Excerpt
Contents
LIST OF FIGURES
LIST OF TABLES
LIST OF ABBREVIATIONS
PART I
CHAPTER 1: INTRODUCTION
1.1 Context and Relevance
1.2 Objective of the Study
PART II
CHAPTER 2: THE INNOVATION PROCESS
2.1 Entrepreneurship and the Diffusion of Innovation
2.2 Systems Model of Innovation by Csikszentmihalyi
2.3 Investors in Innovation and Risk-Taking
2.4 The Venture Capital Business
2.5 Critical Summary and Conclusions
CHAPTER 3: STRATEGY DIMENSION
3.1 Strategic Considerations of Venture Capitalists
3.2 Strategic Resources Approaches
3.2.1 Sustainable Competitive Advantage
3.2.2 Resource Dependence Approach
3.3 Sustainable Resource Management
3.4 Paradox Management
3.5 Critical Summary and Conclusions
CHAPTER 4: THE TRUST PERSPECTIVE
4.1 Trust as a Concept
4.2 Models of Trust-Building
4.3 Trust-Control Duality
4.4 Levels of Trust
4.5 Critical Summary and Conclusions
PART III
CHAPTER 5: DEVELOPMENT OF A FRAMEWORK
5.1 Venture Capitalists as Gatekeepers
5.1.1 The Innovative Entrepreneur
5.1.2 The Leapfrog Concept of Innovations
5.1.3 Gatekeeper Mechanism
5.1.4 Value Creation of Innovation
5.1.5 Critical Summary and Conclusions
5.2 The Sustainability Dimension
5.2.1 Relationship between Shareholders and Entrepreneurs
5.2.2 Direct Survival Resources
5.2.3 Stakeholder Management
5.2.4 Indirect Survival Resources
5.2.5 Sustainability Circuit
5.2.6 Critical Summary and Conclusions
5.3 Trust-Control Balance
5.3.1 The Trust-Building Process
5.3.2 Active Trust
5.3.3 Shared Visions
5.3.4 Critical Summary and Conclusions
CHAPTER 6: THE GATEKEEPER-MODEL AS AN INTEGRATIVE FRAME- WORK FOR ENTREPRENEURS AND VENTURE CAPITALISTS
6.1 An Integrative Framework
6.2 Summary of the Implications of the Integrative Framework for Entrepreneurs and Venture Capitalists
6.2.1 Entrepreneurs
6.2.2 Venture Capitalists
6.3 Concluding Remarks
BIBLIOGRAPHY
LIST OF FIGURES
Figure 1.1: Overview of the study
Figure 2.1: Systems Model of Innovation
Figure 2.2: Financing Sequence
Figure 5.1: Circularity
Figure 5.2: Leapfrog Concept of Innovations
Figure 5.3: Gatekeeper Mechanism
Figure 5.4: Resource Allocation Opportunities
Figure 5.5: Sustainability Circuit
Figure 6.1: Venture Capitalist-Entrepreneur Relationship
Figure 6.2: Shareholder-Entrepreneur Relationship
Figure 6.3: Integrative Gatekeeper-Model
LIST OF TABLES
Table 2.1: Risks of Venture Capital Funding
Table 2.2: Venture Capital Investment Process
Table 5.1: Contrary Interests
LIST OF ABBREVIATIONS
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1. INTRODUCTION
1.1 Context and Relevance
“You can run fast alone, or run far together.” -- African Proverb
“The tourists have left. […] Young entrepreneurs who thought they could get rich quickly with just a good idea are now gone and those now left standing recognize the challenges and tenacity needed to establish and build a sustainable business” (Heesen, 2009, p. 4). Venture capital is a dynamic industry which has been constantly subject to changing developments and conditions. Over the last decade, entrepreneurs viewed venture capital as an easy source of funding, but a changing economic landscape and a couple of down cycles led to a consolidation of this industry. Florida and Kenney (1988) argue that venture capitalists act as catalysts or “technological gatekeepers” who facilitate and accelerate innovations. They propose a new model which presents a third path to Joseph Schumpeterʹs dichotomy of entrepreneurial versus corporate innovations: “Venture capital-financed innovation overcomes financial, technological and organizational barriers which characterize both entrepreneurial and corporate-based innovation” (Florida and Kenney, 1988, p. 120).
Over the last decades, venture capital has evolved as a special group of financial intermediaries to actively invest in new, unproven business concepts which are disregarded by traditional financial institutions. This group of financial intermediaries occurs within the context of what Schumpeter calls ʺradical innovationsʺ. They are “agents of innovation, performing a technological gatekeeping function” (Florida and Kenney, 1988, p. 135) and “intervening to help create new companies and actualize important breakthroughs” (p. 128). Despite their immense economical impact1 on innovations and funding of well-known high-technology companies such as Apple Computer, Intel, Facebook, Google, and Microsoft over the last decades, viewing the venture capitalist as a gatekeeper has not been pursued or further developed by Florida and Kenney or other scholars.
Radical innovations and technological revolutions substantially change the marketplace, set new standards and create novel ways of how people and businesses interact. These changes are commonly initiated by high-tech entrepreneurs with a novel business idea or concept. If venture capitalists are considered as gatekeepers, their criteria and screening processes become relatively significant to the emergence of breakthrough technologies within an economy. Muzyka et al. (1996) identified up to 35 different criteria that venture capitalists use to select the right candidates. They are categorized into decision criteria such as entrepreneur and management team, product and services, market and industry, and financial criteria. Manigart and Sapienza (2000) found that the most important criterion is the entrepreneur and the management team: “[…] the most important criterion is human capital, especially the judged ability and character of the entrepreneur and the entrepreneurial team. This criterion is typically followed in rankings by market and product characteristics and expected financial outcomes” (p. 245).
Nevertheless, it is important to point out that because venture capitalists operate in highly complex environments, they do not always make the most rational decisions. They are also partly restricted by bounded rationality . The intertwined process of decision- making create trade-offs between the different criteria that sometimes lead to opportunistic investment behavior (Muzyka et al., 1996). Shepherd and Zacharakis (1999) challenge the concept that venture capitalists have thoroughly understood their decision- making process: “VCs have a tendency to overstate the least important criteria and understate the most important criteria compared to their ‘in use’ decision policy” (Shepherd, 1999, p. 76; emphasis in original). Overconfidence in the venture capitalists’ judgment may have a negative influence on their decision-making (Zacharakis and Shepherd, 2001, p. 328): “[…] VC overconfidence will likely lead to a reduced information search, decreased motivation to self-improvement, and the funding of inappropriate venture”. Hisrich and Jankowicz (1990) observe that experienced venture capitalists make their decisions based on their gut feelings .
The lack of understanding of their own decision and selection process may be partly due to a missing conceptual framework of scholars and practitioners. With the “systems model” by Csikszentmihalyi (1996) – a result of his in-depth study on creativity – a progress of closing that gap can be made and is undertaken in this study. Understanding the key role of certain experts or “gatekeepers” in any system (called “domain”; Csikszentmihalyi, 1996, p. 27) facilitates greater transparency in the process of how a new idea becomes a relevant innovation. Thus, picking up on the idea of Florida and Kenney (1988) that view the venture capitalist as a gatekeeper makes it possible to re-frame venture capital concepts within the innovation process.
Reviewing the current literature and considering a changing industry that is subject to cyclicality of available capital and investment opportunities, it is necessary to update the perspective on current approaches and frameworks of venture capital within the innovation process. Strategic considerations and long-term planning have barely been observed by venture capital scholars and are in need of further research. In a changing industry making the short- and long-term tensions of the investment process and the relationship with entrepreneurs more transparent may not only benefit the venture capitalist in addressing current and future challenges, but also helps the entrepreneur to gain a better understanding of the decision process of the venture capitalist.
In the venture capital literature, the relationship of venture capitalists and entrepreneurs is considered from a principal-agent perspective where the relationship is solely reduced to single-sided control mechanisms ensuring that the entrepreneur behaves desirably. In practice, however, elements beyond pure control instruments of venture capital firms can be detected. As a New Yorker venture capitalist put it on his blog: “Like a marriage, a venture investment is a long term relationship.[…] Tolerance is critical to a successful long term relationship [and it is] absolutely critical to get those relationships right and sustain them for the long haul” (Wilson, 2009; accessed 11.11.2009). Evidently, scholars need to integrate a perspective that complements the control bias of venture capital research which is conceptualized in this study as trust.
However, based on the complexity of factors influencing the emergence of innovations, an integrative framework is needed to show how entrepreneurs win venture capitalists and how both parties create fruitful relationships in the long-run.
1.2 Objective of the Study
The objective of this thesis is to create a better understanding of the factors orientated along a self-developed gatekeeper-model that influence the decision criteria and the relationship between entrepreneurs and venture capitalists within the innovation process.
Therefore the thesis at hand is divided into three parts in which Part I (Chapter 1) introduces the context and relevance and the objective of this study, Part II (Chapters 2, 3, and 4) presents the main concepts and builds a theoretical fundament for understanding the complexity of this issue, and Part III (Chapters 5 and 6) applies and integrates the preceding theoretical findings and develops an integrative framework based on the objective of this thesis (for an overview of the structure see Fig. 1.1).
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Fig. 1.1 Overview of the study Source : compiled by the author
The current theoretical fundaments in combination with concepts applied in this study are necessary to build a theoretical framework for the venture capital-entrepreneur relationship (Part II). Chapter 2, “The Innovation Process”, deals with the aspects of entrepreneurs as a pivot for the diffusion of innovations. Subsequently, the “Systems Model” by Mihalyi Csikszentmihalyi is presented which builds the theoretical fundament for the gatekeeper-model. As a special intermediary the venture capitalist fills this gatekeeper position. The innovation process is not isolated from the socio-economic context; rather it is a process which takes place in the interaction of actors embedded in an environment. Thus, in Chapter 3 “Strategy Dimension”, strategic decision-making and a sustainability dimension are connected to venture capital research. Conceptualizing trust as an economic function adds to the dominating control perspective in venture capital research which is presented in Chapter 4 “The Trust Perspective”.
Part III develops an integrative framework for venture capitalists as gatekeepers for innovations. Chapter 5 is subdivided into three sections that build up on the findings of Part II. Section 5.1 analyzes the particular modules of the “systems model” and applies it to the innovation process. Venture capitalists depend on numerous variables that need to be considered in the decision-process of funding entrepreneurs which is depicted in Section 5.2. In Section 5.3, it is illustrated that in the relationship of entrepreneurs and venture capitalists, they need to develop “shared visions” as a trusting element that binds both parties in the long-term. Chapter 6 summarizes the previous chapter and develops an integrative framework of entrepreneurs and venture capitalists. While Section 6.1 describes the different layers of the integrative framework, Section 6.2 offers recommendations for each party based on the findings of this study.
PART II
2. THE INNOVATION PROCESS
2.1 Entrepreneurship and the Diffusion of Innovation
Entrepreneurship can be characterized as a process which is performed by someone who discovers, creates, and exploits opportunities to introduce future goods and services (Venkataraman, 1997). Research of entrepreneurship can be characterized by its multidisciplinary approach. Low and MacMillan (1988) refer to the multifaceted topic and state that “[the] phenomenon of entrepreneurship is intertwined with a complex set of contiguous and overlapping constructs such as management of change, innovation, technological and environmental turbulence, new product development, small business management, individualism, and industry evolution” (p. 141; added by the author). This diversity of thoughts makes it difficult to form a uniform definition of entrepreneurship and attribute what makes the entrepreneur so unique.
As Schumpeter (1939) suggests, being an entrepreneur is neither a profession, nor a lasting condition. Thus, it makes sense to approach the entrepreneur and entrepreneurship from the historical development of the term. Over the last three centuries, the term entrepreneur has fluctuated between being irrelevant (for neoclassic economics) and playing an essential role in economic development.
Hébert and Link (1989) contributed to the analysis of entrepreneurship in history by marking out the different periods that evolved over time. Richard Cantillon (1680-1734) was the first person to coin the term “entrepreneur” in an economical context. In the course of time different notions of entrepreneurship have emerged ranging from an uncertainty-bearer (Cantillon2, Knight2) who has to sell his goods at uncertain prices, a coordinator (Say2, Marshall2) who coordinates the production process, an arbitrageur (Kirzner2, von Hayek2) who perceives profit opportunities and tries to act upon them, to the innovator (Schumpeter ; see also Faltin, 2001) who takes an invention or an idea to exploit it commercially (see Hébert and Link, 1989). Over the course of the neoclassical period the term entrepreneur almost faded away from economic theory. The assumptions of the homo economicus and complete market led to a sole optimization problem which can be solved mathematically. In a complete market, an entrepreneur becomes redundant in regards to the predictability of the future and economic growth.
In the long-run, economic growth is driven by technological changes and innovation. Paul Romer has developed a theory that states that the accumulation of technological knowledge creates economic growth. Higher investments made in knowledge and human capital generate more productive outputs, but also indirectly creates spillovers of knowledge. The accumulation and spillovers of knowledge are the factors that endogenously lead to economic growth and prosperity. This endogenous growth model (Romer, 1990) assumes more realistically the basis for economic progress, where neoclassical theory proposes an equilibrium – a complete market.
Kenneth Arrow (1962) points out that knowledge differs from traditional factors of production (such as physical capital and unskilled labor) that result in a gap between general knowledge and what he termed economic knowledge. In his view, knowledge is a public good that is non-rival and non-excludable. The endogenous growth model (Romer, 1990) assumes these characteristics implying that technological knowledge automatically spills over. In practice, agents value available knowledge differently and decide differently. Romer’s (1990) theory fails to answer the question of how to differentiate useless from valuable knowledge and what is the driving force behind the separation (Acs, 2006). Acs and Varga (2005) argue that this gap opens up for the role of entrepreneurs within an economy and identify them as “knowledge filter”. Thus, the entrepreneur embodies this filter system by his or her thinking, decision-making and acting.
The Knowledge Spillover Theory of Entrepreneurship (Acs et al., 2004) provides a valuable understanding of the filter mechanisms and how entrepreneurs close the gap between spillovers and economic growth. The theory consists of two filters stressing on the importance of the first, the entrepreneur as the knowledge filter, and the institutional environment as the second filter.
Research labs and Research and Development (R&D) by incumbent firms create a wide and diverse range of general knowledge. It is suggested that general knowledge is not the same as economic knowledge and that new knowledge does not automatically result in spillovers as the endogenous growth model assumes. The knowledge filter is a mechanism that prevents knowledge spillovers from transforming into economically useful knowledge (Acs et al., 2009). This gap between general knowledge and economic knowledge imposes a lower rate of knowledge spillovers.
The production of new knowledge creates entrepreneurial opportunities. Recently, scholars have shifted their research focus in entrepreneurship from cultural and psychological traits (i.e. identifying those people in society who prefer to become entrepreneurs) towards the individual-opportunity nexus (Shane and Venkataraman, 2000). It is problematic to simply base entrepreneurship on the characteristics of agents. Thus, Eckhardt and Shane (2003) emphasize that the nexus of valuable opportunity and enterprising individuals is crucial in understanding economic growth. It is important to point out, however, that new knowledge is neither equally distributed within and between societies nor does it evolve in “neat packages”, rather it has to be discovered and then packaged (Acs, 2006). The process of knowledge spillover is a process of discovery where knowledge is a non-rival good (Acs and Varga, 2005). The two main sources of opportunity discovery are academic (carried out in universities and research institutes) and industrial (carried out in R&D departments in industrial firms or governmental laboratories) (Acs et al., 2004). While entrepreneurship is a mechanism that exploits knowledge spillover, it is irrelevant whether the entrepreneur is also the individual who discovers this opportunity (i.e. the entrepreneur does not have to be the inventor as well).
The Knowledge Spillover Theory of Entrepreneurship helps to understand the emergence and function of entrepreneurs by explaining the incentives for the discovery and exploitation of opportunities. Incumbents that are not exploiting technological opportunities efficiently leave space for the prospective entrepreneur to exploit it in the context of a new venture.
For the discovery of opportunities, Michael Polanyi (1958, 1967) made an important distinction between codified and tacit knowledge. Codified knowledge is defined as knowledge that is possible to record or transmit in symbols or manifested in some type of form. In comparison, tacit knowledge is that which cannot easily be captured in a transferable form, but is acquired through observation or interaction, what Arrow (1962) calls “learning-by-doing”. This has implications for the exploitation of technological opportunities where the transmission of tacit knowledge is bounded to spatial proximity.
The second filter mechanism is conceptualized in the entrepreneurship literature primarily as the institutional environment, i.e. regulations, financing and bureaucratic constraints (Acs et al., 2004; Acs et al., 2009). Knowledge spillover and entrepreneurship are crucial for economic growth. However, the Knowledge Spillover Theory of Entrepreneurship still leaves a gap of understanding between technological change and the emergence of innovation.
Acs (2006) views the role of entrepreneurs as individuals who identify opportunities and then go on to exploit them. They are constantly searching for opportunities, characterized by alertness, prior knowledge, and have a wide social network. Schumpeter distinguishes between the economic player, the initiator, and the imitator. In his view, imitators are relevant for the diffusion of technological knowledge and the innovation itself. An imitator is defined as someone who copies the innovation in the same market as a competitor and spreads it across the economy. The entrepreneur is the initiator of the innovation while the imitator accounts for the macroeconomic ascertainable impact within an economy. Thus, growth processes and a changing economic structure depend on both, the initiator who introduces the innovation to the market and the imitator who pushes the diffusion of the innovation. Other theorists such as Kirzner view the imitator as the key element in instigating change in the marketplace. Baumol (1993) argues in the line of Schumpeter and ascribes the innovating entrepreneur the pivotal element of economic growth and progress in productivity. A faster changing economy with shorter product cycles ought to devote more attention to the entrepreneur who holds an important function within a highly information and knowledge-orientated economy and is responsible for transforming existing knowledge into innovative goods and services.
Joseph Schumpeter (1939, 1942) argues that innovations are the cornerstone of economic development leading to an inseparable combination of short-term instability and long- term growth. For economic reasons, there has to be a distinction made between an invention and an innovation. Invention is the first occurrence of an idea of a new product or process, while innovation is the first successful step to carry it out into practice. This transformation requires combining several different types of knowledge, skills, and resources. The impact of the innovation varies widely. Schumpeter characterizes the continuous improvement of an existing technology as “incremental” or “marginal” innovation, as opposed to the “radical” innovation (i.e. an introduction of a totally new form) or “technological revolution” (i.e. clustering of several innovations that combined have profound impact on the economy). In his view, radical innovations constitute what he calls creative destruction and ascribes them more importance to economic progress. For him it is one of the basic functions of capitalism. The emergence of innovations in an economy oscillates between radical changes followed by incremental innovations. However, marginal improvements build the foundation for the next technological revolution and one might argue that the cumulative impact of incremental innovation is as great, if not greater than disruptive innovations.
Radical innovations and technological revolutions are mostly pursed by entrepreneurs with the vision and perseverance for their venture. In his earlier work, Schumpeter states that entrepreneurship is a mechanism through which changes in the system create radical innovation and entrepreneurs are the agents of “creative destruction” (Schumpeter, 1939; Mark I). Later he shifted his position and argued that large firms, rather than small firms are more proportionally innovative (Schumpeter, 1942; Mark II). However, empirical research over the last 30 years suggests that young and entrepreneurial firms have a greater advantage in innovation (see Acs and Audretsch, 1990).
“[The entrepreneur is] someone who specializes in taking responsibility for and making judgmental decisions that affect the location, the form, and the use of goods, resources, or institutions” (Hébert and Link, 1989, p. 155; added by the author). The emergence of novelty is often facilitated in niches where opportunities and lack of institutional constraints enable a more preferable result that might lead to an architectural change that will enable full realization of potential (Nooteboom, 2000). New ventures that are created by entrepreneurs who exploit opportunities in a fertile environment increase the “[c]hances for both short-term survival and long-term success” (Chea, 2009, p. 37; adapted by the author). Acs and Audretsch (1990) note that small firms are more conducive to create this kind of environment, because decisions to innovate are made by relatively few people and innovative activity may flourish the most in environments with less constraints. It seems that entrepreneurial entrant firms have greater flexibility and are able to identify protected market niches that are too small for larger corporations (see Chen and Hambrick, 1995). Moreover, incumbents often fail to spot market opportunities and lack innovativeness, not only in entering new markets but also when creating innovative products and services (Berchicci and Tucci, 2006). Timmons (1999, p. 29) shows that since World War II 95 percent of all radical innovations came out of the formations of new businesses. Wyatt (1985; quoted in Nooteboom, 2000) conducted a study based on the data of the Science Policy Research Unit (SPRU) in Brighton and found that the relative innovative efficiency (innovative output divided by innovative input) of small firms is much higher than in larger firms. Small firms seem to have an advantage when it comes to a higher average rate of innovation (see Acs and Audretsch, 1990).
2.2 Systems Model of Innovation by Csikszentmihalyi
Innovation requires human creativity that is essential for economic progress in particular and welfare in general. In “The Rise of the Creative Class”, Richard Florida (2002) talks about the Creative Age and elaborates on the notion of creativity as extracting or discovering novel and useful forms of knowledge. Yet, individual ingenuity is not sufficient enough to specify the characteristics of innovation; it also requires a complex process of exchange relations. A novel concept does not automatically translate into an innovation. Only if others recognize and adopt the novel idea can creativity retain a useful meaning, and thus become a product of a social system.
In his systems model Mihaly Csikszentmihalyi argues that creative ideas would disappear without an audience that assesses and acknowledges them. Csikszentmihalyi (1996) defines creativity (and innovation) “[as] any act, idea, or product that changes an existing domain, or that transforms an existing domain into a new one… [and] that domain cannot be changed without the explicit or implicit consent of a field responsible for it” (p. 28; added by the author). This framework integrates the complex interactions of different actors. According to Csikszentmihalyi (1996) creativity evolves from the interaction of three core elements that define a system: A “domain” containing symbolic rules and a certain structure, an “individual” who brings a novelty into a certain domain, and a “field of experts” that recognize or reject the novelty. The field of experts includes all actors that act as filters to help avoid information overload, which would otherwise dissolve, by choosing relevant inputs that may lead to an innovation in the domain.
Attention is scarce and creativity requires places where there is abundance of societal and individual attention; where it allows individuals to learn and to experiment beyond their immediate needs. The existing structure imposes constraints on the potential of novel elements in order to preserve the functioning of the existing system (see Nooteboom, 2000). Commonly, most novel ideas or concepts do not survive and will be quickly forgotten. The group entitled to make decisions on what should and should not be included in the domain inherits a gatekeeper -function that results out of their position in the system. For instance, in the case of Albert Einstein only a few leading university professors were enough to certify that his ideas were truly creative. The judgments of this small group of experts convinced people around the world that Einstein made a breakthrough with his theory. In another example, Csikszentmihalyi (1996) uses the domain of modern art to demonstrate that the gallery owner and not the painting itself, sets the standard for what constitutes creativity in society.
Figure 2.1 illustrates the process an individual has to go through in order to bring a novel idea into the domain. This mechanism varies widely from quite formal gate-keeping (e.g. official review process in scientific journals) to highly informal gate-keeping (e.g. early adopters).
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Fig. 2.1 Systems Model of Innovation
Source : compiled by the author based on Csikszentmihalyi (1996)
Most of the actors try to preserve the status quo in the domain and only a few others actually work on innovative advancement in order to keep the domain competitive in comparison to others. Experts have a deeply rooted interest in an attractive domain because of all the tangible and intangible benefits that evolve from their position within the field. The riskier the invention is, the more cautious the experts are as they do not want to be associated with failure.
Centers of different cultures and lifestyles seem to nurture creativity where the space for new combinations of ideas and alternative ways of thinking exists. Florida (2002) describes the social environment where creativity flourishes as “one that is stable enough to allow continuity of effort, yet diverse and broad-minded enough to nourish creativity in all its subversive forms” (p. 35).
Over time more specialized domains, so-called sub-domains, have evolved through the accumulation of new information and knowledge. Domains are embedded in the socio- cultural context which help or hinder innovation based on the clarity of structure, the centrality within the culture, and accessibility (Csikszentmihalyi, 1996). Most cultures prove to be conservative and reject the majority of the produced novelties thus guaranteeing only a small percentage of the innovations will ever arrive in the market. The field of experts can actively affect the rate of innovations (created by creativity) in three different ways.
- Experts are either reactive or proactive towards the novelty or invention. These experts can stimulate creative actors in their ideas to increase the rate of innovations.
- The field applies either a narrow or a broad filter in selecting attractive novelties. The field decides how many ideas they allow to enter the domain at any given time, which at the extreme determines if the domain will face overload or is underserved by innovations.
- The field of experts can also support the novelty by leveraging their network through connecting the creative individual with crucial players (other experts) in the social system.
The gatekeepers who are embedded in a socio-cultural and economic environment decide if an invention becomes an innovation or not. Once the field of experts has accepted the innovation, the new “cultural meme” (Csikszentmihalyi, 1993; Dawkins, 2006) replaces the old ones and will be maintained from now on and preserved by the gatekeepers. Innovations can take place at the macroeconomic level as well as on the organizational level of society. Although both levels are an important part of economical change the work at hand focuses only on the economical level. The organizational level is about the process within large firms which have complex internal structures – that imply their own ecosystem. This would be rather an interesting research field for intrapreneurship (entrepreneurs within a corporation).
2.3 Investors in Innovation and Risk-Taking
All novelty involves some degree of risk which means that innovation is a form of risk- taking. Entrepreneurs mostly lack sufficient capital to bring their idea to fruition and must rely on outside financiers. However, those financial entities that control the bulk of money are unlikely to have the time or expertise to invest in high-tech start-ups. Audretsch (2002) found that, on the one hand, birth rates and growth rates of small firms exceed large firms, especially for those which are technology-orientated. On the other hand, the death rates for small firms are higher than for large firms, in particular the ones with a technology orientation. Innovative entrepreneurs usually have high capital needs, characterized by the fact that they need long-term investment financing for the growth of the company. The next rounds of funding of the company are crucial and constitute growth barriers for most of the start-ups which often result in the omission of the entrepreneurial opportunity. Therefore, external financiers represent an important interface of the implementation of innovations in an economy. While some entrepreneurs can use debt, such as bank loans as a traditional form of financing, others are limited to access equity capital because of four critical factors (Gompers and Lerner, 2004, p. 157):
- uncertainty,
- the nature of firm assets,
- asymmetric information,
- the conditions in the relevant market.
Especially, the early-stage of an innovative start-up company is marked with uncertainty. The product or service offered may or may not succeed because of an unproven business model, an unexplored niche market, or a novel technology. Young companies usually find it difficult to obtain debt financing because of the nature of their firm assets. Firms with tangible assets – for instance, machines, buildings, or other physical assets – may find it easier to finance their projects than start-ups which must rely mostly on intangible assets. Asymmetric information creates an advantage to an entrepreneur over an investor. While the entrepreneur manages the day-to-day business, an investor knows less about the entrepreneurs’ intention to exploit or act favorably on agreed terms. If these information asymmetries could be eliminated, debt or equity financing would be neutral. Providers of capital are aware of these agency problems and, as a result, outside investors demand a higher rate of return for their share.
The last critical factor of raising high-risk capital is varying market conditions. Especially, high-tech start-ups face a range of quickly changing conditions – for example, increasing intensity of competition or undiscovered consumer behavior.
These critical factors make it difficult for high-tech entrepreneurs to finance their business ideas through bank loans, so that they have to rely mostly on bootstrapping or equity investments. Private equity as an alternative asset class includes growth capital, leveraged buyouts, mezzanine, and angel investment as well as venture capital. The group of business angels and venture capitalists focus on early-stage ventures, while the others finance transformational or restructuring events of non-publicly traded companies. Most entrepreneurs start their venture by bootstrapping, i.e., self-financing out of savings, but the combination of fast growth and high risk leads them to raise additional money. Even if the bulk of entrepreneurs may prefer to self-finance their businesses or rely on debt financing in order to retain control of the company, this is not always possible or in some cases not advisable. Bootstrapping is more cost intensive and it takes longer to raise the needed amount. Nonetheless, Bhidé (2000) that only 5 percent of Inc. 500 companies in 1989 in the United States began with venture capital funding, while 80 percent bootstrapped from other sources. It is assumed that entrepreneurs have no own wealth and must rely on an outside investor to fund their project. Moreover, because they often lack experience in commercial matters, they do not only seek capital but also strategic business advice.
Start-up companies require significant up-front expenditures for their ventures (i.e. prototype development, business infrastructure etc.). From an investor’s point of view, the financing sequences is illustrated in Figure 2.2, which is an adaption of the “developmental funnel” commonly used in new product innovation management (Wheelwright and Clark, 1992, pp. 111-132).
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Fig. 2.2 Financing Sequence
Source : adapted and extended from Wheelwright and Clark (1992, pp. 111-132) and Callahan and Muegge (2004)
Many business opportunities enter the funnel and over time the amount of actual funded ideas shrink down to only a few. Venture opportunities arrive at the “fuzzy front end” pursued by the entrepreneur and the entrepreneurial team. The progress of the ventures depends on the attainment of required milestones that are also requested by outside financiers. These milestones may include having a business plan, developing a prototype, making a first sale, and becoming a positive cash flow. At each stage, portions of these opportunities fail. Gupta and Sapienza (1992, p. 349) see an advantage in venture capital compared to big institutional investors (e.g. pension funds) and outline how it creates value. First, it is an interface bringing investors and entrepreneurs efficiently together. Second, venture capitalists can make a more subtle investment decision in comparison to ordinary investors. Third, they add value to the start-up.
2.4 The Venture Capital Business
The investment of venture capital provides funds to entrepreneurs. Even if today’s venture capital industry is fairly new, early observations of financing entrepreneurs by individuals and organizations can be dated back in history to Babylon (Coopey, 2005). The first modern venture capital firm, American Research and Development (ARD), was established in 1946 by local business leaders in order to commercialize technologies developed at MIT. During the late 1970s and early 1980s, the funds inflow into the venture capital market increased dramatically because of regulatory and policy changes (Gompers and Lerner, 2004) that paved the way for the development towards an important financial intermediary for innovative and high-risk firms. Venture capital became an important part of capital market in the United States and in the early 1990s in Europe as well. The capital inflows in the United States rose from $3 billion in 1990 to $103 billion in 2000 (Woodward and Hall, 2004). In 2003, companies that were backed by venture capital accounted for 9.4 percent of the private sector labor force in the United States, and generated $1.8 trillion in sales, or 9.6 percent of all business sales (Shane, 2008). Even if the venture capital industry has a huge impact on the economy, the number of firms is only around a few thousand. The distribution of venture capital investment in the United States is highly concentrated; around 80 percent of all these investments are made within 15 metropolitan areas (Zook, 2005, p. 57). Well-known high-technology companies like Apple Computer, Intel, Facebook, Google, and Microsoft have been backed by venture capitalists over the last decades.
The formal venture capital market can be categorized into incubators, corporate venture capital, government supported venture capital, and independent venture capitalists, which this study focuses on. Usually venture capitalists possess entrepreneurial experience, managerial expertise, and detailed industry knowledge. Venture capital can be defined as a company, which is independently managed with dedicated pools of capital that focus on equity or equity-linked investments in young privately held, high- growth companies for the primary purpose of capital gain (see Gompers and Lerner, 2004). The size of a venture capital firm varies from a few employees to larger ones with 50 to 100 employees.
Venture capitalists concentrate their activities on entrepreneurs in businesses with high growth potential in hopes of achieving a high rate of return on invested funds (Timmons, 1999). Venture capital literature argues that venture capitalists rarely invest outside the two main sectors of information technology (such as computers, telecommunication or semiconductors) and life sciences (mainly biotechnology, medical instruments and medical services), but in practice venture capital firms diversify their investments. For many entrepreneurs venture capital financing is an attractive source of funding ( informed capital : financial as well as knowledge and network input), but not every start-up should request venture capital because of the business model does not the meet the venture capitalists’ requirements.
The venture capitalists’ investments in businesses with a high risk-reward ratio bear uncertainty towards the entrepreneur as well as the industry. Firms that usually receive venture funding have substantial intangible assets which are difficult to value, the markets on which they operate are highly variable, and the relationship between investor and investee is characterized by information asymmetries. Table 2.1 shows a compilation of the various risks venture capitalists are faced with.
Tab. 2.1 Risks of Venture Capital Funding
Abbildung in dieser Leseprobe nicht enthalten
Source : compiled by the author
Scholars have conducted in-depth studies on the different tools employed by venture capitalists to mitigate the problems. These include screening methods; due diligence; active monitoring (Hellmann, 1998) of internal (e.g. management team quality), external (e.g. market size) and complexity risk (e.g. technology innovation); staging financing (Bergemann and Hege, 1998); investment syndication (Admati and Pfleiderer, 1994); and compensation contracts (Kaplan and Strömberg, 2003) to reduce the possibility of failure in an uncertain environment.
The venture capitalist faces the trade-off of spreading the risk by diversifying or the specialization of the investments in the portfolio. Some firms channel their investments into only one sector; others have more resources and capabilities and are able to diversify their investments. The diversity of investment opportunities and changing economic structures has created a broad heterogeneity of venture capital firms over time. However, within the venture capital industry a certain type of investment process has evolved that can be generalized. The venture capital process involves the raising of the venture capital funds, making investments, proceeding with monitoring and adding value to the firms, and finally, the venture capitalist exits successful deals and returns capital to the end- investor. Each venture capitalist has its own individual recipe of successes . However, Table
2.2 outlines the main seven stages of the venture capital investment process (Bygrave and Timmons, 1992, p. 14; Sweeting, 1991, p. 603; Tyebjee and Bruno, 1984).
Tab. 2.2 Venture Capital Investment Process
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Source : adopted from Sweeting (1991, p. 603)
Fund-raising from big institutional investors is essential for the rest of the investment process and constitutes one of its main elements. Fund providers can include big financial institutions such as banks, pension funds or insurance companies, the government or universities – all of which put a small percentage of their total funds into these high-risk investments. They expect a return of between 25 to 35 percent per year over the lifetime of the investment. The limited partnership (LP) became the dominant organizational form in venture capital investments.
While the venture capitalist serves as a general partner and manages the fund, the investor only monitors the fund’s progress as a limited partner and as a result does not get involved into the operational management activities (Gompers and Lerner, 2004), otherwise the LP would risk its limited liability. Such partnerships involve aspects of both limited liability (for the investors or fund providers) and of unlimited liability (for the venture capitalist). While the venture capitalist should be specialized, LPs are diversified in investing in a wide range of asset classes.
Zider (1998) argues that institutional investors place only a small percentage of their portfolio on venture capital, so that the venture capitalist has the latitude to raise additional capital. That lead the investor to invest in a fund is not the specific investment but the venture capital firm’s track record, the fund’s “story”, and their confidence in the partners themselves.
LPs expect a certain investment profile (i.e. sectors and stages that the venture capitalist invests in). In the beginning, the limited partner and the general partner agree on the funds’ terms, including the fund’s life cycle that is between ten to thirteen years and the compensation that contains a fixed annual share of 1.5 to 3 percent of the committed capital and around 20 percent of the fund profits. Venture capitalists frequently disburse funds in stages to show their investors that their money is not invested in unprofitable ventures. “Higher returns lead to greater capital commitments to new funds” (Gompers and Lerner, 2004, p. 28). The initial partnership agreement governs the relationship over the funds’ life and is rarely renegotiated. Government policy and a healthy stock market may have a great impact on the commitment of venture capital funding (Gompers and Lerner, 2004; Jeng and Wells, 2000).
“Deal flow” refers to the influx of business plans which is also an essential part of the investment process determining the quality of the investment opportunities that the venture capitalist can make. Usually, a venture capitalist receives around 1,000 business plans per year (NVCA, 2009). Only a few of these proposals get a second look, most of them ending up in the drawer. In fact, for every 100 business plans that request venture funding, usually ten receive a serious look, and only one might be funded by a venture capital firm (NVCA, 2009).
Relevant candidates get 10-15 minutes for the first screening in regard to the investment volume, geography, the industry and the financing stage (Sweeting, 1991, p. 610). The first screening also reviews if the proposal fits the firm’s investment profile. Business plans from trusted sources or personal network have a higher chance for closer screening.
The deal evaluation starts with the letter of intent to protect the venture capitalist that sets the path for due diligence. It allows the venture capitalist to scrutinize serious candidates extensively through a wide range of instruments. During that time, the entrepreneur is not allowed to look for other sources of funding. Due diligence includes meetings with the entrepreneur, entrepreneurial team, and consultation with external sources (such as potential customers, market surveys, experts etc.). Due diligence investigations are usually extremely time-consuming and costly.
When the venture capitalist is positively convinced about investing in the venture, both parties move on to deal structuring. The contract negotiations about the deal price include the number of shares that venture capitalists invest, the venture capitalists’ rights, reporting standards, board-meetings, entrepreneur’s salary, and capital structure or change of business model (defined in term sheet). If both parties agree, the venture capitalist makes an investment proposal and closes the deal. The venture capitalist then adds the new investment to the portfolio of the fund.
One of the major functions of venture capital is value adding to the portfolio company. The dynamic development of young companies requires frequent support as well as constant controlling of the high risk venture. “Venture capitalists play a catalytic role in the entrepreneurial process [offering] fundamental value creation that triggers and sustains economic growth and renewal” (Bygrave and Timmons, 1992, p. 1; added by the author). Their strategic advice is generally regarded as one of the major contributions to the portfolio companies (Gorman and Sahlman, 1989; MacMillan et al., 1988). Post- investment activities include a wide range of value adding services such as attending board meetings, consulting management team in strategic decisions (e.g. introduction to potential customers, suppliers, or experts etc.) as well as monitoring the portfolio companies. The venture capitalist is in control of the value added through her or his seat at the board of directors.
There are different types of involvement between the exchanging parties. The information flow from the entrepreneur to the venture capitalist refers to the term monitoring and vice versa to advising . If both parties have a bilateral information flow it is called assisting or value adding which are executed through the board seat (Manigart and Sapienza, 2000, p. 248). The function of value adding is, on one hand, risk mitigation via controlling, on the other hand, increasing the value of the investment via consulting. While these processes are very labor intensive and time consuming, the involvement intensity varies among the venture capitalists and each portfolio company appreciates this support differently (Barney et al., 1996).
Ideally, venture capitalists should serve as a “sounding board” (MacMillan et al., 1988, p. 31) by providing information and exchange of idea for the entrepreneur and its team. Time is a scarce resource and the venture capitalist has to decide on what portfolio companies to spend his or her available time. The venture capitalist has around two to four hours per week to support and advise one of the portfolio companies (see Gorman and Sahlman, 1989). The time spent on value adding activities (such as directing, monitoring and recruiting new management members) is estimated at about 70 percent of available hours of the venture capitalist (Zider, 1998). The directors that represent the venture capital firm possess in many cases special expertise and useful networking connections, contributing to strategic decision-making by offering social capital-based and knowledge-based forms of value adding (Rosenstein et al., 1993). They use their expertise in corporate governance to reduce agency and business risk. In exchange, they demand a preferred equity share of the new venture, along with favorable upside and downside investment protections. The degree of involvement (MacMillan et al., 1988) depends on the different preference of venture capitalists, conceived differences in business- and agency-risk (Barney, 1986), regional and national differences in venture capitalists’ approach (Sapienza et al., 1996), and other factors (such as degree of innovation, distance to venture capitalist, experience of the people involved etc.).
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1 The capital inflows in the United States rose from $3 billion in 1990 to $103 billion in 2000 (Woodward and Hall, 2004). In 2003, companies that were backed by venture capital accounted for 9.4 percent of the private sector labor force in the United States, and generated $1.8 trillion in sales, or 9.6 percent of all business sales (Shane, 2008).
2 All sources see Hébert and Link (1989)