In the last decades venture capital has emerged as the major source of financing for young and innovative firms, replacing more and more bank credits, but also creating a new market niche for start-ups with a high risk of failure that may create substantial returns. With success stories of companies like Apple Computer, Intel, Federal Express, Microsoft, Sun Mircosystem, Compaq or SAP, this form of funding is meanwhile widely accepted. In the late 1970s the venture capital industry increased dramatically in the United States. In contrast, the venture capital sector in continental Europe used to be a very small market up to 1990. Figure 1 in the appendix shows the development of funds committed to independent US and European venture capital funds.1Today the venture fund market in Germany has reached a managed fund size of US$ 43 billion, an increase of 13.2 percent in regard to the previous year.2Therefore venture capital plays a crucial role in respect to innovation of an economy and has significant positive effects on society and a country’s economy.
According to Sahlmann (1990) the term “venture capital” is defined as a “professional managed pool of capital that is invested in equity linked securities of private ventures at various stages in their development”. Gompers and Lerner (2001a) limit the definition to investments in privately held, high growth companies. Originally, the intent of venture capital is to finance young innovative companies. The term private equity describes the investment of equity in companies that are already established, e.g. companies in later stages of their life cycle. Today the two terms are often used as synonyms.
In this paper we keep focusing on companies in early stages of life and thus use the term venture capital only. It should be mentioned that the focus of venture capital firms can be quite different. First venture capitalists can concentrate on different stages of companies (seed, start-up, first, second, third, fourth stage, bridge stage and liquidity stage financing) and second, venture capitalist can finance different industries or focus on a special group. The specialization has the advantage to gather deepened technological knowledge about an industry that can be used within the “venture cycle”. The innovative high-tech sectors, such as biotech or nanotech, would be good examples.
At a glance
- Grade: 1.0 (1.0 is the best grade)
- Appendix compares agency conflicts and possible solutions across both venture-capital relationships
- Appendix presents Gompers’s financing model across entrepreneur and project types
- 53 sources in the bibliography
- 3 figures and 2 tables
Table of Contents
1. Introduction
2. Multiple-Agent relationship of a venture capitalist
2.1 Structure of Venture-Capital Firms
2.2 Theoretical Background
2.3 Relationship between Venture Capitalist and Entrepreneurs
2.4 Relationship between Venture Capitalist and Investors
3. THE INVESTMENT PROCESS OF A VENTURE CAPITALIST
3.1 Mitigation of Venture Capitalist-Entrepreneur Relationship
3.2 Mitigation of Relationship Problems between Investors and Venture Capital Firms Exit Decisions & Returns
4. Conclusion
Aims and Topics
This work examines how venture capital firms finance young growth companies and manage their relationships with investors and entrepreneurs. It asks how information asymmetries and conflicting interests affect these relationships, and which incentives and contractual controls can mitigate the resulting agency problems.
- The venture capitalist’s dual role as principal and agent
- Adverse selection, moral hazard and hold-up
- Screening, contracting and monitoring of portfolio companies
- Staged financing, convertible securities and control rights
- Fund compensation, covenants, reputation and exits
Excerpt from the Book
2.2 THEORETICAL BACKGROUND
One of the most stated a fact concerning the relationships in the venture capital business is an inevitably high degree of information asymmetries. Reasons can be found in the nature of venture capital financing. The founder of a young growth company has a venture that needs to be financed. The missing track record, the high share of intangible assets of the young company makes it difficult to measure the risk of the venture. On the one hand external risk is present for all three players of the venture capital business. The uncertainties are governed by the highly volatile market for young companies. Additionally, a second risk component arises during the time of the partnership agreement. The internal or behavioral risk is in contrast to the exogenous risk (risk of the market) suggestible through the venture capitalist and the entrepreneur. The behavioral risk is caused by the problem of different interests among the contracting parties. The incentive of each party is to maximize their respective utility. The party with superior information will use them and behave opportunistic. The less informed party reacts to this opportunistic behavior by anticipating the opportunities of the better informed party and determine her actions or incentives.
The information asymmetry, the different interests and the cost due to the information asymmetry form the original foundation of the principal-agent theory. The agency problems can be distinguished in three categories, (1) the adverse selection problem, (2) moral hazard and (3) the hold-up problem. The three terms are described in the following paragraphs related to the venture capital business.
In generally the agency theory considers a situation where one party of the contract having less information (principal) would like to delegate the party that is better informed (agent). The agent can use her superior information to maximize private benefits with the result that the principal loses welfare. This part of the benefit is the internal risk of the relationship and is governed by the agent.
The agency theory distinguishes between two types of information asymmetry, hidden information and hidden action. Hidden information happens at the time of contracting, if one person is better informed than the other. In case of a wrong decision of the principal which is caused by the hidden information, the problem is known as adverse selection. Hidden action results after contracting, because individual actions cannot be observed by the other party.
Chapter Summaries
1. Introduction: Introduces venture capital financing for young growth companies and sets out the work’s focus on relationships and agency problems.
2. Multiple-Agent relationship of a venture capitalist: Describes the venture capital market and applies principal-agent theory to the relationships between investors, venture capitalists and entrepreneurs.
3. THE INVESTMENT PROCESS OF A VENTURE CAPITALIST: Examines screening, financial contracting and monitoring alongside fund-level provisions, compensation, reputation and exit decisions.
4. Conclusion: Summarizes the agency conflicts and mechanisms discussed across both sides of the venture capitalist’s intermediary relationship.
Keywords
venture capital, private equity, principal-agent theory, information asymmetry, adverse selection, moral hazard, hold-up, financial contracting, staged financing, convertible securities, monitoring, covenants, carried interest, exit decisions
Frequently Asked Questions
What is this work about?
It examines principal-agent relationships in venture capital financing, focusing on investors, venture capitalists and entrepreneurs.
What are its central topics?
The main topics include information asymmetry, agency conflicts, investment screening, contract design, monitoring and fund governance.
What is the main question?
The work asks how incentives and control mechanisms can mitigate conflicts between participants in venture capital financing.
What research method is used?
The authors conduct a literature-based review, drawing on principal-agent theory and published research on venture capital contracts and investment practices.
What does the main body cover?
It explains the venture capitalist’s intermediary role and discusses tools for addressing problems in both entrepreneur and investor relationships.
Which keywords characterize the work?
Key terms include venture capital, principal-agent theory, adverse selection, moral hazard, staged financing and monitoring.
Why does the venture capitalist have a dual role?
The venture capitalist acts as a principal when financing an entrepreneur and as an agent when managing capital supplied by fund investors.
How are milestone financing and round financing distinguished?
The discussion describes milestone financing as providing capital upfront subject to goals, while round financing supplies funding after specified conditions are met.
Which mechanisms are discussed for managing fund-level conflicts?
The work discusses fund lifetimes, withdrawal rights, compensation arrangements, distribution policies, covenants and reputation.
- Quote paper
- Steffen Schupp (Author), Elias Gansel (Author), 2005, Principal Agents in Venture Capital and Private Equity Contracting, Munich, GRIN Verlag, https://www.grin.com/document/62951
