set against these
advantages the following
disadvantages.
Firstly, the fractional share of
the original owners in the
company necessarily
declines. This means three
things: (a) at a given value of
the company the wealth of
23
the owners declines ; (b) some
control is relinquished to
outsiders (at least initially),
since the VC will normally
require a majority of voting
shares; (c) the owner-manager
(OM) with high probability will
be replaced over time as his
skills are recognised as
inadequate to the task
confronting him (Hannan et al,
1996; Cressy and Hall, 2005).
The OM will also find that if he
fails to meet certain specified
milestones conditional
for funding his share and likely
control of the company will
decrease further.
4.4.2 To the VC
The VC needs to monitor and
advise investee management on
a regular basis. Thus he
will pay the company regular
visits, sit in on board meetings,
make regular phone
calls to the directors, etc.
However, he will also have to
draw on the services of
external advisors like
accountants, lawyers,
recruitment consultants, etc. on
behalf of
the company.
Venture capital contracts are
written in the context of great
uncertainty implying that
an exhaustive specification of
the outcomes of the investment
is impossible. This
means that the environment is
one of ‘incomplete contracting’
- see Hart(1995),
Aghion and Bolton(1992),
Hellmann(1998). In lieu of a
complete contract stating who
owns what when a given event
happens the parties instead
agree who has control of
key variables in key
circumstances, for example, if a
company fails to meet a
‘milestone’ set by a VC (say a
sales target) the contract may
specify that the VC has
the choice of either not
investing at all or of investing
only at a much lower price.
4.4 Disadvantages of venture capital

4.4.1 To the investee companyWe can set against these advantages the
following disadvantages. Firstly, the fractional share of the original owners in the
company necessarily declines. This means three things: (a) at a given value of the
company the wealth of the owners declines23; (b) some control is relinquished to
outsiders (at least initially), since the VC will normally require a majority of voting
shares; (c) the owner-manager (OM) with high probability will be replaced over
time as his skills are recognised as inadequate to the task confronting him
(Hannan et al, 1996; Cressy and Hall, 2005). The OM will also find that if he fails to
meet certain specified milestones conditional for funding his share and likely
control of the company will decrease further.

4.4.2 To the VCThe VC needs to monitor and advise investee management

on a regular basis. Thus he will pay the company regular visits, sit in on board
meetings, make regular phone calls to the directors, etc. However, he will also
have to draw on the services of external advisors like accountants, lawyers,
recruitment consultants, etc. on behalf of the company. Venture capital contracts
are written in the context of great uncertainty implying that an exhaustive
specification of the outcomes of the investment is impossible. This means that the
environment is one of ‘incomplete contracting’ - see Hart(1995), Aghion and
Bolton(1992), Hellmann(1998). In lieu of a complete contract stating who owns
what when a given event happens the parties instead agree who has control of
key variables in key circumstances, for example, if a company fails to meet a
‘milestone’ set by a VC (say a sales target) the contract may specify that the VC
has the choice of either not investing at all or of investing only at a much lower
price.