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.
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
3.1.1. Screening
3.1.2. Contracting
3.1.3. Monitoring
3.2 Mitigation of Relationship Problems between Investors and Venture Capital Firms Exit Decisions & Returns
4. Conclusion
Research Objectives and Focus
This paper examines the multiple-agent relationships within the venture capital industry, focusing on the economic transactions and relational problems between investors, venture capitalists, and entrepreneurs. The primary research goal is to identify and demonstrate the mechanisms used to mitigate agency problems, such as adverse selection, moral hazard, and hold-up issues, through efficient contract design and monitoring.
- Analysis of the principal-agent relationships in venture capital financing.
- Evaluation of screening, contracting, and monitoring mechanisms between venture capitalists and entrepreneurs.
- Examination of the investor-venture capitalist relationship and the mitigation of agency conflicts.
- Overview of the venture capital investment cycle and the role of security design in aligning incentives.
Excerpt from the Book
2.1 STRUCTURE OF VENTURE-CAPITAL FIRMS
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.
Venture capital firms are intermediaries between investors (the capital suppliers) and entrepreneurs (the founders or investees). The venture capitalist typically serves as general partner and the investor as limited partner (relationship A). The capital of venture funds is committed by the limited partners, who are typically pension plans and life insurance companies but also endowments, banks, corporations and wealthy individuals. Unlike the investor, whose liability is limited to her committed capital, the general partner bears unlimited liability. Venture capitalists are responsible for managing a partnership’s investment and contribute only a small fraction of the partnership’s capital personal (around one percent). Hence, the important part to investigate is the amount of effort that they invest into the partnerships to increase the value of their portfolio. This effort is primarily put into the relationship between venture capitalist and entrepreneur (relationship B). Therefore capital commitment is only one part of the relationship and consulting the other one. According to Houben (2002) the effort in consulting of a portfolio company is the main difference between venture capital financing and standard debt or direct equity financing. It plays a crucial role considering the return on investment. On average a venture capitalist spends more than one hundred hours a year in consulting a portfolio company. Generally they become a member of the board of directors and support the entrepreneur primary in respect to establish tactics and strategies or recruit or dismiss key individuals. Only in some cases he is involved in the day-to-day operations. This effort of the general partner is not compensated in cash. The compensation of the venture capitalist can be divided into two main parts, the management fee, and some percentage of the profit in the life of a fund. Typically management fee increases annually with the rate of consumer price inflation.
Summary of Chapters
1. Introduction: This chapter provides an overview of the venture capital industry's growth, defines the core terminology, and outlines the focus on early-stage company financing and the associated agency relationships.
2. Multiple-Agent relationship of a venture capitalist: This chapter describes the structural relationships between the three main players (investor, venture capitalist, entrepreneur) and establishes the theoretical foundations concerning agency problems like adverse selection and moral hazard.
3. THE INVESTMENT PROCESS OF A VENTURE CAPITALIST: This chapter details the practical mitigation tools used in venture capital, including screening, staging of capital, contracting, and monitoring, to align interests between the various parties.
4. Conclusion: This chapter summarizes the findings, reiterating that the venture capital industry has developed an investment process that successfully uses sophisticated contract designs to mitigate agency risks and ensure incentive compatibility.
Keywords
Venture Capital, Principal-Agent Theory, Information Asymmetry, Moral Hazard, Adverse Selection, Hold-up Problem, Screening, Staging, Contracting, Monitoring, Private Equity, Agency Costs, Investment Process, Entrepreneurship, Financial Incentives.
Frequently Asked Questions
What is the core focus of this research?
The work focuses on the economic and relational transactions between investors, venture capitalists, and entrepreneurs in the venture capital industry, specifically addressing how agency problems are identified and mitigated.
What are the primary agency problems discussed?
The central agency problems analyzed include adverse selection, moral hazard, and the hold-up problem, which arise due to information asymmetries and divergent interests among the involved parties.
What is the main objective of the proposed mitigation strategies?
The objective is to achieve incentive compatibility by aligning the interests of principals and agents, thereby minimizing agency costs and maximizing the potential return on investment.
Which scientific methods are primarily utilized?
The research is based on a comprehensive literature review of principal-agent theory and its specific applications within the venture capital contracting process, utilizing institutional economic analysis.
What is covered in the main section of the paper?
The main section (Chapter 3) examines the specific mechanisms used in the investment process, such as screening of entrepreneurs, sophisticated contract structures (e.g., convertible securities), and post-investment monitoring and advisory activities.
Which keywords best characterize this research?
The key themes include Venture Capital, Principal-Agent Theory, Agency Costs, Information Asymmetry, and Contracting Mechanisms.
How does the "staging" of capital function as a control mechanism?
Staging forces entrepreneurs to meet specific milestones to secure continued funding, which helps reduce information asymmetry and provides a credible threat to punish poor performance or misuse of funds.
What role does the "Advisory Role" play for the venture capitalist?
Beyond providing capital, the venture capitalist acts as a strategic consultant, helping the company professionalize through tactics like recruiting key personnel or assisting in strategic decision-making, which is positively correlated to success.
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- Steffen Schupp (Autor:in), Elias Gansel (Autor:in), 2005, Principal Agents in Venture Capital and Private Equity Contracting, München, GRIN Verlag, https://www.hausarbeiten.de/document/62951
