Question

Opportunistic and overoptimistic behavior transforms the principal-agent relationship between investor and entrepreneur into a principal-agent problem.’ Explain why the above statement is true and outline the mechanisms which are available to both parties to reduce this problem.

Answer 1

The organization of the venture capital market has three major players and an assortment of minor ones. Figure 1 shows the double-sided relationship of the venture capital process.
Structure of Venture-Capital Firms
To understand the relationship of investor, venture capitalist and entrepreneur it is necessary to understand the venture capital cycle. The first step of the venture capitalist is to develop an investment strategy and find potential capital suppliers, e.g. for raising a fund. Each partnership has a limited lifetime, which is mostly ten years. The success of fund raising depend primary on the vibration of the public market and according to Prowse (1998b) also on the reputation of the venture capital firm. Typically the number of limited partners that commit capital to the fund is not fixed, but mostly varies between ten to thirty investors. On the other hand the portfolio companies which are funded typically consist of ten to fifty investees.[18] The fundraising process is followed by the investment process. This one is distinguishable in the collection of information about potential portfolio companies, checking whether these companies meet the criteria of the investment strategy and than negotiate about investment condition with the portfolio companies. After the investment has been made, entrepreneur and venture capitalist try to increase the value of the company. The last stage of the “venture cycle” is the exit of the investment. Five main groups can be classified: initial public offering (IPO), acquisition exit, secondary sale, buyback exit and write-off. Typically, the most profitable exit opportunity is an initial public offering; however the administrative costs and requirements for information disclosure are high.[19] In general, this process repeats itself, after three to five years, when the investment phase of the existing partnership has been completed. Thus the investment is a continuous process.

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.[21] 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.[22] 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.[23] 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.

Relationship between Venture Capitalist and Entrepreneurs

In this relationship the venture capitalist acts as principal and the entrepreneur due to her superior information as agent. The venture capitalist is the investor that may provide the funds for the venture of the entrepreneur. The first problem in this relationship arises during the selection of the entrepreneur by the venture capitalist. Reasons for the selection problem are different qualifications among entrepreneurs. The entrepreneur knows her project best and has the incentive to overstate her position, because she may obtain a bigger stake in the financial return of the company or get a lower discount rate.[33] If the venture capitalist tries to preselect by using very high discount rates, he might have the unintended effect to scare away the most competent entrepreneurs to seek for alternative capital sources like dept financing. A counterproductive result could be the adverse selection in a pool of entrepreneurs that have no other financing options.[34] More recent literature like Houben (2002b) analyses in context to venture capital relationship the adverse selection problem from a double-sided point of view. It is obvious that the entrepreneur has much more information about the technical part of the project. On the other side the venture capitalist may have much deeper insight into the economic quality of the project, i.e. he knows if there might be a market for the project or not. The statement of Gorman and Sahlman (1989) that venture capitalists are screening several hundreds of investment proposals each year confirms the difficulty of the adverse selection problem.