A report on

Venture Capitalist-Entrepreneur relationship:

A Prisoner's Dilemma Approach

Asian Institute of Technology

School of Management

MSc International Finance

SM80.36 Game Theory and Competitive Strategy

August-September term 2022

Submitted to:

Dr. Syed S. Khan

Submitted by:

Sparsh Jung Rana

st122298
Executive Summary

In this report, we establish a conceptual model of the relationship between

entrepreneurs and VCs throughout the post-funding stage. Previous related literature

backs up that cooperation between these parties is a critical condition for mutual

benefit. This report then presents a conceptual model of the prisoner’s dilemma which

is an efficient model for understanding the decision-making criteria. Previous studies

do not shed light properly on how to make the relationship work strongly in long term

with the involvement of self-interest, therefore this model develops various approaches

which increase the possibility of a cooperative relationship between both parties

maximizing the mutual benefit. Finally, this report concludes by discussing the

implication, and application of the model for future researchers, entrepreneurs, and

venture capitalists.

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Table of Contents

Executive Summary ....................................................................................................... 2

Introduction .................................................................................................................... 4

Knowledge Specificity ............................................................................................... 4

Resource Scarcity ....................................................................................................... 5

Literature Review........................................................................................................... 6

Conceptual Framework .................................................................................................. 7

An overview of the Prisoner’s Dilemma Approach ................................................... 7

The Prisoner’s Dilemma and the Venture Capitalist- Entrepreneur Relationship ..... 8

Possible reasons for defection ........................................................................................ 9

Mutual Defection Decisions ....................................................................................... 9

Entrepreneur Defection Decisions ........................................................................... 10

Venture Capitalist Defection Decisions ................................................................... 10

Approaches to establish cooperative relationship ........................................................ 11

Implications.................................................................................................................. 13

Further Research ...................................................................................................... 13

Practice ..................................................................................................................... 14

Bibliography ................................................................................................................ 15

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Introduction

Every business starts with an idea. However, an idea no matter how groundbreaking

cannot get into operation without optimum resources. In the early stages, start-ups face

the problem of limited resources. According to (Yang, Shi, Wu, Zhang, & Xie, 2021),

most entrepreneurs regard raising funds as a significant obstacle to their operations. To

expand their operations, they continuously seek external financial support. Getting

funded through Venture capital has become a popular and essential source of financing

which also has a substantial positive impact on driving economic value.

The research proposes that venture capitalists (VCs) can further enhance the success of

the firm with financial as well several nonfinancial guidance with their vast

experiences, (Dijk, Scherevel, Stormbroek-Burgers, & Blomee, 2014). Technological

development and innovations flourish with a strong relationship between entrepreneurs

and VCs. In contrast, a clashing relationship is one of the significant catalysts leading

to venture’s failure in the long run, (Bouzoukas, 2018). This illustrates that maintaining

a cooperative relationship with trust is crucial for the venture's prosperity by utilizing

each party's specialization in building financial networking and exploiting untapped

opportunities.

Knowledge Specificity

Every individual has unique talents and develops specialized interests with life and

professional experiences. According to (Cable & Shane, 2012), knowledge specificity

refers to the contribution entrepreneurs and VCs pour into the venture with their

individual knowledge and experiences which grants them to exploit the market and gain

competitive advantages in the early development of the firm. In the absence of an

efficient market, merging these skills is vital for the venture’s success.

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Entrepreneurs are always relentless in their search for untapped prospects and are keen

to use their day-to-day business operations specializing in exploiting those

opportunities. On the other hand, VCs have expertise in maintaining a huge business

network which enables them to pursue capital cheaply. Therefore, an ideal VC–

entrepreneur relationship results in a blend of specialization and contributes to a

venture’s efficiency, productivity, and effectiveness in a more economical way, (Dijk,

Scherevel, Stormbroek-Burgers, & Blomee, 2014).

Resource Scarcity

According to (Turcan, 2008), there are several hurdles in the way of a smooth

cooperative relationship in the long term with the involvement of self-interest of the

parties at the expense of the other. Therefore, in the absence of an efficient market,

long-term cooperation is vital to build trust and to be upfront about the goals of the

venture. The expertise held by both the party is specific to the individuals. For example,

as discussed earlier, having the tenacity to develop and exploit an untapped opportunity

is specific to, particular entrepreneurs.

Therefore, VCs have less possibility to replace that entrepreneur with other

professionals as replacements are in short supply for both the entrepreneurs as well as

VCs. In addition to this, it gets expensive with the additional search and negotiations

expenses. Furthermore, nowadays words spread out rather fast and the reputation of

both the party can be damaged loudly if they are entitled to be non-cooperative where

the need for cooperation is so critical.

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Literature Review

Previous study suggests that the harmony in the relationship between the entrepreneur

and VCs is more significant than the fund invested by the VC itself, (Dijk, Scherevel,

Stormbroek-Burgers, & Blomee, 2014). This illustrates the value of the nonfinancial

guidance and experiences VCs contributes along with the relentless nature of

entrepreneurs to tap into unexploited opportunities for the well-being of the venture.

According to (Hajj & Chidiac, 2022), developing a cooperative relationship between

entrepreneurs and VCs is a critical driver for economic and technological development.

Over the years, we have seen the exponential growth of venture-backed start-ups

namely Facebook, Amazon, and Google which contribute to economic development

and support in fighting unemployment problems. Therefore, this relation contributes to

the larger strata of society in addition to their mutual benefits.

Achieving cooperation is not an easy task with the involvement of self-interest. The

dilemmas that both parties must overcome to agree on a strategy and move forward

with it takes a toll on the overall development of the venture. Therefore, pen

communication can be a crucial factor in building trust and confidence between

entrepreneurs and VCs, (Turcan, 2008).

According to (Cable & Shane, 2012), the use of the Prisoner’s Dilemma is an efficient

approach to understanding the cooperation or defection decisions made by

entrepreneurs and VCs as it overtly presents the social relationships that develop

between parties which eventually intensifies the likelihood of cooperation and common

benefit.

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Conceptual Framework

An overview of the Prisoner’s Dilemma Approach

The Prisoner’s Dilemma is one of the most popular game theory concepts of decision

analysis used worldwide where the players have an incentive to decide according to

their self-benefit which creates a less optimal outcome for the group, even though they

understand that they will be better off deciding to cooperate, (Investopedia, 2022).

In the real economic scenario, most interactions and transactions are repeated more than

once, therefore, the rationale for choosing this game for the report is its adaptability in

multiple stages and reward structure. The repeated decision-making will allow both

parties to observe each other’s moves and respond accordingly with the trust needed to

develop a cooperative relationship. According to (Cable & Shane, 2012), the Prisoner's

Dilemma model succeeds to illustrate the social background that the relationships

between parties have the likelihood of growing cooperation with trust and goal

congruence over the period of repeated interactions. Furthermore, this game theory

approach has more dynamism required to deal with the ever-changing scenarios which

the static agency theory approach lacks.

However, over the period, people have worked out a variety of solutions to prisoner’s

dilemmas to overcome individual incentives in favor of the common good. A true

prisoner's dilemma is typically played only once, so the repeated played game can help

in escaping the dilemma comes out as some of the limitations of the presented game

theory approach.

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The Prisoner’s Dilemma and the Venture Capitalist- Entrepreneur
Relationship

The concept of the game is that the players have an incentive to decide according to

their self-benefit which creates a less optimal outcome for the group, even though they

understand that they will be better off deciding to cooperate

Fig. 2*2 payoff matrix for 2 players Prisoner’s Dilemma Game

As illustrated in the above figure, the possible strategies for both parties can either be

to cooperate (develop trust to achieve mutual benefits) or defect (seek self-interest

benefits at the expense of long-term mutual gains). If they both cooperate, then both

the players will earn a profit of 500 each. If the entrepreneur defect and VC cooperate,

then the profit maximizes for the entrepreneur at 1000 at the cost of VC remaining

with nothing and vice-versa. However, if both the players defect, each will only be

able to earn a profit of 200.

Here, the payoff structure demonstrates the dilemma that exists for both parties as they

repeatedly negotiate their ongoing terms in the venture, (Turcan, 2008). We can notice

that each of the players would be better off collectively if they cooperate. But we cannot

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say that both parties will always cooperate with the involvement of self-benefit over

the other party as both parties can experience higher short-term payoff for defection

than cooperation regardless of the other party action resulting in a (defect, defect)

equilibrium as highlighted in the above figure.

Possible reasons for defection

As discussed earlier, with the presence of the prisoner’s dilemma for both the parties,

cooperation is far from obvious. Some of the possible reasons for defection are

discussed as follows from three different perspectives.

Mutual Defection Decisions

The mutual decision is significantly linked to the uncertainties that come with the

commencement of a new venture. Both parties will be figuring out the opportunity cost

of investing their time, energy, and capital in this venture. There are several factors in

the market that can be unpredictable and carries a high risk for the operation of a new

venture. In addition to this, an entrepreneur is always relentless in the search for

untapped opportunities. Therefore, an entrepreneur will be motivated to defect when

they are aware of a new opportunity that possesses a higher scope of success. Similarly,

if a VC finds an investment opportunity that offers them a higher financial return, they

will be motivated to defect instead of having the probability of loss with a start-up.

Furthermore, in an absence of an efficient market the flow of asymmetric information

is inevitable, (Cable & Shane, 2012). This can lead to both parties formulating different

subjective evaluations of the venture with different ranges of information regarding a

cutting-edge technology or an economical financing tool which can create negative

expectations. So, since the short-term payoff is higher, the party holding the negative

information has the incentive to defect.

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Entrepreneur Defection Decisions

Although most entrepreneurs are able to recognize the importance of cooperating with

venture capitalists, multiple defection temptations do exist. According to (Cornell

University , 2015), entrepreneurs are often guilty of clamming up technical details or

altering significant information about the technology may serve as a short-term payoff

strategy for those self benefits. In addition to this, entrepreneurs often feel threatened

about their position in the venture when VCs do not agree to sign a Non-Disclosure

Agreement (NDA). Another common practice is to overestimate one’s value in the

product to secure funding. Entrepreneurs also might manipulate negative information

because it may have an impact on VCs’ investment decisions. The mounting impact of

these outcomes results in an aftermath of making information tempering a short-term

attractive strategy which has a long-term impact on the overall relationship. Start-up

founders are often short on capital which might make the incoming funds tempting to

defect misusing for their personal benefit.

Venture Capitalist Defection Decisions

According to research done (Turcan, 2008), VCs are often overambitious and have the

desire to go for IPO as soon as possible which can be premature at times. This can help

to boost their reputation in the market and can have a vital impact on their overall

portfolio. VCs are liable to provide their partners the return on their investment so they

can be tempted to defect to oblige it rather than thinking about re-investing in the

venture for further expansions, (Cable & Shane, 2012). To maintain diversification in

their huge portfolio, VCs must distribute their time and investments across different

start-ups which can be considered as defecting in this venture being able to provide

only limited guidance.

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Approaches to establish cooperative relationship

With the reference of past research as well as the application of prisoner’s dilemma, we

have figured out that both parties can achieve maximum joint profit through

cooperation. To achieve the sweet spot depicted in the figure below, entrepreneurs and

VCs can implement the following approaches to strengthen their trust and cooperative

relationship.

Fig. 2*2 payoff matrix for 2 players Prisoner’s Dilemma Game

No business personnel like to get their time wasted for no reason with incremental cost

depending on a certain deadline. Therefore, having time pressure on making an

agreement as a chip on their neck both parties will be more likely to cooperate, (Cornell

University , 2015). VCs have an obligation to distribute the return on investment of

their partners and entrepreneurs are obliged to complete the project under a certain

deadline. So, the time constraints will lead to building up achievable demands along

with reducing costs. Furthermore, quick action on a new venture enables the firm to

have a first mover advantage and a substantial opportunity to gain a competitive

advantage.

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As depicted in the above figure, both parties earn a high payoff with the cooperative

relationship. In addition to the financial, reward both parties can achieve valuable

nonfinancial gains. Entrepreneurs can expect valuable nonfinancial benefits from

cooperating with venture capitalists such as expert business advice, market movement

signals, and exposure to capital market risks. In comparison to the VCs, entrepreneurs

are less diversified and have a substantial portion of their personal wealth linked to the

start-up which motivates them more to cooperate. On the other hand, venture capitalists

are always keen to learn more about the industry that they invest in. Therefore, a strong

long-term cooperative relationship enables them to learn the technical and operative

side of the venture from the entrepreneurs, (Cable & Shane, 2012).

The discussion in the report suggests that mutual benefits are directly related to the

success of the relationship which means that communication of information is vital. It

is far more important when the situation is rough, because parties may misinterpret each

other's strategies. Better, more frequent, and more open communications between

entrepreneurs and venture capitalists appear to result in more cooperative strategy

choices and lead to building trust between the partners as without trust, it is almost

impossible to accomplish anything, (Bouzoukas, 2018). According to (Turcan, 2008),

“Goal congruence is the degree to which two partners hold common beliefs regarding

their relationship.” Having said this, the strategies related to the execution of the

ultimate objectives can be interpreted in different ways by both parties. Therefore,

having a similar work ethic and dedication toward reaching the objectives proves to be

crucial in developing strong cooperative relationships.

According to (Cable & Shane, 2012), several noncooperative penalties can be

promoted in encouraging cooperative relationships between entrepreneurs and VCs.

This requires proper supervision of consequences by the partners as each may be

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tempted to defect. For example, entrepreneurs attempting to misuse the capital invested

by the VC or VCs trying to overshadow entrepreneurs’ opinions or trying to replace

them with other professionals ensuring the protection of their respective property.

Implications

Further Research

Future researchers might get tempted to apply the principal-agent model to analyze this

relationship. However, it would be too restrictive to interpret such a dynamic

relationship in a repeated game, (Cable & Shane, 2012). Furthermore, more emphasis

can be given to the objective angle of the variables such as time pressure or payoff

generation which will present more concise findings. (Turcan, 2008), argues that we

must keep in mind that previous research suggests that cooperation is necessary for

achieving mutual benefit and the success of the venture, but it is not a guaranteed

formula for achieving success. There are lots of indirect variables that are involved in

this dynamic such as market demand, and innovations that can change the dynamic of

the model quickly. In this report, we only observed two players. In future research more

than two, ‘N’ players can be incorporated which will enable more extensive research.

In this report, we observed that asymmetric information is difficult to deal with from

both perspectives, so future researchers can work out a model to better tackle this

setback.

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Practice

According to (Cornell University , 2015), the Prisoner’s Dilemma is one of the most

popular and constantly used in business and economic environments to determine

certain business decisions in the market. It is applicable in a government-business

relationship, pricing decisions, advertising (repeated game) as well as the decision to

launch a new innovative product or not. If we look at the rivalry between Coca-Cola

and PepsiCo for example, we can see the impact that game theory and the Prisoner’s

Dilemma have on these company’s’ decisions. If one company decides to cut the price

of one of its drinks, it leads to a decision that needs to be made by the other in order to

stay competitive in the market. Furthermore, (Cable & Shane, 2012), argues the

importance of external governing bodies for efficient cooperative entrepreneur-venture

capitalist relationships. Both the players can become egoistic with the involvement of

individual knowledge, and a higher and more powerful authority must be established

to supervise over them.

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Bibliography

Yang, H., Shi, H., Wu, Y. J., Zhang, L., & Xie, S. (2021). "Entrepreneurial Passion
and Venture Capitalists’ Willingness to Invest: The Role of Relational Capital".
Hong Kong.
Dijk, E. v., Scherevel, Stormbroek-Burgers, R. v., & Blomee, R. J. (2014). "How to
Create an Effective Venture Capitalist–Entrepreneur Relationship: An
Entrepreneur’s Perspective". SAGE.
Bouzoukas, K. (2018, April 17). "The VC-Entrepreneur Relationship: 3 critical
factors". Retrieved from "The Startup": https://medium.com/swlh/the-vc-
entrepreneur-relationship-3-critical-factors-1964dbe0c051
Cable, D. M., & Shane, S. (2012, May 05). "A Prisoner's Dilemma Approach to
Entrepreneur-Venture Capitalist Relationships". 22(1), 142-176.
Turcan, R. V. (2008, July 11). "Entrepreneur–venture capitalist relationships:
mitigating post-investment dyadic tensions". Venture Capital, 10(3), 281-304.
Hajj, M. C., & Chidiac, M. (2022, 2). "Exploring the relationships between
entrepreneurs and venture capitalists: Control and trust". Questions de
Management, 39(2), 55-66.
Investopedia. (2022, August 04). "What Is the Prisoner's Dilemma and How Does It
Work?". Retrieved from Investopedia :
https://www.investopedia.com/terms/p/prisoners-
dilemma.asp#:~:text=A%20prisoner's%20dilemma%20is%20a,many%20aspe
cts%20of%20the%20economy.
Cornell University . (2015, March 10). "A look at the Entrepreneur-Venture Capitalist
Relationship and the Prisoner’s Dilemma". Retrieved from Cornell Blogs :
https://blogs.cornell.edu/info4220/2015/03/10/a-look-at-the-entrepreneur-
venture-capitalist-relationship-and-the-prisoners-dilemma/

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