Type of Investors

AdvancesinBehavioralFinance&Economics:TheJournaloftheAcademyofBehavioralFinanceVolume1,Issue1,Winter201142-62Copyright2011AcademyofBehavioralFinance,Inc.Allrightsreserved.ISSN:1551-9570

InvestorType,CognitiveGovernanceandPerformanceinYoungEntrepreneurialVentures:AConceptualFramework*

ChristopheBonnet,PeterWirtz

GrenobleEcoledeManagementandUniversitLumire(Lyon2)

Abstract

This article contributes to a better understanding of the process of entrepreneurial finance from abehavioral perspective. We specifically examine the cognitive features and interaction of three key-actors inentrepreneurial finance: entrepreneurs, business angels and venture capitalists and derive implications forperformance (value creation and growth) when a young venture raises external equity capital. Concepts ofcognitivecostandvalueenhancetheoreticalinsightintowhyBAandVCinterventionistypicallysequential.WealsopredictinwhatspecificsituationsoneshouldexpectsimultaneouscoinvestmentbyBAsandVCsandhowinvestorscanusecognitiveleverstoinfluencethespeedofgrowth.

Keywords:BusinessAngel,VentureCapitalist,CognitiveGovernance,VentureGrowth.

Introduction

Youngentrepreneurialfirmsareanessentialvectorofeconomicgrowthanddynamism.Suchventures face especially strong challenges in managing the dynamics of growth (Hambrickand Crozier, 1985) and attempting to tackle specific strategic hurdles (Graebner andEisenhardt, 2004). Part of the challenge is to gain access to and assemble various criticalresources inaneffort to fuel growthandget theventureon an expansionpath.Frequently,resourceneedscomeintheformoffinancialcapital.Wheninternalfundingandthefounderspersonal wealth are insufficient to cover the financing needed for further growth, externalinvestors, suchasbusinessangelsorprofessionalventurecapitalists,maycontributecriticalresourcesintheformofequityfinance.Thisbringsaboutsignificantchangeintheownershipstructure.Bringing in new shareholders then raises the question of the nature and quality of therelationshipbetweenthedifferentshareholdercategoriesandtheentrepreneur,inasmuchasthe investors may exert significant influence over venture performance (Lindsay, 2004;Mason&Harrison,2002;Wiltbank,2005;Wiltbanketal.,2009).Therelationshipsbetweentheentrepreneurandthenewexternalinvestorsaretypicallymediatedbyvariousgovernancemechanisms such as investor participation on corporate boards (Rosenstein et al. 1993;Sapienzaetal.,1996),termsofcontract(KaplanandStrmberg,2004)andincentiveslinkedtoownershipstructure(Bitleretal.,2006).

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C.Bonnet,P.Wirtz/AdvancesinBehavioralFinance&Economics:TheJournaloftheAcademyofBehavioralFinance1(2011)

The academic literature on the governance of entrepreneur-investor relations has mainlyapproachedtheissuefromtheperspectiveofagencytheory(Dailyetal.,2003),accordingtowhich the corporate governance system essentially assumes a disciplinary role, improvingperformance through economizing on agency costs (Jensen and Meckling, 1976; vanOsnabrugge,2000;Bitleretal.2006).Morerecently,empiricallygroundedstudieshavecometo question such an exclusive focus on the disciplinary role of corporate governance,especiallyinthefieldofyoungentrepreneurialventures.GraebnerandEisenhardt(2004),forinstance,observedventurecapitalistsandbusinessangelsplayasupportivestrategic role incorporategovernance,thelatterworkingasasyndicateofcooperatingpeersratherthanasamonitorofprincipal-agentrelationships.An alternative approach to corporate governance, borrowing from knowledge-based andbehavioral theories, hasbegun to emerge and topresentamajor challenge to thedominantdisciplinaryapproach.Thisalternativeviewmaybequalifiedascognitive,for it recognizesthepotentialroleofgovernanceintheprocessofstrategyformulationandintheacquisitionof managerial capabilities. Prominent examples of studies devoted to cognitive aspects ofgovernance are Forbes and Milliken (1999), Rindova (1999), Charreaux (2002), Kor andSundaramurthy (2008). According to these studies, the role played by the various actorsinvolved in corporate governance and their impact on strategic outcomes and performancemaybe dependent on their specific cognitivebackground (experience, education, mindsets,decision-makingheuristics...)andinteraction(learning,cognitiveprocess...).FilatotchevandWright (2005)promote the ideaof theexistenceofacorporategovernancelife cycle, thereby suggesting that the specific role played by corporate governance inmediating entrepreneur-investor relationships may actually depend on a firms stage ofdevelopment. The present article is focused on the governance of young entrepreneurialventureswhichraiseexternalequitytofinancefurthergrowth.Entrepreneurialfirmsmaybeassumed to face especially strong cognitive challenges, for at least three reasons: (1)entrepreneurshavebeenshowntopresentspecificcognitivefeaturesaffectingtheirdecision-making process (Busenitz and Barney, 1997 ; Forbes, 1999; Krueger, 2003; Sarasvathy,2001), (2) entrepreneurs specific education and experience may lead to the discovery ofbusiness opportunies not evident to people with different mindsets (Shane, 2000), (3)entrepreneurs may lack the requisite managerial capabilities to exploit the perceivedopportunitiesandsustainhighlevelsofgrowth(HambrickandCrozier,1985;HellmannandPuri, 2002; Wasserman, 2001). For all those reasons, the arrival of and interaction withspecificinvestortypesmayhavestrongimplicationsfortheperceptionoftheventuresbeststrategic opportunities and of the best way to capture and exploit them. Differences incognitionbetweenentrepreneursandinvestorsmayinducecostsorincreasevalue,dependingon theprecisenatureof suchdifferencesand theunfoldingdynamicsof interaction.Hencecosts may arise when mutually inconsistent mindsets lead to strong conflict over the beststrategicoptionsthatshouldbeadopted,whereasvaluemayemanatefromtheheterogenousexperienceandcapabilitieswhichcertaininvestorsbringtotheventure,stimulatingprocessesoforganizationallearning.The present study develops a conceptual framework of the governance of youngentrepreneurial ventures that open their capital to external investors in pursuit of a stronggrowth strategy. We do not challenge the fact that considerations of personal interest, asagency theory would have it, are present in entrepreneur-investor interactions and thatinvestors seek to protect themselves from the consequences of potential managerialopportunism.Rather,we think thatconcepts ofcognitive cost andvalue, represent a usefulcomplement to deepen our understanding of venture governance and its impact onperformance andvaluecreation. Our proposal is that issuesof discipline and cognition areboth relevant to the governance of investor-entrepreneur relations., Cognitive issues do

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howeverappeartobeparticularlyimportantatanearlystageinthegrowthprocessofyoungventures.Onecentralcontributionofourframeworkistogobeyondtheconcentrationoftheownership structure to consider the specific impact of different owner categories onperformance. Business angels and venture capitalists have been shown to be significantsuppliers of growth capital togrowing entrepreneurial firms. Theydiffer in many respects.Business angels are frequently experienced entrepreneurs who invest their own money,preferably in industries that they already know. They are not only driven by financialobjectives (Morrissette, 2007). Venture capitalists are more typically professionals whomanagefundswiththeobjectiveofmaximisingthefinancialreturnfortheirfundproviders.Althoughsomeofthemmaybeformerentrepreneurs,theyhavediversifiedbackgroundsandthey generally invest in a larger span of industries than business angels. These differencesmightimpactinvestorsbehaviourandtheinteractiontheyestablishwithentrepreneurs,fromboththedisciplinaryandthecognitiveperspective.OurframeworkhasempiricalimplicationsconcerningthevariousrolesofangelinvestorsandVCsinthegovernanceprocessesofyoungentrepreneurialventuresandfortheirimpactonthecreationofvalue.The remainder of the study is structured as follows. Section 1 gives a brief review of thedominantapproachofgovernancerelatedtoentrepreneurialfinance,questionsitsrelevance,andthengoesontoputspecialemphasisonthecognitivefeaturesofentrepreneurialfinance.Section 2 presents a review of the literature on angel financing and venture capital andcharacterizestypicalfeaturesofthesetwoinvestorcategories,whichcanbeexpectedtohavea bearing on agency costs and on cognitive costs and value. Section 3 proposes empiricalimplicationsderivedfromthecombinedframework.

1.InvestorRelationsinEntrepreneurialFinance:BeyondAgencyTheory1

JensenandMeckling(1976)madetheseminalcontributiontopositiveagencytheorywhichhas become the dominant theoretical framework for analyzing shareholder-managerrelationships.ThestartingpointinJensenandMecklingsanalysisisanentrepreneurialfirm,wherethefounderistheonlyshareholderandthemanageratthesametime.Inthissituation,agencyconflictsareabsent,becausetheentrepreneurcompletelyinternalizesthevalueimpactof his decisions. Things change when the entrepreneur sells outside equity because such ascenariocreatesanincentivefor the founder/manager topursuehispersonal interests to thedetriment of the new shareholders. Consequently, when a new shareholder enters, agencycosts arise. Such an increase can however be reduced by putting in place the appropriatemonitoring and incentive mechanisms. Hence, from the agency perspective, corporategovernance follows an exclusively disciplinary orientation, functioning as a check onconflictinginterests.Thequestionarises,however,whytheentrepreneurshouldopenuphisventuretoinvestorsinthefirstplacesincethisbringsaboutagencycostswhichwillbeanticipatedandpricedbythepotentialexternalshareholdersanyway.JensenandMecklingsanswerisintherecognitionofthe entrepreneurs personal budget constraint. That is to say that the sale of outside equitymaybe theonlymeanstocapturecertainvalueenhancing investmentopportunities, simplyby loosening the firms budget constraint. Thus, outside equity brings the firm on a valueenhancing expansion path, as long as the incremental value generated from expansionexceeds themarginalagencycosts inducedby thedecreaseof theentrepreneursownershipstake.Thevaluecreatedbyanexternalshareholder,sayaprivateequityfirm,stemsfromthefunds it contributesand itscapacityofcontrollingmanagerial agencycostsbydevising theappropriateincentiveandcontrolmechanisms.IndiscussingtheO.M.ScottLBOforinstance,

1Thissectionstronglybuildsonearlierworkbyoneoftheauthors(Wirtz,2010).

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Baker and Wruck (1989) make a case for the private equity firms ability to designgovernance mechanisms (remuneration design,management participation, board of directorfunctioning,covenants)whichhelpdecreaseagencycosts.Itshouldhoweverbenotedthat,intheinitialagencymodel,theoutsideshareholdersplaynoroleinconstructingtheinvestmentopportunitysetitself.Thelatterisgiven,andtheroleofoutsideshareholdersisrestrictedtobringinginfinancialcapitalandtosupportingtheresidualrisk,whilecontrollingtheobjectiveattributesof their investments bymaintaining transparencyon information flows. In suchamodel, outside shareholders governance activity is restricted to monitoring and contractenforcement.Agency theory thus focuseson controlling costs of conflicting interestswheninformation is asymmetrically distributed. Investors enhance value through governance bycrafting the appropriate monitoring and incentive mechanisms. Monitoring reducesinformation asymmetry, whereas incentives align the entrepreneurs interests with those ofexternal shareholders. Jensen (1993) considers the governance mechanisms developed bycertainprivateequityfirmsasespeciallyefficaciouswhenitcomestoeconomizingonagencycosts.Though thismaybeone important explanationfor the successofcertainventures, inmanycases, the success and performance of entrepreneurial growth firms is not due to financialincentivesandmonitoringalone.Infact,onemajorshortcomingofagencytheorylies in itsimplicitassumptionsabouttheoriginandtherecognitionofopportunitiestocreatevalue.Theorigin of strategic opportunities and the recognition of their value creation potential areactuallyexogenoustothetheory,anditissimplyassumedthatgood(positiveNPV)andbad(negativeNPV)projectssomehowexist.Theyaregivenbytheenvironment,andtomaximizevalue,itisimportanttohaveaccesstoinformationaboutthegoodprojects,togiveincentivestotheentrepreneurtochoosethegoodonesandtomakehimexpendoptimaleffort.Thestrategicmanagementliteraturehoweverhasalongstandingtraditioninrecognizingthatmakingacompetitivestrategyisasmuchaboutcognition(HambrickandMason,1984;Huff,1990;Walsh,1995),vision(Fransman,1994;Witt,1998),anddifficulttoimitatecapabilities(Penrose, 1959; Teece, Pisano, Shuen, 1997), as it is about mere information. What anentrepreneurperceivesasthebeststrategydependsonhisorherspecificmindset.Thesamegoesforaninvestor.Mindsetsareinfluencedbyindividualandcollectivelearningprocesses,whichmaybehighlyspecificandpathdependent.Partofsuchlearningistacitinnatureandthusdifficult tocommunicate toothers.One implicationof thecognitivenatureof strategyformulation is the fact thatmanyvaluecreationopportunitiesdonotexist independentlyofthepeoplewhoconceive them in specific organizational settings.The art of strategy is notsimplyaboutchoosingtheobjectivelybeststrategyinapredefinedmenu.Strategyiscreatedinprocessesofindividualandorganizationallearning(Nonakaandal.,2001),whichrelyoncapabilitiesthatgobeyondthecontrolofconflictinginterests.Fransman(1994)illustratesthecentralimportanceofknowledgeincreatingandrealizingthepotentialofcorporatesuccess.Heactuallydrawsacleardistinctionbetweeninformation,asitis present in agency theory, and knowledge, as employed in strategic management andevolutionaryeconomics(NelsonandWinter,1982).Informationisinfactdefinedasobjectivedataaboutstatesoftheworldandstate-contingentoutcomes.Assuch,itisaclosedset.Itmaybe asymmetrically distributed, but its transfer from one stakeholder to another is possible,albeit at a cost (monitoring costs). In such a context, an informations meaning isunambiguous.Thingschangewhentheprecisemeaningofanygiveninformationdependsonpeoplesmindsets.Thus,evenifknowledgeevolveswiththeacquisitionofinformation,thereisloosecouplingbetweenthetwoconcepts,which is tosay that the interpretationofanypiece of information in terms of value creation is not self evident but depends onpeoplesmentalpatternsatthetimetheyreceivetheinformation.Thelattermaythenhaveanimpactonmentalpatternsandbeliefstructures,butthesechangeinahighlypath-dependentway,so

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thattheknowledgegainedfromnewinformationissometimesverydifferentfromonepersonto another, depending on education and personal experience. In fact, Fransman definesknowledgeasdynamicmentalconstructs.So,incomparisontoagencytheorysconceptionofinformation,knowledge isanopen set. It is created inanongoing learningprocess,partofwhichistacit(Nonakaandal.,2001).Beyond their privileged access to information in the above defined sense, top managersspecificknowledgestructurescanhencebecrucial inanefforttocreatevalueandstimulategrowth. In their work on upper echelons, Hambrick and Mason (1984) actually consider afirms strategy and performance to be a reflection of its top managers cognitive base andvalues. Since there is only loose coupling between objective information and knowledgegained, some people perceive opportunities for value creation and others do not, even ifinformation is distributed symmetrically. In such a situation, monitoring and incentivealignment alone are insufficient to increase a firms value and engage in the dynamics ofgrowth.Thisisbecauseinformationfromtheenvironmentisperceivedthroughthelensofanentrepreneursspecificmindset.The latter influencesstrategyformulationand,ultimately,afirmsperformance(HambrickandMason,1984).One important implication is that theremay be a conflict between an entrepreneur and hisfirmsinvestorsaboutthebeststrategytofollow,independentlyofanyproblemofconflictinginterests,andthatcognitionmayhenceinfluencethedynamicsofgovernance.AsConnerandPrahalad(1996)putit:[...]truthfulindividualshonestlymaydisagreeaboutthebestpresentandfuturecourseofactionfortheirbusinessactivities.Or,thepartiesmaypossessdifferentmindsetsgenerally.Discordfundamentallyderives frompersonalknowledge that cannotbecommunicated fully toothersat the timeof thedisagreement. (p. 483).Consequently, ourunderstanding of entrepreneur-investor relations may gain from admitting the existence ofcognitive (or knowledge) asymmetry, which is different in nature from mere informationasymmetry.Such cognitive asymmetry is likely to induce conflicts due to mutual misunderstandingamongstakeholders (e.g. theentrepreneurandcertainexternal shareholders).Suchconflictsarenotrootedinmutuallyinconsistent interestsandthuscannotbetackledbythemeansofinterestalignmentalone,astraditionalagencytheorywouldhaveit.Theirresolutiondependsonstakeholdersinitialskillsandknowledge,aswellasontheirwillingnessandcapabilitytolearn.Thuscognitiveconflictscausecostswhichmaybelabelledascognitivecosts.The costs stemming from cognitive conflicts are different in nature from costs rooted inagency conflicts. They are related to the various efforts undertaken by stakeholders toovercomedifferencesintheperceptionofopportunities,toconvinceothersof therelevancyof their conceptions (e.g. an innovative business model), as well as to eventual losses ofefficiencyduetolastingdifferencesinunderstanding.Table1sketchesoutdifferenttypesofpotentialcognitivecostsincomparisonwiththetraditionalagencycosts.

[Table1here]

The above presentation of cognitive costs emanating from the relationship betweenentrepreneurs and external stakeholders, such as business angels and venture capitalists,showsthatthesecostsarelinkedtolearningprocessesthatpotentiallyleadtoatransformationof strategic knowledge (which may reduce the gap between different mindsets) and to anacquisition of new managerial capabilities. It is however important to emphasize thatcognitive conflict differs from traditional agency conflict in a fundamental way. In fact,agencyconflictisalwaysvaluereducing,andaslongasthemarginalcostofmonitoringandbondingremainsinferiortothemarginalreductioninresiduallosses,thelattersminimizationwill maximize value. Not so with cognitive heterogeneity, which can actually be value

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enhancing(ForbesandMilliken,1999;Hambricketal.,1996),inasmuchasitopensupnewstrategicperspectives and allows to sustain an ongoing process of learning and innovation.Consequently,thespecificmindsetsofexternalstakeholders,saybusinessangelsorventurecapitalists,differentfromtheentrepreneursown,notonlygeneratecognitivecost,butmayalso contribute cognitive value by bringing in new perspectives and valuable experience.Dependingontheirspecificcognitionandthelattersrelativematchwiththeentrepreneursmindset,investorsmayactinsuchawayastoenhancethedynamicsofmutuallearningandthussupportstronggrowth.Inthiscase,governancewouldactuallyincreaseentrepreneurialdiscretion,furtheringthecapabilitiesrequiredtomanagethedynamicsofstronggrowth.Young technology ventures evolve in a highly uncertain environment, where knowledgeabout the best strategic opportunities is especially ambiguous. This makes cognitionpotentiallyahighlyrelevantvariableinentrepreneur-investorrelations.So,onemaywonderifthedisciplinaryapproach,rootedinagencytheoryandpreoccupiedwithcloselymonitoringmanagerial discretion, is sufficient when it comes to explaining the dynamic interactionbetween entrepreneurs and investors in entrepreneurial ventures at an early stage in theprocess of growth. We may expect to gain explanatory power from combining basicprinciplesofagencytheorywiththecognitiveapproach.Accordingtothelatter,investorsusecorporate governance to gain better understanding of entrepreneurial opportunity and as alevertoenhancestrategicvisionandmanagerialcapabilitywithapotentiallystrongimpactonperformance.

2.BusinessAngels,VentureCapitalistsandGovernance

From the above, it follows that, in as much as specific investors have specific cognitivefeatures, investor typecanbeexpectedtohaveasignificant impactonventureperformanceandsuccess.Thismayhelpunderstandspecificconfigurationsofinvestorsatspecificstagesofventuregrowth.Twobroadinvestorcategoriesareespeciallyimportantforentrepreneurialfinanceandhavebeenshowntoassumecomplementaryroles(Harrison,Mason,2000)whenitcomestosupportingventuregrowth:businessangelsandventurecapitalists.Whataretheirspecific roles and contributions to the governance and performance of young ventures?Empirical research has shown them to differ by their origin, previous experience andobjectives. They tend to establish different types of contractual and informal relationshipswith venture founders. They assume complementary roles over the life cycle of youngventures, as BAs generally invest small amounts ofmoney at early stages whereasventurecapitalfundsinvestlargeramountsattheexpansionstage.Incertaincases,however,theydoinvestsimultaneouslyinthesameventure.In this section we first document major empirical differences between BA and VCcharacteristcs, as well as the specific investment and governance processes they typicallyengage in. Inasecondstep,wederive theoretical implicationsfor thegovernanceofyounggrowthventuresbyVCsandBAsfromthetwobasictheoreticalframeworks:agencytheoryandthecognitiveapproach.

2.1.EmpiricaldifferencesbetweenBAsandVCs

ThetypicalBAandVCeachhavespecificcharacteristicsIn the literature on entrepreneurial finance, BAs are described as resembling more toentrepreneurs than to VCs (Farrel, 1998), as being closer to entrepreneurs than VCs are(Kelly & Hay, 2003), as having an entrepreneurial orientation (Lindsay, 2004). BAs arepredominantly actual or former entrepreneurs who invest their own money (Morrissette,2007),whereasVCsarefinanceprofessionalswhomanageinvestorsmoney.ThereforeBAs

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knowledge base and cognitive process are close to entrepreneurs. Due to their experiencetheygenerallyhavegoodknowledgeofaspecifictechnology,industrialsectorormarket,andthey express a preference for investing in industries they know (Wright & al., 1999; vanOsnabrugge, 1999). VCs, although some of them may have technological or industrialexperience or expertise, often have a more generalist background (MBA, consulting orfinancialexperience).With regard to cognitive process typical in entrepreneurial decision making, two importantspecificitiesemergefromtheliterature:intuitionandeffectuation.Entrepreneurialintuitionisdefined by Mitchell & Friga (2005) as the dynamic process by which entrepreneurialalertness cognitions interact with domain competence (e.g., culture, industry, specificcircumstances, technology, etc.) to bring to consciousness an opportunity to create newvalue.AccordingtovanOsnabrugge&Robinson(2000,inMorissette)BAsprimarilyassessthe entrepreneur (vs. the business model) in their selection process and largely base theirdecisionsontheirownjudgmentandgutfeelingrather thanonextensiveduediligence.Theproper assessment of the entrepreneurs intuition hence plays a significant role. To thecontrary,VCsuseamoreformal,extensiveandanalyticalapproachbasedontheanalysisofentrepreneursreferencesandpastexperience,ofventuretechnology,ofpotentialmarketandcompetition,andoffinancialprojections(Wiltbank,2005).ThismaybeduetodifferencesincognitiveabilityandstylebetweenBAsandVCs,butalsotothefactthatVCsmanageotherpeoplesmoneyandneedthereforetodocumentandjustifytheirdecisionsinordertoshowtotheirfundprovidersthattheybehaveinaresponsibleandrationalmanner(vanOsnabrugge,2000).Effectuation,oreffectuallogic,isaconstructthataimsatdescribinghowentrepreneurstakestrategic decisions in uncertain environments (Sarasvathy, 2001). Rather than using apredictive approach (i.e. trying to forecast future outcomes using detailed market studies,financialprojections,etc.)inordertopre-determinepreciseopportunities,goalsandexpectedreturns,asVCsusuallydo,manyentrepreneursuseaneffectual,nonpredictive,approach.This means that they donot try to first predict future outcomes and then match them withresources needed to attain predicted outcomes. Effectuators rather try to control (shape)outcomes(possibleeffects)basedontheirinitialendowmentswithresources,strengths,socialnetworks, and progressively manage to transform their environment as they go along thuscreatingnewopportunities.AccordingtoWiltbank&al.(2009),BAsusebothpredictiveandnon predictive (effectual) approaches in their investment decisions, albeit in differentproportion.Theysuggestamoderatetendencytowardonedominantapproachovertheother,someBAsbeingmorepredictive(muchlikeformalventurecapitalists),othersmoreeffectual(like the entrepreneursof theventures they invest in). Interestingly, BAs who emphasize anon predictive (effectual) approach experience a reduction in investment failures without areductioninsuccessrates.BAsinvestmentobjectivesalsoappeartobeclosertoentrepreneursthanthoseofVCs.BAswanttomakemoneybuttheygrantlessimportancethanVCstopreciseIRRandexittimingobjectives,andtheyappeartohavediversenonfinancialgoalssuchaschallenge,fun,helpingto start a new company, that are as (or more) important for them as (than) financial goals(Farrel, 1998; Kelly&Hay, 2003; Morrissette, 2007). VCs set their objectives in financialtermsonlyandneedtocontrol theexitas theyarecommitted tocreatevaluefor theirfundprovidersinalimitedtimeframe.Therespectivecharacteristicsoffirst-timeentrepreneurs,BAsandVCsastheyemergefromtheentrepreneurshipliteraturearesummarizedintable2.

[table2here]

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BAsandVCsusedifferentinvestmentprocessesThe dynamics of venture capital investing can be represented as a five step process: dealsourcing, deal screening, deal evaluation, deal structuring, and post-investment activities(monitoring, exit) (Tyebjee & Bruno, 1984). In as far as it has an impact on managerialdiscretion, the investment process at large may be analyzed as an exercise in corporategovernance.Wepresentintable3acomparisonoftherespectiveproceduresusedbyBAsadVCsbasedontheliteratureonangelandventurecapitalinvesting.The main distinctive features of BAs investment process, compared to VCs, may besummarizedasfollows:

BAs are typically more intuitive, less formal and analytical in deal selection andevaluation.

Theybring specificentrepreneurshipexperienceandsectorknowledge, and look forclose interactions with management in order to contribute assistance, advice andpersonal contacts to the venture. VCs bring more extensive financial and generalmanagementexperience.

BAsnegotiatelessextensivecontracts,relyingmoreontheircapacitytointerveneaseventsunfold(effectuation),whereasformalVCstrytoanticipatemajorrisksasmuchaspossibleandconsequentlyputmoreweightonclausesaimingat reducingagencyrisk.

[table3here]

2.2.TheoreticalimplicationsfortherespectiverolesofBAsandVCsinventuregovernanceandperformance

InformalandFormalVentureFinanceintheLightofAgencyTheoryAccordingtoagencytheory,agencyrisksexistinyoungventurefinancingbecauseofstronginformation asymmetry (on the quality of the project and of the entrepreneur) and of theexistenceofpotentialconflictsofinterestbetweenfinancialinvestorsandentrepreneurs.Theymaybesignificantbecausemostyoungventuresrelymainlyonintangibleassetsandonthegoodwill,ethicsandabilitiesoftheentrepreneurialteam(vanOsnabrugge,2000).TheseriskstheoreticallyexistforBAsandVCslikewise.Itisconsequentlyassumedthatinvestorsmainlyuse governance mechanisms to reduce agency risks, through active monitoring andcontractualclausesdesignedtoenhancetheircontrolovertheventure,tolimittheirdownsiderisk,andtoincentivizeentrepreneurstocreatevalue.

[table4here]

Agencytheoryhasfrequentlybeenappliedtotheexplanationofventurecapitalgovernance.Kaplan&Strmberg (2004) identify four typesofagency risks thatVCsmayencounter intheirinvestmentprocess.Basedontheirfindingsandonsimilarstudies,wematchintable4specificgovernancemechanismstypicallyusedbyVCswithspecificagencyrisks.PreviousresearchindicatesthatVCstendindeedtoreinforcethesegovernancemechanismswhentheyperceiveincreasedagencyrisks(KS,2004;Barney&al.,1994).AgencytheoryhasalsobeenusedtostudyBAsinvestmentprocess,withresultsthatfeaturesomenotabledifferenceswithVCs.BAsarenotunawareofpotentialagencyrisks,buttheytypicallymanagethembydifferentmeans.Theyseemtorelymoreontheirowncapacitytoact,thanonup-frontcontracts.Vis--vistheadverseselectionproblem,theyrelysignificantlyontheirownjudgmentandontrustedreferralsourcesmorethanonextensiveduediligence(van Osnabrugge, 2000). They also seem to consider that they can manage agency risks

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throughtheirlevelofinvolvementinthepost-investmentphase,byestablishingatrustingandpositiverelationshipwithentrepreneurs(Landstrm,1992).Theyworkwithinaframeworkofincomplete contracts and, consequently, bother less about due diligence and contractualdetailthanVCs,astheythinktheywillbeabletoreachpositiveoutcomesthroughtheirpost-dealinvolvement(vanOsnabrugge,2000).Ina surveyof106UKbasedBAs,Kelly&Hay (2003)havehowever identified fivenonnegotiable clauses (i.e. that are almost always included by BAs in the contracts withentrepreneurs) : (i)veto rightsoveracquisitions/divestitures; (ii)priorapproval forstrategicplansandbudgets;(iii)restrictionsonmanagementsability to issueshareoptions;(iv)noncompete contracts required from entrepreneurs upon termination of employment in theventure; and (v) restrictions on the ability to raise additional debt or equity finance.Interestingly,clausesfrequentlyusedbyVCsareabsent fromthis list, suchasperformancedependant compensation, liquidation claims and anti-dilution clauses, forced exit, vestingentrepreneursshares.BAsseemtobemorepreoccupiedwithcontrollingstrategicdecisionspost-investmentthanwiththeprovisionoffinancialincentivestoentrepreneurs.Howeveroneshouldnote thatBAswitha longer investmentexperiencetendtonegotiate tighterfinancialclauses,thusadoptingabehaviourclosertoVCsinmonitoringentrepreneurs.The above developments indicate that BAs and VCs may be concerned with agency riskslikewise, albeit to different degrees. So agency theory would predict that BAs as well asformal VCs conduct the investment process by using various governance mechanismsprimarily as a means to control for objective agency risks, at each stage of the process.Although the precise nature of the governancemechanisms employedmay differ from oneinvestor to another (Kaplan and Strmberg, 2004), their economic role is supposed to beidentical: maximize shareholder value through strong financial discipline. Governance issupposedtograntinvestorsaccesstoobjectiveinformation(notsubjectiveknowledgeintheabovedefinedsense)andachieveinterestalignement.Beit throughformalduediligenceorelaborate contractual arrangements (in the case of VCs) or through personal contact andhands-onmonitoring (in thecaseofBAs), agency theory is focussedon interest alignment,notcognition.Fromthisperspective,whatistherespectiveroleofBAsandVCsinthecaseofa co-investment in the same venture? On the one hand, the multiplication of differentinvestorsmayintensifypotentialagencyconflicts,becauseofthediversificationofinterestsatstake.Ontheotherhand,specificinvestor-typesmayhaveaccesstospecificinformation,duetothespecificgovernancemechanismstheyhavedeveloped(cf.Jensen,1993,referringtothegovernance mechanisms developed by private equity firms). So BAs and VCs might beconsidered tobecomplementary in termsof the specific informationeach is able to access(andcertify),whichshouldleadtoadecreaseininformationasymmetry.BusinessAngelsandVentureCapitalistsinaCognitiveFrameworkThe above quoted litterature on BAs and VCs indicates that these two investor categoriestypicallyhavedifferent cognitive features, be it in termsof knowledgegained from formaleducationandprofessional experience, or in termsof cognitive style and process (intuitionandeffectuationvs.prediction).Thismayinduceagapbetweeninvestorsmindsetsandthoseof entrepreneurs of varying magnitude at the time these different actors first come intocontact. Bringing in different investor categories hence theoretically creates cognitiveheterogeneity which is a potential source of cognitive conflict and cost. If the cognitivemismatch between a particular investor and the entrepreneur is too strong, the relationshipmaybeinterruptedrapidly,withoutanyfinancingtakingplace,notbecauseofanabsenceofobjective information, but because of mutual misunderstanding. The cognitive distancebetweenBAshaving strongentrepreneurial experienceandentrepreneurs shouldbe smallerthanbetweenVCsandentrepreneurs.Reducedcognitivedistancemayallowforanintuitiveunderstanding of the intrinsic value of an entrepreneurs original project, without formal

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financial projections. Conversely, the typical VCs mental distance from first-timeentrepreneursmaybestrongerthaninthecaseofBAs,forreasonsofdifferencesintrainingandintheresultingspecificmodesofreasoning.BAswithanentrepreneurialbackgroundpresentmanysimilaritieswithentrepreneursintermsofcognitiveprocessandknowledgebase.Infact,theyofteninvestinindustriestheyalreadyknow, which should facilitate their understanding of the new ventures strengths andweaknesses. However, the similarity between BAs and entrepreneurs is not complete.Although having a lot in common, they still may have different mindsets and knowledgebases, partially due to differences in their specific prior experience. We therefore expectexternalizingcostsfromentrepreneurstowardsBAstobemoderate.BAs who seek strong involvement and close interaction with entrepreneurs can thus sharetheir entrepreneurial experience, provide mentoring and fill the competence gap existing inthetopmanagementteamofthenewventureatarelativelylowcognitivecost.Wecanexpectthis involvement to be a source of knowledge transfer to the entrepreneurial team. It cantherefore be assumed that BA/entrepreneur interaction has the potential to produce a highcognitivevaluethroughlearning,particularlyinthecaseoffirsttimeentrepreneurs,whomaybenefitmore from the transfer ofpreviousentrepreneurial experiencebyBAs. It shouldbenoted however that maintaining a close interaction with entrepreneurs may be excessivelytimeconsumingandcostly if theventureis locatedfaraway,whichmayexplainwhymostBAsinvestlocally(Kelly&Hay,2003).The likelihood of a cognitive gap between VCs and entrepreneurs is greater than betweenBAsandentrepreneursatanearlystageofventuregrowth, ifweconsider thefactthat theygenerallyworkfromadifferentknowledgebase,havedifferentpriorexperience,andspecificcognitive processes. Cognitive conflict may be strong during the pre-investment phase,particularlyiftheVCadoptsarigidattitudeindue-diligenceandincontractnegotiation.Forexample,inexperiencedentrepreneursmaybeupsetby(whattheyconsidersas)anexcessivetendency towards theuseof formalanalysis,predictiveapproach (detailedactionplansandfinancial forecasts), downside contractual protections for investors and forced exit clauses,simplybecausetheydonotsharethesamecognitivelogicthanVCs.Entrepreneursmayneedto engage in costly externalizing activities in order to convince VCs of the value creationpotentialoftheventure,asthelatterlackspecificindustrialandtechnicalknowledgeandwantto conduct formal and extensive due diligence. We therefore anticipate that there may berelativelyhighcognitivecostsresultingfromVC-entrepreneurinteractions.Howeverthismaybemoderatedbyseveralfactors:- Cognitiveconflictmaydiminishovertime,evenduringthepre-investmentphase,asitcanbeexpectedthatmutualunderstandingandsharedknowledgewilldevelopintheprocessofinteraction;- ExperiencedVCsmaybe less rigid andmoreprone tounderstanding entrepreneurslogicthanyoungVCs,whoneedtoestablishatrackrecordandwhohaveashorterexperienceofdealingwithentrepreneurs.EntrepreneursmayalsobemoreabletounderstandVCslogicwhentheyhadpreviousopportunitiestodealwiththem;- In thecaseofaco-investmentbyBAsandVCs,BAsmayhelpreducethecognitivegapbetweenVCsandentrepreneursas theyappear tobein themiddle,sharingcognitivecharacteristicswithboth,andbeingclosetoentrepreneurs(aspeers)aswellastoVCs(asco-investors).According toprevious research,VCsviewBAsactive involvement in thepost-investment phase, and their ability to fill possible competence gaps in the entrepreneurialteam,asmajoradvantagesofco-investing(HarrisonandMason,2000).It should be emphasized that particular entrepreneurs and investors respective mentalfeatures are not static, but can be expected to evolve in a complex process of interaction.Hence,thedifferentactorsspecificexperiencecountsverymuch.ItisthuspossiblethataVC

51


compensatesa lackofpersonalexperienceasanentrepreneur throughhis frequentcontactswith the entrepreneurshe funds.VCs, BAs and entrepreneurs featuring a certain degreeofcognitiveheterogeneityattheoutsetlearnintheprocessofinteraction.WhenVCsandBAscoinvest in the sameventure, theymaybe supposed tomakecomplementarycontributions,due to their heterogenous cognitive resources. It may thus be supposed that, early in theinvestment process, before any formal contracts are put in place, BAs play an especiallystrong cognitive role, inasmuchas theygain intuitiveunderstandingof theentrepreneursproject,beingable to translate theentrepreneurial idea intofinancial language. In fact,BAscangainan intimateunderstandingofbothworlds theentrepreneurialand the financialthroughtheirpersonalexperience.Theycanthusplayahelpfulroleearlyinthefundraisingprocess,helpingtheentrepreneurtoexplainhisventuresintrisicvalueatalowcognitivecosttoprofessionalinvestors,potentiallywillingtocontributefunds.TheVCscognitiveroleandenhancementofperformance,differentinnaturefromtheBAs,canbesupposedtoincreaseat later stagesofventuregrowth. In fact,VCshavebeen reported tocontributemanagerialcapabilities in a mentoring effort leading to a professionalization of functional capabilities(HellmanandPuri,2002).Suchprofessionnalizationisinstrumentalintacklingthechallengesthatarisewhencrossingcertainorganizationalthresholds.Table5summarizes theabovedevelopmentsconcerning the impactof interactionsbetweenentrepreneurs, business angels and venture capitalists on agency costs, cognitive costs andvalueand,hence,onventureperformance.

[table5here]

3.Investortype,governanceandvaluecreationinentrepreneurialventures

Thecombinedframeworkpresentedabovehasseveralempiricalimplicationsfortheprocessofentrepreneurialfinance,therelatedarrangementsintermsofgovernance,andtheirimpactontheperformanceofyounggrowingventurescreatedbyrelativelyinexperiencedfirst-timeentrepreneurs. Knowledge has been shown to be a dynamic construct, and concepts ofcognitive cost and value are consequently highly time dependent. The potential of agencyproblems can also be considered to be time-dependent, in as much as agency costs arepositively related to a firms sizeandcomplexity (Famaand Jensen, 1983).The respectiveroles of BAs and VCs in venture governance and their impact on performance may thusdepend on the stages of venture growth and on the speed with which such growth isaccomplished.Ataveryearlystageinventuregrowth,theentrepreneurstacitknowledgeisoftencrucialforthefirmsfurtherdevelopmentandsuccess.Iftheentrepreneurhasnopreviousexperienceinfoundingaventure,hemayfinditdifficult tofullycommunicatehisperceptionofstrategicopportunitiestoprofessionalinvestors,sincehedoesnotspeakthesamelanguageanddoesnotnecessarilyreasonaccordingtopredictivelogic.Infact,entrepreneurshavebeenfoundtorely heavily on intuition and effectuation. So cognition should be considered as a highlyrelevantvariable in theprocessof raisingequity finance,especiallyataveryearlystageofventuredevelopment.Strongdifferencesincognitivemapsandprocessesbetweenfirst-timeentrepreneurs and professional VCs may hence lead to high cognitive costs, offsetting theventures value creation potential2. Business angels, especially when they are former

2Thecognitivecostsmustofcoursebecompared to thesizeof funds invested.Certainearly stagedealsmay

simplybe toosmall forVCscompared to theabsoluteamountofcognitivecosts (e.g. the total learningeffortthat has to be undertaken to fully understand and value the ventures strategic growth opportunities).Consequently, beyond the availability of capital, cognition may be one possible explanation for why VCs

52


entrepreneursthemselves,canbesupposedtohaveamoreintuitiveandtacitunderstandingofan inexperiencedentrepreneursproject and aspirations,without incurring thehigh costsofextensive formal due diligence. Furthermore, when they share with the founders a similarprofessionalbackground in termsof industrial sector, technological andmarket knowledge,they can appreciate the strategic potential of a young venture at a relatively low cognitivecost.SotheyounggrowingventuremaybeabletoattractBAfundingwithoutthe(cognitive)cost of capital offsetting the ventures value creation potential. Informal direct interactionbetweenBAsandentrepreneursaseventsunfold,maythenallowformentoringtotakeplace,whereBAscan serveasa soundingboard instrategyformulationandmayshare theirownpersonal experience as entrepreneurs. Learning thus potentially creates cognitive value,increasingthechancesofventuresuccess.BAswithstrongentrepreneurialexperienceoftheirownandaneffectualapproachtodoingbusinessareabletocontributecriticalfinancialandknowledgeresourcestoyoungventuresatalowcognitivecost,henceproposition1.

Proposition1:BAshaveaparticularlystrongimpactonventuresuccessandperformanceintheearlystagesofventuregrowth.

As the growth process unfolds, the entrepreneurial firm grows larger and more complex,leadingtoaheightenedpotentialofagencycosts.ProfessionalVCfirmsareknowntohavedeveloped a series of governance mechanisms (formal due diligence, board participation,incentive contracts ...) designed to keep agency costs at a low level. Beyond certainthresholds,amoreformalapproachtogovernanceandacertaindegreeoffinancialdisciplinemay become necessary to attract further growth capital. Furthermore, the nature of theprimary cognitive challenges may change once a fast growing venture crosses certainorganizational thresholds. Indeed,atmoreadvancedstagesof theventureprocess, itcanbesupposedthatentrepreneurslearntobetterexternalizetheirintitiallytacitknowledge(maybewiththehelpofBAs),whichhelpsreducecognitivecosts inrelationshipswithprofessionalinvestors. Whereas specific entrepreneurial capabilities, such as the discovery of strategicopportunities,arecriticalat theveryearly stagesof theventureprocess,certainmanagerialand functional capabilities become a critical resource at the stageof expansion, sometimesreferredtoasafirmsadolescence.Empiricalresearchhasshownventurecapitaliststoassistfirms in theirportfoliowhen itcomes toprofessionalizingmanagerial functions.Thus, asaventure grows more complex, agency costs are raised and coordination becomes moredifficult.Henceventuresuccessmaycruciallyhingeongovernancemechanismswhichkeepacheckonagencycostswhilesimultaneouslyallowingforatransferofmanagerialknow-how.

Proposition2:VCshaveapotentiallystrongimpactonventuresuccessandperformanceatanadvancedstageofventuregrowth(adolescence).

Typically,infastgrowingventuresfoundedbyfirst-timeentrepreneurstheaboveargumentsleadustoexpecttheprocessofentrepreneurialfinancetobesequential,thetypicalsequencebeing(1)fundingfromBAsatrelativelyearlystagesofgrowthand(2)fundingfromVCsatlaterstagesofexpansion(adolescence).Intheprocess,cognitivegovernance(mentoring)andcertificationbyBAscanbeexpectedtopreparethenextstageoffinance.Previousresearchactuallysuggests thatventureshavingreceivedprevious financingfromBAshavefarmorechancestoattractfundsfromVCs(Madilletal.,2005).AlargeproportionofVCsconsiderthatapreviousinvestmentbyBAsenhancesthecredibilityofabusinessandisanindication

typicallyinvestlargeramountsthanBAs.Infact,thelargerthefundsinvested,thelightertherelativeweightofcognitivecostscanbeexpectedtobe.

53


that theentrepreneursarewillingto takeaccountofoutsiderspointsofview(HarrisonandMason, 2000). Thus VCs may interpret the involvement of BAs as the sign of a lowerpotentialneedofmonitoringandasapotentialmeanstobridgethecognitivegap.

Proposition 3: Funding from BAs at an early stage of venture growth increases theprobabilityofsuccessfullyraisingfundsfromVCsatlaterstagesofthegrowthprocess.

In theUK,58%of theVCfundmanagersand36%of theBAssurveyedbyHarrisonandMason(2000)declaretohaveco-investedwiththeothercategoryinatleastoneventure.VCsconsider the main advantage of co-investing with BAs is that they fill gaps in knowledge,expertiseandcontacts (thusprovidingacognitivevalueadded), andBAssay that themainadvantageofco-investingwithVCs is thatVCsprovide steady, systematic and formalduediligence(i.e.providingformalmonitoring).Incertaincases,coinvestmentbyBAsandVCsdoesnotoccursequentiallybuttakesplacesimultaneously.Whenshouldwetypicallyexpectsuch simultaneous coinvestment by BAs and VCs and what is its impact on performance(growth,valuecreation)?Withan increasingnumberofdifferent investors (BAsandVCs),we can predict an increase in the number of potentially conflicting interests and, hence, ahigher potential level of agency costs. On the other hand, BAs alone may have limitedbudgetsandmaybeunabletoprovideallthefundsnecessaryforfirmswithverylargegrowthopportunities.SoVC-financemaybethemoreappropriateanswertohelptheventuregrowfaster thanwhatBAscouldachieve.OnemayhoweverwonderwhyoneorseveralVCsdonot invest alone but alongside BAs. The cognitive approach to governance contains onepossible answer. In fact, it has been shown that VCs typically do not invest at very earlystages in the growth process but at expansion stages when firms already have some trackrecord.Cognitivegapisapossiblecause.Consequently,simultaneouscoinvestmentbyVCsandBAshasadvantagesforveryyoungventureswherethecognitivegapbetweenVCsandentrepreneursispotentiallylarge,butwhereaveryfastpaceofgrowthrapidlyoutgrowsthefinancialcapacityofBAs.Coinvestment thustakesplacewhentheincreaseofagencycostsinducedbythegrowingdispersionoftheownershipstructureissetoffbythecombinedeffectof a reduction of cognitive costs and the value creation potential inherent in growthopportunities with capital needs which exceed BAs budget constraints. Hence, we shouldexpectthefollowing.

Proposition4:CoinvestmentbyBAsandVCshasapositiveimpactonthepaceandspeedofventuregrowth.

Conclusion

This article is intended to contribute to a better understanding of the process ofentrepreneurialfinancefromabehavioralperspective.Wespecificallyexaminethecognitivefeaturesandinteractionofthreekey-actorsinentrepreneurialfinance:entrepreneurs,businessangels and venture capitalists and derive implications for performance (value creation andgrowth)whenayoungventureraisesexternalequitycapital.Twotheoreticalframesagencytheory and the cognitive approach to governance are briefly reviewed as potentialcomplements inexplaining thedynamicsofentrepreneur-investor interactionand its impactonventureperformanceandsuccess.Combiningthetwotheoreticalframesyieldsaseriesofpropositionswhich lend themeselves to subsequent testing.ThesepropositionshelpexplainBAs and VCs respective roles in governance and influence on performance at differentstages of venture growth. Concepts of cognitive cost and value enhance theoretical insightinto why BA and VC intervention is typically sequential.We also predict in what specific

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situationsoneshouldexpectsimultaneouscoinvestmentbyBAsandVCsandhowinvestorscanusecognitiveleverstoinfluencethespeedofgrowth.

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Table1Agencycostsandcognitivecostsinentrepreneur-investorrelations

Agencycosts(JensenandMeckling,1976) CognitivecostsMonitoring aims at reducing informationasymmetry(e.g.throughawellinformedindependentboardofdirectors).

Mentoring aims at the transfer of knowledge andskills frombusinessangelsandVCs toentrepreneursandmayprovidepsychologivcalsupport..Mentoringcan take the form of serving as a sounding board,giving strategic and financial advice, helpingentrepreneurs to acquire new managerial capabilities...Itaimsatreducingknowledgeasymmetry.

Bonding is the activity whereby managers conveycredible(andthuscostly)signalsthattheywillbehaveinaccordancewithexternalshareholdersinterests.

Externalizingtacitknowledge(Nonakaetal.,2001)consists of an entrepreneurs efforts to transform histacitknowledgeintoexplicitknowledgewhichcanbecommunicatedtoandappraisedbyexternalinvestors.The costs of externalization are different frombonding costs. The latters role is to convinceshareholders that the managers interests are alignedwith shareholder interests,whereas externalization ofa partially tacit mindset is aimed at convincing(potential) shareholders of the intrinsic quality ofstrategicprojects.

Residual loss is due to the fact that informationasymmetry can never be completely eliminated andthatinterestalignmentisneverperfect.

Cognitive heterogeneity persists becausemindsets are specific and path-dependent and, thus,neverperfectlyaligned,inspiteofmutualinteraction.Thus, some degree of mutual misunderstanding mayalwayspersist.

AdaptatedfromWirtz(2010)

Table2Stylizedcharacteristicsoffirst-timeentrepreneurs,businessangelsandventurecapitalists

Entrepreneurs Businessangels VenturecapitalistsKnowledgebase

technological,specificindustrialsectorandclientmarket

technological,specificindustrialsectorandclientmarket

financial,variousindustrialsectors(toalesserextent)

Experience formeremployee,entrepreneurial(recent)

entrepreneurial(strong) asaprofessionalVCsometimeswithconsultingorentrepreneurialexperience

Cognitiveprocess

intuititiveeffectual(nonpredictive)

intuitivepredictiveornonpredictive(dependsonBA)

quasi-rationalpredictive(consistentwithaprofessionalinvestmentstyle)

Interests/utility selfachievementgoodwillbuildersremuneration

returnoninvestmentgoodwillbuilderschallenge,fun,gettinginvolved

returnoninvestmentoverapredeterminedhorizon

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Table3Investmentprocessesfeaturingbusinessangelsandventurecapitalists

Businessangels VenturecapitalistsDealsourcing

Sources

Dealflow

PersonalnetworkBAclubs/networksVCreferral

Small

SpontaneousdealflowOtherVCorBAreferralPersonalnetwork

LargeDealscreening

Dealtype

Dealfrequencyanddiversification

Small,earlystage(limitedresources)

Low

Large,expansionstage

High:extensiveresourcespluscontractwithinvestors(timeconstrainttoinvest,minimaldiversification)

Dealevaluation Duediligence

process

Selectioncriteria

InformalandpartialUseintuition,ownjudgment,industryknowledgeUsetrustworthyreferers

Entrepreneur(maincriteria):fit,trust,competenceSector:linkwithexperienceandknowledgeFinancial:IRR,minimizeriskoftotallossChallenge/excitement/funPossibilitytoaddvaluetoventureSocialbenefit(jobscreation)Venturelocation(close)

FormalandextensiveUseownjudgmentandconsultantsCertificationbyBAorotherVC

Entrepreneur:competence,experience,completenessofTMT,similaritySector:partoffundobjectivesBusinessmodelFinancial:maximizeIRR/gain

Dealstructuring ContractsenablingBAtobehandsonaseventsunfoldTightercontractsonexitandgainsharingwhenBAismoreexperiencedTightercontractswhensyndicationwithVC

Pro-activedealmakingContractsenablinginformation,monitoring,exitcontrol,gainsharingContractsusedasprotectiontoperceivedagencyproblems

Post-investment OfferinghelpCloseinteractionswithmanagementBringsentrepreneurialexperienceFillscompetencegapinTMTPreparationandaccreditationforVCinvestmentinlaterstageBeinghandsonreducesnegativeexitsExittimingisnotakeyissue

CheckinguponyouInfluenceandcontrolonmanagementActiveinshapingstrategy/businessmodelBringsfinancialexperienceMayinitiatechangesinTMTtofillgapsExittimingisessential(contractwithinvestors)

Sources:BoekerandWiltbank(2005);Farrel(1998);Fiet(1995);KaplanandStrmberg(2004);KellyandHay(2003);Landstrm(1992);MasonandHarrison (2002);VanOsnabrugge (2000);Wiltbank(2005);Wrightetal.(1998).

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Table4Agencyrisksandgovernancemechanismsusedbyventurecapitalists

Agencyrisk GovernancemechanismInvestordoesnotknowentrepreneurquality/ability(adverseselectionproblem;increasesifentrepreneurhaslimitedexperience)

DuediligenceonmanagementCompensationdependantonperformance(goodentrepreneurswillbemorewillingtoaccept)StagedfundingLiquidationclaimsandanti-dilutionprovisionsCertificationbybusinessangel

Entrepreneurmaynotworkhardenoughtocreatevalueinthepost-investmentphase

ActivemonitoringCompensationdependantonperformanceStagedfunding

ConflictbetweenVCandentrepreneurinthepost-investmentphase

ContractgivingboardcontroltoVCForcedexitclause(becauseexittimingiskeyforVC)

Holdupbyentrepreneur(threatenstoleave) VestingentrepreneurssharesNoncompetecontracts

MainlyfromKaplanandStrmberg(2004);plusBarneyetal.(1994),Madilletal.(2005).

Table5Relationshipsbetweenentrepreneursandinvestor-typesandtheirsupposedimpactonagencycost,cognitivecostandvalue

Entrepreneurs Businessangels VenturecapitalistsAgencytheory

Potentialconflictofinterestsandagencycosts

- Increases as the founders relative ownership stakedecreases (Jensen and Meckling, 1976; Bitler et al.,2006)

- Increaseswiththenumberofdifferentinvestors- Depends on investors typical incentive and control

mecanisms (Baker and Wruck, 1989; Jensen, 1993):BAs monitoring relies on strong involvement ex-postwhereas VCs monitoring is more formal and ex ante(contracts) (Kelly and Hay, 2003; Van Osnabrugge,2000)

Cognitiveapproach toentrepreneur-investorrelations

Potentialcognitivecost

Moderate(becauseofmutuallyconsistententrepreneurialattitudeandcognition;Murneiksetal.,2007)

Moderate(becauseofBAspriorentrepreneurialexperienceandtrackrecord)

- Potentiallyhighattheoutset(pre-money)foryoungandunexperiencedVC(whorequirestrackrecord),may

decreaseintheprocessofmutualinteraction- LowerforexperiencedVC(butstillhigherthanforBA)

Potentialcognitivevalue

Transferofentrepreneurialexperience,fillingcompetencegapsinmanagementteam

TransferofsectorknowledgebyBA(HarrisonandMason,2000)

Potentialprofessionalizationofmanagerialcapabilities(increaseswithVCexperience,Gompersetal.,2006)

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0.2 Inside Pages1. BerylChang2. Maymin Metanoia3. Bonnet and Wirtz4. Glackin5. Fredrickson6.1. Call 2011.ABF6.2. ABF Groups6.3. Call 2011.AEF6.4. Yazdipour-Advances6.5. Yazdipour-Advances

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