Download - The substitution of bonding for monitoring in venture capitalist relations with high technology enterprises

THE SUBSTITUTION OF BONDING FOR MONITORING IN VENTURE

CAPITALIST RELATIONS WITH HIGH TECHNOLOGY ENTERPRISES

JAY B. BARNEY Ohio State University

JAMES 0. FIET Clemson University

LOWELL W. BUSENITZ University of Houston

DOUGLAS D. MOESEL Lehigh Universio

This paper presents a theory-based rationale that new venture team managers may utilize to reduce the cost of monitoring their venture. Because monitoring is costly and is eventu- ally charged back to the venture, the present analysis suggests that there is at least one way for managers to protect their equity stake from such assessments. Drawing on concepts from institutional economics, it is shown that the level of monitoring depends upon the level of market and agency risk associated with the investment. However, actions taken by venture managers are shown to substitute for risk-reducing measures that could be taken

by venture capitalists, which would otherwise result in the reduction of the equity stake of the managers. Moreover, a willingness by team members to bond themselves to the deal may increase the value of their stake in it, whereas resorting to monitoring can only depre-

ciate the value of their stake.

Direct all correspondence to: Jay B. Barney, Ohio State University, Department of Management and Human

Resources, Fisher College of Business, Columbus, OH 43210;James 0. Fiet, Clemson University, Department of Management, Clemson, SC 29634.1305;e-mail: [email protected];Lowell W. Busenitz, University of Houston,

Department of Management, Houston, TX 77204-6283; Douglas D. Moesel, Lehigh University, Department of

Management, Bethlehem, PA 18015.

The Journal of High Technology Management Research, Volume 7, Number 1, pages 91-105 Copyright@ 1996 by JAI Press, Inc. All rights of reproduction in any form reserved. ISSN: 1047-8310.

92 THE JOURNAL OF HIGH TECHNOLOGY MANAGEMENT RESEARCH VOL. 7/NO. l/ 1996

I. INTRODUCTION

A significant amount of research has focused on the conditions under which new ventures

will or will not obtain funding from venture capital firms (Kozmetsky, Gill, & Smilor,

1985; Tyebjee & Bruno, 1984). While understanding the conditions under which venture

funding will or will not be forthcoming is an important research question, it drastically

simplifies the actual relationship that exists between venture capital firms and new

ventures. For not only does a venture capital firm have to decide whether or not it will

fund a new venture, it must also decide how best to structure the financing to protect its

own interests, while simultaneously enhancing the likelihood that the new venture will

succeed. This “striking the deal” goes beyond the funding decision to specify the structure

of the ongoing relationship between venture capital firms and the new ventures they fund (Myers, 1993; Tyebjee & Bruno, 1984).

This paper begins to more fully explore relationships that may exist between venture

capital firms and the firms they fund by examining the determinants of the structure of

governance that emerges between these firms (Fiet, 1995; Williamson, 1975). The notion

of governance used here is taken from institutional economics, and refers to the social,

institutional, and contractually-based agency relationships within which an economic

exchange occurs (Granovetter, 1985; Jensen & Meckling, 1978; Williamson, 1979). The

particular economic exchange studied is the movement of capital from venture capital firms to new ventures, in return for future capital gains. Of particular interest in this study

are the determinants of the levels of monitoring and control built into the governance

devices that emerge between venture capital firms and the new ventures they fund (Barney, Busenitiz, Fiet, & Moesel, 1994a; Barney & Ouchi, 1986; Jensen & Meckling, 1978).

Institutional economics is ideally suited to examine agency relationships, which are

contracts “under which one or more persons (the principal(s)) engage another person (the

agent) to perform some service on their behalf which involves the delegation of some

decision making authority to the agent” (Jensen & Meckling, 1978, p. 308). We adopt

Williamson’s (1988) notion that institutional economics includes both agency theory

(Jensen & Meckling, 1978; Jensen, 1994; Fama, 1970; Miller & Modigliani, 1958, 1963;

Stiglitz, 1972) and transaction-cost economics (Griesinger, 1990; Jones, 1983; William-

son, 1971, 1975, 1979, 1985, 1988, 1991). Although each of these treats questions of how

to efficiently design contracts, agency theory primarily addresses questions of ex ante

incentive alignment while transaction-cost economics is “concerned with the crafting [of]

ex post governance structures within which the integrity of [a] contract is decided” (Will-

iamson, 1988, p. 570). The paper begins by developing a theory, which is grounded in institutional economics,

of the determinants of the level of monitoring and control that exists in the governance relationship that emerges between venture capital fiis and new ventures. We hypothesize that specific forms of bonding can be used to substitute for costly monitoring in

venture capitalist relationships with high technology enterprises. It is our view that the venture capital industry is an ideal site for examining substitution because firms within it routinely reduce their contracts with new enterprises to writing, which makes them much

easier to recall for subsequent analysis. Next, two measures of the level of monitoring and control that exist in a venture capital

relationship are proposed, along with several measures of the market and agency risk that impact this relationship. Then, a series of hypotheses focusing on the structure of venture

Bonding in Venture Capitalist Relations 93

capital governance is examined using a sample of 54 electronics firms that have received first round venture capital funding. The paper concludes by summarizing its theoretical arguments and briefly discussing some of their applied implications.

We have partially reported these results elsewhere (Barney, Busenitz, Fiet, & Moesel, 1989); however, we have not developed their theoretical underpinnings. Nor has any known research attempted tovalidate this substitution hypothesis, which was first theo- rized by Ronald Coase (1937). Thus, our purposes for this study are to explore it both theoretically and empirically, and then to use these results to indicate how the managers of

new enterprises can increase their relative equity stake, as well as improve their prospects for securing funding.

II. A THEORY OF MONITORING AND CONTROL

Williamson (1971, 1975, 1979) argues that governance mechanisms emerge to protect parties to economic exchanges from the uncertainty of unforeseen events, or self-interested actors. He suggests that uncertainty and self-interest are two “dimensions” of factors that impact transactional efficiency, and relatedly, governance and substitution (William- son, 1979, p. 259). Later, as a result of the pioneering work of Klein, Crawford, and Alchian (1978), he adopts specificity as an additional transactional dimension (1985). Thus, before we can hypothesize optimal forms of governance for particular venture capital transactions, we must first understand how these dimensions impact the cost of governance (Williamson, 1971).

Self-Interest Seeking

There are two types of self-interest seeking identified in the institutional economics literature: (1) simple self-interest seeking, and (2) opportunism. Simple self-interest seeking

describes actions by agents that result from the separate and possibly divergent interests of principals and agents (Berle & Means, 1932; Fama & Jensen, 1983; Jensen & Meckling, 1978). The simple variant assumes a degree of innocence on the part of the agent and allows for the possibility that he or she does not plan to harm anyone else, but only to pursue his or her separate interests. Opportunism implies deviousness, or “self-interest seeking with

guile” (Williamson, 1985, p. 47). “It is not necessary that all agents be regarded as opportunistic in identical degree. It suffices that those who are less opportunistic than others are difficult to ascertain ex ante . . .” (Williamson, 1979, footnote 234), which results in costly monitoring or bonding measures for even those who may be altruistic. This research does not distinguish between simple self-interest seeking and opportunism because a prudent

venture capitalist would be willing to bear the cost of governance for either type up to the expected level of his average losses. Their problem is that they cannot distinguish between altruists and opportunists until after they fund a deal. Thus, if they are to fund any deal, they must incorporate some type of governance to protect themselves from possible opportunism. For our purposes, we will refer to both types of self-interested behavior as opportunism.

Uncertainty

Uncertainty increases the cost of providing equity capital for both venture capitalists and new enterprises. According to Galbraith (1973, p. 5), it is the “difference between the

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amount of information required to perform the task [i.e., to fund the deal] and the amount of information already possessed by the organization [venture capitalist].” Or, we may

think of it in the engineering sense as the “absence of information needed to resolve known questions, measured in terms of the number of possible answers that must be falsi-

fied in order to identify the true answer” (Griesinger, 1990, p. 483). Economically speak- ing, uncertainty is a condition that exists when the probability distribution of future events

is unknown (Knight, 1933). In contrast, a situation where we assume that we know the

probability distribution of future events is one that is risky, rather than uncertain (Fiet, in press). Venture capitalists must believe that any new enterprise funded by them is capable

of managing the risk inherent in its operation. It would be simply irrational to fund a business whose prospects were uncertain because there would be no way to select a prudent level of governance.

Specificity

One aspect of a venture capital transaction that increases its riskiness is the specificity

of the funding arrangement. That is, while a venture capital firm may fund several ventures simultaneously, its fortunes for a specific component of its portfolio are never-

theless tied to the performance of the particular venture. Specificity suggests that while a

principal in such an arrangement may be able to salvage some of a venture’s value if it were to fail by converting it to another use, any alternative use would be less valuable (cf., Klein, Crawford & Alchian, 1978; Griesinger, 1990; Williamson, 1985, 1988).

The Logic of Governance

In conditions where uncertainty, opportunism, and specificity’ combine, the risk of adverse economic consequences is greater, and parties to an exchange must erect elaborate

governance structures to protect themselves. These governance structures make it possible for parties to an exchange to monitor each other’s behavior and to control the actions of

other parties to the exchange (Jensen, 1994); however, they are costly. If the probability of

adverse consequences due to uncertainty or opportunism is low, parties to an exchange

will prefer less elaborate governance characterized by lower levels of monitoring. According to Williamson (197 1):

The discriminating alignment hypothesis to which transaction-cost economics owes much of its predictive content holds that transactions, which differ in their attributes, are aligned with governance structures, which differ in their costs and competencies in a discriminating (mainly, transaction-cost economizing) way (p. 277).

In other words (our words), Williamson (1971, 1975, 1979) hypothesizes a positive relationship between the risk of adverse consequences, due to uncertainty and/or oppor-

tunism, and the use of elaborate types of governance. This logic of governance can be extended to the relationship between venture capital

firms and the new ventures they fund. These relationships may be characterized by different levels of uncertainty and potential opportunism. In “striking the deal,” venture capital firms and new ventures are likely to balance the need for additional monitoring and control to protect themselves from adverse consequences against the costs of these more elaborate governance devices (Brennan, 1994).


The Alignment of Governance with Risk

The probability of venture capital firms experiencing adverse consequences from their relationships with the new ventures they fund reflects two kinds of risk-market risk and agency risk. The level of market risk in this relationship is a function of the uncertainty associated with obtaining returns on an investment in a new firm due to that firm’s competitive environment (Porter, 1980). Agency risk, on the other hand, reflects the probability that managers in a new firm will make decisions that are inconsistent with the

wealth maximizing interests of venture capitalists (Jensen & Meckling, 1978). In general, the greater these risks, the more likely it will be that venture capitalists will attempt to structure the deal so that they can exercise close monitoring over their new ventures.

In most previous transaction-cost and agency theory research, the level of market and agency risk that characterizes an economic exchange is treated as a constant, exogenous to the relationship between parties to an exchange. The competitive situation facing firms is assumed to be outside the influence of managers, and the probability of opportunism on the part of managers is assumed to be fixed (Williamson, 1975).

These assumptions are abandoned in this paper, in favor of a model that recognizes that the level of risk associated with a new venture can be affected by decisions made by managers in the new venture. Venture capitalists could engage in a wide variety of activities to monitor the decisions and activities of the new venture team (cf., Barney & Ouchi, 1986; Fiet, Busenitz, Moesel & Barney, 1995). In principle, such monitoring should increase the probability that the managers of new ventures would make decisions consistent with the self-interests of venture capitalists. To go further, the managers of these ventures could bond themselves to the venture capitalists by agreeing to arrangements that penalize themselves as individuals if they were to make decisions that were not in the interests of the outside investors. However, according to Jensen and Meckling (1978) no matter what monitoring and bonding arrangements are utilized, at least some conflict of interests will generally persist.

These ongoing conflicts, together with the bonding and monitoring devices intended to reduce them, are costly. When we refer to agency risk, we are in effect referring to the sum of its associated costs, which include (1) bonding expenditures made by the new venture

team to the venture capitalist, (2) monitoring expenditures by the venture capitalist to regulate the conduct of the new venture team, and (3) costs due to unresolved conflicts of interest between a new venture team and its venture capitalist (Barney & Ouchi, 1986).

Jensen and Meckling (1978) next question who must underwrite these agency costs. They argue that in efficient capital markets, the agent (new venture team) bears the entire cost of losses due to agency risk. By efficient, they are suggesting that investors in public equities make decisions based on all publicly available and historical information (Fama, 1970). As a result of research by Bygrave (1987, 1988a, 1988b), Fiet (1995), and others, we understand that venture capitalists co-invest in tightly connected formal networks, which in effect create their own market for deals. Their deal market seems to work so well for them that it may in fact simulate the type of informational and allocational efficiency that is present in public equity markets.

With access to this degree of information about individual deals and those who represent them, venture capitalists can anticipate the total agency costs of their relations with a new venture team and discount the amount that they are willing to pay to invest in a deal; or they can raise the cost of the money that they do invest. Their precautions are formally incorpo- rated into the terms and conditions of the funding agreement. Thus, in their attempt to raise


capital, new venture teams bear all the anticipated economic burden of the agency costs of

their deal, which typically would include bonding and monitoring expenses. Even though new venture teams must pay for anticipated agency costs, it is our view

that they can chose alternative methods for doing so, ‘a supposition that has not been previ-

ously recognized in the literature. For example, one alternative would be through bonding.

Managers who are willing to bond themselves to the venture capitalist would do so by

tying themselves financially to a new venture by investing a substantial portion of their

personal savings in it. Bonding the new venture team to a venture reduces the agency risk

that would otherwise be borne by venture capitalists. Because the wealth of managers

depends upon the future value of their new venture in the same way that the wealth of

venture capitalists depends on its future value, incentives for managers to make decisions

that are inconsistent with the wealth maximizing interests of venture capitalists are

reduced. Also, new venture managers that take actions to increase the profitability of their

firm are reducing the market risks that would otherwise be borne by venture capitalists. Actions taken by managers that reduce the agency and market risk associated with

investing in a new venture affect the structure of governance through what could be

termed a “substitution effect. ” If actions taken by managers actually reduce the risk borne

by venture capitalists, venture capitalists will not have to institute as elaborate governance

devices to monitor managers as they would have to do if managers had not taken these

actions. That is, managerial risk reducing behaviors, such as bonding, act as a substitute

for costly monitoring of the venture. Thus, for example, when managers tie their personal

wealth to a firm’s financial success, thereby reducing agency risk, venture capitalists need

less elaborate devices to monitor and control managers. All else being equal, managerial

decisions to closely link their financial success with their new business are a substitute for

elaborate governance. The same substitution effect exists, all else being equal, when a firm’s financial success

reduces the market risk to be borne by venture capitalists. Here, firm profitability acts as a

substitute for elaborate governance. Developing a profitable venture may require substan-

tial investments of personal time and effort, which would be costly for the new venture

team. In this way firm profitability serves in many ways as a proxy for a venture capital

team’s dedication of time and effort. Not only are time and effort costly to a new venture

team by themselves, their dedication requires a certain amount of specificity of purpose

that diminishes their value in any other endeavor. These are some of the reasons underlying

our view that firm profitability can be taken as a signal to the venture capitalist that the new

venture team is bonding itself to the venture in an effort to secure it against market risk. Using these ideas, it is possible to specify the determinants of the structure of venture

capital governance. In general, the greater the market and agency risk associated with investing in a new venture, the more comprehensive will be the monitoring in the relation-

ship between a venture capital firm and a new venture. Moreover, actions taken by manag-

ers that reduce the market and agency risk associated with investing in a new firm will

substitute for less comprehensive monitoring on the part of venture capitalists.

III. MEASURES

To examine this theory of the determinants of the structure of venture capital governance, it is necessary to develop measures of the level of monitoring, market risk, and agency


risk. Based on interviews with a large number of venture capitalists and managers in new

ventures, the following measures of these concepts were included in this analysis. Two measures of the level of monitoring were suggested: (1) the percentage of a new

firm’s equity held by venture capital$rms, and (2) the percentage of seats on a new firm's board of directors held by venture capitalists. The first stems from the venture capitalist’s

financial commitment to the venture and its legal right to influence how it is monitored.

The second increases the available opportunities for monitoring by board members. In

general, the higher these two percentages, the greater the ability of venture capital firms to

monitor the actions of managers, and the greater the ability of venture capital firms to

control the actions of managers (e.g., through threatening to replace, or actually replacing,

managers). The measure of the level of market risk associated with investing in a new business

venture included in this research is the level of profitability of a new venture in the year

that it receivedfirst round venture capital. In general, the more profitable a new venture is

before it obtains venture capital, the less risky is the investment made by venture capital-

ists in the firm. Three measures of agency risk are included in the study. The first is the number of

years the CEO has spent working in a firm. This measure is an indicator of firm-specific

investment made by the CEO (Klein, Crawford, & Alchian, 1978), which is actually a

form of bonding in the sense suggested by Jensen and Meckling (1978). As a rule, the

larger this firm-specific investment, the more managers “have to loose” should a venture

not generate substantial capital gains when managers sell their equity in the firm. In this

way, managers bond themselves to maximize the wealth of venture capitalists, thus reduc-

ing a venture capitalist’s agency risks. For this measure of agency risk, the firm-specific

investments made by CEOs are their time, energy, and reputation. Another agency measure is the percentage of a new firm’s initial financing that came

directly from the CEO’s personal savings. This is a way for a CEO to bond himself or

herself to the firm by making a specific investment that would have a diminished value in

an alternative use. However, here the investment is in the form of cash from personal

savings, rather than time and energy committed to a firm. In general, the more CEOs have

financially invested in their firms, the less likely they are to make decisions that reduce the

value of their investment, and thus the less likely they are to behave in ways inconsistent

with venture capitalist interests. The final measure of agency risk included in this study is the percentage of a firm’s

equity held by managers in a firm. Again, this is another form of bonding that measures

the level of firm specific investment. However, in this case, it is not just the CEO’s invest-

ment, but the entire new venture team’s investment in the firm that is evaluated. In

general, the more financially committed managers in a new venture are to that new

venture, the lower the agency risk.

IV. THEORY TESTING

Using these measures of monitoring, market risk, and agency risk, it is possible to develop

a series of testable hypotheses concerning the determinants of the structure of governance that emerges between a venture capital firm and the new venture it funds. We will first

consider substitution hypotheses related to market risk and then others related to agency


risk. In each of these cases, we explore ways of substituting managerial bonding for

venture capitalist monitoring.

Market Risk Hypotheses

As we have previously argued, a new venture’s profitability can be taken as a signal by

a venture capitalist that the new venture team is willing to bond its own financial rewards

to the ultimate success of the venture. One way to increase the effectiveness of monitoring

would be to bargain for a greater legal right to influence the decisions of the board and

new venture team. The requisite price of such influence is normally purchasing a greater

percentage of the new venture’s equity. Assuming that new venture teams can chose to

substitute firm profitability for higher levels of equity ownership by the venture capitalist,

we expect that the two factors are negatively related. Formally stated,

HAl: The profitability of a new venture will be negatively related to the

percentage of the new venture’s equity held by venture capital firms

after first round funding.

Another way that venture capitalists can increase their ability to monitor the actions of

the new venture team is to increase their percentage of seats on the venture’s board.

However in accordance with our substitution theory, if the venture is already profitable,

we would expect that these two factors would be negatively related. That is, firm profit-

ability substitutes for venture capitalist board seats, which leads to our second hypothesis,

HA2: The profitability of a new venture will be negatively related to the

percentage of seats on the board of directors of the new firm controlled

by the venture capital firm after first round funding.

These two hypotheses build on the assertion that the level of market risk associated

with investing in a new venture is linked with the need for monitoring in the governance

structure that emerges between a venture capital firm and a new venture it funds. The less

risky the investment (as measured by the profitability of the new venture), the less

complete the monitoring and control (as measured by venture capital equity ownership

and seats on the board of directors).

Agency Risk Hypotheses

When the CEO of a new venture has been associated with it for several years, we have

argued that his or her invested time and effort will be worth less in another venture. The

number of years dedicated to the venture will bond him or her to it and should serve to protect

the venture capitalist against inappropriate self-interest seeking. Thus, the years of CEO

service in the venture will substitute for costly monitoring by the venture capitalist, which would be purchased by an increased percentage of equity in the venture. Formally stated,

HBl: The number of years a CEO has been associated with a new firm will be negatively related to the percentage of equity held by venture capital

firms after first round funding.


Extending our substitution theory, CEO service would also be negatively related to another form of monitoring, the percentage of seats on the board controlled by venture capital firms, which leads to the second agency hypothesis,

HB2: The number of years a CEO is associated with a new firm will be nega-

tively related to the percentage of seats on the board control by venture capital firms after first round funding.

Our third agency theory hypothesis again substitutes bonding, the percentage of initial financing that is derived from the CEO’s personal savings, for monitoring, the percentage of equity held by venture capital firms after the first round Pending. The rationale for each of these variables has already been explored. Using our substitution theory as a predictor of relative levels, we expect that once more they will be negatively related.

HB3: The percentage of initial financing that is derived from a CEO’s personal savings will be negatively related to the percentage of equity held by venture capital firms after the first round funding.

Accordingly, the percentage of initial financing derived from a CEO’s personal savings would also substitute for another form of monitoring, the percentage of seats on the board controlled by venture capital firms after the first round funding, which brings us

to our fourth agency hypothesis:

HB4: The percentage of initial financing that is derived from a CEO’s personal savings will be negatively related to the percentage of seats on the board controlled by venture capital firms after the first round funding.

So far, we have examined ways that CEOs of new ventures can personally bond themselves to their ventures. The last agency hypothesis tests our prediction that the new venture team members can collectively bond themselves to a venture by purchasing equity

in it, which would reduce, or substitute, for the equity owned by the venture capitalist.

HBS: The percentage of equity held by a new firm’s management team will be negatively related to the percentage of seats on the board controlled

by venture capital firms after the first round funding.

Again, these agency risk hypotheses are built on the assertion that the level of agency risk in a venture capital investment will be associated with the level of monitoring incor- porated in the governance structure that emerges between a venture capital firm and new venture. The less agency risk (as measured by the years a CEO has been with a firm, the percentage of a new venture’s financing coming from the CEO’s personal savings, and the percentage of a new firm’s equity held by managers), the less will be the level of monitoring and control (as measured by the percentage of equity owned by venture capitalists, and the percentage of seats on the board controlled by venture capitalists).

Three additional comments are necessary about these hypotheses. First the measures of monitoring, market risk, and agency risk examined here are only a few among a broad number of such measures suggested in interviews with venture capital firms and managers of new ventures. However, analyses with these alternative sets of measures were consis-

loo THE JOURNAL OF HIGH TECHNOLOGY MANAGEMENT RESEARCH VOL. 7/NO. I/ 1996

tent with results reported below. In practice, however, preliminary research suggests that

different venture capital firms may use different (though conceptually related) measures of market and agency risk in evaluating new ventures.

Second, there are no hypotheses that test the relationship between the percentage of equity held by managers in a firm and the percentage of a firm’s equity held by venture capitalfirms afterfirst roundfinding. This is because these measures are computationally linked, and thus any correlation between these variables would be tautological.

Finally, these hypotheses all focus on firms receiving first round funding. While the theoretical arguments developed above should apply at any stage of venture capital financing, one stage of financing-first roundfinancing-was chosen to simplify discussion and analysis.

IV. METHODS

A sample of 270 electronics firms that received first round venture capital from 1983 through 1985 was selected. These firms were selected by matching announcements of

venture capital investments in the Venture Capital Journal with entries in the American Electronics Association membership directory. A pre-tested survey instrument was mailed to each of these firms, and 102 of them responded. However, there was substantial missing data in these responses, and only 54 firms responded to all the variables of interest. Thus, this study is based on a response rate of 20%. However, a comparison of the measures for these 54 firms with the measures for firms not included in this study revealed no significant differences.

The hypotheses were tested using OLS regression, one model for each dependent vari-

able. The test of the hypotheses depends upon the sign and significance of each regression coefficient. The predicted sign for all coefficients is negative.

V. RESULTS

The mean, standard deviation, and correlation of all variables included in the analysis are presented in Table 1. Regression results are presented in Table 2 and Table 3. The depen-

dent variable in Table 2 is the percentage of a firm’s equity owned by venture capitalists

TABLE 1 Means, Standard Deviations, and Correlations

of Measures Monitoring and Control, Market Risk, and Agency Risk

Variable Mean SD. Correlations

1 2 3 4 5 6

1. % equity owned by VC (VCEQUITY) Sl .I9 1 Sl** -.34** -,36*** -.29** -,60***

2. % board seats held by VC (VCSEATS) .48 .18 I -,44*** -.34*** -.15 -.36***

3. Profits/year of 1st round funding (PROFITS) -1.lM 1.8M 1 .20 .20 .29

4. Years CEO is with firm (CEOYEARS) 4.1 2.8 1 .45*** .33**

5. % equity from CEO savings (CEOSAVE) .11 .26 1 .I9

6. % equity from managers (MGREQUITY) .48 .24 1

Notes: ***p < .0001; **p < .Ol; *p < .05 (two-tailed tests)


TABLE 2

Regression Analysis-Dependent Variable:

Percent of Equity Owned by VC (VCEQUITY)

Independent Variables Parameter Estimate T Statistic

Profits/year of 1st round funding (PROFITS) -.06 -1.83*

Years CEO is with firm (CEOYEARS) -.04 -2.98**

% equity from CEO savings (CEOSAVE) p.24 -2.36*”

Nores: F-Value = 7.X52***, R2 = 0.32; N = 54; *** p <. 001; **p < .Ol; *p < .05 (one-tailed tests)

TABLE 3

Regression Analysis-Dependent Variable:

Percent of Board Seats Held by VC (VCSEATS)

Independent Variables Parameter Estimate T Statistic

PROFITS -.24a8 -2.38**

CEOYEARS -0.02 -1.75*

CEOSAVE -0.08 -.p97

MGREQUITY PO.26 -3.01

Nom: F-Value = 9.537*“*, R’ = 0.4377; N = 53; *** p <. 0001; **p < .Ol: *p < .05 (one-tailed tests)

after first round funding (VCEQUITY), and the dependent variable in Table 3 is the percentage of seats on a firm’s board of directors controlled by venture capitalists after first round funding (VCSEATS).

Hypotheses Al and A2 were supported. The profitability of the firm was negatively associated with both the percentage of equity owned by venture capital firms after first round venture capital, and the percentage of seats on the board controlled by venture capitalists after first round funding. Hypotheses B 1, B2, B3 and B5 were also supported. Thus, the number of years a CEO is associated with a firm is negatively associated with both the percentage of a firm’s equity held by venture capitalists and the seats on the board controlled by venture capitalists. Also, the percentage of a new venture’s financing

provided by the CEO’s personal savings and the percentage of a venture’s equity owned by its managers are both negatively associated with the percentage of seats on a new firm’s board controlled by venture capitalists after first round funding. Hypotheses B4 was not supported, although this coefficient had the expected sign. The equations in Table II and III are each highly significant with an R2 of 0.32 and 0.44, respectively. These results are consistent with the theoretical discussion developed above.

VI. DISCUSSION

While specifying the conditions under which new ventures will or will not receive venture capital is an important research objective, it marks only the beginning of understanding the full relationship between a venture capital firm and the new ventures it funds. It is also important to understand why the funding is structured the way it is, and what impact this structure has on venture capital firms and new ventures. This paper has continued this


work, in a limited way, by examining the determinants of the level of monitoring built into the governance structure that emerges between venture capital firms and new ventures.

Building on concepts taken from institutional economics, it has been argued that the level of monitoring built into the governance structure that emerges between venture capital firms and new ventures is a function of the level of market and agency risk associated

with that investment. Using simple measures, seven hypotheses were developed and tested. Results were consistent with theoretical expectations.

Specifically, there is a negative relationship between bonding to control either market

or agency risk and the costly monitoring that the venture capitalist would otherwise be forced to dedicate to the venture to protect its interests. Our results indicate that the new venture team may choose to bond itself to the venture, in the ways we have discussed, which in themselves are costly in the short term, or it can absorb the cost of monitoring that the venture capitalist can be expected to anticipate and thus pass on to the new venture team. Either way, the new venture team is going to pay for monitoring or bonding. So why does it matter? It matters because the choice is actually an investment decision for the venture capitalist team. If it chooses bonding over monitoring, it may in the end earn a

positive return on its investment for its choice. This return could come from risk taking associated with increased equity or increased initial firm profitability. To the extent that monitoring is intended to align the interests of the new venture team, and not to provide

useful advice, it becomes a sunk cost from which no return on investment can be expected. Thus, in the future, an investment in bonding may generate a positive net present value whereas an investment in monitoring will always generate a negative net present value.

This theoretical approach may have other practical applications as well. It is often the case that managers of new ventures complain that either they cannot obtain venture capi-

tal, or the costs of obtaining it (in terms of how much equity they have to give up, or how much control they must relinquish to the venture capitalist) are too high. This paper suggests that actions taken by managers to reduce the market and agency risks associated with investing in their firm will be reflected in less costly venture capital. That is, firms may be able to retain higher percentages of their equity and maintain control over more seats on their board. In particular, new ventures that are unable to obtain venture capital, or believe that it is too costly, may want to consider some of the actions listed in this

paper: reporting more profitability from their new venture (perhaps by deferring long-term investments), financially linking their CEOs and managers to the success of the firm, or creating other firm-specific investments by managers in the firm. To the extent that these actions reduce market and agency risk, they should be reflected in less elaborate monitoring and control mechanisms-in particular, less equity owned by venture capitalists, and less venture capital influence on the board.

VII. FUTURE RESEARCH

Institutional economics provides a rich framework for understanding venture capitalist relations with the firms they fund. We have only examined a few theoretical issues, concentrating mainly on the implications of our substitution hypothesis. Moreover, the venture capital industry is ideally suited for such investigations because of the tractability of the relationships among venture capital firms, the availability of actual written contracts documenting their agreements, and the pecuniary nature of the ventures themselves. That is, they are entered into to make money, and it is quite difficult to argue that their purpose


was to champion some greater social interest or utility. In fact, we argue that there is no

other known industry that lends itself as well to the testing of institutional economics. We

will now enumerate a few areas of research that appear particularly promising to us. Extending the present study, the choice of bonding over monitoring as a possible net

present value investment assumes that venture capitalists contribute little else to the deal,

which recent research seems to contradict, particularly in the areas of strategic and opera-

tional advice (c.f. Barney, Busenitz, Fiet, & Moesel, 1994b; Chan, 1983; Rosenstein,

Bruno, Bygrave, Taylor, 1990; Sapienza, 1992). However, no known research has exam-

ined the advantages of different forms of bonding. For example, are some forms of bond-

ing less costly than others while still providing adequate protection for the venture

capitalist so that a deal can still be consummated? Another issue that has both important theoretical and practical implications is the inves-

tigation of ongoing actions that the new venture team can take to keep the venture capitalist committed to the deal. Theory suggests that a specific investment such as funding a

new venture creates a bilateral trading relationship between the venture capitalist and the new venture team (Williamson, 1985). The beneficial result for the new venture team is

that it removes its deal from the rather public and very efficient venture capital market

where it can expect to have all of the costs of bonding and monitoring shifted to it.

However, as soon as the bilateral trading relationship is created, (e.g., they sign their venture capital agreement and funds flow to the new venture team) there is no public

market for it. The costs of all bonding and monitoring from that point forward must be

negotiated on terms that are more or less mutually acceptable (Alchian & Demsetz, 1972).

Relatedly, whether there is a market for a deal after it has been consummated depends in

part on the willingness of other venture capital firms to refrain from bidding. How perva- sive is collusion among venture capital firms in the after market for failed deals?

And finally, we are certain that a more exhaustive examination of different forms of

monitoring and bonding will need to be conducted to deepen our understanding of substitution. We look forward to these efforts.

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