Handbook of Venture Capital

HANDBOOK OF RESEARCH ON VENTURE CAPITAL
Handbook of Research on Venture

Capital
Edited by
Hans Landström
Institute of Economic Research, Lund University, Sweden
Edward Elgar
Cheltenham, UK • Northampton, MA, USA
© Hans Landström 2007
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or
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otherwise without the prior permission of the publisher.
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is available from the British Library
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ISBN 978 1 84542 312 4 (cased)
Printed and bound in Great Britain by MPG Books Ltd, Bodmin, Cornwall
Contents
List of contributors vii

Foreword ix
Acknowledgements x
PART I VENTURE CAPITAL AS A RESEARCH FIELD
1 Pioneers in venture capital research 3

Hans Landström
2 Conceptual and theoretical reflections on venture capital research 66
Harry J. Sapienza and Jaume Villanueva
3 Venture capital: A geographical perspective 86
Colin Mason
4 Venture capital and government policy 113
Gordon C. Murray
PART II INSTITUTIONAL VENTURE CAPITAL
5 The structure of venture capital funds 155

Douglas Cumming, Grant Fleming and Armin Schwienbacher
6 The pre-investment process: Venture capitalists’ decision policies 177
Andrew Zacharakis and Dean A. Shepherd
7 The venture capital post-investment phase: Opening the
black box of involvement 193
Dirk De Clercq and Sophie Manigart
8 Innovation and performance implications of venture capital involvement in
the ventures they fund 219
Lowell W. Busenitz
9 The performance of venture capital investments 236
Benoit F. Leleux
10 An overview of research on early stage venture capital: Current status and
future directions 253
Annaleena Parhankangas
11 Private equity and management buy-outs 281
Mike Wright
PART III INFORMAL VENTURE CAPITAL
12 Business angel research: The road traveled and the journey ahead 315
Peter Kelly
13 Investment decision making by business angels 332
Allan L. Riding, Judith J. Madill and George H. Haines, Jr
v
vi Handbook of research on venture capital
14 The organization of the informal venture capital market 347

Jeffrey E. Sohl
PART IV CORPORATE VENTURE CAPITAL
15 Corporate venture capital as a strategic tool for corporations 371

Markku V.J. Maula
16 Entrepreneurs’ perspective on corporate venture capital (CVC): A relational
capital perspective 393
Shaker A. Zahra and Stephen A. Allen
PART V IMPLICATIONS
17 Implications for practice, policy-making and research 415

Hans Landström
Index 427
Contributors
Stephen A. Allen, Babson College, USA

Lowell W. Busenitz, Michael F. Price College of Business, University of Oklahoma, USA
Douglas Cumming, Schulich School of Business, York University, Canada
Dirk De Clercq, Faculty of Business, Brock University, Canada
Grant Fleming, Wilshire Private Markets Group and Australian National University,
Australia
George H. Haines, Jr, Eric Sprott School of Business, Carleton University, Canada
Peter Kelly, Helsinki School of Creative Entrepreneurship and Helsinki University of
Technology, Finland
Hans Landström, Institute of Economic Research, Lund University, Sweden
Benoit F. Leleux, IMD International, Lausanne, Switzerland
Judith J. Madill, Eric Sprott School of Business, Carleton University, Canada
Sophie Manigart, Vlerick Leuven Gent Management School and Department of
Accounting and Finance, Ghent University, Belgium
Colin Mason, Hunter Centre for Entrepreneurship, University of Strathclyde, UK
Markku V.J. Maula, Institute of Strategy and International Business, Helsinki University
of Technology, Finland
Gordon C. Murray, School of Business & Economics, University of Exeter, UK
Annaleena Parhankangas, Institute of Strategy and International Business, Helsinki
University of Technology, Finland
Allan L. Riding, University of Ottawa, Canada
Harry J. Sapienza, Center for Entrepreneurial Studies, Carlson School of Management,
University of Minnesota, USA
Armin Schwienbacher, Finance Group, University of Amsterdam, the Netherlands and
Université catholique de Louvain, Belgium
Dean A. Shepherd, Kelley School of Business, Indiana University, USA
Jeffrey E. Sohl, Center for Venture Research, Whittemore School of Business and
Economics, University of New Hampshire, USA
Jaume Villanueva, Center for Entrepreneurial Studies, Carlson School of Management,
vii
viii Handbook of research on venture capital
Mike Wright, Nottingham University Business School, UK

Andrew Zacharakis, Babson College, USA
Shaker A. Zahra, Center for Entrepreneurial Studies, Carlson School of Management,
Foreword
In today’s modern economy a country’s or region’s competitiveness lies in its capability to

innovate. Whilst earlier old and established companies were reliable producers of innov-
ation as well as jobs, that is changing. The big corporations are outsourcing and down-
sizing, and the new technologies are emerging from companies that did not exist 20 years
ago. Governments have come to realize that in order to sustain economic growth and
create jobs they must have a policy that facilitates entrepreneurship. One of the important
components in this policy is the supply of venture capital. Nowadays there are few fast-
growing high technology companies that have not been financed by venture capital at
some stage. If they haven’t obtained venture capital, they probably tried to obtain it.
Governments all around the world are creating schemes and policies that will facilitate the
supply of venture capital.
The increased attention given to venture capital from policy makers is also evident
within the research. The amount of research and literature on venture capital is enormous.
There are several academic journals devoted solely to venture capital, and venture capital
research is occurring in a large number of journals; numerous books on venture capital
are published yearly. Though the venture capital phenomenon is not new, it generates an
increasingly large amount of research.
We are at a stage when it is suitable to synthesize the research findings and see what we
know and what we do not know about venture capital. This volume presents the state of
the art in venture capital research. It includes writing from the elite of the venture capital
researchers around the world and covers the most central aspects of venture capital
research. This volume gives the reader a unique opportunity to understand what venture
capital is and how it works.
The Swedish Institute for Growth Policy Studies (ITPS), Swedish Foundation of Small
Business Research (FSF), and Swedish Agency for Economic and Regional Growth
(NUTEK) have as their mission to improve the entrepreneurial climate and the economic
growth in Sweden. We see the supply of venture capital as one of the crucial factors to
unleash the growth potential in the economy. We are proud to sponsor this handbook, and
we are convinced that it will be a frequently read resource for anyone interested in venture
capital and in fostering economic growth – as well as those who want to understand the
modern economy.
Sture Öberg
Swedish Institute for Growth Policy Studies (ITPS)
Anders Lundström
Swedish Foundation of Small Business Research (FSF)
Sune Halvarsson
Swedish Agency for Economic and Regional Growth (NUTEK)
ix
Acknowledgements
I first became interested in venture capital in the mid-1980s when writing my thesis on the
development and growth of new technology-based firms in Sweden. At that point in time
there was not much research available on the subject of venture capital – with the excep-
tion of some seminal studies by researchers who are today regarded as pioneers within the
field. Venture capital has always fascinated me, and I have written a large number of art-
icles and reports on different aspects of it. At the same time we have witnessed an enor-
mous increase in academic research within the field internationally, thus we know a great
deal more about venture capital today than we did a mere decade ago.
When I was asked by Edward Elgar Publishing to be the editor of a state-of-the-art
book on venture capital I was naturally very honoured, but I also found it timely in the
sense that we have been researching venture capital for about 25 years, and in my view, it
is important to reflect now and then on the knowledge acquired in order to establish a
basis for further development of the field.
The first phase of the process involved in the production of the Handbook of
Research on Venture Capital was to invite the most prominent international researchers
within the field to participate in the project and write a chapter on a specific topic.
I was encouraged to find that their reactions were very positive – the need to summar-
ize and synthesize our knowledge after almost three decades of venture capital
research was obvious. The writing and reviewing process has been intensive, and the
chapters have gone through three rounds of revision. At the end of the process (29–31
May, 2006) the authors met in Lund, Sweden, in order to discuss and provide feed-
back on each other’s chapters. I sincerely thank all the authors for their willingness to
generously share their knowledge on venture capital and for all the work they have
devoted to this project.
In connection with the meeting in Lund we also organized a ‘Workshop on Venture
Capital Policy’ with more than 80 participants including a good mix of researchers and
policy makers interested in venture capital, and during these days we achieved a very
intense and interesting dialogue between leading researchers and policy makers within the
field. As such events do not organize themselves I wish to thank Gertie Holmgren and
Elsbeth Andersson of Lund University School of Economics and Management as well as
the whole group of researchers and doctoral students within the research programme on
Entrepreneurship and Venture Finance at the Institute of Economic Research and
CIRCLE for their great efforts in organizing the workshop in Lund.
I am very grateful to the Swedish Agency for Economic and Regional Growth
(NUTEK), the Swedish Institute for Growth Policy Studies (ITPS) and the Swedish
Foundation for Small Business Research (FSF) for their financial support of the project.
Sincere thanks to the project committee made up of Birgitta Österberg and Karin Östberg
from NUTEK, Marcus Zachrisson of ITPS, and Anders Lundström and Helena Ericsson
from FSF for their valuable help and comments throughout the project.
I have written the first and last chapter in this handbook, and I thank Doctor Jonas
Gabrielsson, Doctor Diamanto Politis and Doctor Joakim Winborg for their valuable
x
Acknowledgements xi
comments on my chapters. In addition, I am grateful to Professor Olle Persson at Umeå

University for helping me with the bibliographical analysis of the research field.
Finally, a special thanks to Francine O’Sullivan at Edward Elgar Publishing for inviting
me to be the editor of the handbook, and for her excellent support throughout the process.
Hans Landström
Institute of Economic Research School of Economics and Management
Lund University, Sweden
PART I
VENTURE CAPITAL AS A
RESEARCH FIELD
1 Pioneers in venture capital research
Hans Landström
Introduction
The importance of venture capital

We need growth-oriented entrepreneurial ventures in society. These ventures represent an
important power in an economy – they create innovations and dynamics, new jobs, income
and, not least, wealth. Although growth-oriented entrepreneurial ventures, or what Birch
(1987) calls ‘gazelles’, can be found in all industry sectors and locations (urban as well as
rural), there are some indications that the ventures with the highest growth potential are
often characterized as knowledge-based and technologically driven – primarily based on
intangible assets, operating in rapidly developing fields and with no documented history.
One of the main problems facing these growth-oriented entrepreneurial ventures is raising
capital for the growth of the business and gaining access to the competence, experience and
networks necessary for growth which most entrepreneurs lack (Brophy, 1997). It is in this
domain of growth-oriented entrepreneurial activities that we need an efficient venture
capital market that can provide adequate capital and management skills. For example, it has
often been argued that the scope and sophistication of the US venture capital industry is
one reason for the exceptional ability of the US economy to turn innovative ideas from uni-
versities and R&D laboratories into high growth companies such as the Intel Corporation,
Cisco Systems, Microsoft, Oracle, Amazon.com, Yahoo!, etc. (Maula et al., 2005).
Thus, growth-oriented ventures are important in society, and venture capital is a sig-
nificant vehicle for promoting their growth. The importance of venture capital makes it
essential to understand the way the venture capital market operates, and how business
angels and venture capitalists manage their investments. In this book we will summarize
and synthesize the knowledge in the area of venture capital: what do we know? what do
we not know? And what can we learn from existing knowledge (or lack of knowledge)?
The aims of the book

The scholarly interest in venture capital began in the 1970s and expanded substantially in
the following two decades. This interest was especially strong among researchers in the
US, which is also the home of the most dynamic venture capital market. Thus, systematic
venture capital research is less than 25 years old, or a little more than half of an acade-
mic career. But during those 25 years our knowledge has grown exponentially, and we
know a great deal more today about the venture capital market, business angels, venture
capitalists’ investment decision, and so on than we did 10 to 15 years ago. For example,
an analysis of the Social Citation Index reveals an increase in the number of scientific arti-
cles written on venture capital since the 1980s – from about 10 articles per year at the end
of the 1980s to 25 articles in the mid-1990s, while today the annual number of articles on
venture capital is between 60 and 70 (see Figure 1.1), and the last five years (2001–2005)
account for 48 per cent of venture capital related research.
3
4 Handbook of research on venture capital
80
70
60
50
40
30
20
10
0
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
Figure 1.1 Number of articles on venture capital
In this state-of-the-art book we will try to summarize and synthesize 25 years of venture
capital research. In addition, our aim is to communicate new and future directions of our
knowledge to scholars, venture capitalists, entrepreneurs and policy-makers, in order to
increase the understanding of the venture capital phenomenon.
Some comments regarding the content of the book will first be made to help the reader.
If we look at our knowledge on venture capital, we can conclude that most venture
capital research concerns the supply side of the market (from the investor perspective)
whereas little work can be found on the demand side – related to the decision-making
processes of ventures seeking venture capital. Obviously, this state-of-the-art book –
which attempts to summarize and synthesize existing knowledge within the field – reflects
this bias.
Second, in a citation analysis performed by Cornelius and Persson (2004; 2006) it
was revealed that the venture capital research community was divided into two sepa-
rate clusters of researchers. With the exception of some very important core authors
within the field who are generally cited (such as William Sahlman, Paul Gompers and
William Bygrave), there seems to be surprisingly little intellectual cross-fertilization
between the two clusters. One cluster of researchers has a background in finance and
economics and mainly analyses venture capital on a macro level, using, for example,
agency theory, capital market theory, and so on as theoretical frameworks in their
studies, which are published in financial and economics journals. Another cluster of
researchers has its roots in management and entrepreneurship research and thus has a
stronger managerial focus on venture capital with more heterogeneity in the research
paradigms employed. These researchers publish their works in entrepreneurship man-
agement journals. The present book focuses on the managerial aspects of venture
capital – although several chapters in the book also cover more aggregated discussions
concerning the development of the market, regional aspects of venture capital, and
policy implications.
Finally, there is a geographical bias in our knowledge about venture capital. Since the
emergence of the research field in the 1980s, venture capital has been regarded as a US
phenomenon dominated by Anglo-Saxon (mainly US) researchers – and this has contin-
ued, in spite of increased interest on the part of scholars all over the world since the 1990s.
Pioneers in venture capital research 5
As a consequence, our knowledge is heavily influenced by the US context and model of

venture capital. However, not only is US research dominant; as venture capital has a ten-
dency to concentrate in certain geographical regions such as metropolitan areas and high-
technology clusters, our knowledge on venture capital does likewise and is mainly derived
from dynamic regions such as Silicon Valley and Boston. As this is a state-of-the-art book,
these geographical biases will be reflected. However, we have tried to select authors from
different parts of the world and have asked them to consider venture capital as a global
phenomenon.
Venture capital – what are we talking about?

Venture capital is a specific form of industrial finance – part of a more broadly based
private equity market, that is investments (with private equity) made by institutions, firms
and wealthy individuals in ventures that are not quoted on a stock market, and which have
the potential to grow and become significant players on the international market (Mason
and Harrison, 1999a; Isaksson, 2006). The private equity market can be divided into two
different parts (although the distinction is not always easy to make):
1. Venture capital, which is primarily devoted to equity or equity-linked investments in

young growth-oriented ventures; and
2. Private equity, which is devoted to investments that go beyond venture capital –
covering a range of other stages and established businesses including, for example,
management buy-outs, replacement capital and turnarounds.
Venture capital will usually be regarded as an active and temporary (5 to 10 years)

partner in the ventures in which they invest, and they are normally minority sharehold-
ers. They achieve their rate of returns mainly in the form of capital gain through exit
rather than by means of dividend income.
The venture capital market consists of different submarkets, and in this book we will
focus on three of them: institutional venture capital, corporate venture capital, and
informal venture capital.
Institutional venture capital It is not an easy task to provide a generally accepted defin-
ition of institutional venture capital (also called ‘formal venture capital’) – the number
of definitions is almost as great as the number of authors writing articles on the subject.
Institutional venture capital firms act as intermediaries between financial institutions
(such as large companies, pension funds, wealthy families, and so on) and unquoted
companies, raising finance from the former to invest in the latter (Lumme et al., 1998).
Wright and Robbie (1998) defined institutional venture capital as professional invest-
ments of long-term, unquoted, risk equity finance in new firms where the primary
reward is eventual capital gain supplemented by dividends. Elaborating on this defin-
ition, Mason and Harrison (1999a, p. 16) stated that ‘the institutional VC industry
comprises full-time professionals who raise finance from pension funds, insurance com-
panies, banks and other financial institutions to invest in entrepreneurial ventures.
Institutional venture capital firms take various forms: publicly traded companies,
“captive” subsidiaries of large banks and other financial institutions, and independent
limited partnerships.’
As indicated in the definition by Mason and Harrison, an institutional venture capital

firm can take different organizational forms, depending on the ownership structure, but
usually consists of:
● Independent limited partnerships, in which the venture capital firm serves as the
general partner, raising capital from limited partners such as institutional investors
(for example, pension funds, insurance companies and banks).
● Captive venture capital firms, which are mainly funded by the internal resources of
a parent organization – often a financial institution, such as a bank or insurance
company, but sometimes by a larger non-financial company (so-called ‘corporate
venture capital’).
● Government venture capital organizations, which are financed and controlled by
government institutions.
Since the 1980s the limited partnership has emerged as the dominant organizational
form in venture capital. In a limited partnership, the venture capitalists are general part-
ners and control the fund’s activities, whereas the investors act as limited partners who are
not involved in the everyday management of the fund (see Figure 1.2).
A fact that makes the definition of institutional venture capital even more complicated
is that the understanding of institutional venture capital differs from country to country.
In addition, the characteristics of the venture capital industries in Europe and the US are
not the same, indicating that the view and definition of venture capital differ substantially
between them. Bygrave and Timmons (1992) distinction between two types of venture
capital may be helpful to illustrate the differences:
● Classical venture capital funds – where the capital is raised from patient investors,
for example, wealthy individuals and families. The funds are managed by investors
with entrepreneurial experience and industrial knowledge, who invest in early stage
ventures and who actively operate in the companies in which they invest.
● Merchant venture capital funds, which raise capital from institutional sources with
short-term investment horizons, where the funds are managed by individuals with
a background in investment banking or other financial organizations, who invest at
INVESTOR
Returns Fundraising
VENTURE
CAPITALIST
Equity Cash
VENTURE
Figure 1.2 The venture capital process

a later stage or undertake management buy-outs (MBOs) and who focus strongly
on analytical and financial engineering, deal-making and transaction crafting.
Bygrave and Timmons argue that, due to the growing dominance of institutional invest-
ments in venture capital funds in the US, and not least in Europe, merchant venture
capital funds have taken over at the expense of classic venture capital. Accordingly, the
definitions of institutional venture capital in Europe are somewhat different and venture
capital is usually considered synonymous with ‘private equity’ in a more general sense and
includes investments in terms of early and expansion stage financing as well as those
covering a range of other stages such as funding of management buy-outs, consolidations,
turnarounds, and so on. On the other hand, in the US, the term ‘venture capital’ is nar-
rower and refers to early stage investments in growth-oriented companies, or what
Bygrave and Timmons term ‘classic’ venture capital.
Corporate venture capital One distinguishable part of the institutional venture capital
markets is ‘corporate venture capital’ as a ‘captive’ venture capital organization. Maula
(2001) defines corporate venture capital as ‘equity or equity-linked investments in young,
privately held companies, where the investor is a financial intermediary of a non-financial
corporation’ (p. 9). Thus, the main difference between institutional venture capital and
corporate venture capital is the fund sponsor – in corporate venture capital the only
limited partner is a corporation, or a subsidiary of a corporation.
Corporate venture capital should be seen as a specific strategic tool in the corporate
venture toolbox. There are many other tools that can be used in order to develop new busi-
ness, and Maula (2001) distinguishes between (i) internal corporate venture, in which
innovations and new businesses are developed at various levels within the boundaries of
the firm, and (ii) external corporate venture, which results in the creation of semi-
autonomous or autonomous organizational entities that reside outside the existing firm.
It is within the frame of external corporate venture that corporate venture capital is used
as a tool for strategic considerations and business development, together with other tools
such as venture alliances and acquisitions.
Following this reasoning and using a rather broad definition, McNally (1994) states
that corporate venture capital can take two main forms: externally managed investments,
Table 1.1 Corporate venture capital
Corporate Venture Capital

Type of investment Externally managed Internally managed
Investment via independently Direct subscription for minority
managed venture capital fund. equity stake.
Investment vehicle Independently Independently In-house corporate Ad hoc/one-off
managed fund managed captive managed fund investments, e.g.
fund strategic alliances/
‘spin-offs’ from
company
Source: Adapted from McNally (1994, p. 276)

in which large corporations finance new firms alongside independently managed venture
capital funds, and internally managed investment, that is making investments through
their own internal organization (see Table 1.1).
Informal venture capital This book will also discuss the informal venture capital market,
which for many years has been associated with and regarded as equivalent to ‘business
angels’. Originally, the term ‘angel’ was used to describe individuals who helped to finance
theatre productions on Broadway (‘theatre angels’). The ‘angels’ invested in these pro-
ductions mainly for the pleasure of rubbing shoulders with their favourite actors. It was
a question of high-risk investment – the individuals lost their money if the production
was a flop but shared the profits if it was successful (Benjamin and Margulis, 2001;
Mason, 2007). Later on, William Wetzel (1983) was one of the first to coin the term ‘busi-
ness angels’ for people providing the same kind of risk investments in young entrepre-
neurial ventures. Following this line of thought, Lerner (2000) defines a business angel as
‘a wealthy individual who invests in entrepreneurial firms. Although angels perform many
of the same functions as venture capitalists, they invest their own capital rather than that
of institutional or other individual investors’ (p. 515).
In empirical studies we have successively seen a broadening of the study of object, from
focusing entirely on ‘business angels’ to include a broader range of private investors
making equity investments in entrepreneurial ventures (Landström, 1992; Avdeitchikova,
2005), with more and more emphasis on ‘informal investors’ (see Figure 1.3). A common
definition in this respect is based on Mason and Harrison (2000a) ‘private individuals
who make investments directly in unlisted companies in which they have no family
Narrow Business angels High net worth individuals who invest a proportion
definition of their assets in high-risk, high-return
entrepreneurial ventures (Freear et al., 1994).
Apart from investing money, business angels
contribute their commercial skills, experience,
business know-how and contacts taking a hands-on
role in the company (Mason and Harrison, 1995).
Informal Comprised of private individuals who invest risk

investors capital directly in unquoted companies in which they
have no family connection (Mason and Harrison,
2000a). Thus, informal investors include business
angels as well as private investors who contribute
relatively small amounts of money and do not take
an active part in the object of investment.
Informal Defined as any investments made in start-ups other

investors, than the investors’ own businesses, i.e. including
including family investments, investments by friends,
Broad family and colleagues, etc., but excluding investments in stocks
definition friends and mutual funds (Reynolds et al., 2003).
Figure 1.3 Definitions of ‘business angels’ and ‘informal investors’

connections’ (p. 137). This definition of informal investors includes not only investments
by business angels but also those made by private investors who are less active in the ven-
tures in which they invest as well as private investors who invest smaller amounts of
capital in unlisted companies. On the other hand, the definition excludes investments
made by ‘family and friends’, and this perspective is not uncontroversial. For example, in
the large international research project Global Entrepreneurship Monitor, investments
made by ‘family and friends’ are included in the study of informal investments in different
countries (Reynolds et al., 2003). However, a central argument in the definition by Mason
and Harrison (2000a) is that investments made by close relatives and friends are based on
other considerations and investment criteria than those of external investors and, there-
fore, family-related investments should be excluded from the definition.
Without taking a definite position, we can conclude that there are many different defini-
tions of informal venture capital: from (i) ‘business angels’ in a narrow sense, to (ii) the
broader definition of ‘informal investors’, and (iii) also including investments made by
family and friends. In empirical studies, the terms ‘business angels’ and ‘informal investors’
are sometimes used to distinguish one from the other, but more often are interchangeable.
Needless to say, this lack of rigour makes empirical studies on informal venture capital
difficult to interpret and compare. Business angels and other types of informal investors
differ significantly – in the way they make decisions, their ability to add value, and so on,
and there is a need to divide the informal venture capital market into relevant segments.
A comparison between three sources of venture capital An overview of the similarities and
differences between institutional venture capital, business angels and corporate venture
capital is an appropriate way in which to conclude this discussion about the definition and
different sources of venture capital. The overview (Table 1.2) shows that different sources
of venture capital seem to represent partially complementary and partially overlapping
sources of finance: complementary in the sense of investment in different venture devel-
opment phases and the amount of capital provided; overlapping in that each category of
investors makes investments in a broad range of ventures.
As can be seen in Table 1.2, institutional venture capital, business angels and corporate
venture capital seem to have some distinctive characteristics. Obviously, the source of
funds and legal status differ, as do the investment motives – all venture capitalists have
some form of financial motive (and even if intrinsic rewards are evident among business
angels, there are also financial reasons for the investment), although corporate venture
capitalists place greater emphasis on strategic considerations. Investment and monitoring
differ, and especially it is the business angels that distinguish themselves in that their
investment capacity and time for due diligence are much more limited; also they have a
much more informal control process compared to institutional and corporate venture
capitalists.
A final comment needs to be made regarding the definitions of venture capital. The field
of venture capital is characterized by vague definitions and a great deal of confusion
regarding central concepts. Of course, unclear definitions make knowledge accumulation
more difficult, and many authors who contributed chapters to the handbook call for
clearer and consistent definitions within the field. However, we do not consider it the aim
of this book – which outlines past and present research on venture capital – to provide
such authoritative recommendations on definitional issues, although in order to develop
Table 1.2 Characteristics of institutional venture capital, business angels and corporate
venture capital
Institutional venture Corporate venture

capital Business angels capital
Source of funds Primarily institutional Investing their own Investing corporate
investors who act as money funds
limited partner
Legal form Limited partnership Private individuals Subsidiary of a
large company
Motive for investment Equity growth Equity growth Strategic and
Intrinsic rewards equity growth
Investment Experienced investors Experience varies Experience within
industry/technology
Large investment Limited investment Large investment
capacity capacity capacity
Extensive due Limited time for due Extensive due
diligence diligence diligence
Monitoring Formal control Informal control Corporate control
Source: Adapted from Mason and Harrison (1999a), Månsson and Landström (2005) and De Clercq
et al. (2006)
the field of venture capital research we should spare no effort to clarify the concepts
employed.
Reality and research

The social sciences are not developed in isolation from the rest of society and, as in many
other social sciences, we can find a strong linkage between the development of the venture
capital industry (the reality) and the interest among scholars in focusing on venture
capital (research), although with a certain time lag due to the ‘natural conservatism’ that
characterizes most research. In this section we will describe the development of venture
capital in the US as well as in Europe and the rest of the world. We will also show that
early research contributions by a number of pioneering researchers, often geographically
located near dynamic venture capital markets, took place in the context of an emerging
venture capital industry.
The birth of venture capital

Venture capital as a phenomenon is a very ancient activity. Private individuals have always
had a tendency to invest in high-risk projects. Examples of entrepreneurs raising capital
from private financiers can be found in the Babylonian era as well as in early medieval
Europe. One extraordinary example is the decision by Queen Isabella of Spain to finance
the voyage of Christopher Columbus, which can be regarded as a highly profitable (for the
Spanish) venture capital investment. It could also be argued that in many countries the
investments by private individuals were influential in the development of the industrial
revolution during the nineteenth and the early twentieth century. For example, in the US,
groups of domestic and European private investors were responsible for financing the
development of several new industries, such as railroads, steel, petroleum and glass. One
such successful investment, made by a group of wealthy individuals, was the merger and
financing of a few less successful companies into what became International Business
Machines (IBM) in 1924. These kinds of investments are not unique to the US – we can
find similar success stories in many other countries (Rind, 1981; Benjamin and Margulis,
2001; Gompers and Lerner, 2003).
In a more institutional sense, the venture capital industry can be regarded as an out-
growth of the informal venture capital market – the industry originated in the manage-
ment of the wealth of high net worth families in the US such as the Rockefeller (Douglas
Aircraft and Eastern Airlines), Phipps (Ingersoll Rand and International Papers), and
Whitney (Vanderbilt) families during the early decades of the last century. Gradually,
these operations became more and more professional, employing outsiders to select and
manage the investments, forming the nuclei for what ultimately became independent
venture capital groups (Gompers and Lerner, 2003).
The Boston area was perhaps the first region to show some degree of organized venture
capital. By 1911, the Boston Chamber of Commerce was providing financial and tech-
nical assistance to new ventures and, in 1940, the New England Industrial Development
Corporation was launched to provide a similar kind of assistance (Florida and Kenney,
1988). Boston was also the home of the first venture capital company in the US. The idea
of venture capital came from Ralph Flanders, president of the Federal Reserve Bank of
Boston, who was concerned about the lack of new company formation and the inability
of institutional investors to finance new ventures. Flanders proposed fiduciary funds,
which would enable institutional investors to invest up to 5 per cent of their assets in
equity in new ventures (Bygrave and Timmons, 1992). The proposal was supported by
General Georges Doriot (professor at Harvard Business School) and together with Carl
Compton (president of MIT) and some local business leaders, Doriot established
American Research and Development (ARD) in 1946. ARD made investments in young
firms with a basis in technologies developed for World War II, often with close ties to the
Harvard and MIT communities. Its first investment was in the High Voltage Engineering
Corporation, which was founded by engineers from MIT and which later became the first
venture capital-backed firm listed on the New York Stock Exchange. However, not all
investments were successful – almost half of ARD’s profit during its 26-year existence
came from its $70 000 investment in the Digital Equipment Company in 1957, which had
increased in value to $355 million by 1971 (Bygrave and Timmons, 1992; Gompers and
Lerner, 2003).
In Silicon Valley/San Francisco, another region with a dense cluster of technology-
based enterprises, venture capital groups began to emerge during the late 1950s and early
1960s. The first venture capital firm in California – Draper, Gaither and Andersen – was
founded in 1958, and the late 1950s became a seminal period witnessing the establishment
of more than a dozen venture capital firms in the Silicon Valley and San Francisco area
(Florida and Kenney, 1988).
The development of venture capital in the US

Although the venture capital phenomenon can be regarded as a very ancient activity,
the venture capital industry grew slowly. The market was fragmented and geographically
concentrated (Brophy, 1986). One key point in the development of the industry was the
creation of Small Business Investment Companies (SBIC) in 1958 – privately operated
investment companies that could receive tax benefits and borrowing rights from the Small
Business Administration (from 1992 it was also possible to obtain equity capital from the
US Treasury at attractive rates), which meant that private investors could benefit from
advantageous federal loans as well as favourable tax rules. However, despite these mea-
sures to improve the venture capital industry in the US, the amount of venture capital was
rather limited. The flow of money into venture capital funds between 1946 and 1977 never
exceeded a few hundred million dollars annually (often much less). At the beginning of
the 1970s, the venture capital market stagnated even more, mainly due to a sharp rise in
capital gains tax – from 25 to 49 per cent – which reduced the potential profit on invest-
ments. At the same time, the industry experienced several failures and the venture capital
companies did not succeed in managing the situation that arose; thus general mistrust of
the venture capital industry emerged. At the end of the 1970s, the venture capital indus-
try was very small, homogeneous in strategy and practice, and competition for deals was
weak. Few investors and entrepreneurs considered the venture capital market particularly
important for new and growing ventures, and the interest from scholars in academia
was limited.
However, in the early 1980s, the venture capital industry grew dramatically, due to an
increase in investment opportunities and the introduction of tax-related incentives. The
market increased from approximately 200 venture capital firms and a pool of venture
capital of $2.9 billion in 1979 to almost 700 firms and a pool of more than $30 billion in
1989 (Timmons and Sapienza, 1992). There are several reasons behind this growth
(Bygrave and Timmons, 1992; Gompers and Lerner, 1996; 2003):
● Before 1979 the possibility for pension funds to invest in venture capital was limited,
but following clarification by the Department of Labor (the Employers’ Retirement
Investment Security Act, ERISA) the rules explicitly allowed pension funds to
invest in high-risk assets such as venture capital funds – known as ERISA’s ‘Prudent
Man Rule’.
● An associated change was the increased role of investment advisors. As venture
capital represented a very small proportion of pension fund portfolios, almost all
pension funds invested directly in venture funds, and the monitoring and evaluation
of these investments were rather limited. In the mid-1980s, advisors (so-called ‘gate-
keepers’) entered the market to advise institutional investors in the area of venture
investments and pooled the resources from their clients, monitored existing invest-
ments and evaluated potential new funds.
● Capital gains tax was successively reduced from 49 to 28 per cent – a measure that
was not only important for the supply of capital, but also had positive effects on the
entrepreneurial activity which created more investment opportunities.
● The emergence of new technologies in the economy (microprocessor and recombi-
nant DNA) provided a fertile ground for venture capital investments.
The tremendous growth of the venture capital industry in the 1980s caused fundamental
changes in the structure and function of the industry. Venture capital firms increased both
in number and size and, as a consequence, the market showed increased heterogeneity
across firms, and greater specialization in investment stage, industry and region. Venture
capitalists changed their strategy – and moved towards later stage and larger investments
(Bygrave and Timmons, 1992; Timmons and Sapienza, 1992).
After this period of growth in the US venture capital industry, the development during
the 1980s and 1990s was characterized by ‘ups’ and ‘downs’. In the mid-1980s, the returns
on venture capital funds started to decrease, basically due to over-investment in various
industries and the entry of inexperienced venture capitalists, thus investors became
disappointed with lower returns and fund raising as a consequence. The end of the
1980s was characterized by a drop in venture capital and a ‘shake-out’ in the industry, and
the number of venture capital firms declined. Venture capitalists tended to invest in later
stages, and specialization and differentiation of investment strategies continued (Timmons
and Bygrave, 1997).
There was renewed interest at the beginning of the 1990s – due to new possibilities on
the initial public offerings (IPO) market and the exit of many experienced venture cap-
italists (Gompers and Lerner, 2003). The industry ‘shake-out’ consolidated and stabilized
the market. Returns had improved – mainly due to a robust IPO market. However, we
must bear in mind that the venture capital industry was still heavily concentrated in a few
geographical areas in the US and could be regarded as fairly limited. Despite an overall
improvement in the US venture capital industry, the total investment made by venture
capitalists never exceeded $6 billion until 1996, and it was the end of the 1990s before the
market really showed exceptional growth. In the year 2000 the total investment spending
reached an astonishing $102 billion, and the average investment was about $18 million per
company. Since then, the venture capital market in the US has declined due to the dot.com
crash (Megginson and Smart, 2006), where the drop was more significant than in many
other countries.
The diffusion of venture capital to Europe

For a long time, venture capital was more or less regarded as an American phenomenon.
Even though an emerging venture capital industry in Europe could be found already in
the late 1970s – much earlier we could find individual companies that provided equity
capital to unquoted firms, for example, 3i in the UK, Investco in Belgium and SVETAB
in Sweden. But these companies were rather isolated initiatives, and in general venture
capital was virtually non-existing outside the US during the 1970s. The development of a
European venture capital market mainly took place in the UK, which had just over 20
venture capital funds at the end of the 1970s with a total investment of £20 million. A
little more than a decade later, in 1992, the venture capital industry in the UK had grown
significantly, investing in a total of £1326 million in 1297 ventures (Murray, 1995).
However, it was not until the late 1980s that a more significant venture capital industry
emerged in Europe, and at that point in time its growth outperformed that of the indus-
try in the US – between 1986 and 1990 venture capital in Europe grew from about $9
billion to $29 billion (Bygrave and Timmons, 1992). This growth was associated with the
introduction of secondary stock markets in many countries, which enabled rapidly
growing ventures to make IPOs and venture capitalists to obtain returns on their invest-
ments. A number of secondary stock markets were created, such as the Alternative
Investment Market in the UK, Nouveau Marché in France, and the Neuer Markt in
Germany, and later on a pan-European secondary stock market (EASDAQ). However,
most of these markets were unsuccessful due to low levels of trading and liquidity (Lumme
et al., 1998).
When describing the venture capital markets in different countries, it is important to
emphasize that venture capital can differ from one country to another, depending on the
characteristics of the financial markets. For example, Black and Gilson (1998) distinguish
between bank-centred markets such as in Japan and Germany, and stock-market-oriented
markets as in the US. The authors argue that a well-developed stock market and initial
public offerings as well as a high level of private pension fund investments (Jeng and Wells,
2000) are of significant importance for venture capital financing. Differences in the char-
acteristics of the financial market in various countries make venture capital more or less
important, and venture capital operates in different ways.
Following this line of reasoning, we can find several similarities between the venture
capital industries in the US and Europe (Manigart, 1994; Sapienza et al., 1996; Jeng and
Wells, 2000) but also many important differences. For example: (i) venture capitalists in
Europe seem to rely more heavily on investment from financial institutions (banks and
insurance companies) compared to the US, where a great deal of capital comes from
pension funds; (ii) venture capital firms are organized in different ways, for example, in the
US and the UK firms are usually limited partnerships whereas in other European coun-
tries we can find different organizational structures; (iii) historically, European venture
capital has been less focused on early-stage investments compared to venture capitalists in
the US; (iv) active involvement differs across countries – venture capitalists in Europe are
not always as actively involved in managing their investment as their counterparts in the
US; and (v) due to the lack of liquid stock markets for entrepreneurial ventures in many
European countries, the exit strategies have differed and the returns on investments were
lower compared to the US (Jeng and Wells, 2000; Megginson and Smart, 2006).
Venture capital worldwide

It was not until the end of the 1990s, and the boom in the dot.com industry, that we could
really talk about the growth of the venture capital industry worldwide. The total invest-
ments in the US exceeded $100 billion in the year 2000, and the corresponding figure for
Europe is €35 billion (Megginson and Smart, 2006). In addition, the venture capital indus-
try in Asia grew significantly between 1995 and 2000, although less rapidly than in the US
and Europe – mainly due to the moribund venture capital industry in Japan. The most
promising venture capital market in Asia was in India, and to some extent China,
although the latter seemed to lack the basic legal infrastructure needed to support a
venture capital market, and Chinese stock markets have remained inefficient (ibid.).
The Asian market is highly heterogeneous – at one end of the spectrum there are coun-
tries like Japan and Australia with long-established market economies as well as newly
industrialized countries while, at the other, there are countries such as China, India,
Malaysia and Vietnam with emerging market economies (Lockett and Wright, 2002).
However, a general characteristic of the venture capital market in Asia is that the insti-
tutional framework – regulatory and legal as well as the venture capital culture – is not
yet established to support venture capital. In addition, several NASDAQ-type stock
markets have been established, such as the ‘growth markets’ in Hong Kong, Singapore
and Taiwan, but so far they have shown only limited success in funding fast growth firms.
The lack of an institutional framework on many Asian venture capital markets means
that venture capitalists have to place more emphasis on employing personal networks to
carry out venture capital operations – indicating that venture capital practice in emerg-
ing markets in Asia diverges somewhat from the Anglo-Saxon model (Ahlstrom and
Bruton, 2006).
Since the 1990s venture capital markets have emerged all over the world. However, the
growth has not been unproblematic – the bursting of the Internet and dot.com bubble at
the end of the 1990s marked a historical peak in terms of capital volume and valuations,
but the market collapse that followed had a major effect on the venture capital market,
not least in the US. As a consequence, the number of venture capital firms declined and
the amount of capital invested decreased dramatically. The dot.com bubble also affected
the behaviour of venture capitalists, who became ‘entrapped in the psychic prison of the
internet bubble’ (Isaksson, 2006).
The market recovered gradually, and in 2006 the size and activities of the US venture
capital market returned to the pre-dot.com level of 1998. The European market is not
much smaller than the US venture capital market, and there are growing venture capital
markets in many Asian countries. We can conclude that venture capital has emerged from
being a source of finance for high growth ventures in the US to a worldwide phenome-
non. At the same time, the markets in different parts of the world exhibit a great varia-
tion in their degree of maturation, for example, US venture capital is regarded as a
significant source of finance for entrepreneurs in high growth ventures whereas other
countries have less well developed markets in which venture capital still has to prove their
contributions to entrepreneurial ventures.
The pioneers who created the research field

In all emerging fields of research there are always some researchers who appear to have a
greater influence than others – researchers who make a new phenomenon visible, who ask
the interesting questions, who encourage other researchers to explore new and promising
fields – pioneers who open up new areas of research. These pioneers seem to play a major
role in giving direction to the emerging field of research (Crane, 1972).
Venture capital is an old phenomenon and, as shown earlier in this chapter, the insti-
tutional venture capital market was established by the end of the 1940s. However, it was
not until the growth of the venture capital industry in the 1980s that it aroused interest
among scholars. The reason behind this time lag may be the fact that for many years
venture capital was a relatively small industry and, even at the end of the 1980s, the
venture capital industry in the US never exceeded a couple of billion dollars. By all stand-
ards, it was a very small market, and few researchers realized that it would be an import-
ant phenomenon for the development of entrepreneurial ventures. However, during the
1980s, pioneers within the field of venture capital research appeared, such as William
Bygrave at Babson College, William Sahlman at Harvard Business School, Ian
MacMillan at New York University/Wharton School of Business, and Tyzoon Tyebjee
and Albert Bruno at University of Santa Clara, who took an interest in the institutional
venture capital market. There was also Kenneth Rind with experience as an active cor-
porate venture capitalist in New York, and William Wetzel at the University of New
Hampshire who researched the business angels market, and all these researchers were geo-
graphically located near the dynamic venture capital markets around Silicon Valley/San
Francisco, Boston and New York.
The subsequent emergence of the venture capital industry in Europe aroused interest
among scholars during the early 1990s, especially in countries with an early and dynamic
venture capital industry. For example, early research contributions were made by Mike
Wright, Richard Harrison and Colin Mason in the UK, Sophie Manigart in Belgium, and
Christer Olofsson in Sweden.
The exponential growth of venture capital worldwide at the end of the 1990s and begin-
ning of the 2000s – measured in terms of the number of researchers, published articles,
and so on – was underlined by the launch of Venture Capital – an International Journal of
Entrepreneurial Finance in 1999 – which was mainly dedicated to venture capital research.
There was also an increased number of contributions on venture capital from Asia. In
many cases, these studies were conducted by Anglo-Saxon researchers in collaboration
with domestic partners.
The remainder of the chapter will highlight the contributions of the pioneers within the
field of venture capital. My objective is not only to provide an insight into the key con-
tributions of these pioneers, but also to familiarize the reader with them as researchers.
There are many researchers, who can be regarded as pioneers of venture capital research,
and I do not claim to provide a complete picture – the selection is, to a large extent, based
on my own subjective view. However, the scope of research on institutional, corporate and
informal venture capital differs, which is reflected in the space each part of the venture
capital market is given regarding the pioneers as well as in the book in general.
Research on institutional venture capital
Some early contributions

In 1981 Jeffry Timmons wrote that research on venture capital by academics was practic-
ally non-existent, which was true at that point in time for rather self-evident reasons – the
venture capital industry was still small and rather insignificant for the majority of high
growth firms as well as for economic development in a more general sense. However, we
can find some pioneering contributions to the research on venture capital as early as the
1950s. The first PhD thesis on the topic of venture capital, entitled ‘Corporate profits and
venture capital in the post-war period’, was written by Hussayni in 1959 and published at
the University of Michigan. However, it was during the 1960s and 1970s that new topics
emerged in venture capital research (Brophy, 1982; 1986; Timmons and Bygrave, 1986).
One of the earliest interests in venture capital in the 1960s came from scholars in the
field of management through works on entrepreneurship who became interested in the
characteristics of new technology-based firms, and the problem of external financing in
these ventures (see for example early contributions by Shapero, 1965; Roberts, 1969;
Cooper, 1971; von Hippel, 1973). In addition, these management scholars stimulated a
series of studies on the financing of growth-oriented companies seen from the entrepre-
neur’s point of view – demand perspective (see for example Baty, 1963; Aguren, 1965;
Briskman, 1966; Rogers, 1966; Hall, 1967). Several of the latter studies were published as
MS theses at MIT in Boston and can in many cases be regarded as ‘one shot’ studies,
whose authors did not develop a sustained body of work in the field.
Another research strand came from scholars in the field of finance who, especially in
the 1970s, became interested in venture capital. For many years, knowledge of equity
markets in finance theory has been well developed. These theories were typically oriented
towards equity finance of large publicly traded companies. However, venture capital was
different in several respects; venture capital invested in young firms with little performance
history, the relationship between investor and investee was characterized by a higher
degree of involvement and the investments were often illiquid in the short term due to the
lack of efficient exit markets. As a consequence, there was an open field for theory devel-
opment – trying to apply financial models to venture capital, and researchers also
addressed the issue of market efficiency on the venture capital market with early contri-
butions by, for example, Donahue (1972), Bean et al. (1975), Charles River Associates
(1976), Leland and Pyle (1977), Cooper and Carleton (1979), and Chen (1983).
A third area of early interest was the venture capital process, from the investment decision
to the exit of the investment. Throughout the 1970s attention was devoted to examining the
investment and screening process from the venture capitalist’s point of view – a supply per-
spective (see for example Briskman, 1966; Aggarwal, 1973; Wells, 1974) – and most of the
studies confirmed the general belief that the quality of the entrepreneur/founding team and
the marketability of the idea are central for success. Another issue of interest in venture
capital research was the performance of venture capital investments, and in several studies
the annual rate of returns on these investments was calculated (see for example Faucett,
1971; Wells, 1974; Hoban, 1976; Poindexter, 1976; Dorsey, 1977; Huntsman and Hoban,
1980; DeHudy et al., 1981). The conclusions that can be drawn from these studies were that
it was difficult to find reliable data and the results of the studies were highly varied.
Methodologically, most of the research at this time was based on anecdotal data and/or
survey studies using small samples, and venture capitalists were not always willing to provide
information that could be made public – factors that made the research less reliable.
The emergence of research on institutional venture capital

As the venture capital industry grew in scope and importance during the 1980s, interest
among scholars increased. A main point of departure was that venture capital concerned
‘building businesses’ and no single discipline could claim to possess sufficient knowledge to
provide complete understanding of this process. Therefore, a number of scholars, from
different disciplines – mainly management and entrepreneurship as well as from the field of
finance and economics – ‘rushed’ into this emerging topic – providing different concepts and
methodological approaches in order to understand venture capital finance. Thus, one such
group had a background in management and entrepreneurship and focused their attention
on the venture capital process (from fund raising, pre-investment activities, to exit of the
investment) from a managerial point of view – a micro-level focus – or what we will call
‘managerial-oriented venture capital research’. Several pioneering studies were presented in
the 1980s, and some examples are given in Table 1.3. It should be emphasized that the selec-
tion of studies is based on my own subjective view, not on any bibliographical analysis.
Another group of researchers with roots in finance and economics concentrated on the
venture capital market – a macro-level focus – trying to analyse and understand the flow
of venture capital, its role in the development of new industries, regional aspects of
venture capital, and so on – or what we will term ‘market-oriented venture capital
research’. Some of the pioneering studies of the 1980s are presented in Table 1.4.
As noted by Sapienza and Villanueva in Chapter 2 of this book, the early contributions
to venture capital research can be characterized as highly descriptive, where the researchers
primarily aimed to document a more or less unknown phenomenon. As such, early research
Table 1.3 Topics in managerial venture capital research
Topics of research Pioneering studies

Pre-investment activities Tyebjee and Bruno (1984), ‘A model of venture capitalist
and investment decision investment activity’, Management Science, 30 (9), 1051–66.
criteria MacMillan et al. (1985), ‘Criteria used by venture capitalists to
evaluate new venture proposals’, Journal of Business Venturing,
1, 119–28.
MacMillan et al. (1987), ‘Criteria distinguishing successful from
unsuccessful ventures in the venture screening process’, Journal of
Business Venturing, 2, 123–37.
Venture capital Robinson (1987), ‘Emerging strategies in the venture capital
investment strategies industry’, Journal of Business Venturing, 2, 53–77.
Syndication/Co-investing Bygrave (1987), ‘Syndicated investments by venture capital firms:
A networking perspective’, Journal of Business Venturing, 2, 139–54.
Bygrave (1988), ‘The structure of the investment networks of
venture capital firms’, Journal of Business Venturing, 3, 137–57.
Governance and Sahlman (1990), ‘The structure and governance of venture-capital
contracting organizations’, Journal of Financial Economics, 27, 473–521.
Post-investment Gorman and Sahlman (1989), ‘What do venture capitalists do?’,
activities/board of Journal of Business Venturing, 4, 231–48.
directors/value added Rosenstein (1989), ‘The board and strategy: Venture capital and
high technology’, Journal of Business Venturing, 3, 159–70.
MacMillan et al. (1988), ‘Venture capitalists’ involvement in their
investments: Extent and performance’, Journal of Business
Venturing, 4, 27–47.
Sapienza and Timmons (1989), ‘Launching and building
entrepreneurial companies: Do the venture capitalist add value?’,
in Brockhaus et al. (eds), Frontiers of Entrepreneurship Research,
Wellesley, MA: Babson College, 245–57.
Success factors, returns Bygrave et al. (1989), ‘Early rates of returns of 131 venture
and performance capital funds started 1978–1984’, Journal of Business Venturing,
4 (2), 93–105.
has been extremely useful in that it has not only contributed to a deep understanding of the
industry and the way in which venture capitalists operate, but also provided a sound base
for further theory building. The ‘descriptive’ period of venture capital research during the
1980s was followed by a growing interest in more theory-driven venture capital research.
Before discussing the development of venture capital research during the 1990s, I will
comment on the importance of databases in this regard. A contributing factor in the
emerging interest in venture capital among researchers was the fact that data on venture
capital became available not least from sources such as Venture Economics. Venture
Economics gathered data from venture capital firms regarding their investment activities,
and the information was published monthly in the Venture Capital Journal. But there were
Table 1.4 Topics in market-oriented venture capital research
Topics of research Pioneering studies

Flow of venture capital Brophy (1986), ‘Venture capital research’, in Sexton and Smilor
(eds), The Art and Science of Entrepreneurship, Cambridge, MA:
Ballinger.
Venture capital as a Cooper and Carleton (1979), ‘Dynamics of borrower–lender
financial intermediator interaction: Partitioning final pay off in venture capital finance’,
Journal of Finance, 34, 517–33.
Chen (1983), ‘On the positive role of financial intermediation in
allocation of venture capital in a market with imperfect
information’, Journal of Finance, 38 (5), 1543–61.
Venture capital and the Sahlman and Stevenson (1985), ‘Capital market myopia’,
development of industries Journal of Business Venturing, 1 (1), 7–30.
Kenney (1986), ‘Schumpeterian innovation and entrepreneurs in
capitalism: A case study of the US biotechnology industry’,
Research Policy, 15, 21–31.
Regional aspects of Florida and Kenney (1988), ‘Venture capital and high technology
venture capital entrepreneurship’, Journal of Business Venturing, 3, 301–19.
Martin (1989), ‘The growth and geographical anatomy of venture
capitalism in the United Kingdom’, Regional Studies, 23, 389–403.
Policy-oriented venture Timmons and Bygrave (1986), ‘Venture capital’s role in financing
capital research innovation for economic growth’, Journal of Business Venturing,
1, 161–76.
also other databases available such as the Investment Dealer’s Digest on initial public
offerings of securities, and the Center for Research in Securities Prices with daily return
data on IPOs. The increased availability of data made the research on venture capital
more methodologically sophisticated, and it became possible to test theories, thus leading
to more reliable and valid research.
As indicated above, during the 1990s we could increasingly identify a theoretical devel-
opment in venture capital research. An interesting observation in this respect by Sapienza
and Villanueva (Chapter 2) is that the emergence of venture capital research coincided
with the development of the entire field of management science, and it was natural that
early contributions in venture capital research followed the prevailing trends of theoret-
ical development in management science in general, with a reliance on rational economic
models and use of agency theory as a dominant theoretical framework.
The number of researchers and published articles on venture capital grew significantly
during the 1990s (see Figure 1.1). At the same time the research became more theoret-
ically oriented and, as shown by Cornelius and Persson (2004; 2006), the field became
partly divided into two separate clusters of researchers – one with a background in finance
and economics and the other rooted in management and entrepreneurship theory. For a
review of earlier research on institutional venture capital, see for example Wright and
Robbie (1998), Mason and Harrison (1999a) and the three-volume compilation of key
articles on venture capital research by Wright, Sapienza and Busenitz (2003).
Theoretical background
Management and Finance and
Entrepreneurship Economics
Main focus
Examples: Examples:
Jeffry Timmons, William Paul Gompers, Josh Lerner,
Macro Bygrave, Gordon Murray Raphael Amit, Thomas
Hellman, Bernard Black,
Ronald Gilson, Leslie Jeng,
Philippe Wells
Level of
analysis Main focus
Examples: Examples:
William Bygrave, Harry Paul Gompers, Josh Lerner,
Sapienza, Lowell Busenitz, Mike Wright, Raphael Amit,
Micro Jeffry Timmons, Anil Gupta, James Fiet, Anat Admati, Paul
Andrew Zacharakis, Dean Pfleiderer
Shepherd, Sophie Manigart,
Vance Fried, Robert Hisrich
Figure 1.4 Researchers on institutional venture capital
Many important contributions to venture capital research were made during the 1990s,
and it would be impossible to choose two or three that could be regarded as more impor-
tant than the others. However, in Figure 1.4 I will present some of the leading scholars
within the field during the 1990s – researchers who showed a growing interest in theoret-
ical understanding of the venture capital phenomenon and used more sophisticated
methodological approaches.
One conclusion that can be drawn from the study by Cornelius and Persson (2004; 2006)
is that there are two different clusters that seldom meet or cite each other’s work. In order
to develop our knowledge of institutional venture capital, I believe it is necessary to encour-
age cross-fertilization between these two clusters of researchers. The building of a social
structure among researchers within the field goes hand in hand with the cognitive develop-
ment of the research. For example, it is important to develop a ‘cognitive style’ that includes
a professional language and clear definitions of central concepts within the field of venture
capital. In order to establish this cognitive style, it is essential to develop a ‘social culture’
within the field, which requires regular and intensive forums for discussions, where infor-
mal communication between researchers is of central importance. Informal networks are a
prerequisite for the exchange of ‘tacit’ knowledge, consensus regarding definitions, discus-
sions on methodological approaches, and so on. Such ‘research circles’ (Landström, 2005)
can be achieved through the establishment of research centres and well-developed informal
international networks – promoting cross-fertilization within venture capital research.
Pioneers of institutional venture capital research

In this section I will present some of the pioneers of institutional venture capital research:
Tyzoon Tyebjee, Ian MacMillan, William Bygrave and William Sahlman. I will provide a
short summary of the seminal articles of each pioneer, followed by an interview with each
of them in order to present their reflections on their own contribution to knowledge, as

well as their views on the venture capital industry and venture capital research. I will start
with Professor Tyzoon Tyebjee and the article he wrote together with Albert Bruno in
Management Science – which is one of the most cited articles in venture capital research.
Picture 1.1 Tyzoon Tyebjee, Professor of Marketing, University of Santa Clara, USA
BOX 1.1 TYZOON TYEBJEE
Born: 1945
Career
1977 – Leavey School of Business,
Santa Clara University, USA
Professor of Marketing
1975–1977 Wharton School, University of Pennsylvania
Education
1976 PhD in Marketing
University of California, Berkeley
1972 MBA in Marketing
University of California, Berkeley
1969 MS in Chemical Engineering
Illinois Institute of Technology, Chicago
1967 B Tech in Chemical Engineering
Indian Institute of Technology, Bombay
Seminal article
The article by Tyzoon Tyebjee and Albert Bruno ‘A model of venture capitalist invest-
ment activity’ published in Management Science in 1984 can be regarded as a truly seminal
work within venture capital research. It was based on two empirical studies. The first
comprised a telephone survey of 46 venture capitalists in California, Massachusetts and

Texas, while in the second, Tyebjee and Bruno used Pratt’s directory of venture capital
(1981) to identify 156 venture capital firms, 41 of which participated in the study. The
venture capitalists were sent a questionnaire for the purpose of evaluating deals under
consideration by the firm, and 90 completed evaluations were returned. On the basis of
the studies a venture capital process model was developed, in which the investment
process was described as consisting of five phases: (1) deal origination; (2) screening;
(3) evaluation; (4) deal structuring; and (5) post-investment activities. The authors par-
ticularly focused on the evaluation phase in which venture capitalists assess a new venture
proposal based on a multidimensional set of characteristics.
The venture capitalists who participated in the study were asked to rate deals that had
passed their initial screening according to 23 decision criteria. Based upon a factor analy-
sis Tyebjee and Bruno concluded that venture capitalists evaluate deals in terms of five
basic characteristics: (i) market attractiveness; (ii) product differentiation; (iii) manage-
ment capabilities; (iv) environmental threat resistance; and (v) cash-out potential.
The score of each deal estimated on the basis of the five dimensions was related to
subjective estimates of the level of expected return and perceived risk using a linear regres-
sion model. The results indicated that two aspects seemed to have a significant impact on
the risk associated with the deal – a lack of managerial capabilities significantly increases
the perceived risk followed by ‘environmental threat resistance’, whereas the attractive-
ness of the market and the product’s differentiation are related to the expected return.
In the sample of 90 deals, 43 were regarded as acceptable investments while 25 were
rejected. A discriminant analysis was used to examine whether the level of perceived risk
and return could be used as a means of distinguishing between rejected and accepted
deals. According to the results of the study, the decision to invest is determined by the risk
versus return expectations, and venture capitalists seem to be profit oriented and averse
to risk, although they are willing to invest in risky deals if the risk involved is offset by the
profit potential.
As indicated above, this seminal work by Tyzoon Tyebjee and Albert Bruno is one of
the most cited articles within venture capital research and forms the basis for many of the
studies that constituted a strong research stream within venture capital research during
the 1990s on the criteria used by venture capitalists when assessing new deals.
Interview with Tyzoon Tyebjee
What attracted your interest in venture capital and venture capital decision-making?
I studied engineering and came to the US from India in the late 1960s to take my gradu-
ate degree. Following some work as an engineer, I decided to go to business school, and
in pursuing a PhD I specialized in the area of marketing, in particular consumer choice
behaviour. After a brief stay in the faculty at Wharton Business School I joined Santa
Clara University. At Santa Clara University, in the heart of Silicon Valley, my interests in
business, and my former interest in engineering and technology really came together,
because I was now in an environment where the commercialization of technology played
a very significant role. So, it was not a big issue for me to go into the area of venture
capital, but my interest was really sparked by some funding which was made available by
the National Science Foundation in order to carry out research on what was then a
relatively young industry. My co-author Albert Bruno and I received a fairly large amount
of funding for the project.
The interest of the National Science Foundation was actually a little different from our
interests. The government wanted to know what happened to ventures that received no
funding . . . in other words, was the venture capital market efficient in terms of recogniz-
ing strong opportunities, or were some commercially viable opportunities ignored by the
venture capital industry, and if so, did these ventures find alternative sources of funding?
My personal interest was to try to introduce consumer choice behaviour and apply choice
behaviour models to how venture capitalists made choices.
Your study was published in Management Science and became one of the truly seminal
articles within the field of venture capital research . . .
At that time there was very little published work on venture capital in mainstream acad-
emic literature. Most of the venture capital research was very descriptive . . . size of deals,
amount of equity investments, profile of venture capital firms and ventures, and so on.
And those kinds of studies were not very often published in the academic literature. I
think one of our significant contributions was the legitimization of both area and topic
by modelling them in a way that gave them academic credibility and, in this regard, the
aspect of the study that focused on venture capital decision-making and venture capital
choice behaviour was a piece that really lent itself best to serious modelling.
You have followed the development of the venture capital industry for a long time. What
changes in venture capital have taken place since the 1980s?
I think a couple of things have happened in the venture capital market in the US. One is
that there is a much greater number of venture capitalists today who were actually entre-
preneurs themselves . . . people who have been through the start-up process themselves
and, as a result, they are not just financiers, they are people who bring operational exper-
tise. Having said that, the venture capital industry has become more professional with less
reliance on pure instinct, far more analysis, far more financial models applied to valua-
tion, resulting in a significant improvement in technical skills within the venture capital
decision-making process.
In addition, the geographic scope of investments has widened considerably. The focus is
no longer local. There was a saying 25 years ago that people invest so that they can visit the
venture and sleep in their own bed that same night . . . that is not so any more . . . venture
capital has become a global industry and that represents a big change. Globalization is also
apparent if you look at what the venture capital network is composed of . . . in the 1980s,
the members of the venture capital associations were all basically American white males.
Today, the membership is global . . . firms employ the skills of people who have either lived
or were born outside of the US and who have very strong networks over there.
Another big change is that there is a distinction now between funding products and
funding businesses. I think there is a discussion which did not take place 25 years ago that
if an entrepreneur has an innovative product – that is no longer enough . . . the venture
capitalist asks: Is this product the foundation . . . has it got the potential to spin off a wider
range of portfolio products or opportunities? A good example is Google. Google which
basically started out as a search engine, but its business today has far exceeded that . . .
basically, a product has to be a platform for building a wider range of businesses.
Looking at the venture capital industry today, is there anything that can be learned from your
study in the early 1980s?
One of the things that I think we contributed to, besides the decision-making criteria
model, was to model a process that identified the stages of the venture capitalists’
decision-making process. A good venture capitalist, today as well as in the past, is strong
in each of these areas, they have good networking in order to be able to locate and iden-
tify deals, they have strong evaluation methodologies to be able to focus on deals to which
they can bring the highest level of added value as a venture capital firm as well as those
which are most likely to succeed. Third, they have strong skills in terms of structuring
these venture capital arrangements, and finally, they are very strong in terms of the post-
investment contributions they make in the venture, especially in the area of board repre-
sentation and in their networking ability.
If you were to conduct your study today, what changes would you make?
I think that I would have included a wider range of criteria to reflect today’s environment,
and certainly the globalization of business and the ability of the venture to respond to the
market would have been something that I would have focused on . . . at that time it was
not much of an issue.
Let us look at venture capital research in a general sense . . . what development can you see
in venture capital research?
I think it has broadened the questions that have been asked. It has drawn on a wider range
of disciplinary interests, which in my opinion has been very useful. For example, the
finance community has become a much stronger discipline for venture capital research,
and they have brought a methodology and line of inquiry that was lacking 25 years ago.
So, questions such as what affects valuation, what affects the value of the firm when it goes
public . . . these were not questions which were really pursued 25 years ago . . . focus was
more on the venture capitalist and less on the venture, and I think that has changed.
However, I still think that there is not enough cross-fertilization between the research
which emerges from traditional entrepreneurship surveys and interviews and the more
secondary financial database oriented research which has been carried out by the finance
community.
The second thing that has changed is that there are much stronger quantitative data-
bases today, and these have been made available to members of the academic community,
facilitating a line of inquiry much broader than self reports.
So, as I see it, it is more that methodology and disciplinary perspectives have changed.
In terms of the questions themselves . . . I think that the basic questions have remained
the same. These questions are: how do you select a deal, what affects its success, and to
what extent does the value added by the venture capitalists influence that success . . . these
are the fundamental questions.
What advice would you give to new PhD students on venture capital?
My advice to them would be to push the issue to another level in terms of trying to bring
new approaches by means of new questions rather than simply doing some incremental
advances on previous studies . . . I think a great deal of the research is based on that. For
example, referring to our own study . . . five criteria became six (or maybe seven), and the
labels changed . . . but there has really been no significant advance in terms of looking at
it in a new way.
A second piece of advice is to recognize that this is an area in which obtaining good
data is very difficult, particularly if you are relying on venture capitalists and surveys of
them as the source of such data. So, I think that an advance should come from new
research in the area of methodology concerning how to obtain insightful data on venture
capital.
A third area that I would emphasize, and this is a far narrower observation than the
previous two, is to try to understand the role that the portfolio of the venture capital firm
plays in the success of an individual venture. We have looked a great deal at the relation-
ship between the venture capitalist and the venture, while the relationship between a par-
ticular venture and the others in the portfolio has not received as much attention in spite
of the fact that it would facilitate an understanding of how the network of relationships
within a venture capitalist’s portfolio leverages individual ventures.
Fourth, I think it would have been useful to ask: has the structure of the venture capital
industry changed? For a long time we have talked about two legs: institutional and angel,
and corporate venture capital has been added as a third. But are there other emerging
forms of venture capital? I think it is very useful to look at the context . . . different kinds
of venture capital emerge in different contexts. For example, if we look at the Asian
markets where family business structures are very strong; how does the idea of venture
capital and family business overlap and intersect?
Finally, if we look more specifically at venture capitalists’ decision-making, one area
that requires some improvement is that when we study venture capital decision-making
we pretend that there is a single decision-maker . . . which is rarely the case. In a venture
capital firm there are multi-parties who jointly make a decision, so I think that it is impor-
tant to try to understand how multiple inputs in a multi-decision-maker environment end
up in an investment decision as well as how these decisions flow over the multi rounds of
investment in the same firm. So, a longitudinal decision-making approach over a single
venture . . . that is something that I haven’t seen.
Policy aspects of venture capital are always a ‘hot topic’: what can we learn from the US in
order to improve the venture capital market in other countries, for example in Europe?
About 15–20 years ago I wrote a paper called ‘Venture capital in Western Europe’ in an
attempt to understand what aspects of the US environment differ from Europe. I think
several things have changed. At that time tax policy in Europe was very restrictive, but I
think it is much less restrictive today. There are no strong cultural heroes, and there was
less of a tendency to pursue something outside of the established business institutional
structure by striking out on your own. I think that has also changed . . . not as strongly
as in the US but there has nevertheless been a change.
One of the areas in which US venture capital has been extremely successful is the flow
of knowledge . . . historically, much of that has been due to the US immigration laws. If
you look at many of the venture capital successes you will find that there is an immigrant
somewhere in the venture, and I think Europe has been very restrictive in that regard – in
terms of allowing people to bring knowledge capital. So, an efficient venture capital
market requires not only the free flow of capital, but the free flow of knowledge . . . and
I think that policy-makers will have to encourage that.
In general, from a policy point of view, I think the basic idea is to get out of the way . . .
and that means allowing people to be successful and become wealthy which obviously
involves tax policy, allowing knowledge to flow freely, while at the same time protecting
that knowledge by means of patents. Thus, I think that rather than focusing on venture
capital per se, it is necessary to focus on the overall environment in which venture capital
operates.
Picture 1.2 Ian MacMillan, Professor of Management, Wharton School of Business, USA
BOX 1.2 IAN MACMILLAN
Born: 1940
Career
1986– Wharton School, University of Pennsylvania
1986– Director, Sol C. Snider Entrepreneurial Research
Center
1986–1999 George W.Taylor Professor of Entrepreneurial Studies
1999– Fred R. Sullivan Professor
1984–1986 New York University
Professor and Director of the Center for Entrepreneurship Research
1976–1983 Associate Professor, Columbia University
1975 Visiting Researcher, Northwestern University
1965–1970 Chief Chemical Engineer, Consolidated Oil Products, South Africa
1963–1964 Scientist, Atomic Energy Board, Government Metallurgical Labs,
South Africa
Education
1975 DBA, University of South Africa
1972 MBA, University of South Africa
1963 BS, University of Witwatersrand, South Africa
Seminal articles
Following on Tyebjee and Bruno, Ian MacMillan together with colleagues wrote some
very important articles on decision-making in venture capital in the mid-1980s. The first
article was ‘Criteria used by venture capitalists to evaluate new venture proposals’ in 1985,
and it was intended as a follow-up and a replication of an earlier study by Tyebjee and
Bruno presented at the Babson Conference in 1981. In the article, Ian MacMillan and his
colleagues elaborated on the question: what criteria do venture capitalists use when evalu-
ating venture proposals? Based on interviews with 14 venture capitalists in the New York
area and a questionnaire sent to 150 venture capitalists, the results indicated that venture
capitalists evaluated ventures in terms of six risk categories (which correspond closely
with the findings of Tyebjee and Bruno, 1981):
1. Competitive risk, i.e. little threat of competition and an existing competitively insu-
lated market.
2. Risk of being unable to bail out if necessary.
3. Risk of losing the entire investment.
4. Risk of management failure, i.e. whether the entrepreneur is capable of sustained
effort and knows the market thoroughly.
5. Risk of failure to implement the venture idea, i.e. whether the entrepreneur has a clear
idea of what s/he is doing and whether the product has demonstrated market potential.
6. Risk of leadership failure, i.e. whether the entrepreneur has leadership qualities.
The main conclusion in the study was that the most important criteria had to do with
the entrepreneur’s experience and personality, which MacMillan expressed in the follow-
ing way: ‘There is no question that irrespective of the horse (product), horse race (market),
or odds (financial criteria) it is the jockey (entrepreneur) who fundamentally determines
whether the venture capitalist will place a bet at all’ (p. 128).
However, the fact that venture capitalists use certain criteria does not mean that such
criteria can distinguish between successful and unsuccessful ventures. In a later article, in
1987, entitled ‘Criteria distinguishing successful from unsuccessful ventures in the venture
screening process’, MacMillan and his colleagues tried to determine the extent to which
criteria are useful predictors of performance. A questionnaire was designed in which 220
venture capitalists were asked to rate one of the most successful ventures and one of the
least successful ventures they had funded, based on 25 decision criteria. In addition, the
venture capitalists were asked to rate the venture’s performance on seven performance
variables. In total, 150 evaluations were usable in the study.
The results indicated that the major difference between a winner and a loser seemed to
be some ‘difficult-to-define’ entrepreneurial team characteristics, and MacMillan con-
cluded that ‘. . . it is not surprising that venture evaluation remains an art, a long way from
becoming a science’ (p. 129). Another interesting finding was the identification of two
major criteria as predictors of venture success: (1) the extent to which the venture is ini-
tially insulated from competition; and (2) the degree to which there is demonstrated
market acceptance of the product.
It is interesting to note that these two criteria are market- rather than product- or
entrepreneur-related and neither was considered essential in the 1985 study. The question
was: why were criteria related to the entrepreneurial team and the entrepreneur, which
were emphasized in earlier studies, not regarded as predictors of success? In this respect,
MacMillan made a distinction between necessary and sufficient conditions for success.
Venture capitalists will not back ventures with a bad entrepreneurial team. Success or
failure has to do with those ventures that receive funding. The evaluation of the entre-
preneurial team is essential in order to obtain financial backing from venture capitalists
whereas the two criteria – threat of competition and market acceptance of the product –
are predictors of success for firms already financed by venture capitalists.
Another topic in MacMillan’s early contributions on venture capital was the interest in
the added value brought by the venture capitalists to the ventures in which they invest.
The article ‘Venture capital involvement in their investments’ (1988) followed some earlier
studies on venture capitalists’ involvement and value-adding (see for example Gorman
and Sahlman, 1989; Timmons and Bygrave, 1986) indicating that, in addition to provid-
ing capital, venture capitalists also play many other roles in their portfolio firms. However,
none of these studies correlated the venture capitalists’ involvement with the ventures’
performance – which MacMillan and his colleagues attempted to do in this study.
The study is based on a questionnaire distributed to a sample of 350 venture capitalists
(response rate 18 per cent or 62 usable responses), in which the venture capitalists were asked
to indicate their involvement in each of 20 activities for a specific venture. The results show
that serving as a sounding board for the entrepreneurial team and different financially ori-
ented activities had the highest rating, whereas the lowest degree of involvement occurred
in activities related to ongoing operations. However, the most interesting results concern the
identification of three distinct levels of involvement adopted by venture capitalists:
● Laissez-faire involvement – the venture capitalists exhibited limited involvement.

● Moderate involvement.
● Close tracker involvement – the venture capitalists in this group exhibited more
involvement in virtually every activity than their peers.
Some interesting conclusions emerged from the study. For example, it appeared that
venture capitalists exhibit different involvement levels as a matter of choice, and not due
to different characteristics of the ventures. When the performance of the ventures was
examined, it was evident that there were no significant performance differences among
ventures in the three clusters – each involvement strategy is about equally effective, that is
‘close tracker venture capitalists’ were no more or less successful than the other groups.
Interview with Ian MacMillan
Let’s start with the seminal studies on venture capital decision criteria that you conducted in
the mid-1980s, and which were published in the Journal of Business Venturing in 1985 and
1987. Why did you become interested in this topic?
In 1975 I came from South Africa to the Northwestern University in Boston, but after a
few years I moved to Columbia University in New York. In the early 1980s a decision had
been taken by New York University to launch a Center for Entrepreneurship, and in 1984
I was offered the position as professor and director of the Center for Entrepreneurship
Research. I remained in that position until 1986, when I moved to Wharton School of
Business in Philadelphia.
In New York we had a fair amount of contact with venture capitalists in the area. We
found out that there seemed to be some criteria that all venture capitalists looked for when
evaluating a new deal, but the thing that struck me was that there were also some idio-
syncratic criteria that differentiated venture capitalists from each other – some venture
capitalists seemed to use a different set of decision criteria – but although most venture
capital investments are highly risky and have a high failure rate, the venture capitalists
were still able to deliver a significant rate of return to their investors – that attracted my
interest: what criteria do venture capitalists use when evaluating new investment propos-
als? And, does it matter?
In the first study we found that the quality of the entrepreneur and the entrepreneurial
team was of great importance in the venture capitalists’ evaluation, but we didn’t know
anything about performance in relation to the criteria used by the venture capitalists – as
the criteria emphasized by the venture capitalists were not necessarily correlated with the
success of the ventures. The big surprise in the second study was that the emphasis the
venture capitalists attached to the quality of the entrepreneur and the entrepreneurial
team didn’t correlate with performance. So, there was a huge emphasis on the entrepre-
neur, but when we looked at the impact of these criteria on outcomes it turned out that it
was not the entrepreneur that mattered so much but rather the demand for the product in
the market place and protection against competitive attacks . . . and this was a puzzle.
We went back to the venture capitalists and said: ‘Here is an anomaly . . . you place a
tremendous amount of emphasis on the entrepreneur, but the reality is that when we
looked at performance, it is the product characteristics in the market place that seem to
matter!?’ The explanation was that we were overlooking the fact that the characteristics
of the entrepreneur and the entrepreneurial team were used to screen out the certain
losers . . . people that the venture capitalist would not invest in . . . and what was left
over is a bunch of people who, despite their qualities, provide no indication of whether
or not they will be successful. And what may determine the success of a project is an
established demand in the market and that the product is protected from competitive
attacks. Thus, while the entrepreneur is a necessary condition, s/he is not sufficient for
success. What basically happened was that we went beyond simply accepting the results
and said: ‘Let’s try to find the reasons why these results do not line up with our obser-
vations of the real world.’
You also looked at the venture capitalists’ involvement in the ventures in which they invest . . .
a study that was published in the Journal of Business Venturing in 1988.
Many venture capitalists that we met claimed that they did more than just invest in a
company . . . that they brought an added value beyond capital . . . but at that point in time
we had very little hard data on this added value. I became intrigued by the ways in which
venture capitalists could add value. To me it was obvious that venture capitalists could
add value – they had experience and expertise from active involvement in many ventures.
To bring one of the leading venture capitalists into the venture meant not only money,
but access to the venture capitalist’s experts and legitimizing the venture, which has a
domino effect.
What we found in the study was that venture capitalists seemed to work in various ways
based on their own decisions, but there was no significant difference in performance
related to their involvement strategy. This was interesting, but you have to remember that,
as in many earlier studies, we had some problems measuring input as well as output vari-
ables. So, when you have judgemental data as well as messy dependent and independent
variables, it should come as no surprise that the relationships are ‘messy’. This is probably
a very complex relationship. It might be a good thing for the entrepreneur to involve a
venture capitalist in the venture, but such involvement also means a host of issues that
could be very harmful . . . it is the mix of good and bad that leads to inconsistencies in
the results of the study, and we were unable to sort that out . . . a problem that researchers
still have.
How would you describe the research on venture capital that followed from your and others’
pioneering studies?
I think what we needed back in the 1980s was to get some scope and terrain identifica-
tion. Much of the early work that I did on entrepreneurship and venture capital was
more in the nature of documentation of phenomena that had not been described before,
and categorizations of phenomena, rather than the development of new theories . . .
going into emergent fields or topics and seeing if we could identify the decisive key vari-
ables, to pass them on to other researchers to explore in greater depth . . . it made further
work possible . . . in that respect I think our early work was important. Once you have
done your explorative work somebody must bring some theory into it, and that is what
I think happened in the 1990s. Researchers started to think about the phenomenon of
venture capital in the context of theory and in particular brought economic concepts
and theories, not least agency theory, into venture capital research . . . that is a natural
progression.
The concern is of course if you let these theories totally dominate the research . . . then
you increasingly have the kind of research that we find in a lot of management research
today. We are not there yet, but there is a danger that it will happen – an incredibly sophis-
ticated analysis of basically trivial problems . . . and less emphasis on what we can learn
that provides us with insights for people operating in the ‘real world’ – we need to develop
meaningful knowledge.
Looking to the future. What kind of research questions would you like to see in the years
to come?
I will give you two examples of venture capital research that I would very much like to see
in the future: first, as you know, I have been involved, together with Rita McGrath, in the
development of what we call ‘option reasoning’, and I would very much like to see venture
capital research based on option reasoning. Second, I would like to see more room for
researchers who study venture capital investments as a sociological phenomenon . . .
more attention to understanding how networks of venture capitalists make decisions . . .
maybe to see the venture capital community as a neural net – a bunch of nodes making
decisions and being aware of the decisions that are made by others.
You are a very experienced mentor and supervisor of doctoral students. What advice would
you give to a new doctoral student who wants to start research on venture capital?
This is perhaps one of the most difficult questions to answer. I have spent many years
trying to tell my doctoral students to think in terms of relevance . . . the research must be
relevant and important to society, and you need a great deal of confidence and intellec-
tual capabilities to produce ground-breaking work that is relevant to and important for
society. This is a challenging task and you never know if you will make it and be able to
develop a number of papers that set you up for the tenure race . . . and, it is difficult to
encourage young researchers to take this path.
As a doctoral student you need to get published . . . have enough articles published to
obtain tenure. Therefore, most doctoral students will work on more incremental studies,
extending knowledge with a few minor variations, with greater chances of getting pub-
lished . . . because journals are more interested in statistical, robust results than in relevance
to society. This is a strategic decision for a doctoral student – it is a trade off between rele-
vance, newness and big risks, compared to replication, incremental development of knowl-
edge, and less risk of failure. My heart indicates the first path, but not many people make
it. The problem is that the research easily becomes trivial. So, all doctoral students who I
work with today must go through my ‘six-people-test’. If you are going to do research you
need to do something that couldn’t be solved by six smart people in a two-hour discussion.
If they come to the same conclusion as you do from research, then why do the research?
Why not talk to six smart people? Research must go beyond what is self-evident.
Picture 1.3 William Bygrave, Professor of Entrepreneurship, Babson College, USA
BOX 1.3 WILLIAM BYGRAVE
Born: 1937
Career
1985– Babson College
1991– Frederic C. Hamilton Chair for Free Enterprise Studies
1993–1999 Director, Arthur M. Blank Center for Entrepreneurship
1982–1985 Associate Professor, Bryant College
1984 Associate Professor, Boston University
1979–1982 Associate Professor, Southeastern Massachusetts University
1970–1978 Deltaray Corporation
1963–1978 High Voltage Engineering Corporation
Education
1989 DBA in Management (Policy), Boston University
1979 MBA (Executive Program), Northeastern University
1963 D.Phil. in Physics, Oxford University
1963 MA (Physics), Oxford University
1959 BA (Physics), Oxford University
Seminal articles
One of the most influential pioneers of venture capital research, and a researcher who has
dedicated his life to our knowledge of venture capital, is William Bygrave. During the
1980s Bygrave presented several pioneering contributions in venture capital research. One
study that deserves mention is ‘Venture capital’s role in financing innovation for economic
growth’ together with Jeffry Timmons (1986). The aims of the study were to (i) determine
the characteristics of technology-oriented venture capitalists and entrepreneurs in these
high-tech firms, (ii) examine the factors that influence the supply of venture capital for the
development of small high-tech companies, and (iii) elaborate on whether or not public-
policy instruments could be used effectively in this process. In the study, the authors used
the Venture Economics database and classified 464 venture capital firms according to
their investments in ‘highly innovative technological ventures’ (HITV) and ‘least innova-
tive technological ventures’ (LITV).
The study shed new light on the flow of venture capital to highly innovative ventures
at that point in time. The reduction of the capital gains tax at the end of the 1970s
had led to an unprecedented growth in the venture capital industry, and not least in
HITV investments. However, HITV investment requires less capital than initial invest-
ments in LITV – what is required is quite specialized management, not capital, and there
was a core group of highly skilled and experienced venture capitalists that accounted for
a disproportionate share of HITV investments. In terms of policy implications, the
general view in the article was that government should take a ‘hands-off’ approach to
the venture capital market – active government involvement could well do more harm
than good.
A second study that received a great deal of attention was on the subject of the
co-investment networks of venture capital firms, and Bygrave elaborated on this issue in
several seminal articles. The first article that appeared in the Journal of Business
Venturing (1987), ‘Syndicated investments by venture capital firms’, is an examination
of linkages of venture capital firms through syndication investments. In this article
Bygrave posed the following questions: why do venture capitalists network? Do the
reasons differ for various types of venture firms? Bygrave used a sample of 1501 port-
folio firms for the period from 1966 to 1982 and analysed the joint investments of 464
venture capital firms.
The results show that co-investments were more common among venture capitalists in
high than low innovative technology ventures, and in early-stage compared to later-stage
investments. Thus, the innovativeness and technology of the portfolio companies were
crucial in explaining networking among venture capital firms. Bygrave argues that more
co-investments are made where there is greater uncertainty and that the primary reason for
co-investing is the sharing of knowledge rather than the spreading of financial risk –
venture capital firms gain access to the network by having knowledge that other firms need.
The second article on venture capitalists’ co-investment networks, ‘The structure of
investment networks of venture capital firms’ (1988), builds on his previous work and uses
his classification of ‘high innovative’ (HIVC) and ‘low innovative’ (LIVC) venture cap-
italists, depending on their investment profile. He employed this categorization to analyse
the differences between HIVC and LIVC, but also to identify regional differences in
network patterns. The venture capital firms from the Venture Economics database were
classified into three groups: (i) the top 61 firms – in terms of most investment in portfolio
firms; (ii) the top 21 HIVCs – subset of the 61 firms that mainly invested in high-tech com-
panies; and (iii) the top 21 LIVCs – venture capital firms among the top 61 that mainly
invested in low innovative firms.
The conclusion was that the venture capital industry in general could be regarded as a
rather ‘loosely coupled system’, but the coupling of HIVCs, and especially those in
California, was quite tight. In this kind of tight system, external influence can affect the
entire system, as information can flow through many channels and make the behaviour in
these systems more uniform – which may also explain why herds of HIVCs stampede into
or out of new industries.
Finally, in another seminal work by Bygrave, together with some collaborators at
Venture Economics, ‘Early rates of return of 131 venture capital funds started
1978–1984’, published in the Journal of Business Venturing (1989), the authors noted the
lack of reliable data and systematic analysis of the rates of return on venture capital
investments. On the other hand, there was no shortage of anecdotal accounts and folk-
lore about the rate of return in the venture capital industry – often indicating returns of
30 per cent or more. Bygrave compiled a database of 131 venture capital funds reporting
their rate of return on investments – covering about 50 per cent of the new capital com-
mitted to private funds at the beginning of the 1980s.
The contribution of this study is mainly the compilation of the database – for the first
time ever it was possible to analyse the rates of return in the venture capital industry in
a systematic way – although the analysis reported in the article was rather premature
and it was too early to draw any clear conclusions (for example the oldest fund in the
database was 7 years old and the youngest not more than 15 months old). However, the
preliminary analysis of the annual compound rates of return in the period 1978 to 1985
was disappointing compared to the myths that flourished about them in the industry,
which, in general, declined at the beginning of the 1980s, although the oldest funds in
the database showed a great performance – far in excess of the oft-quoted expectation
of 25–30 per cent.
Interview with William Bygrave
You have an interesting background with a PhD in physics and many years as a manager.
Can you give a short summary of your career?
Yes, I did my PhD in Physics at Oxford in 1963. But I always had an interest in the com-
mercial world – I grew up in a micro-business context, most of my relatives were entre-
preneurs. So, when I graduated from Oxford in Physics I was recruited by an American
firm, the High Voltage Engineering Company. I was employed as sales manager for three
years, and after which I moved to America in 1966 and took charge of the commercial-
ization of new products.
Interestingly, the High Voltage Engineering Company was a public company on the
New York Stock Exchange, and it turned out to be the first ever venture capital backed
company, funded by Georg Doriot and his venture capital company American Research
and Development back in the 1940s.
After a couple of years I became more and more frustrated by the fact that the company
didn’t put enough resources into products that I thought had huge potential, and I left
in a friendly fashion. In 1969, together with an MIT professor, I started the Deltaray
Corporation, a high tech company that manufactured ultra-stable, high voltage power sup-
plies. We raised money from venture capitalists – at that time the venture capital market was
very small and the market almost unknown, but we succeeded. In 1974 we sold the company
to the High Voltage Engineering Company . . . my former employer . . . and I stayed with
them for a couple of years and became marketing manager – but I didn’t enjoy it.
I took an executive MBA at Northeastern University in 1979. Jeff Timmons was the
leader of the programme. I met Jeff and it turned out that we had many things in common.
At one meeting Jeff said to me ‘I think you are a pretty good teacher. Have you ever
thought about an academic career?’ I said ‘why not?’ . . . my family wasn’t keen on me
starting another business. So, I became a teacher and I enjoyed it. However, I soon real-
ized that I couldn’t go further than teaching at a rather average university without doing
research within the field. I went to Boston University and started on their doctoral pro-
gramme on a part-time basis in 1981. I contacted Jeff Timmons and Jeff replied immedi-
ately and told me that he had a project on venture capital for which he tried to get funding
from the National Science Foundation.
At that time, the beginning of the 1980s, there were many myths about the venture
capital industry, for example, that the rate of return was at least 40 per cent, the most crit-
ical factor for the flow of capital was a reduction in the capital gains tax, and venture
capital was more than money – venture capitalist brought value-added. But very little was
really known about the industry. Some work had been carried out in the 1960s, mainly
from a financial perspective, and there were some studies done at MIT . . . mostly as
master theses . . . but that was all. Very few knew about the industry, about the flow of
capital, and where the industry was going.
We obtained funding for the project, and the National Science Foundation wanted to
know a great deal, but primarily to understand the flow of venture capital to innovative
companies. I started to look at this issue together with Venture Economics . . . which was
a company just a mile from Babson College, and they had a database with about 450
venture capital firms and 4000 portfolio firms. At that time everything was stored in a
mini-computer with 20 Mbyte, and it was a real limitation in terms of the amount of data
that could be stored electronically as opposed to physically.
The first thing we did was to characterize the industry based upon technological
innovativeness, the flow of capital in the market and, most especially, capital for
high-tech companies. We developed a scale for classifying the portfolio firms depend-
ing on their degree of innovativeness. Some rather interesting results came out of the
study, and it became my first paper for the Babson Conference in 1983, after which
some of the results were presented in my Journal of Business Venturing article with Jeff
Timmons in 1986.
But did that study not produce even more results?

Yes, we had a good database from Venture Economics, and we had developed a catego-
rization in which we could distinguish between ‘highly innovative technological ventures’
and ‘least innovative technological ventures’, which we could use to look at the networks
among venture capitalists through their syndication investments.
We divided the venture capitalists into 21 ‘top high-tech venture capital firms’, 21 ‘low-
tech venture capital firms’, and 61 firms that didn’t have any preferences. We contrasted
the high-tech firms with the low-tech firms, and what we found was that there were
differences between venture capitalist networks on the east coast and the west coast – the
California network was much tighter than its counterpart on the east coast, which also
influenced the flow of information. But, what we couldn’t disclose in the articles that were
published in the Journal of Business Venturing in 1987 and 1988 were the names of the
most central venture capital firms in the network – the most central one being Kleiner
Perkins.
You also performed a study on the rate of returns in the venture capital industry?
Shortly after the first study, Venture Economics called me up and asked me to put a data-
base together, which included the rates of return in the venture capital industry. That must
have been in 1985. The problem was that the venture capital funds wouldn’t let us have
the information, but we could obtain it from the limited partners. Most of the limited
partners, such as pension funds, didn’t even know about their rate of return from their
venture capital investments because they didn’t have any software to measure it . . . but
we said that we could put together a data set if they only allowed us access to their records.
In that way we put together a data set including the rate of return for more than 200 funds
in America.
I’ll never forget the first time that we printed out the results. It took about 20 minutes
to run . . . we could see it printing, but after a couple of minutes it stopped. In order to
make the programme run efficiently, I designed the rate of return algorithm to have a
maximum 84 per cent rate of return . . . I never dreamt that anyone could achieve that, so
that wouldn’t be a problem . . . but, the printer stopped, and finally, I had to double the
upper limit in my algorithm, and the printer started to run again. So, guess what . . . it
was Kleiner Perkins once again, not only were they the most central in the venture capital
network, their rate of return was so high that it broke my algorithm. That is wonderful . . .
seeing something nobody else knows on your computer screen.
However, Kleiner Perkins was one of the few winners. Looking at the industry in
general, the average rate of return was only 15 per cent in 1985, not the 40 per cent that
everyone was talking about. Venture Economics wouldn’t publish the figures, but the
results leaked out to journalists. The reactions from industry were mixed – some venture
capitalists were furious, others more grateful that correct figures now had been made
public. But I couldn’t use the results in my research because the information was bound
to secrecy until 1988 when Venture Economics agreed that we could publish it, and it
became a Babson Conference paper in 1988 and then an article in the Journal of Business
Venturing in 1989.
I was also doing my dissertation, and all these studies were included in my doctoral
thesis entitled ‘Venture capital investing: a resource exchange perspective’, which I pre-
sented in 1989 at Boston University.
How would you characterize the development of the research field since your pioneering
studies in the 1980s?
In the 1980s the venture capital industry was shrouded in mystery . . . it was an industry
full of myths, but it is fair to say that, by the beginning of the 1990s, venture capital was
an ‘open book’ and the research very much from a practitioner’s point of view . . . such
as venture capitalists, policy-makers, and entrepreneurs. Today, a great deal of research
on venture capital is more rooted in the theory of sociology, psychology and economics.
Nothing wrong with theory, but research doesn’t have much impact on practice anymore.
Frankly, I think there is too much research being done on venture capital. If venture
capital disappeared tomorrow in America, we wouldn’t see any effects on entrepreneur-
ship . . . a few years down the road there would be consequences because the growth of
technological innovations would be slower, but venture capital does not develop new ven-
tures, it merely takes existing ventures and accelerates their growth. I have realized more
and more that venture capital is so rare in start-ups that it is negligible – only 1 in 10 000
start-ups will have venture capital when they start their business – and in fact, when I
lecture my MBA students, I say; ‘forget about venture capital . . . try to get informal
investors instead’.
So, that is your advice to your MBA students, but what would your advice be to a new PhD
student interested in venture capital?
Don’t research venture capital! Since I started my research in the 1980s the proportion of
money going to early stage ventures has just kept declining, but if we look at the informal
investors market – it is enormous. When we did the GEM study, the biggest surprise for
me was to see the amounts of money from informal investors, in a broader sense than
‘business angels’. I estimated that about 100 billion dollars a year comes from informal
investors in America, and a great deal goes into early stage ventures. And from the entre-
preneurs’ perspective the action is in the informal investors’ market, and it is there that we
as researchers should make an effort.
The risk is that we are doing ‘easy’ research . . . where we can obtain easy data, as
opposed to research that is relevant to policy-makers and entrepreneurs. If we study the
informal investors’ market, it isn’t easy to obtain data, we have to work with messy data
and less elegant databases, and we have to give credit to young researchers who are willing
to work with this kind of data. Such research will be far more influential in terms of advice
to entrepreneurs and policy-makers.
Finally, if we look at policy implications, what should government do to promote an active

venture capital market?
Looking back, we can conclude that the changes in the pension fund rules at the end of
the 1970s were most influential for the flow of venture capital in America. However, the
changes in capital gains tax only seem to have had minor effects. Capital gains tax only
affects individuals and over the years the proportion of individuals investing in the
venture capital industry has dropped. A majority of the money for venture capital is sup-
plied by non-taxable sources such as pension funds, endowments and foreign investors. In
addition, I have also learned that there is only one thing that really affects the flow of
venture capital and that is the strengths of the public offering market – forget anything
else – you need to have a strong second tier market.
Picture 1.4 William Sahlman, Professor of Business Administration, Harvard Business

School, USA
BOX 1.4 WILLIAM SAHLMAN
Born: 1951
Career
1980 – Entrepreneurial Management, Harvard Business School
1999–2002 Co-chair Entrepreneurial Management Unit
1991–1999,
2006– Senior Associate Dean
1990– Dimitri V. D’Arbeloff Professor of Business
Administration
Education
PhD in Business Economics, Harvard University
MBA, Harvard University
A.B. degree (Economics), Princeton University
Seminal articles
With his roots in financial economics, William Sahlman has been extremely influential
in venture capital research. His early studies are still among the most cited works
within the field. His article ‘Capital market myopia’ in 1985 was the lead article in the
first issue of the Journal of Business Venturing. In the article, William Sahlman and
Howard Stevenson focused their attention on a phenomenon that they call ‘capital
market myopia’ in which participants in the capital market ignore the logical implica-
tions of their individual investment decisions – each decision seems to make sense,
but when taken together they are a recipe for disaster and lead to over-funding of indus-
tries. The article uses the Winchester Disk Drive industry as an example of this
phenomenon.
The Winchester Disk Drive industry, that is high-speed data storage devices for com-
puters, grew rapidly in the late 1970s and early 1980s. The technology was first introduced
by IBM in 1973, and many new entrants followed, resulting in an inexorable increase in
the performance of computers as well as disk drives. The expectations of the industry
were high, and there were many spin-offs where executives in firms that were active in the
data storage industry decided to go after a share of the growing market and started their
own companies.
Finding venture capital for start-ups in the disk drive industry was easy. The industry
was perceived as attractive, there was a large group of high quality management, and the
equity capital market was increasing. The late 1970s and early 1980s were characterized
by a rapid growth in the venture capital industry in the US as well as robust stock market
performance. Many of the firms in the disk drive industry received money from venture
capitalists – from 1977 to 1983 just over $300 million was invested in the industry by
venture capitalists – and a number of firms began to raise capital through the public stock
market rather than continuing to rely on venture capital funding.
However, something began to happen in the industry and many companies ran into
difficulties; new technologies were introduced and competition increased, many compa-
nies were unable to produce acceptable quality drives, and the market for computers (the
customers of the disk drive companies) showed a significant downturn in the rate of
growth. Sahlman and Stevenson argued that the venture capitalists could have been aware
of these changes if they had used available information on the market, the technology and
competition – ‘the data necessary to anticipate the problem were readily available before
the industry shakeout began and stock prices collapsed’ (p. 7).
In another seminal article, ‘The structure and governance of venture-capital organiza-
tions’ (1990), William Sahlman was one of the first to describe and analyse the structure
of venture capital organizations. In the article Sahlman provides an analysis of the rela-
tionship between the venture capital firm and its fund providers as well as between the
venture capitalist and their portfolio firms. The article provides an in-depth understand-
ing of how venture capital organizations are governed and managed.
Regarding the relationship between venture capital firms and their fund providers,
Sahlman devotes particular attention to the financial contract that governs the relation-
ship and highlights the agency problems involved in the relationship. He argues that
venture capitalists have many opportunities to take advantage of the fund providers and
that agency problems are exacerbated by the legal structure of the limited partnerships in
which limited partners are prevented from playing a role in the management of the
venture capital firms. In order to protect the limited partners the contract needs to be
designed in such a way that the venture capitalists will not make decisions against the
interests of the limited partners, for example, by the inclusion of a limitation on the life
of the venture capital fund, a compensation system that gives the venture capitalists
appropriate incentives, and a contract that addresses obvious areas of conflict between
the venture capitalist and the limited partner.
The article also includes a discussion about the relationship between the venture cap-
italist and his/her portfolio firms. Sahlman drew particular attention to the information
asymmetry between the venture capitalist and entrepreneur, which may cause monitoring
problems. In this respect, Sahlman provided a rationale for venture capitalists to stage
their commitment of capital, devise compensation schemes that provide the entrepreneur
with appropriate incentives through active involvement in the portfolio firms, and pre-
serve mechanisms to make investments liquid.
Finally, in the article ‘What do venture capitalists do?’ (1989) Michael Gorman and
William Sahlman shed some light on how venture capitalists spend their time. Based on
the results derived from 49 responses to a questionnaire distributed to venture capitalists
in 1984 they concluded that:
● Venture capitalists spend about 60 per cent of their time monitoring nine portfolio
firms, in five of which they are the lead-investor.
● As lead-investors they devote 80 hours of on-site time and 30 hours of phone time
per year to each portfolio firm.
● The most common services for the portfolio firms were to help build the investor
group (raise additional funds), formulate their business strategy and fill the man-
agement team (management recruitment).
Even though the article is very descriptive, it has been heavily cited and can be regarded
as very influential in terms of understanding venture capitalists’ involvement in the firms
in which they invest – the venture capitalist–entrepreneur relationship, monitoring activ-
ities and value-adding effects.
Interview with William Sahlman
In the 1980s you wrote several seminal articles on the venture capital industry. What
awakened your interest in venture capital and the venture capital industry?
My background was that I had a degree in economics from Princeton, and for a short
period I worked in the area of finance in New York. I came to Harvard Business School
(HBS) in 1973. As I was graduating from the MBA programme I applied to the PhD pro-
gramme in Business Economics at HBS . . . I was accepted for the programme, but spent
a year in Europe writing cases for Harvard Business School. I wrote my thesis in eco-
nomics on the interaction between investment and financial decisions in companies and
joined the faculty of the Department of Finance at HBS in 1980.
In 1982 we started to plan for a conference on entrepreneurship at HBS, for which I
wrote a paper ‘The financial perspective: what should entrepreneurs know’. In the paper
I tried to understand entrepreneurship, what financial decisions were like for entrepre-
neurs, who the players in the financial market were, and whether or not finance for entre-
preneurial firms was different from what could be called ‘traditional finance’. We had a
very interesting conference, which included a number of practitioners, including quite a
few from the venture capital industry as well as some entrepreneurs. The purpose was to
set an agenda for HBS – what should HBS do to understand these kinds of activities? You
have to remember that ten years after graduation just under 50 per cent of all HBS grad-
uates describe themselves as ‘entrepreneurs’, a large proportion of all venture capitalists
have their roots at the Harvard Business School, and the group of people who started the
venture capital industry in the US . . . Doriot, Perkins, to mention a few . . . all came from
HBS. So, the school is deeply rooted in entrepreneurship and the venture capital industry.
I began to write cases about entrepreneurship and about people in the venture capital
industry – in total I have written almost 160 cases for HBS. In the mid-1980s I decided to
launch a new course in ‘Entrepreneurial Finance’ which was introduced in the spring of
1985. I also decided to write all my own material and cases for the course . . . as I developed
course materials, I observed several interesting questions in the venture capital industry, like
why did they use securities that seem inappropriate for risky ventures; why did they stage
the commitment of capital; what decision rights do they retain; what happens down the
road depending on the performance of the venture, etc.? So, there were many interesting
questions to be explored.
Based on this experience I wrote a note called ‘Note on financial contracting’ that resulted
in an article entitled ‘Aspects of financial contracting in venture capital’ in the Journal of
Applied Corporate Finance, in 1988, which then evolved into the article ‘The structure and
governance of venture-capital organizations’ in the Journal of Financial Economics, in 1990.
Yes, the article ‘The structure and governance of venture capital organisations’ is probably
your most cited article in venture capital research. What do you see as its major findings?
At that point in time, no-one had really laid out the main issues in the venture capital indus-
try – there was not much written about the venture capital industry – and the article was
an attempt to take a financial economist’s lens and apply it to a field-based research project.
I think the most important part of the article was to show the interconnectedness
between the governance of the funds and the investments in individual ventures – the
interconnectedness of those two systems. Researchers often study one system but not the
other, but you cannot understand why venture capitalists make bets and how they struc-
ture the deals with individual entrepreneurs, without understanding how the funds are
structured. Another important contribution in my opinion was to provide some rationale
for staged capital commitment, and I also tried to compare that with how capital is allo-
cated in larger companies.
Does fund structure matter?

Well . . . on the one hand, you can say that limited partnerships are no better or worse
than other fund structures but, on the other hand, I believe there are several aspects that
make limited partnership an important way of governing the venture capital funds. I con-
sider that the structure of staging the capital committed to venture capital funds is
extremely important . . . making the venture capital funds pay all the money back before
giving them more money is a remarkably powerful control mechanism . . . that kind of
structure works much better than providing a permanent pool of capital.
Looking at performance it seems as if US funds always outperform European VC funds . . .?

Yes, historically you are correct . . . due to a stronger ‘right hand tail’ of successful com-
panies in the US as well as a more active exit market – most exits have been IPOs in the
US, as opposed to mergers, and IPOs yield higher returns. But as the economy becomes
more global, we will see more successful ventures all over the world and stronger exit
markets – and the differences between countries or continents will level out.
This leads us to some policy issues. What do you think policy-makers can do in order to create
an efficient venture capital market?
Well, I think there is essentially very little that governments can do to encourage
venture capital. My view is that venture capital follows people and ideas . . . venture
capital doesn’t lead them . . . in many cases policies are based on the notion
that money attracts entrepreneurs, but I think it has a tendency to attract the wrong
entrepreneurs and the wrong ideas. So, what you have to do is to encourage
entrepreneurship.
However, one thing has to do with failures and bankruptcies. In many countries, it
is a dishonour to fail, and if you go bankrupt there are a host of personal legal
implications as well as high costs – that context is damaging to entrepreneurship and
you will have fewer people starting new ventures. But it is not only a question of the
downside of failures, the question is also: what is the upside of entrepreneurship – the
right hand tail . . . to be successful – is far less attractive in many countries than it is in
the US.
In another early article that you wrote together with Howard Stevenson, ‘Capital market
myopia’, you were very critical of the venture capital industry.
Yes, I noticed that all venture capitalists seemed to rush into the same industry at the same
time. Why did that happen, and what can be learned?
Historically, it turns out that every industry ever created seems to have the same course
of development. In the beginning, you start with a large number of entrants and many
players – it is the same if you look at the railroad industry, the telephone industry, or what-
ever – and all will be financed in the early days by informal capital, by business angels.
There will be some early successes. But, we also know that as the industry matures, many
firms will be over-valued and some will disappear from the market, and there will be many
losers. So, this is not a new phenomenon. What was new in the Winchester Disk Drive
industry in the 1970s and 1980s was the new class of professional investors and a new tech-
nology that very few people understood. The entrepreneurs within the industry all had
the same origin in companies like IBM, Memorex, etc. and they were all desperately
searching for faster, cheaper, smaller products . . . in this case disk drives. Every single
venture capitalist who invested in the industry believed that his team and their technol-
ogy were going to win. As expected, not everyone can obtain a 10 per cent market share –
at least not 130 companies – so, inevitably there were a large number of failures. But there
were not only losers – in the venture capital industry you know that there is a high likeli-
hood of losses – there are a small number of interesting firms that will generate remark-
able profits. So, the question was ‘Did it all make sense?’ and ‘Why were people assuming
that their company would win?’
We see this over and over again, in e-commerce, in nanotechnology, etc. Don’t venture
capitalists learn anything?
You have to remember that this is a difficult game. If we look back 15 years, 50 per cent
of all distributions in the venture capital industry came from 30 firms. So, venture capital
returns are heavily concentrated . . . the nature of the game is that everybody has to try
to find the winners. In this respect, it is not necessarily stupid to invest in companies where
there is a high likelihood of failure, as long as you place your bets so that you end up with
some companies in the ‘right hand tail’ of the distribution – the great winners. It is a ques-
tion of understanding the industry. And if we look at the disk drive industry itself, it was
not very structurally attractive . . . it had no network effects, low operating margins . . .
so, the likelihood of a huge pay-off in the ‘right hand tail’ is much smaller than in many
other industries. And, I think, the venture capital community has learned a bit about
which industries may create big winners.
A third article that has been influential in venture capital research is ‘What do venture
capitalists do?’ published in the Journal of Business Venturing in 1989.
Yes, I must admit that I am surprised that the article has been cited so often. It was based
on a student project and contains very little analysis and interpretations, but to some
extent the data speak for themselves and I think researchers had never looked into the
work of venture capitalists in a systematic way.
Does venture capitalist involvement in the firms in which they invest really matter?
I believe that . . . there is a tremendous amount of evidence to suggest that venture cap-
italists are beneficial in many different ways – introducing people to a network that they
have cultivated over a long period of time, making it easier to get access to future finance,
and there is a certification process that helps to legitimize the venture in the market place.
Have you seen any changes in the way venture capitalists work today compared to your study
in the 1980s?
Yes, there is a change in the sense that venture capitalists today have much more capital
to allocate per partner – they are involved in more ventures and spend less time with each
company, and accordingly, they are not as helpful as they were before.
I think of venture capital as an art in which judgement and wisdom play a critical role.
So, therefore, it is not a single attribute that makes a successful venture capitalist. For
example, we have seen venture capitalists with quite different backgrounds who have been
successful . . . venture capitalists with a financial background, in other cases former top
managers, etc. . . . and they are not always experts in the industries in which they invest –
in this respect the venture capitalist hasn’t changed.
Finally, if we look at venture capital research in the future, what are the questions that ought
to be asked?
I would say that there are some important questions that have not yet been addressed.
First, venture capitalists allocate a great deal of money to projects and new ventures, but
so do large corporations . . . and, how do we compare the relative efficiency of these two
models? Thus, I would very much like to see comparative studies of different models of
venture capital investments. Second, I don’t think researchers have done an adequate job
in understanding the dynamics of venture capitalists’ portfolios. Looking at the port-
folio of investments as opposed to individual investment I would liked to ask a series of
questions, for example; what was the proportion of failures, what was the proportion that
recouped more than ten times the money invested, what was the likelihood of obtaining
a second round of financing, what was the pay-off structure for the investments, etc.? A
third area of importance in which we haven’t seen a great deal of research is the board
of directors in venture capital-backed firms. What is an effective and ineffective board
structure?
One problem with these kinds of questions is that they require information from inside
the firms, not from databases . . . this is not an industry you can study without inside
knowledge that current databases do not provide. So, there is much hard work to be done.
Research on corporate venture capital
A history of corporate venture capital investments and research on corporate venture

capital
Probably the first corporate venture capital investor was DuPont back in 1919 when one
of its important customers ran out of funds, and DuPont purchased 38 per cent equity
interest in the company – General Motors. They brought in a new president, Alfred Sloan,
and General Motors grew substantially over the years. After World War I, American
Telephone, General Electric and Westinghouse made several investments. Soon after
World War II a small company, Haloid Corporation, funded the commercialization of a
new technology developed by Chester Carlson and the Battelle Memorial Institute – later
the company changed its name to Xerox Corporation (Rind, 1986). In the late 1950s
several larger corporations became interested in venture capital activities, and venture
capital firms funded by larger corporations or a subsidiary of a corporation, emerged in
the mid-1960s, pioneered by companies such as Xerox and AT&T. Since then corporate
venture capital has gone through several cycles (Rind, 1981; Gompers and Lerner, 1999;
Birkinshaw et al., 2002).
The initial wave of corporate venture capital occurred at the end of the 1960s. More
and more companies established divisions that acted as venture capitalists and in the early
1970s more than 25 per cent of the Fortune 500 firms implemented corporate venture
capital programmes. However, the market diminished dramatically in 1973, following the
oil price crisis, the abrupt decline in the market for new public offerings, and the ensuing
recession.
The second wave, beginning in the late 1970s and early 1980s, was fuelled by the growth
of the computer and electronic sector and reached a peak in 1986 when corporate venture
capital funds managed $2 billion, or almost 12 per cent of the total pool of venture capital
in the US. However, when the stock market crashed in 1987 and the market for new IPOs
dropped, larger corporations scaled down their venture capital investment commitments.
Finally, the third wave emerged in the 1990s linked to the technology boom and the
dot.com era, and in 1997 corporate investors accounted for about 30 per cent of the com-
mitments to new funds compared to an average of 5 per cent in the period from 1990 to
1992. As in the earlier waves of corporate venture capital, the interest was stimulated by
the success of the venture capital industry in general – rapid growth of funds and attrac-
tive rates of return. The market peaked in 2000 before the great crash (the collapse of
high-technology stocks, the loss of faith in internet-based businesses, and a number of
high-profile corporate failures). The conclusion arrived at by Gompers and Lerner (1999)
is that, over time, corporate involvement in venture capital has mirrored the cyclical
nature of the entire venture capital industry.
The emergence of the industry during the 1980s led to some pioneering scholarly work
on corporate venture capital, and in Table 1.5 some of the early contributions will be pre-
sented. All of these contributions can be regarded as highly descriptive (and normative)
in their approach. It was a way of making the ‘new’ corporate venturing tool visible and
discussing its advantages and limitations, that is corporate venture capital was considered
in the frame of strategic management and the corporate venture process.
However, after these pioneering works, the research on corporate venture capital was rel-
atively scarce with a few exceptions (for example, Gompers and Lerner, 1996; McNally, 1994)
Table 1.5 Early contributions on corporate venture capital
Pioneering studies
Fast (1978), The Rise and Fall of Corporate New Venture Divisions, PhD Thesis, Ann Arbor, MI:
UMI Research Press.
Rind (1981), ‘The role of venture capital in corporate development’, Strategic Management
Journal, 2 (2), 169–80.
Hardymon et al. (1983), ‘When corporate venture capital doesn’t work’, Harvard Business Review,
61, 114–20.
Burgelman (1984), ‘Managing the internal corporate venturing process’, Sloan Management
Review, Winter, 33–48.
Siegel et al. (1988), ‘Corporate venture capitalists: Autonomy, obstacles and performance’,
Journal of Business Venturing, 3 (3), 233–47.
Winters and Murfin (1988), ‘Venture capital investing for corporate development objectives’,
Journal of Business Venturing, 3 (3), 207–22.
Sykes (1990), ‘Corporate venture capital-strategies for success’, Journal of Business Venturing,
5 (1), 37–47.
until the late 1990s and early 2000s (linked to the third wave of corporate venture capital
investments) when a large number of studies on corporate venture capital appeared. A state-
of-the-art review of recent studies can be found in Chapters 15 and 16.
Pioneers of corporate venture capital research

As can be seen in Table 1.5, there were several early research contributions on corporate
venture capital in the 1980s. One of the pioneers in this respect was Kenneth Rind, who
in 1981 published an early article on corporate venture capital in the Strategic
Management Journal. Rind can be regarded as an active advocate of venture capital, not
only in the US but internationally, being a mentor for new venture capitalists, the author
of several articles and a notable speaker on venture capital. He is also regarded as one
of the pioneers in introducing venture capital to countries such as Japan, Singapore,
Israel, and Russia. In this section I will summarize his SMJ article and present an
interview in which he looks back on four decades as an active international venture
capitalist.
Seminal article
Kenneth Rind was one of the first to recognize corporate venture capital as a tool in the
corporate development toolbox. His observations were based on his experience of being
responsible for acquisitions and venture capital investments at Xerox Development
Corporation, but were also influenced by the second wave of corporate venture capital
that emerged in the late 1970s as a result of the growth of the computer and electronics
sector. In his article ‘The role of venture capital in corporate development’ (an extended
version was later published in the Handbook of Strategic Planning in 1986 entitled
‘Venture capital planning’), corporate venture capital is mainly seen as a strategic tool,
and in the introduction to the article Rind states (p. 169):
Picture 1.5 Kenneth Rind, Venture Capitalist, New York, USA
BOX 1.5 KENNETH RIND
Born: 1935
Career
1961–1962 Post-doctoral Argonne National Laboratory
1963–1964 Assistant Professor of Physics, City University of New York
1964 Founder, Quantum Science Manager, Samson Fund
1968–1969 Associate, Rockefeller Family & Associates
1970–1976 Vice President – Corporate Finance at Oppenheimer & Co., Inc.
1973 Founding Director of the US National Venture Capital Association
(NVCA)
1976–1981 Corporate Development Venture Capital Executive – Xerox
Development Corporation
1981 Co-founder of Oxford Partners – venture capital company
1993 Co-founder of the Nitzanim-AVX/Kyocera Venture Capital Fund in
Israel
1998 Co-founder of the Israel Infinity Venture Capital Fund
Education
1956 BA in Chemistry at Cornell University
1961 PhD in Nuclear Chemistry at Columbia University
Strategic managers have a variety of tools available which they may use to gain competitive
advantage and to optimise the business portfolios of their corporations. While the use of acqui-
sitions and joint ventures for this purpose is well understood, few corporations are familiar with
the benefits or the pitfalls of the various types of venture capital programmes . . .
However, it was not any successes of companies investing in venture capital at the end
of the 1970s that fuelled the increased activity. Rind argues that a combination of several
factors led to the resurgence of interest, for example, the excess corporate liquidity at that
point in time, a relentless toughening of anti-trust regulations regarding acquisition, and
the entry of foreign companies to the US market.
In the article, Rind compared corporate venture capital with conventional institutional
venture capital and he also put corporate venture capital in the context of other corpo-
rate development strategies. He provided an overview of corporate venture capital activ-
ities in the US at the time of the second wave of corporate venture capital, but the main
part of the article contains a discussion about the benefits for corporations involved in
corporate venture capital activities as well as the problems of and difficulties involved in
corporate venture capital programmes in different companies.
Focusing on the benefits of introducing a corporate venture capital programme,
Rind reports strategic advantages such as: engaging quickly with companies whose
product/technology could play an important role in the future, a better understanding of
the management strengths and weaknesses of potential acquisitions, obtaining products
at a lower cost and more efficiently than could be done in-house, and an early window on
new technologies and new markets that show future potential.
However, not all corporate venture capital programmes succeeded – in fact only 7 per
cent of active corporate venture capital organizations regarded themselves as very suc-
cessful, and over half did not even rate themselves as marginal successes. In the article
Rind emphasizes that the difficulties experienced from these less successful cases usually
arose from one of the following sources:
● Lack of people with appropriate skills;

● contradictory rationales (investee company versus the parent organization);
● legal problems; and
● inadequate time horizon (success in early-stage venture capital can take seven to ten
years, and corporate venture capital funds are generally terminated before that).
As a consequence, many corporate investors changed their investment approach and

started to make investments through venture partnerships. A venture capital partnership
provides the opportunity to attract good people, problem investments become less visible,
management time is saved, long-term commitment is assured and many legal liabilities are
eliminated.
Rind formulated his conclusion in the following way (p. 179): ‘venture capital is a useful
tool for corporate development. It is difficult but possible to do internally, and an outside
partnership investment can be either an alternative first step or a beneficial supplement to
a direct corporate venture capital programme.’
Interview with Kenneth Rind
You had a long career as a venture capitalist. Could you say something about your
background?
I obtained my PhD in nuclear chemistry at Columbia University, and after a couple of
years as a post-doc at Argonne National Laboratory I returned to New York in 1963 as
an Assistant Professor at the City University of New York teaching nuclear physics.
However, the promises made to me were not kept, and although I was offered tenure, I
stayed there for only two years. My room mate at the university, whose father was in the
finance business, encouraged me to start consulting on technology evaluations for the
financial community. So, I first did part-time consulting and after a couple of years it
became a full-time business, and I co-founded Quantum Science/Samson Fund. We were
retained by 8 out of the 10 largest mutual funds in the US, 5 out of 6 then operating
venture capital firms, and 3 out of 5 of the largest banks.
One of my clients was the Rockefeller family, and they recruited me to be their tech-
nology analyst but I also became involved in their venture activities. You can say that I
served my first apprenticeship there. While I was at Rockefeller we made a couple of very
interesting investments, for example, we were an initial investor in Intel – in the then new
integrated circuit business.
After a few years with the Rockefeller family I was recruited by Oppenheimer, a very
large money manager in those days. I was responsible for a venture capital fund in which
I became the senior partner – you could say that I continued my apprenticeship at
Oppenheimer.
In 1973 I also became active in forming the National Venture Capital Association, and
I was one of the initial Directors. Our main concern was to lobby for making venture
capital investments more attractive, and we were successful in so far as many changes were
made in the US regulations and tax system in the late 1970s – of which the ‘Prudent Man
Rule’, allowing pension funds to invest in venture capital funds, was the most important.
In 1976 I joined the Xerox Corporation and became responsible for their venture
capital and acquisition programme. You could say that this was a bad decision for me, but
maybe a good decision for the world. One consequential thing that I did was to go back
to my colleagues at Rockefeller and ask what they were investing in. They told me about
a personal computer manufacturer which sounded like an ideal supplier for Xerox. We
put a million dollars into Apple Computer, so that Apple would develop a computer that
Xerox had exclusive rights to – but Xerox rejected the design, and Apple produced it more
cheaply and called it MacIntosh. In general, I must admit that I was very sad about
Xerox – as the management made some rather peculiar decisions after I had left.
After Xerox I formed my own venture capital firm – Oxford Partners . . . after the street
where I lived, and not the university in the UK . . . I started to look for investors in 1980
and the fund was ‘closed’ in 1981. As I had been active in corporate venture capital at
Xerox, I brought in a large number of corporations, and within several years we had com-
panies like Xerox, IBM, ATT, Siemens and General Motors as investors.
You have been referring to my article in the Strategic Management Journal in 1981, and
I think you should consider my arguments in the article in the context of my experience
at Xerox and my new operation as an independent venture capitalist. In Xerox I had
experienced the difficulties associated with corporate venture capital, and I had seen a new
wave of corporations made venture capital investment. Many of these programmes failed,
and corporate venture capitalists were not always well regarded in the venture capital
community due to suspicions regarding their motives and doubts about their longevity –
and I wanted to teach how they could succeed. I was also on my own . . . launching my
own independent venture capital firm, and I went out to search for corporations to invest
in my fund. I travelled around making speeches, and the article in the SMJ was more or
less a way of selling my new fund – it was successful in encouraging over 25 corporations
to give us money instead of trying to invest in corporate venture capital by themselves.
But you have also been very active as an international venture capitalist and regarded as one
of the pioneering venture capitalists in Japan and Israel, and now you are actively working
to introduce venture capital in Russia . . .
Yes, I first became involved in international venture capital when I was at Oppenheimer.
My senior partner called me up and said that there was a Japanese company that would
like to learn about venture capital. I hosted them for a summer, and I introduced them to
venture capital situations and showed them what was happening in US technology . . . but
on condition that they invite me to Japan and allowed me to look at venture investments
in Japan . . . that must have been 1973 or 1974 . . . I went over and lectured about venture
capital, but I was turned down by MITI for making investments in Japan. However, at
Oppenheimer I hosted a number of people from Japan who had come to learn about
venture capital.
In 1986 I was asked by the Israeli government to come over and consider starting a
venture capital fund in Israel. I went over, but realized rather quickly that it was impossi-
ble to make money – the best engineers were working for the military, the government did
not like business, the inflation rate was 100 per cent per annum, etc. – and I concluded
that there was nothing for me to invest in. However, a few years later I received a phone
call from a friend of mine, who had a factory in Jerusalem, and he told me that the Israeli
government wanted to increase a venture capital activity and asked if I would be willing
to help set up a fund in Israel. Based on my earlier experience, I was doubtful, but he con-
vinced me that things had changed a lot in Israel by the early 1990s. So, in 1993 I founded
my first fund in Israel – Nitzanim-AVX/Kyocera Venture Fund – which was a part of the
government-supported Yozma programme.
In 1997 I was asked to join the board of an organization set up by the US Congress to
find useful work for Russian weapon scientists – the United States Civilian Research and
Development Foundation – and I became interested in technology developments in
Russia. I started to visit Russia, I held speeches on why venture capital should be encour-
aged, and tutored people to understand venture capital. However, progress has been very
slow . . . there is no tradition and no entrepreneurial spirit, and as I see it, it will take time
to foster venture capital in Russia.
You have been involved in introducing venture capital in many emerging venture capital
markets. What is your advice to policy-makers who want to encourage venture capital in a
country?
Over the years, foreign governments have learned more about venture capital . . . they
recognize that venture capital is a good thing . . . and when I make my presentations,
which are based on my experience from several different countries, I always say that
venture capitalists want to have (1) partners with an entrepreneurial spirit – drives and
visions; (2) a financial and scientific infrastructure; (3) world-class products and experi-
enced management teams; (4) large world markets with unfulfilled needs; (5) easy exits;
and (6) a context characterized by low taxes, low capital gains taxes, and the ability to
repatriate funds.
I usually advise governments on what has been done elsewhere to promote an active
venture capital market (see Table 1.6). I am not suggesting that all these initiatives work
in every country, but government should know what possibilities exist, and what has been
successful in other countries.
Table 1.6 Rind’s advice to governments on how to promote an active venture capital
market
Taxes Other financial programmes Non-financial programmes

1. Reduce capital gains rate 1. Encourage non-taxable entities 1. Encourage military/
– more for long-term to invest (‘Prudent Man Rule’) government labs/universities
capital gains to spin-out projects
– defer taxes if 2. Provide leverage through the pro- – help organize venture
re-invested in qualified vision of equity/loans/grants capital funds to finance
entity spin-out ventures
3. Ensure that investors will not – foster co-operation with
2. Give tax credits to lose capital start-ups
individuals/
corporations for 4. Pay for % of R&D/new 2. Improve liquidity/capital
investments in qualified facilities costs/labour raising
small firms, qualified (training) – create exchanges
venture capital funds, – lessen listing requirements
and R&D activities 5. Fund incubators/companies
in incubators 3. Allow investors to control
3. Waive corporate income investees
taxes, sales taxes, and 6. Make grants for generic – no cap limit on ownership
property taxes for R&D programmes
qualified start-ups 4. Require US-compatible
7. Establish Bird-F type of reporting (so firms can list
4. Allow investor losses to activity on NASDAQ)
offset ordinary income
8. Finance training abroad for 5. Permit immigration of
5. Lower taxes on venture capitalists skilled talent
management fees/bonus
9. Establish agencies to provide 6. Allow LLCs
6. Permit option grants/ consulting/support
exercise without taxes – 7. Encourage foreign
tax only when 10. Relax bank lending criteria corporations to: open
cash received development centres, invest,
11. Coax émigrés to return and acquire
7. Tax exemption for (e.g. housing)
foreign investors 8. Make successful
(irrespective of 12. Create industrial parks entrepreneurs into heroes;
tax treaty) encourage networks
13. Allocate part of government-
managed pension fund 9. Don’t ostracize failures
investments
As I see it, the most important way of encouraging venture capital is to promote an
entrepreneurial spirit in the country – people must feel it is a good thing to be an entre-
preneur, to build something that the world wants, and to become wealthy.
In addition, government should try to keep away from attempting to pick the winners
and losers by themselves – it is always a disaster – anything they do to encourage the
industry should be alongside experienced venture capitalists . . . and/or if the venture

capitalists select the companies, the government could say that they will leverage and
invest alongside the venture capitalists, but the venture capitalists are responsible for
making the company a success.
You have been active as a venture capitalist for four decades, you have been a mentor for
new venture capitalists, writing articles, making speeches about venture capital . . . what is
necessary to be a successful venture capitalist?
This is a very difficult question to answer . . . a venture capitalist succeeds by making good
investment, but you never know in advance which investments will be good – many com-
panies fail and venture capitalists lose money on most of their investments. But at least
you should, as a venture capitalist, have the skills to help the companies in which you
invest. The difference between venture capital and predicting stock market prices is that
venture capitalists can help to change the odds. In this respect, I strongly believe that
venture capital is a business that requires an apprenticeship . . . you can’t teach it, one has
to experience venture capital situations and learn from them . . . and we need a trained
cadre of people who know how to operate in the world of venture capital.
And I can see a problem . . . the people who founded the venture capital industry in the
US are now retiring, and new people who are coming in should apprentice . . . but a whole
bunch of people came in during the dot.com boom who didn’t know what they were doing.
Thus, venture capitalists must have the experience to help the companies in which they
invest. One of the most important decisions to make is replacing the founding entrepre-
neur at the right time and bringing in someone who is capable of running a growing
company. At the same time it is important to keep the founder on board, so that he/she
can continue to contribute from a technical point of view, as a spokesperson, etc. Unless
they have done that several times . . . people can’t learn that – they have to experience it
by themselves.
I also teach entrepreneurs how to make exits and always tell them not to make the
company dependent on having an IPO, but to run the company at all times as if either an
IPO or takeover is imminent and to make contact with corporate venture capitalists who
could be potential acquirers – even if they have no interest in investing in your company
at that point in time they should get to know you.
It is also important to emphasize that venture capital is a rather heterogeneous phe-
nomenon. I would say that there is no single way in which venture capitalists operate.
There are venture capitalists doing seed investments, others wait until there is a developed
business plan, some only invest in particular technologies, etc. And different venture cap-
italists are successful in different ways.
In your view, what will the venture capital market look like in the future?
I am sorry, but it is impossible to answer that . . . the only thing I know is that the market
goes through cycles and will always go through cycles – for the same reasons as the stock
market – people are greedy and will invest when the market goes up, and that is good for
venture capital. However, when a lot of money goes into the venture capital market,
venture capitalists invest in too many companies that are doing the same things, so many
go out of business. Thus, investors lose money, then there will be too little money, and we
will start all over again . . .
Historically I can also say that most of the returns have come from the top quartile of
venture capitalists – the most experienced venture capitalists – and I expect the future will
be no different.
Finally, some advice for the research community. What would you say will be the most impor-
tant questions for researchers on venture capital to answer in the future?
The one question that I have never been able to answer is how to keep a corporate venture
capital activity going. For example: how do you offer incentives to people in a way that it
doesn’t make corporate management and the internal people working with the corporate
venture capital group jealous?
In addition, I have given advice to many governments about what is needed to encour-
age venture capital in a country, and of course, I would be very happy to see research that
could confirm and sort out the initiatives that are successful – probably certain initiatives
would be more or less successful in different cultures and contexts.
Research on informal venture capital
Some early contributions

The interest in the informal venture capital market among policy-makers and researchers
started in the 1950s and 1960s. In particular, the financial problems experienced by many
young technology-based firms provided a starting point for studies on informal venture
capital. For example, in the late 1950s the Federal Reserve performed a couple of investi-
gations regarding the initial financing of new technology-based firms – studies that preceded
the Small Business Investment Act of 1958, which led to the creation of the Small Business
Investment Company (SBIC) programme in the US. The interest in early financing of young
technology-based firms originated in an emerging interest in business angels as an impor-
tant external source of finance for entrepreneurial ventures with a basis in new technologies.
Some of these early contributions during the 1950s and 1960s are summarized in Table 1.7.
However, it was the pioneering work by Professor William Wetzel at the University of
New Hampshire in the US that led to an increasing interest in the informal venture capital
Table 1.7 Early contributions on informal venture capital
Pioneering studies
Rubenstein (1958), Problems of Financing and Managing New Research-based Enterprises in
New England, Boston, MA: Federal Reserve Bank of Boston.
Baty (1964), The Initial Financing of New Research-based Enterprise in New England, Boston,
MA: Federal Reserve Bank of Boston.
Hoffman (1972), The Venture Capital Investment Process: A Particular Aspect of Regional
Economic Development, PhD Thesis, University of Texas at Austin.
Brophy (1974), Finance, Entrepreneurship and Economic Development, Institute of Science and
Technology, University of Michigan, Ann Arbor.
Charles River Associates Inc. (1976), ‘An analysis of capital market imperfections’, prepared for the
Experimental Technology Incentive Program, National Bureau of Standards, Washington, DC.
market. Wetzel’s study was based on the widely held perception that new technology-
based ventures encountered problems when raising small amounts of early-stage financ-
ing. On the other hand, anecdotal evidence indicated that ‘business angels’ played a role
in solving this problem. Little was known about the characteristics of business angels and
the flow of informal venture capital and in his study Wetzel wanted to ‘put some bound-
aries on our ignorance’.
Some central themes in informal venture capital research

Following Wetzel’s seminal study in the early 1980s, interest in the informal venture
capital market grew among researchers in the US and around the world. Researchers felt
a need to quantify and describe the informal venture capital market, thus the research has
been fairly descriptive and focused on three main questions:
● How large is the informal venture capital market? – The market scale.
● What characterizes the informal investors/business angels – ABC of angels (their
attitudes, behaviour and characteristics).
● How can a more efficient venture capital market be created? – Policies and infor-
mation networks.
The market scale Estimating the size of the informal venture capital market is a difficult
task. In one of his first research articles on informal venture capital, William Wetzel (1983)
concluded that the informal venture capital market is ‘unknown and probably unknowable’
(p. 26). Despite conceptual and methodological problems in researching the informal
venture capital market, a large number of scholars have been trying to estimate its size –
mainly defined as business angel investments. The result varies significantly between coun-
tries – from about 2.75 per millage of the GDP in the US to about 0.78 per millage in
Sweden – partly due to the different methodological approaches used to measure the scope
of the informal venture capital market (Mason and Harrison, 2000a; Avdeitchikova, 2005).
The conclusion that can be drawn from earlier studies is that the estimations of the
informal venture capital market are problematic in various ways (Mason and Harrison,
2000a) due to the private and unreported nature of the investment activity and the desire
of most informal investors to preserve their privacy. In addition, as indicated earlier, there
are severe problems of definition, for example, in some estimations investments by ‘family
and friends’ are included, whereas they are excluded in others, while some estimations
concentrate on the group of investors known as ‘business angels’. Most of the studies
relied on convenience sampling, and it remains unclear whether these samples are repre-
sentative of the underlying population of informal investors (Riding, 2005). Finally, many
earlier studies had very small samples and low response rates (Mason and Harrison,
2000a). Thus, the estimates made in the various studies must be considered very crude cal-
culations of the informal venture capital markets in different regions.
ABC of angels It was not only essential for researchers to estimate the size of the infor-
mal venture capital market – another question of importance was to characterize the indi-
viduals making informal investments, mainly the group of informal investors we call
‘business angels’ and to describe the attitudes, behaviour and characteristics of these indi-
viduals (ABC of angels). As far back as the 1980s, several studies were conducted in
different parts of the US in order to describe the ABC of angels in different regions.
However, at the end of the 1980s and early 1990s, academic and public policy interest in
the informal venture capital markets started to grow internationally and continued to do
so throughout the 1990s (for a review of the characteristics of angels, see Chapter 12 by
Peter Kelly).
Although the conditions for an active business angel market differ from region to
region and country to country, it is worth emphasizing that there seem to be many sim-
ilarities in business angels’ attitudes, behaviour and characteristics irrespective of context
(Lumme et al., 1998) as well as over time (Månsson and Landström, 2005). For example,
the ‘typical’ angel investor seems to be a middle-aged male with a reasonable net income
and net worth and previous start-up experience, who makes about one investment a year,
usually close to home. The primary method of finding new investment opportunities is
through friends and business associates, and they prefer high-technology and manufac-
turing ventures, with an expectation to sell out in three to five years (Mason and
Harrison, 1992).
However, despite many common characteristics, early research has repeatedly indicated
that the informal venture capital market is highly heterogeneous – almost individualistic
in character – and in the research we can find various attempts to develop categories of
investors that describe the market in more nuanced ways (see for example Gaston, 1989;
Coveney and Moore, 1998; Sørheim and Landström, 2001; Avdeitchikova, 2005). One
conclusion that can be drawn from these attempts is that there does not appear to be much
agreement with respect to the categorization schema developed in the various studies, and
the usefulness of the categorizations can be questioned: (i) informal investments are
unlikely to be mutually exclusive – informal investors may invest in a variety of different
ventures, including both ‘love money’ and ‘business angel investments’, and (ii) their
investment profile may change over time (Riding, 2005).
Thus, the conclusion that can be drawn is that we know a great deal more today about
informal investors and business angels but, despite 25 years of research, much more
remains to be learned about the characteristics of the investors and the dynamics of the
informal venture capital market.
Policies and information networks Wetzel’s pioneering work in the early 1980s addressed
the fact that the informal venture capital market experienced severe inefficiency problems,
making policy interventions necessary. In many countries there seem to be two major
problems associated with the informal venture capital market: (i) there are too few infor-
mal investors active on the market, and (ii) there are market inefficiencies that make it
difficult for investors and entrepreneurs to find each other (Mason and Harrison, 1997).
Tax incentives for private individuals who invest in unquoted companies have been the
main strategy for increasing the pool of informal investors on the market. The UK has
been the leading exponent of this kind of measure. Since the early 1980s, several strategies
that provide investors with different kinds of tax relief for informal investments have been
introduced. A study by Mason and Harrison (1999b; see also Mason and Harrison, 2000b;
2002) shows that the tax relief available to UK business angels has had a positive impact
on informal venture capital investment activity. The availability of tax relief on informal
investments – which reduces the risks involved – seems to be the most important encour-
agement for informal investors to invest more, whereas reducing the rate of capital gains
tax – increasing the reward – seems to be less influential than front-end tax relief, although
both have an impact on promoting informal venture capital activity. However, Lerner
(1998) argues that new ventures are inherently risky, and there is considerable uncertainty
regarding their survival and growth. Thus, there is always a risk that attempts by govern-
ment to stimulate the informal venture capital market may ‘encourage amateur individual
investors’ which will be counterproductive for society. Lerner concludes that encouraging
informal investments could be ill-advised – some investors may lack the skills necessary to
protect themselves and to accurately value the opportunity in which they invest.
A conclusion that can be drawn is that tax incentives need to be complemented by
micro-level initiatives – one such initiative is ‘business introduction services’. One initia-
tive was the Venture Capital Network (VCN), introduced by William Wetzel in New
Hampshire in 1984 as a business introduction service to provide an efficient channel of
communication between business angels and entrepreneurs. This idea of business angel
networks or matching services was later introduced in several places in the US as well as
in other countries. In this respect the UK has also been at the forefront in encouraging the
establishment of such communication channels. According to Mason and Harrison
(1999b), the performance of business angel networks (BANs) has been varied but, in
general, evidence suggests that on an aggregate level their impact on informal venture
capital activities has been both positive and significant (different kinds of business angel
networks are discussed by Jeffrey Sohl in Chapter 14).
Pioneers of informal venture capital research

In this section I will present the real exponent of informal venture capital research –
Professor William Wetzel – starting with a summary of his pioneering article in the Sloan
Management Review – an article that opened up the research field and inspired many
studies on business angels. I will also include an interview in which he gives his view on
the research on informal investors and business angels.
Seminal article
Until the end of the 1970s the number of studies on the informal venture capital market
was rather limited. However, at the beginning of the 1980s, Professor William Wetzel at
the University of New Hampshire put informal venture capital on the ‘research map’. In
1978 Wetzel conducted a pilot study, based on a questionnaire distributed to 100 individ-
uals with a known interest in venture investment situations. A total of 48 completed ques-
tionnaires were returned and the results showed, among other things, that the total
potential pool of venture capital represented by the respondents exceeded $1 million per
year, the required rates of return were lower than those typically required by professional
venture capitalists, and so on. Wetzel came to the conclusion that ‘business angels’ prob-
ably represent the largest pool of risk capital for entrepreneurial ventures and that the
informal venture capital market plays an essential role in the growth of the high-tech
sector.
Based upon the analysis presented in the pilot study, the Office of Economic Research
of the US Small Business Administration funded an expanded study of the availability
of informal risk capital in New England, USA, in the autumn of 1979. Wetzel and his
colleagues undertook a nine-month search for business angels, resulting in a sample of
133 investors. The results of the study were presented in one of the most cited articles on
Picture 1.6 William Wetzel, Professor of Management, University of New Hampshire, USA
BOX 1.6 WILLIAM WETZEL
Born: 1928
Career
1993– Professor of Management Emeritus University of New Hampshire
1967–1993 Whittemore School of Business and Economics, University of New
Hampshire
1983 Founder of the Center for Venture Research
1983–1993 Director of the Center for Venture Research
1984 Founder of the Venture Capital Network Inc (VCN)
1987–1993 Forbes Professor of Management Chair
1987–1988 Paul T. Babson Visiting Professor of Entrepreneurial Studies,
Babson College
Education
1967 MBA (Finance and Accounting), University of Chicago
1950 BA (Mathematics), Wesleyan University
business angels: ‘Angels and informal risk capital’ published in the Sloan Management
Review in 1983. Some of the findings presented in the article can be summarized as
follows:
● Business angels are accustomed to sharing investment opportunities with friends

and business associates, and make investments together with others.
● Informal risk capital is an important source of external seed capital. Forty-four per
cent of business angel investments were start-ups, and 80 per cent involved ventures
less than five years old. In addition, one third of the respondents expressed a ‘strong
interest’ in financing technology-based ventures.
● Business angels are active investors, typically having an informal consulting rela-
tionship or service on the board of directors.
● Business angels invest in close geographical proximity to their home – 58 per cent
of the firms financed were located within 50 miles of the business angel.
● Risk capital is ‘patient money’. The median expected holding period among the
respondents was five to seven years.
● Business angels were highly influenced by non-financial rewards, including ‘psychic
income’ and social responsibility (for example creating jobs in areas of high unem-
ployment, socially useful technologies, and so on). Between 35 and 45 per cent of
the respondents reported that they would accept lower returns if ‘non-financial
rewards’ were included.
The conclusions from the study by William Wetzel were that business angels seem to
represent a substantial pool of funds for entrepreneurial ventures and to have some
unique characteristics as well as being highly influenced by non-financial incentives to
make investments, but that the market was relatively inefficient in bringing entrepreneurs
and investors together.
William Wetzel made the informal venture capital market visible and revealed its
importance. The study awoke interest among policy-makers as well as scholars and has
been replicated in many different contexts (within the US as well as internationally).
Interview with William Wetzel
Your studies on ‘business angels’ in the late 1970s are truly regarded as a pioneering piece of
work in the area of venture capital research. What aroused your interest in the informal
venture capital market?
I think . . . earlier in my career I worked as a commercial banker in Philadelphia, and in
that position I managed a large commercial office, and many of my clients were family
businesses that needed capital. They often went outside of family and friends to search
for money, and I started to recognize people out there making investments in ventures
with growth potential, which really sparked my interest: how many of these people were
there, what kind of ventures do they look for?, etc.
Later on, as professor at the University of New Hampshire in the mid-1970s, I was
involved in an organization called New England Industrial Resource Development
(NEIRD). NEIRD was often approached by inventors who wanted to commercialize
their ideas, but had no one to back them. Over a number of years NEIRD had informally
assembled names of people with money and experience who could assist the inventors . . .
So, I knew that these people existed.
In 1979 I approached Milton Stewart, the first Chief Counsel for the Office of
Advocacy in the US Small Business Administration and a former venture capitalist, and
applied for a research grant to explore the role played by these invisible private investors
in entrepreneurial ventures. I was successful and received a grant of $55–60 000.
What were the most interesting results of the study?

It goes without saying that there were many interesting results, but one thing that
intrigued me greatly was the list of non-financial rewards that the private investors
reported . . . they either expected a lower return or took a bigger risk if there was some
sort of pay-off that made them feel that they were doing something worthwhile, for
example, developing environmental technology or helping minority entrepreneurs. I felt
that this non-financial dimension was an important determinant for how these private
individuals made decisions.
The study was later published in the Sloan Management Review . . .

I had many problems getting it published. The paper was rejected by the Harvard Business
Review and California Management Review, but I gave it one more try . . . I had sabbati-
cal leave, and I sat down and tried to respond to the criticism in the reviews. Most of it
had to do with the problem of convenience sampling and sample bias. In my response I
acknowledged that this was a descriptive study without hypotheses to be tested. In add-
ition, my style of writing was rather conversational . . . I didn’t use ‘academic jargon’ in
the article . . . because I was not really writing for an academic audience, I wanted to get
visibility out there for the phenomenon . . . but, at last the paper was published.
The article in the Sloan Management Review is definitely the most influential article
that I have published in my career. The study was recognized by scholars interested in
entrepreneurship, saying that ‘the informal investors market is certainly something
that deserves a lot more attention’, but the study also caught the interest of public
policy-makers.
I remember that there was an article in Inc Magazine about the study . . . ‘Business
angels myths and reality’. The reporter came to my office with a bundle of dollar bills and
spread them out on my desk. It made a great picture for the Magazine, but it was not
exactly the message that I wanted to give . . . however, the popular press began to pick up
on my work . . . and I preached the role of business angels in the first round of outside
equity finance – taking the venture beyond the family and friend stage.
The methodological problems experienced in informal venture capital research today seem
to be the same as 25 years ago. Are you disappointed about the progress of the research?
There are many obstacles, and I think many researchers felt that they were beating their
heads against the wall. First, it is difficult and requires a great deal of hard work to locate
these people, and if you find them, they are not always interested in participating in a
study. Second, the obstacle that I struggled with in my article – and researchers studying
informal venture capital still do – is to identify the population from which we can draw a
random sample and claim that it is representative of business angels. Third, as a conse-
quence, informal venture capital research has been rather descriptive, with less testing of
hypotheses and statistical rigour. As a result, the research on informal venture capital
has always been seen as ‘second class’ research, and it didn’t appeal in an academic
sense to those who have been traditionally oriented towards research methodologies and
statistical rigour.
But how can we encourage new researchers, not least doctoral students, into the field?
I would tell them that they will meet some very fascinating and creative people, people
who are willing to take risks but are not gamblers in a Las Vegas sense. In addition, their
research can make a difference. Today it is much easier for entrepreneurs, who have some-
thing promising and with potential, to find the first round of outside equity funding from
business angels than it was 20 years ago . . . and I think in some way our work has facili-
tated this whole entrepreneurial phenomenon. In my opinion there is still a great deal
more work to be done in the area of informal venture capital research – questions that
will end up with important outcomes and make ‘the world a better place to live in’.
It was also a pioneering achievement to introduce the first match-making service on the infor-
mal venture capital market – a ‘dating bureau’ between entrepreneurs and business angels.
The background of this initiative was twofold. It was felt that there was a need on the
part of investors to see a flow of new deals . . . to see a broader range of investment
opportunities, not only based on random situations, for example, that you mention some-
thing at the golf course. The second reason was to ease the frustration of the entrepre-
neurs who were desperately trying to find external money for the growth of their
ventures. Even at that time, the venture capital industry was not really interested in small
amounts of money.
We founded the Venture Capital Network (VCN) in 1984 in order to create a more
effective market for angel finance. In addition to matching entrepreneurs with potential
investors, VCN offered seminars in pricing, structuring, and exiting venture investments.
VCN was initially sponsored by leading accounting firms, banks, and by Digital
Equipment.
However, I think we were mistaken in our belief that we could make this process work
in a more orderly and less random fashion. After five years of no home-run performance
we were unable to obtain additional sponsorship. So, we decided to find another home for
it, a home that would have a higher probability of success. We opened up a discussion
with MIT in Boston, and in 1990 VCN became the Technology Capital Network (TCN)
at MIT.
The VCN was used as a model for more than 20 other networks around the US and
even in Canada. We designed the software for the matching services and sold it to the net-
works. We installed the programme, and trained them how to use it. One of the obstacles
faced by these networks, as with the VCN, was locating a critical mass of investors as well
as entrepreneurs . . . and it is not a question of a static critical mass, because these are
people who come in and go out of their entrepreneurial activities.
In many countries it is important to stimulate an active informal venture capital market.

What policy implication can be drawn from your research?
I am very sorry, but I don’t really believe that there is much of a role for public policy in
this field, because the market is very individual and personal. Maybe there might be
potential for tax incentives. In these kinds of investment there is always a risk/reward
ratio, and if you could reduce the risk and/or increase the reward, that would certainly
have a positive impact . . . but as to how big the effect would be, I cannot say.
However, we know that business angels invest close to home, and unless they have a
strong attraction to a specific technology or market, they will typically not invest much
more than a few hours’ drive away from where they live. This indicates that policy instru-
ments should be anchored locally or regionally. I also believe that there is a need for some
form of learning . . . both for the actors involved as well as with regard to the instruments
used . . . we have a great deal of experience of different measures, and new initiatives don’t
need to start from scratch all the time.
Finally, what are the major lessons to be learned from your research?
I will give you a list:
1. Business angels exist – there are private individuals with know-how and money who
are interested and enthusiastic about backing promising start-up ventures.
2. Business angel investments are very much a personal process and depend heavily on
interpersonal contacts between investors, and between the investor and entrepreneur –
the angel market does not lend itself to institutionalization.
3. The business angel market has a great economic value at regional level – business
angels can be found everywhere, and they invest close to home. At the same time, I
think there are regional differences in taste – for example, investors in Missouri have
different backgrounds than investors in California and will invest differently.
4. There is great potential in the market – not only do business angels have an appetite
for more deals, but there is also a latent market of potential angels – I think the latent
angels out-number their active counterparts by ten to one. Thus, there is a great
opportunity to convert latent angels into active ones.
State-of-the-art venture capital research

In the Handbook of Research on Venture Capital we will cover different aspects of our
knowledge on venture capital as the research field. The book is divided into five parts.
Part I contains some general discussions about venture capital. In the present chapter
(Chapter 1), we present a historical overview of our knowledge within the field and high-
light some of the pioneers of venture capital research who made the phenomenon visible
in the 1980s and attracted other researchers into this new and promising field. In
Chapter 2, Harry Sapienza and Jaume Villanueva will continue the historical journey by
considering the extent to which venture capital research has contributed to the under-
standing of the venture capital phenomenon and to our knowledge of entrepreneurship
in a broader sense. The authors also question some of the underlying assumptions made
in management research in general and venture capital research in particular and make
some suggestions about the future direction of the field as well as arguing for what they
call ‘engaged scholarship’ in which research enriches practice and vice versa. Next, in
Chapter 3, we will look at venture capital from a geographical point of view, where Colin
Mason focuses on the ‘regional gaps’ in the supply of venture capital, that is the under-
representation of venture capital investment in particular regions relative to their share of
national economic activity. Mason argues that there are strong geographical effects char-
acterizing venture capital investment, thus contradicting the economist’s concept of a per-
fectly mobile capital market. Given the positive impact of venture capitalists on firm
creation and growth, the influence of the geographical clustering of their investments con-
tributes to uneven regional economic development. Finally, Part I ends with a chapter on
venture capital policy (Chapter 4), written by Gordon Murray. Venture capital is usually
widely associated with the free market and an entrepreneurial spirit unrestricted by public
interference but, as Murray comments, the state may have an important role in both ini-
tiating risk capital programmes and providing a conducive environment for venture
capital. Murray argues that academic support for a public role(s) in the venture capital
market is, at best, conditional and cautionary. Therefore, policy-makers will have to act
with a deft hand, and there is plentiful evidence that governments are at least as likely to
produce overall negative effects by their involvement in the venture capital market as they
are to engineer a lasting improvement in market conditions. In this chapter Murray will
seek to summarize what consensus may be found in seeking an appropriate role and mode
of action for government in the light of the evidence of both academic studies and policy
experience.
Part II of the book focuses on the institutional venture capital market. It is within insti-
tutional venture capital that we find the longest tradition of scholarly work and the most
extensive research volume. As research on informal venture capital and corporate venture
capital in many cases takes the institutional venture capital market as a point of reference,
it seems reasonable to start our ‘journey’ in this area. In this part of the book, we will follow
the ‘venture capital cycle’ from fund raising to the exit of venture capitalists’ investments.
We start in Chapter 5, in which Douglas Cumming, Grant Fleming and Armin
Schwienbacher discuss how venture capital funds are structured and governed. They not
only look at the typical US market fund structure but show how it varies across geo-
graphical markets. Their conclusion is that the way the venture capital fund is structured
will have an important influence on the way venture capitalists manage their operations,
the strategy and type of firms that receive finance, the willingness to add value, and so on.
After this focus on the structure of the venture capital fund, a couple of chapters serve
to elaborate on our knowledge of the investment process used by institutional venture
capitalists, that is the process from the pre-investment phase to post-investment activities
and exit as well as the financial performance of the ventures. In Chapter 6 we look at the
‘pre-investment phase’, in which Andrew Zacharakis and Dean Shepherd elaborate on the
evaluation process – and especially the decision criteria and process applied when venture
capitalists make investments in new venture proposals. Zacharakis and Shepherd take an
information processing perspective to increase understanding of the process of selecting
new investments. In particular, they examine how biases and heuristics impact on the
investment process. In the following chapter (Chapter 7), Dirk De Clercq and Sophie
Manigart focus on the ‘post-investment phase’ and provide an overview of the knowledge
of venture capitalists’ involvement in monitoring activities vis-à-vis entrepreneurs and
value-adding for their investees. De Clercq and Manigart open the ‘black box’ by dis-
cussing the question of how value-added is created in the venture capitalist–entrepreneur
relationship. In Chapter 8, Lowell Busenitz follows up on this discussion by suggesting
new research directions for venture capitalists’ value-adding activities. Busenitz argues
that research needs to go beyond the broad questions that have been studied so far – and
that in many cases have produced very mixed results – and press forward in looking at
governance arrangements, compensation systems and obtaining follow-on rounds of
funding as well as exploring the broader impact of venture capital investments on innov-
ation and the development of new industries. The chapter ends with a discussion on what
measures to use when evaluating venture capitalists’ performance. In Chapter 9, Benoit
Leleux elaborates further on the performance aspect of venture capital, and raises the
issue of the drivers behind venture capital performance on different levels of analysis. The
key message is that the nature of the industry makes it very difficult to measure value cre-
ation and hence performance over time, and Leleux provides an in-depth discussion on
how to measure financial performance in the venture capital context. In this way the
chapter provides the reader with a solid basis for his/her interpretation of the data pre-
sented on and by the venture capital industry.
In the next two chapters on institutional venture capital, we ‘cut the cake’ in a different
way – instead of looking at venture capital as a process we focus on two extremes of insti-
tutional venture capital investments: (1) early stage ventures, and (2) late stage ventures,
known as equity capital and management buy-outs (MBOs). Based on our knowledge of
early stage venture capital, Annaleena Parhankangas argues in Chapter 10 that early stage
venture capitalists are faced with specific problems associated with the combination of
long-term commitment in a young venture and a considerable likelihood of failure. She
elaborates on the differences between investments in early and late stage ventures and
identifies several management practices available for early stage venture capitalists who
expose themselves to a high level of information asymmetries and risk. At the other end
of the investment spectrum, there are investments in private equity capital and manage-
ment buy-outs, and in Chapter 11 Mike Wright provides an overview of the development
and trend in the private equity and MBO market. He demonstrates the heterogeneity of
the buy-out concept as well as the application of the concept to different firm and country
contexts. In addition, private equity and MBOs are analysed using a life-cycle perspective:
deal generation; screening and negotiation; valuation; structuring; monitoring and
adding value; and exit.
In Part III we turn our attention to informal venture capital (or business angels)
research. As in the case of institutional venture capital, there is a fairly long tradition of
research on informal venture capital (although the volume of research is less extensive)
and the institutional and informal venture capital markets have been regarded as partly
complementary and partly overlapping (see discussion above). Peter Kelly opens in
Chapter 12 by acknowledging that it is 25 years since William Wetzel published his
seminal study on business angels and summarizes and synthesizes the knowledge within
the field: what have we learned about the informal venture capital phenomenon over the
past quarter century? Kelly not only looks at ‘the road that has been travelled’ in business
angel research, but also ‘the journey ahead’ and highlights some of the key issues that
need to be tackled in future research. We then focus our attention on a couple of research
themes that are important not only for informal venture capital researchers but also for
policy-makers and business angels themselves. In Chapter 13, Allan Riding, Judith Madill
and George Haines review recent research literature with regard to how business angels
make investment decisions. The authors employ a model of the investment process includ-
ing: (1) sourcing of potential deals and first impression; (2) evaluations; (3) negotiation
and consummation; (4) post-investment involvement; and (5) exit, as well as examining
recent knowledge pertaining to these stages and elaborating on the way business angels’
investment decision-making influences each stage of the process. In Chapter 14, Jeffrey
Sohl argues that the informal venture capital market is fraught with inefficiencies which
result in two persistent funding gaps: a primary seed gap and a secondary post-seed gap.
These market inefficiencies and funding gaps have led the market to adopt various organi-
zational mechanisms to increase efficiency – angel portals – and in the chapter the author
reviews and discusses current experiences of different kinds of angel portal.
In Part IV we focus our attention on corporate venture capital, that is equity or equity-
linked investments where the investor is a financial intermediary of a non-financial cor-
poration. Corporate venture capital is regarded as a distinct part of the institutional
venture capital market, but research on corporate venture capital is still in its infancy and
the amount of research rather limited. Part IV consists of two chapters. In Chapter 15
Markku Maula argues that the research on corporate venture capital is still quite frag-
mented and has not been systematically reviewed – a challenge that Maula attempts to
take on, and he synthesizes the literature on corporate venture capital with particular
emphasis on research examining corporate venture capital from the corporate investors’
perspective. In Chapter 16 we change perspective, and Shaker Zahra and Stephen Allen
look at corporate venture capital from the entrepreneurs’ perspective. Zahra and Allen’s
point of departure is that many new ventures need to assemble and use resources fairly
quickly in order to develop capabilities that can create and protect a competitive advan-
tage, and corporate venture capital enables them to obtain the financial resources and
business contacts necessary for development and growth. The authors discuss the poten-
tial financial and non-financial benefits that new ventures can gain from corporate venture
capital investments.
Finally, in Part V (Chapter 17), Hans Landström presents a summary and synthesis of
the discussions in the Handbook by elaborating on the question: what advice can be given
based on the knowledge developed in the book? The chapter provides some implications
for venture capitalists, entrepreneurs and policy-makers as well as a discussion about the
future direction of venture capital research.
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2 Conceptual and theoretical reflections on venture
capital research
Harry J. Sapienza and Jaume Villanueva
Introduction
Entrepreneurship and early venture capital literature

As indicated in Chapter 1 the research on venture capital1 dates back at least to the late
1960s (for example Briskman, 1966; Aggarwal, 1973; Wells, 1974; Poindexter, 1976) when
the industry itself was in its infancy. Whereas these early studies in venture capital tended
to focus on the efficiency of venture capital as an investment vehicle or on the decision
criteria used by venture capitalists to assess entrepreneurs and opportunities, other areas
of the more general entrepreneurship literature focused on the nature of the entrepreneur
and on conditions of founding. Thus, early on, venture capital research contributed pri-
marily in the areas of economic implications of this ‘new’ organizational entity (venture
capital) as a financing tool. In truth, the entire field of management or business ‘science’
itself was just forming. Whereas the field of economics was comparatively well-developed,
the examination and study of business organizations as atomistic entities worthy of study
in their own right was just emerging.
Through the 1980s and into the early 1990s, interest in venture capital and its unique
problems and contributions expanded. For entrepreneurship research in general, the
decade began with a focus on the entrepreneur and ended with a focus on the entrepre-
neurial process of new venture creation. Venture capital research complemented this
development by beginning to unravel the mysteries of the venture capitalist–entrepreneur
dyad in this process of venture creation (Sapienza, 1989; Fried and Hisrich, 1995;
Landström et al., 1998). Although venture capital research focused solely on high-
potential ventures (rather than on the vast majority of new ventures), it nonetheless con-
tributed to the broader development of entrepreneurship theory because the majority of
people working diligently in the area were attentive to theory development. Into the
twenty-first century, research on venture capital has remained a vibrant and critical part
of the more general entrepreneurship literature.
Purpose and overview of this chapter

In this chapter we share our reflections on the past, present, and, especially, the possible
future of managerial venture capital research. What we mean by managerial is that we
consider work with a disciplinary focus on management, work produced by management
scholars and published in management journals, rather than on other perspectives such
as finance or economics. We reflect on (without reviewing in depth) the historical pattern
of this domain, considering especially the extent to which this research has contributed
to the understanding of the venture capital phenomenon and to the broader entrepre-
neurship literature. We then turn our attention to suggesting how we would like to see
66
Reflections on venture capital research 67
future study develop. In the spirit of this collection of works, we reflect to some extent on
research including private, institutional venture capital firm (VCF), corporate venture
capital (CVC), and business angel venture capital (BA). However, our primary focus is on
the literature that developed around institutional venture capitalists.
Our thinking is influenced by two recent ‘critiques’ of the management literature pub-
lished by some of its prominent scholars. One critique opines that research has become
increasingly remote from phenomena of interest and suggests an approach of ‘Engaged
Scholarship’ to redress the problem (Van de Ven and Johnson, 2006). The other critique
charges that an exaggerated ‘pretense of knowledge’ in social science combined with the
dominance of unrealistically pessimistic assumptions about the character of individuals
and institutions has led to ‘bad theory’ resulting in bad practice (Ghoshal, 2005). The
former article offers suggestions to guide the engaged scholar to conduct meaningful
research. The latter pleads for a ‘Positive Organizational Scholarship’ movement (for
example Cameron et al., 2003) that will seek answers to the ‘positive’ problems of man-
agement. We tend to share the views expressed in these works. We use them as a frame-
work for suggesting how venture capital research may meaningfully develop in the future.
Our overall conclusion in reviewing past work is that managerial venture capital
research has accomplished a great deal in the twenty or so years since it began to blossom
into a persistent area of study within the developing arena of entrepreneurship research.
The ‘glass half-full’ view is that such research has been at the forefront of growing
attempts to build serious theoretical underpinnings to the study of entrepreneurship
grounded in a variety of disciplines. Important work has been done to apply and extend
economic views such as agency theory (for example Robbie et al., 1997), game theory (for
example Cable and Shane, 1997), resource-based and knowledge-based views (for
example Lockett and Wright, 1999). Further, macro-organizational perspectives such as
population ecology (for example Manigart, 1994), institutional theory (for example
Bruton et al., 2005), and network theory (for example Bygrave, 1988) have figured prom-
inently. Finally, with an outlook and basis quite different from the economic roots of
venture capital research, micro-organizational perspectives have provided important
behavioral insights via such perspectives as social exchange theory (for example De Clercq
and Sapienza, 2001), social capital theory (for example Maula et al., 2003), learning
theory (for example De Clercq and Sapienza, 2005), cognition and cognitive bias theories
(for example Shepherd and Zacharakis, 1999), psychological contract theory (for example
Parhankangas and Landström, 2004) and procedural justice theory (for example
Sapienza and Korsgaard, 1996; Busenitz et al., 1997).
The ‘glass half-empty’ view is that there is still much we have ignored and much we do
not know. We believe that, upon occasion, adopting such a critical view of ourselves will
lead to productive new directions. This chapter provides us with the opportunity to stop for
a minute, take a deep breath, and take stock of where we are and where we want to go before
continuing on our research agendas. We hope to engage you in this exercise with us. We first
offer two cautions: (1) our suggestions do reflect our own biases and preferences; and (2)
some of our suggestions reflect an ‘ideal’ of scholarship that may be more or less feasible
for a researcher to heed, depending upon his or her stage of career and the institutional and
departmental norms faced. We believe that as entrepreneurial scholars (double meaning
intended), however, we prefer to spend energy envisioning where we would like to go rather
than to spend it focusing on the barriers that keep us from getting there.
In short, the most important question we raise in this chapter is: where should we go
as a field? At one extreme, we could become a clinical field, with proliferation of clin-
ical analyses and consulting activities. At the other extreme, we could become theoret-
ically remote from the practice of venture capital but achieve great theoretical elegance.
We endorse the concept of ‘Engaged Scholarship’ (Van de Ven and Johnson, 2006) in
which research enriches practice and vice versa. We believe that theory that is not
informed by practice is neither useful nor interesting; similarly, practice without theory
is particularized and uninformative. Rigorous research with a solid theoretical and
methodological base is essential to advance the field. For us, the best research will also
be meaningful to practitioners. It will not be done ‘for’ practitioners; it will be done
‘with’ them. Perhaps the term ‘practitioner’ is too narrow, for it invokes an incomplete
image of those affected by our research. We suggest that stakeholders (beyond
researchers and their students themselves) include investors, entrepreneurs, policy
makers and broad societal elements such as local communities and regional and
national economies.
The chapter proceeds as follows: first, we analyze the focus of research in venture
capital over time. We identify and discuss the dimensions that have been studied exten-
sively, and we note the ones that have been relatively neglected. We present a stylized figure
that depicts key dimensions of past managerial venture capital research: the stage in the
venture capital cycle, the perspective of the key focal actor (for example venture capital-
ist or entrepreneur), the type of venture capital (institutional, angel, corporate), the level
of analysis used, and the theoretical framework through which works are designed and
interpreted. We also discuss the causes and consequences of the chosen perspectives.
Next, we introduce the concept of ‘engaged scholarship’ (Van de Ven and Johnson, 2006),
examining its applicability to venture capital research. In the penultimate section, we
introduce Ghoshal’s (2005) ‘positive organizational scholarship’ argument and consider
its implications for our field. Finally, we use our stylized model and these two perspectives
to consider avenues for future research.
Causes and consequences of dominant areas of venture capital research

In this brief section we trace the development of managerial venture capital literature
from the rich, detailed descriptions of the phenomenon that dominated early work to the
later theory-driven analyses (see also Chapter 1). We employ a metaphor of the kaleido-
scope to represent the varied perspectives, levels of analysis, phases of the venture capital
process, and actors that have become part of the rich tapestry of the field.2 This metaphor
allows us to introduce a discussion of the dimensions of the field that have received rela-
tively greater attention.
Early contributions
Much early literature focused on what exactly venture capitalists do (Tyebjee and Bruno,
1984; MacMillan et al., 1985; Gorman and Sahlman, 1989). These highly descriptive
works have proven extremely useful for three reasons. First, they helped everyone under-
stand the mechanics of the industry and illuminated the significant ways in which venture
capital differs from other sources of capital for entrepreneurial start-ups and from one
another (for example Elango et al., 1995). This contribution is in line with the engaged
scholar view discussed later.
Second, by opening the black box of practice, early descriptive studies allowed subse-
quent researchers to build theory effectively. The venture capital process itself is highly
complex, and, without a deep understanding of the mechanics of the industry, theorists
would be likely to create incorrect or incomplete theoretical frameworks. That is, a deep
understanding of the issues and practices involved in the phenomenon improves the valid-
ity, sophistication and power of theoretical models developed. Finance theory work such
as Sahlman’s (1990) on the structure of the venture capital industry served to highlight the
agency issues and financial structure challenges faced by venture capital firms. This type
of study paved the way for managerial work such as Gifford’s (1997) that pointed to the
serious issue of the venture capitalist as agent and for Cable and Shane’s (1997) work that
elucidated the powerful forces for collaboration in venture capitalist–entrepreneur pairs.
Third, empirical descriptions chronicle venture capital at various points in time and at
various economic epochs in a manner that allows us to understand the phenomenon and
to see how types of financing interact over time. For example, the chronicling of corpor-
ate venture capital in the aftermath of the economic booms of the late 1980s (for example
Block and MacMillan, 1993) and around the turn of the twenty-first century (for example
Maula, 2001) has added understanding not only of corporate venture capitalists but also
of institutional venture capitalists and business angels. Thus, theory has been aided
because the chronicles allow us to derive the meaning of variation (or non-variation) in
practice in different times and places. As we move into the twenty-first century, we can
build sophisticated portraits that look at the entire ecosystem of venture capital and that
will provide more complete pictures than are currently available.
Expansion of venture capital research along several dimensions

After the early ‘descriptive’ period, managerial venture capital research grew more theory-
driven and developed along several different paths. Figure 2.1 represents the dimensions
by which the most common examples of past venture capital research might be viewed
and classified. The outer circle surrounding the central dimensions in Figure 2.1 repre-
sents the lenses (or theories) that researchers bring to bear on the questions or dimensions
being studied. Think of this diagram as a metaphorical kaleidoscope, one whose internal
dimensions and external circumference can be rotated, bringing various theoretical views
and elements into different juxtapositions and focuses. Imagine each theoretical perspec-
tive as existing at a specific location on the outer ring of the kaleidoscope; imagine further,
then, that we rotate the outer ring. From this new location, the perspective on the dimen-
sions within the internal circle of the kaleidoscope will have changed. Further, think of
the inner circles as also being capable of being rotated; they represent levels of analysis,
for example, individual, group, venture, community, region, country, and so on.3
In the interior of the kaleidoscope, we see three overlapping dimensions: type of
venture capital (for example institutional venture capital – VCF, business angels – BA, or
corporate venture capital – CVC), the interests or perspectives being investigated (for
example investor4 vs. entrepreneur), and the stage of the venture capital process (for
example fund raising, selection). Although each dimension is composed of several ele-
ments, most studies center on one element within each dimension. For example, Shepherd
and Ettenson (2000) examined how an investor type (the institutional venture capital
firm) attempts to maximize returns (investor’s perspective) via decisions made during the
selection stage of the venture capital cycle.
Theoretical frameworks Levels of analysis
Stage in VC cycle
Fund raising
Screening/selection
Negotiation/investing
Monitoring/advising
Exit
Focal perspective VC type

Entrepreneur BAVC
Investor CVC
PFVC
Note: Areas highlighted in bold represent the most frequently studied areas in managerial venture capital
research
Figure 2.1 Kaleidoscope of research in managerial venture capital
We have chosen the metaphor of the kaleidoscope to convey the idea that changing
levels of analysis and/or theoretical lens provides very different views of the phenomena.
For the Shepherd and Ettenson article, the level of analysis is the venture capital firm and
the theoretical framework is the industrial organization perspective. Had they chosen the
entrepreneur’s perspective, different theoretical questions may have arisen such as how to
position their venture to attract capital or how to select venture capitalists if given
options. Other choices of frameworks or levels of analysis would also have resulted in
quite different questions, data and interpretations.
The choice of framework affects the likely questions asked, the levels viewed, and the
data examined. Conceiving of possibilities in this manner may lead researchers to a
variety of questions, some previously studied and some not. Examples of questions sug-
gested if we consider different levels of analysis include: at the individual level, why do
entrepreneurs seek venture capital, and how are their outcomes affected? At the dyadic
level, how do governance structures and mechanisms affect returns, and how do venture
capitalist–entrepreneur interactions moderate these? At the firm level, why do venture
capital firms exist, and why do some venture capital firms outperform others? At the
regional/national levels, how may venture capital activity be fostered, and what is the
appropriate role of government in the venture capital process? The appropriateness of
theories also varies by level: cognitive and behavioral theories are most appropriate at the
individual level; social exchange and power theories at dyadic levels; network, social
capital, resource-based and knowledge-based at the firm level; and population ecology
and institutional theory at the industry/region/nation levels.
Figure 2.1 indicates that the most common studies focus on institutional venture
capital firm type, from the investor’s perspective, in the selection and/or monitoring
stages of the venture capital cycle (for example Tyebjee and Bruno, 1984; MacMillan
et al., 1985; Bygrave, 1988; Gorman and Sahlman, 1989; Sapienza and Manigart, 1996;
Shepherd and Zacharakis, 1999). Despite the well-known fact that institutional venture
capital firm financing is a much smaller phenomenon than is business angel investing
(Mason and Harrison, 1996; Landström, 1998; Freear et al., 2002), both in terms of
number of deals and in terms of absolute capital invested, several factors explain why
institutional venture capitalists have been studied most vigorously. First, the history of
the venture capital industry itself is traced back to such famous institutional venture cap-
italists as ARD (American Research and Development), Kleiner-Perkins, and others.
Second, many high profile ventures such as Apple, DEC, Genentech and the like have
been linked in the popular press to institutional venture capitalists. Third, in comparison
to business angels, institutional venture capitalists are more visible; they are easier for
researchers to locate, and they have more resources to devote to helping in research; and,
in comparison to corporate venture capitalists, the institutional venture capital industry
has been more stable both in terms of number of firms existing at one time and in terms
of the longevity of the firms.
The focus on examining issues from the investor’s perspective is also understandable for
several reasons: first, even though they would not exist without entrepreneurs, venture
capitalists, are, after all, the individuals who comprise the industry itself. Second, venture
capitalists are the most clear and immediate of stakeholders for venture capital research.
Third, as a practical reason, venture capitalists (possibly with the exception of angels) are
more visible than entrepreneurs and are able to provide researchers with access to large
numbers of ventures. Thus, researchers are apt to use institutional venture capitalists and
corporate venture capitalists to locate samples; this allows the possibility, too, of estab-
lishing long-term relationships to which researchers may return for future studies. Because
business angels are often as invisible and as fragmented as the entrepreneurs themselves,
less research is executed in this domain overall. Nevertheless, even work on business angels
tends to take the perspective of the investor (for example Mason and Harrison, 1996;
Sohl, 2003).
The focus on selection and monitoring stages may also have practical roots. First, col-
lecting information on selection criteria is especially amenable to the questionnaire and
interview techniques preferred by early researchers (for example Tyebjee and Bruno, 1984;
MacMillan et al., 1985). Furthermore, as innovations in methods for studying selection
through such techniques as conjoint analysis arose, the selection literature was revitalized
and new empirical and theoretical insights were achieved (for example Shepherd and
Zacharakis, 1999). This technique allows the generation of large sample sizes and high
ability to control contextual factors that may confound typical field work. Second, as
researchers became aware of the dominance of post-investment activities in time spent
overall by investors, the pressure to understand this stage of the venture capital cycle
gained momentum. Thus, a good deal of work attempted to penetrate the issues of exactly
how venture capitalists added value beyond selecting and providing money to entrepre-
neurs (for example Sapienza and Gupta, 1994; Fried and Hisrich, 1995). This research
could draw on a rich tradition of theory in organizational behavior and decision making
to guide research design (for example Sapienza and Korsgaard, 1996; Busenitz et al.,
1997). Third, because many aspects of other stages of the venture capital process involve
individuals outside the venture capitalist–entrepreneur dyad (for example fund raising
involves limited partners, and exit involves several external organizations), research
designs on these other phases are especially complicated.
Dominant focuses
Given the focus on the investor’s perspective, it is unsurprising that the rational economic
framework has been the prominent theoretical lens used. In particular, although its
efficacy in this context has increasingly been called into question (for example Landström,
1993; Cable and Shane, 1997), agency theory has been the dominant approach to exam-
ining the topic. Specifically, the investor has been framed as principal and the entrepre-
neur as agent. This choice of agency theory is in harmony with focusing on institutional
venture capital type and on the investor’s perspective. First of all, among venture capital
types, institutional venture capital is the one in which economic return is most unam-
biguously the sole motivation for venture selection. Second, Jensen and Meckling’s (1976)
seminal presentation assessed in detail the likely consequences of conflict between owner-
managers of firms (entrepreneurs) and outside equity holders (investors); furthermore,
the publication of this article coincided with the emergence of the institutional venture
capital industry and doubtless influenced the emerging research on venture capital. From
an agency perspective the key issue is how outside investors can minimize agency costs
emanating from adverse selection and opportunism.
Seeking both practical solutions and tests of a dominant theory, researchers devoted
special attention to applying agency theory to the selection (MacMillan et al., 1985;
Harvey and Lusch, 1995; Muzyka and Birley, 1996; Smart, 1999) and monitoring phases
(MacMillan et al., 1989; Sapienza and Gupta, 1994; Mitchell et al., 1997) of the venture
capital process. While not all of these studies relied fully on agency theory, they all shared
with it the assumptions inherent in rational economic models. Most importantly, many
prominent researchers, especially within the domain of financial venture capital research,
have demonstrated the potency of agency theory in predicting the structure of venture
capital firms, the development and employment of financial instruments for investing, the
terms of formal agreement, and the nature of syndication among institutional venture
capitalists.5
We can speculate on two additional factors that may have played a role in the predom-
inance of this theoretical framework: (1) as an emerging topic, venture capital researchers
sought to rely on basic and popular theories within the mainstream disciplines; and (2)
because most of the initial venture capital research was developed in the United States, it
may be that governance, conflict and control of agency problems were more relevant in
that context than in other contexts such as those of Western Europe or Japan.6
In short, the dominant elements studied within our metaphorical kaleidoscope (insti-
tutional venture capital firm, investor perspective, selection/monitoring) are logically
coherent, especially when viewed through the rational economic lens. Because the under-
lying agency theoretical framework was a familiar and widely used one even within the
management literature, venture capital researchers have been able to span boundaries
within management literature (for example strategy, and organization theory) and across
business research domains. For example, the issue of how agency concerns affect
risk–return relationships in organizational decision making interests both finance and
organization behavior researchers. On the positive side, then, the particular focus adopted
over the past decade and a half has placed venture capital research at the core not only of
developments in entrepreneurship but more broadly in the mainstream of disciplinary
work outside of entrepreneurship.
At the same time, we must recognize the costs of having focused so strongly on this par-
ticular configuration of elements (institutional venture capital firm, investor perspective,
and selection/monitoring, all through the rational economic lens) in our studies.
Importantly, the costs are ones of omission or lack of knowledge development in the
other areas such as venture type, actor perspective, and stage of the process. Some have
already noted that the level of investment activity in institutional venture capital is
dwarfed by the enormous (but hidden) activity in the realm of business angels (Sohl,
2003). Yet the amount of research conducted on business angels is but a fraction of that
conducted in the institutional venture capital arena. As is evidenced in the other chapters
of this Handbook of Research on Venture Capital, a thriving literature on business angels
does exist (see Chapters 12 to 14). Our point, however, is only that more work in this area
is needed. Although some of the barriers to conducting empirical research on business
angels are much higher than they are for institutional venture capitalists or corporate
venture capitalists, we believe that hurdling such barriers is worthwhile.
As one example of how moving away from the dominant model may enrich our work,
the field of venture capital research would be enhanced by further examinations of the
entrepreneur’s perspective. The work that does exist shows the promise of deep investiga-
tions of entrepreneurs’ perspectives. For example, Busenitz et al.’s (1997) study of the
effects of procedural justice on entrepreneurs’ receptivity to investors has illustrated the
value of examining the process from the entrepreneur’s perspective: their work suggests
that investors who ignore the rules of respect and fairness may be destined to have crit-
ical information distorted or withheld from them. Sapienza et al. (2003) also showed the
value of considering the entrepreneur’s motives. They argued that entrepreneurs’ choice
of financing type (and the particular investor within the chosen type) involves both con-
siderations of economic rationality and of self-determination.
In summary, we have noted above that managerial venture capital research started as
simple descriptions of the processes and practices in the industry and eventually evolved
into more complex studies that focused on several dominant themes or configurations. In
order to represent this complexity and to highlight the areas of emphasis, we used the
metaphor of a kaleidoscope. This metaphor helped to illustrate that certain areas received
much more emphasis than others. Implicitly, then, many areas have not received much
attention. At the end of this chapter we point out which of these areas we believe espe-
cially merit additional study.
Contributions of venture capital research to entrepreneurship literature

Venture capital research directly addresses many of the fundamental issues of interest to
entrepreneurship scholars. For example, much of the research has been devoted to how
investors assess opportunity (MacMillan et al., 1985; Shepherd, 1999; Smart, 1999). The
most common approach has been to look at the criteria that venture capitalists use to
make investment decisions. Smart (1999) takes the central conclusion from this literature
(that is the conclusion that venture capitalists focus most strongly on the quality of the
entrepreneurs themselves) and delves into how venture capitalists assess the entrepreneurs
and whether some assessment methods are more effective than others. Some work, such
as Fiet’s (1995) comparison of institutional venture capitalists and business angels,
assesses how investors attempt to deal with risk in entrepreneurial settings; Fiet argues
that institutional venture capitalists possess potent remedies against agency risks and thus
focus on market risk whereas business angels, lacking such potent contractual leverage,
focus on agency problems. Some have even looked at business angels as entrepreneurs
themselves (Landström, 1998); such work draws an essential but little recognized parallel
between the challenges and issues facing both entrepreneurs and their investors.
In some ways contributions of venture capital research to the field of entrepreneurship
have been indirect. For example, venture capital portfolio companies are usually consid-
ered ‘high potential’ ventures. As such, venture capital provides a convenient sampling
space for studying ‘entrepreneurial’ firms. The venture capital setting provides an easy-to-
identify, comparable and convenient sampling of high-potential firms. Another benefit of
studying in the venture capital setting is that it helps researchers address a common
problem plaguing users of survey designs. Here, the issue of common source bias – the
validity problem of deriving measures of independent variables from the same source as
dependent variables – may be addressed more readily than in other settings. The presence
of two sets of individuals (investors and entrepreneurs) highly knowledgeable about one
another and about the venture in question provides venture capital researchers with a
means to overcome some common source and common method problems that typically
plague entrepreneurship research. For example, using venture capitalists’ rating of
venture outcomes along with entrepreneurs’ rating of venture activities creates valid
ratings and avoids spuriously related measures.
The high profile nature of the institutional venture capital industry and the stream of
good descriptive early studies have made the industry understandable and accessible to
the broader management field. This matters because it makes entrepreneurship itself
accessible to other areas of business scholarship. We can also be proud of the fact that a
very high percentage of the entrepreneurship studies published in the widely distributed,
highly regarded management journals (for example Academy of Management Journal,
Academy of Management Review and Journal of Management Studies) have been about
venture capital. Clearly, venture capital researchers have been able to execute worthy
empirical work and contribute to entrepreneurship and management theory. And,
whereas entrepreneurship research in general has been plagued by lack of replication,
incomparable samples, variations in measures and constructs, and the like, venture capital
researchers have created several relatively coherent streams of inquiry such as venture
valuation, investment decision making, partner interaction and governance.
Yet, we can do more to advance entrepreneurship literature. Given that venture capital
is a multi-stage, multi-actor process, its study can help us understand whether, or in what
ways, the ‘myth’ of the solo, heroic entrepreneur is indeed a myth (Aldrich, 1999; Van de
Ven et al., 1999). The venture capital setting offers a plethora of circumstances in which
teamwork and inter-organizational relations may be carefully studied. We have the oppor-
tunity to view how teams of entrepreneurs work together over a long period of time with
customers, suppliers, government entities, as well as with various sources of informal and
formal financing. Further, we have the opportunity to learn how and when venture cap-
italists operate as lone wolves or as parts of investment syndicates and venture ecosystems
that reach far beyond their own organizations (for example Lerner, 1994; Lockett and
Wright, 1999). As yet, however, we understand little about the interconnections across the
ecological landscape of the entrepreneurial process.
To date, we have but begun to mine the potential in this setting to study the value cre-
ation and organization creation processes. We can come to understand more not only
about value appropriation (as would be a focus of rational economic perspectives) but also
about the elusive areas of value creation. For example, how do the roles of the investor and
investee complement, aid, or thwart one another? Are our current approaches to studying
the phenomenon the appropriate ones, or should we approach the field in new ways? Are
the lenses and attitudes we have adopted the most useful, or are we being blinded by our
own perspectives? We take up in the next two sections recent critiques of the larger field of
management scholarship itself to consider their implications for future research in venture
capital.
Implications of the ‘engaged scholar’ view for future venture capital work
Rather than simply enumerate under-researched topics and gaps in the literature, we
center our suggestions on adopting the ideas laid out by Van de Ven and Johnson (2006)
in this section and by Ghoshal (2005) in the following section. Our view is that lack of
prior study in a given area, by itself, is woefully inadequate justification for its future study.
To warrant study, the understanding of the topic must also be important either to the phe-
nomenon itself or to theory, or to both. In this section, we focus on how future research
in venture capital should be conducted so as to ensure these aims.
What is appealing for venture capital researchers about Van de Ven and Johnson’s
(2006) exhortation for engaged scholarship is that it draws on existing strengths in venture
capital research and promises ways to build where we most need work: enhancing our
scholarly rigor and legitimacy. At the same time, this approach asks not that we become
remote arm-chair theorists but that we become fuller scholars by growing closer to the
phenomenon itself. In short, Van de Ven and Johnson offer five guidelines for engaged
scholarship: (1) design work to study big problems grounded in reality; (2) design research
projects to draw on and create a collaborative learning community; (3) design studies to
examine an extended duration of time; (4) employ multiple models and methods; and (5)
re-examine assumptions about scholarship and the roles of researchers. The implications
of these suggestions for future research in venture capital are the following:7
1. Design the work to study big problems grounded in reality. Asking the big and rele-
vant questions requires practitioner or stakeholder involvement. It is the interaction
between scholars and practitioners, through what Van de Ven and Johnson refer to
as a process of knowledge arbitrage, which produces the questions that are both
grounded in reality and theoretically relevant. Such work is especially likely to fire the
imaginations of scholars and practitioners alike. Big problems grounded in reality
will have appeal to politicians, planners, community groups and many others beyond
investors and entrepreneurs (for example how may high growth opportunities be nur-
tured in our town/city/region in such a way as to preserve culture, build community,
and foster innovation?). Of course, such issues are likely to be complex and thus are
typically not amenable to being studied using a single lens or perspective. Thus, inter-
disciplinary research will be necessary to capture and/or disentangle the complexity.
In short, this guideline suggests that compelling problems or issues of great import-
ance should drive the research questions asked and the means taken to answer them.
In the process of focusing deeply on such problems, many preconceived ideas about
specific theoretical approaches or even disciplines will be set aside. Research should
not be a hammer searching for a nail.
2. Design the research project to be a collaborative learning community. Engaging
venture capitalists and entrepreneurs (as well as community leaders and the like) in
real world research settings requires time to develop trust and reciprocal knowledge.
Such long-term cooperation is unlikely to occur unless all sides are truly participants
in the research process. The process of arbitrage between other stakeholders and
scholars, which ensures that the questions asked are both of theoretical importance
and grounded in reality, requires collaboration. Collaboration between researchers of
different disciplinary backgrounds or ‘research circles’ (Landström, 2005) would also
increase the plurality of perspectives from which important questions can be ana-
lyzed. Some obvious risks and concerns in such collaborative research efforts include
issues of academic objectivity, scientific methodological requirements, and issues sur-
rounding the proprietary use of research findings. Van de Ven and Johnson argue that
with clear rules of engagement between research partners, these problems can be
managed and the benefits will outweigh the risks. In the venture capital setting, such
rules might include ways to minimize effort required on the part of entrepreneurs and
investors, ways to ensure that proprietary knowledge is protected, and ways to
provide broad access to researchers. Put simply, researchers must help their partners
deal with their specific, idiosyncratic problems, and their partners must be willing to
help researchers gain insights into broader issues that may not be of immediate
concern to them.
A practical issue worthy of explicit mention here is that access to the venture capital
community is extremely limited. An engaged scholar would have to be aware that s/he
may face extraordinary challenges both in ‘getting inside’ or getting access to
investors and their limited partners, but also in convincing them of the value of par-
ticipating in the research process and of the trustworthiness of the researcher to fully
protect all proprietary information.
3. Design the study for an extended duration of time. As mentioned above, time is a crit-
ical element to build relationships and trust, not only with research partners in col-
laborative research efforts, but also with research subjects on whose information we
depend to advance our research. Time is thus a necessary condition to achieve the
previously stated objectives of arbitrage and cooperation. Fortunately, studies con-
ducted over an extended period of time also offer the extremely important advantage
of allowing researchers the possibility to make a deeper and more valid assessment
of causality than is possible with cross-sectional studies or snapshots taken at
different points in time. Day-to-day, immersed involvement over a long period of time
and across many ventures is necessary to understand, for example, whether the
problem is bad leadership leading to bad performance or bad performance leading to
bad leadership.
Calls for more longitudinal research are not new in entrepreneurship nor in other
research settings. Virtually every one of the ‘Sexton series’ in entrepreneurship
research from the early 1980s to the present has called both for more longitudinal
research and for higher quality, in-depth qualitative research.8 These calls continue.
For example, Freear et al. (2002) point out the desperate need to examine the process
of business angel investing over time in order to understand the dynamics of
angel–entrepreneur relationships and the role of business angel investing in the entire
process from bootstrapping to angel investing to institutional venture capital and cor-
porate venture capital. Having made the case for long-term research projects, we
understand that structural characteristics inherent to our profession impede efforts
to carry out such research. Still, creative solutions can overcome some of these obsta-
cles. For instance, senior researchers may be able to design and carry out longer-term
research projects with shorter-term subcomponents that can be tackled by more
junior faculty, whose time horizons are apt to be quite short.
4. Employ multiple models and methods. The complexity of the questions that are likely
to emerge from the engaged scholarship approach require multiple frames of refer-
ence. Van de Ven and Johnson point out that triangulation of methods and models
not only increases reliability and validity but also promotes learning among interdis-
ciplinary research partners and facilitates the arbitrage process. For example, some
stakeholders may derive a great deal of benefit from participating in simulation exer-
cises that test cognitive capabilities, whereas others may learn by articulating in con-
versation (using for example a verbal protocol approach) how and why they make
decisions as they do. Of course, structural difficulties also exist for adopting a broad
multi-method approach. Not only do some journals have strong preferences for
certain types of methods over others, but conducting research via multiple methods
is time consuming and inevitably presents dilemmas of interpretation and reconcili-
ation. It must also be mentioned that in many circles the use of multiple theoretical
perspectives in a single work is strongly discouraged.
We propose that venture capital researchers, especially those in senior positions,
should be vigilant in trying as many various methods of inquiry as can be usefully
employed. We also advocate the use of multiple theoretical perspectives, but this latter
suggestion must be accompanied with strong justification for its necessity, given the
bias against such approaches. We firmly believe that such barriers to advancing our
knowledge are counter-productive. We do believe that much of the most innovative
and insightful research in entrepreneurship has indeed occurred in venture capital
research that stretches the boundaries of common practice. For example, venture
capital researchers have already been innovators in terms of methodology via event
studies, experiments, policy capturing, direct observation and case studies, simula-
tions, verbal protocol, conjoint analysis, and many other pertinent methods. And we
have made good use of the more standard secondary database, interview, case, and
survey methods. We have successfully experimented with theoretical perspectives
such as justice theories and social exchange, among other things.
5. Re-examine assumptions about scholarship and the roles of researchers. Engaged
scholarship implies that the degree of researcher intervention is dictated by the nature
of the research problem or question. Preconceived notions that researchers’ objectiv-
ity must be preserved at all costs should perhaps be questioned. Yet the fear of altered
or ‘artificial’ observations or outcomes renders this suggestion highly controversial.

That is, the danger exists that by imposing themselves amidst the phenomenon of
interest, researchers may alter the phenomenon itself. Nevertheless, engaged scho-
larship accepts this limitation on the grounds that what is to be gained in under-
standing, depth, and intimacy makes up for potential loss of objectivity and an
‘undisturbed’ reality. The principle of scientific objectivity remains a worthwhile
ideal, but we should not be afraid to roll up our sleeves and dig into the subject when
necessary. Moreover, many might argue that the ‘pretense’ of objectivity is just that,
a pretense and an ideal.
In sum, we believe that researchers adopting the engaged scholarship approach will
produce innovative insights unavailable through more detached approaches. For example,
venture capital governance occurs largely through the mechanism of the board of direc-
tors, yet little work has explored how these boards actually make decisions because of the
difficulty of gaining access to board meetings (Sapienza et al., 2000). A truly engaged
scholar may be able to develop the level of trust with the entrepreneur and the investors
that allows the kind of access and understanding not previously possible. In terms of the
metaphorical kaleidoscope that we introduced in Figure 2.1, such an approach would
place the scholar amidst the entrepreneur–investor–process triangle in the center of the
figure. A social exchange theory approach would suggest focusing on variations in board
behavior depending on the development of reciprocity (or lack thereof), whereas an
agency perspective might suggest examining the role of the board as a supplement to or
substitute for bonding costs. The vantage from within would result in more intimate views
than would the ordinary position of the scholar on the outer rim of the lens looking in,
and, theoretically, would lead to more valid interpretation of observed behavior.
Besides the time, effort and cost hurdles that ultimately must be dealt with as an
‘engaged scholar’ in any research setting, the venture capital context poses an additional
barrier that must be noted. Venture capitalists have been literally besieged by researchers
seeking their aid in conducting research. The presumption that they would want to
‘engage’ with us is a strong one. We can only note that succeeding in gaining their trust
and attention is a significant challenge.9
Implications of the ‘positive organizational scholarship’ view for future venture

capital work10
A posthumous publication of the views of Sumantra Ghoshal (2005) regarding trends in
the theoretical content of management literature sheds another light upon the issues and
challenges facing business scholars in the twenty-first century. Ghoshal expresses dismay
over several trends in research which he claims are traceable to two common sources: (1)
Attempts by many to treat the social science of business as an exact science; and (2)
Acceptance by the majority of the assumption of rational economic self-interest as the
sole explainer of behavior. Ghoshal’s article expresses a view similar to that stated at
various times over the years by William Bygrave, that is, that business researchers suffer
from ‘physics envy’, a condition in which scholars seek to emulate the physical sciences in
their theorizing, testing and interpretation by assuming that variables interact with a sort
of law-like consistency. Such assumptions have the attractiveness for those seeking ‘pure’
science of making investigations mathematically tractable and parsimonious. Further, the
single motive explanation also simplifies analysis and interpretation. The problem is that
we know that these assumptions are not accurate. As one of our colleagues is fond of
saying, ‘Good theory cannot be generated from bad assumptions.’11
Ghoshal (2005) argues that treating the study of human behavior as an exact science
which can be based on one underlying law leads researchers to (1) an exaggerated ‘pre-
tense’ of knowledge; that is, a greater belief in the certainty of conclusions than is war-
ranted; and (2) an ideology-based gloomy vision of organizational reality which assumes
that the pursuit of self-interest (with guile!) is the sole driver of behavior and ignores the
explanatory power of affect and emotion. Ghoshal argues that the pretense of knowledge
combined with an ideology-based gloomy vision has several very negative consequences
for theory and practice, and his work holds several suggestions for combating these trends.
We review five of them here:
1. Abandon the smug arrogance of certainty about the nature of organizational life.
Ghoshal suggests that the exaggerated ‘pretense’ of knowledge leads to sloppiness in
theorizing, research design and prescription. Consistent with the engaged scholar
view, Ghoshal cautions us to develop deep, accurate understanding of the phenome-
non as a prerequisite for interpretation and prescription. This suggestion runs
counter to the growing emphasis on large samples built on secondary data, data
which is assumed somehow to be more valid and generalizable than carefully col-
lected primary data. In terms of Weick’s (1979) famous ‘dial’ of theory development
(which emphasizes the tradeoffs among parsimony, generalizability and accuracy),
the trend in entrepreneurship research has been to favor generalizability and parsi-
mony over accuracy. This movement reflects attempts to overcome the weaknesses of
anecdotal reflections based on inadequate sample size and selection that plagued
early research in the area. Ironically, entrepreneurship scholars (including those
focused on venture capital) may have become too remote from the phenomenon.
2. Adopt a balanced view of human nature in shaping premises and assumptions.
Ghoshal argues that an ideology-based, inaccurate ‘gloomy vision’ of organizations
has come to infect our theorizing. This negative view dismisses alternative plausible
motivations beyond self-interest and beyond rational calculation of self-serving ends.
Using self-interest as an unquestioned premise has serious consequences for inferring
causes of failings and for prescribing remedies. Ghoshal’s plea for toning down the
‘negativism’ is actually a plea for greater realism. Humans have both self-serving and
other-serving tendencies (Lawrence and Nohria, 2002). Further, both ‘negative’ and
‘positive’ emotions (for example greed, fear, trust or liking) may be important ele-
ments to understand, elements whose ramifications we have hardly tapped. For
example, despite the vast and impressive literature that we have produced on invest-
ment selection, monitoring, CEO replacement, and the like, we still fall short of
understanding exactly how these incredibly important, novel and uncertain decisions
are actually made. In their astute game theoretic analysis of investor–investee inter-
actions, Cable and Shane (1997) portray all of the economic reasons that the
exchange partners should find it in their best interest to ‘cooperate’. Yet, if we dig
beneath the surface, this cold, calculating self-interest veils a deeper game more akin
to coercion than to collaboration. In this world, exchange partners do not keep their
end of the bargain because it is the right thing to do, but only because it is to their
advantage to do so. In this world, promises and integrity are only as meaningful as
the conditions that mandate them – cooperation becomes synonymous with coercion.
As Bhide and Stevenson (1990) astutely point out, in reality people act with integrity
and goodwill a great deal more than can be explained by enlightened self-interest.
Why is that so, and what should it mean for our theorizing and hypothesis testing?
3. Keep human choice and ethics within the equation of organizational decision-
making. According to Ghoshal, the upshot of accepting economic self-interest as the
sole driving force for human endeavor is that we remove individual responsibility and
ethical norms from theoretical consideration. The assumption of economic self-
interest as the sole motivation for action trivializes human choice as a subject for
study. Many venture capital researchers have already explicitly noted that the applic-
ability of assumptions varies with settings and/or with the subjects considered. For
example, Van Osnabrugge (1998) has found that business angels explicitly consider a
range of motives in ‘developing’ or ‘mentoring’ entrepreneurs. Arthurs and Busenitz
(2003) discuss the limitations of explaining investor/investee decisions using either
only agency theory (which assumes self-interest and opportunism on the part of man-
agers) or only stewardship theory (which assumes good faith stewardship on the part
of managers). In short, researchers must avoid succumbing to the temptation to
adopt simple, mathematically tractable assumptions that make hypothesis testing
neat but inaccurate. Expanding our conceptualization of the drivers of human behav-
ior expands the power and accuracy of our theorizing.
4. Remember that our theorizing affects practice. Ghoshal points out that researchers’
negative presumptions become self-fulfilling prophecies, with undesirable conse-
quences not only for the quality of theorizing but also for practice. When theorists
teach students to expect opportunism and self-serving dishonesty, they give such
behavior currency and unintended legitimacy as industry norms. We argue here that
although malfeasance and dishonesty do indeed occur, they are not necessarily the
normal or expected behavior in practice. This suggestion to keep in mind that stu-
dents may come to practice what we preach has overtones that go beyond the ordin-
ary scope of being a researcher. Like entrepreneurs, we as researchers do play a small
part in creating the world we inhabit.
5. Take up the ‘positive challenges of management’. The antecedents of integrity, for-
bearance, and justice might be as productively explored as are the mechanisms to deal
with their absence or betrayal. Although it is perhaps human nature to experience fear
of the negative more strongly than joy in the positive, as researchers of venture capital
we should, like our subjects, seek paths to create or realize the upside potential of our
work. Critical elements of the venture capital process include such positive concepts
as inspiration and innovation, for example. Where do these come from? How may
they be stimulated and enhanced? The rational economic perspective is silent on such
issues, providing little guidance for understanding the sources of inspiration, let alone
such responses as magnanimity. Even in commonly investigated phenomena, such as
the post-investment activities of venture capitalists, too little has been done to under-
stand the creative rather than the fiduciary actions of investors. Most works in the lit-
erature treat investors as concerned solely with avoiding risk or protecting value when
in fact realizing the upside of investments is paramount in many cases. Creating gains
is not the same as avoiding losses.
We can relate the above reflections to our ‘kaleidoscope’ of venture capital research by
employing yet another metaphor. Ghoshal’s portrayal of the modern, cynical researcher
can be understood by comparing this researcher with the title character in Nathaniel
Hawthorne’s short story ‘The minister’s black veil’. In this story, the minister in a small
New England town emerged one morning to face his parishioners wearing for the first
time a black veil through which he now viewed the congregation, and through which they
now viewed him. He now saw everything a bit more darkly, and they too imagined that he
harbored dark secrets and dark thoughts too unpleasant to reveal. Not only were those
on both sides of the veil affected by its darkness, but the dark veil seemed to invest the
minister with a certain power over others. By analogy, this story illustrates two problems
in contemporary management research in general and venture capital research in particu-
lar. First, the assumption of self-interest with guile as the true nature of the human actor
affects both those adopting the view and those glimpsed through it. Further, the assump-
tion of the negative view of human nature (the dark veil) invests its adopters with power.
This power stems from the fear people have of being seen as too naïve, of being portrayed
as seeing the world through ‘rose-colored glasses’. Ghoshal challenges us to do more than
view venture capital activity solely through the dark veil of unbridled opportunism and
self-interest – to see other views of actual and possible realities. Consider, for example, the
meaning of the ‘game’ in Cable and Shane’s (1997) analysis: if reputation and reciprocity
are seen not just as self-serving mechanisms to be calculated about and gambled upon,
but rather as desirable human status to aspire to and uphold, then, collaboration is indeed
collaboration, and coercion is recognized for what it is.
If we indeed let go of our arrogant air of certainty, adopt a balanced view of human
nature, keep ethics and responsibility in the picture, remember that what we teach has
effects, and take up the challenge of unearthing antecedents of positive outcomes we will
complete the circle of theorizing. We believe that the spirit of these two works is not to
repudiate and abandon all that has come before but rather to dig in deeply, questioningly,
and with renewed vigor. Like Ghoshal, our call is not for naïve denial of ill-will but for
balanced recognition of the multiplexity of human choice and action.
Conclusion
This chapter was devoted to giving a taste of how venture capital research in management
sciences has progressed over its brief history and how it might evolve in the future. It was
not our intent (nor would it have been possible) to thoroughly review the works comprising
the managerial view of the venture capital phenomenon, much less the entire literature
which also includes the contributions of finance and economics. We instead broadly
remarked on how the descriptive roots of the literature have provided a sound basis for
further study, and we offered a means of classifying work by focus on venture capital type,
stage in the venture capital process, and whose perspective was being studied. Our metaphor
of the kaleidoscope revealed a few areas of neglect, most of which certainly merit add-
itional study. However, we have suggested here that perhaps more important than merely
noting what has not been studied is to consider how we ought to approach future research
to ensure that it is meaningful, revealing, and valid.12 Echoing the exhortations of Van de
Ven and Johnson (2006) and Ghoshal (2005) we have encouraged management researchers
to immerse themselves in their phenomena, broaden and deepen their theorizing and
methods, and address questions that enrich theory and practice in meaningful ways.
Based on what venture capital researchers have already accomplished, we are optimistic
about the future. Venture capital research (like entrepreneurship research in general) has
benefited from its multidisciplinary roots and its connection to practice. Our exhortation
to take the ‘engaged scholarship’ approach seriously, implies that these roots and this con-
nection should be preserved and enhanced. If we go a step farther and foster the kind of
increased stakeholder cooperation, immersion in the field, and long-term research designs
suggested by the engaged scholar view, we will face significant obstacles in terms of time,
money, access and effort. However, as a relatively unified subfield within the area of entre-
preneurship we have the potential to jointly accomplish some ends that would not be pos-
sible individually.
Our review has surfaced a series of suggestions that represent an ideal of scholarship.
For the most part, these recommendations do not represent single, specific areas of
inquiry but rather approaches to the study of venture capital that might yield significant
insight. These general suggestions may be summarized as follows:
● Stay close to the phenomenon and study ‘big’ issues.

● Develop learning communities among academics and the venture ecosystem.
● Study phenomena over time via multiple theories and methods.
● Seek a balanced, humble view that reaches beyond rational self-interest.
● Explore the ethical and affective aspects of decision-making.
● Explore the bright side of entrepreneurship and its value creating correlates.
Our practical side recognizes the difficulty and burdens of adopting such approaches. We
have suggested, therefore, that efforts to achieve what we have laid out may need to be
accomplished in teams and that these teams might best be led by senior scholars whose
career ‘clocks’ are not ticking quite so loudly. We heartily recommend that junior schol-
ars participate and engage, but we also are cognizant of the fact that they may also need
to nurture parallel conventional studies that have shorter time frames to completion.
In terms of the current dominant rational thinking paradigm, we are suggesting that
future research should neither abandon these roots altogether nor ignore the rational
actor approach in future studies. We do suggest, however, that efforts to look beyond the
narrow confines of rational economic thinking will allow us to discover and conjure some
important, new questions that may have been obscured by the current view. Furthermore,
the broader set of stakeholders (such as local communities, individual entrepreneurs,
institutional representatives and the like) have legitimate interests that have little to do
with profit taking. To provide insights for these interests, we will have to delve deeply into
issues of the processes and mechanisms of value creation unconstrained by assumptions
regarding rent appropriation. In short, we will have to consider societal outcomes beyond
profit generation.
Returning briefly to our kaleidoscope, we can identify several specific suggestions for
future research. Research in the business angel domain would be especially suited to
exploration of the processes of venture and value creation. Furthermore, the role of
emotion and affect is especially amenable to study in the business angel context because
business angels, more so than institutional venture capitalists or corporate venture cap-
italists, have ‘skin in the game’ but are unconstrained by having to justify their decisions
to outside third parties. The corporate venture capital context, on the other hand,
provides an interesting setting in which to contrast entrepreneurial processes and leader-

ship in new versus established organizations. Any of these settings (or perhaps a compar-
ison of the three) could be used to examine the path-dependent nature of investment
decisions, including both the impact of early investment decisions on the development of
the venture as well as on the nature of later decision making. Our positive organizational
scholarship and engaged scholar views suggests that such studies might be viewed from
alternative lenses, over time, via a multiplicity of instruments. We are reminded, too, that
these issues can and should be viewed from the perspectives not only of the venture cap-
italist but of the entrepreneur and upon occasion by that of outside stakeholders.
Finally, we cannot help but conclude that venture capital research is but beginning to
reveal all that it might, not only about its own complex workings, but also about entre-
preneurship itself.
Acknowledgements
The authors are indebted to Hans Landström, Gordon Murray and Andy Van de Ven for
comments on early versions of this chapter.
Notes
1. Broadly construed, ‘venture capital’ refers to provision of outside equity for a claim against increases in
value of an independent entity. We, however, use the term in this chapter not to refer to the broader set of
all private equity, but primarily to refer more closely to what Bygrave and Timmons (1992) call ‘classic
venture capital’, the provision of equity into earlier stage, high potential ventures (see Chapter 1).
2. Gordon Murray pointed out to us that perhaps an astrolabe is a more apt metaphor, given the random-
ness of the outcomes that result when using a kaleidoscope. Nevertheless, we choose the kaleidoscope,
despite its imperfection, because we think it has the advantage of audience familiarity.
3. It should be noted that an additional limitation of this kaleidoscope metaphor is that it implies that the
researcher is on the outside looking in at the phenomenon. As we discuss later, the ‘engaged scholar’ view
places the researcher within the phenomenon as an observer/participant. We are indebted to Andy Van de
Ven for this observation.
4. In this chapter when we use the term ‘investor’ we are referring to the venture capitalist, even though in
the institutional venture capital context the limited partner may be the actual source of the funds invested.
5. In our focus on managerial venture capital literature we almost entirely ignore the vast and significant con-
tributions of Josh Lerner and Paul Gompers to the study of venture capital. From the early 1990s to the
present, these two have produced (singly and/or in combination with one another) the most significant
stream of work on the financial processes and structures in the institutional venture capital industry.
6. This latter reflection on the possibility that agency theory is less appropriate in some contexts outside the
US is not necessarily shared by all venture capital researchers. We thank Gordon Murray for this comment.
7. Please take note that we draw heavily on the work of Van de Ven and Johnson (2006) for these suggestions;
we offer this reminder to avoid filling these pages with repeated references to their work.
8. Donald Sexton (along with several colleagues over time) was a pioneer in publishing early serious scholarly
work in entrepreneurship beginning in 1982 with The Encyclopedia of Entrepreneurship and continuing with
The Art and Science of Entrepreneurship, The State of the Art of Entrepreneurship, Entrepreneurship 2000
and Handbook of Entrepreneurship Research.
9. This observation was suggested by Gordon Murray. Indeed, Professor Murray sees access to venture cap-
italists and their limited partners as perhaps the most daunting and important for the success of future
research on the industry. Gordon sees the presence of industry databases as a two-edged sword, one that
provides significant quantitative information that may help researchers overcome the common method
issues that plague primary research but that also may tempt researchers to conduct studies without ade-
quate depth of knowledge.
10. This section is largely based on Ghoshal (2005); for brevity’s sake, we forgo repeated references. For addi-
tional examples on this topic, see Cameron et al. (2003).
11. Phil Bromiley, former Curtis L. Carlson Professor of Strategic Management, University of Minnesota;
statement made often in conversation.
12. Although we have highlighted new approaches to conducting future research, an explicit mention of areas
requiring greater study is not unwarranted. Gordon Murray suggested the following to us in providing
feedback to this chapter: performance of institutional venture capitalists and their industry; the effects of
venture capital funding on their recipients; the process of raising funds; the internationalization of the
venture capital industry; the role of government as investor and industry supporter.
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3 Venture capital: A geographical perspective
Colin Mason
Introduction
A major focus of applied research on venture capital concerns the ‘equity gap’ – in other
words, the lack of availability of small amounts of finance. In the case of formal (or insti-
tutional) venture capital funds, because of the fixed nature of most of the costs that
investors incur in making investments it is uneconomic for them to make small invest-
ments. Informal venture capital investors – or business angels – are able to make small
investments because they do not have the overheads of fund managers and do not cost
their time in the same way. However, most business angels, even when investing in syndi-
cates alongside other business angels, lack sufficiently ‘deep pockets’ to fully substitute for
the lack of venture capital fund investment. Hence, whereas the market for investments
of under £250 000/$500 000 is served fairly effectively by business angels, and the over
£5m/$10m market is satisfied by venture capital funds, there is a gap in the provision of
amounts in the £250 000/$500 000 to £5m/$10m range which are too large for business
angels but too small for professional investors. This gap is mostly experienced by new and
recently started growing businesses. Governments have responded in a variety of ways in
an attempt to increase the supply of small scale, early stage venture capital (see Murray
in Chapter 4 and Sohl in Chapter 14).
However, much less attention has been given to ‘regional gaps’ in the supply of venture
capital – that is, the under-representation of venture capital investments in particular
parts of a country relative to their share of national economic activity (for example their
share of the national stock of business activity). If it is accepted that venture capital –
both institutional and informal – makes a significant contribution to the creation of new
businesses and new industries then regions which lack venture capital will be at a disad-
vantage in generating new economic activity and technology clusters.
This chapter reviews the literature on the geography of venture capital. It looks sep-
arately at informal venture capital and formal, or institutional, venture capital. The liter-
ature on the geography of informal venture capital is very limited and fairly superficial.
There are enormous difficulties in identifying business angels and developing a database
of investments, hence most studies have been based on small samples with limited geo-
graphical coverage or depth. Moreover, issues of geography, place and space have rarely
been given attention in studies of the operation of the informal venture capital market.
The literature on the geography of institutional venture capital is also limited. It has
mainly been contributed by economic geographers. Because of the tendency for scholars
to work in disciplinary ‘silos’ it means that this literature is largely unknown amongst
‘mainstream’ scholars of venture capital who are typically in the management and eco-
nomics disciplines. A further consequence is that when scholars from such disciplines do
write about the geographical aspects of venture capital they generally ignore these geo-
graphical contributions and treat such geographical concepts as place, space and distance
in simplistic terms. Finally, in order to put boundaries on the scope of this chapter it is
86
Venture capital: A geographical perspective 87
concerned exclusively with the geography of venture capital investing within individual
countries. There is a separate literature on the internationalization of venture capital (see
Wright et al. (2005) for a review).
The next section reviews what can be gleaned from the literature on the role of geog-
raphy of the informal venture capital market (section 2). The chapter then moves on to
consider the formal, or institutional, venture capital market, initially by considering out-
comes, describing the uneven nature of venture capital investing, illustrated by the exam-
ples of the USA, Canada, the UK and Germany (section 3) and then works backwards
to explanations, attributing this uneven geography of investing to the combination of the
localized distribution of the venture capital industry and the localized nature of invest-
ing. The role of long distance flows of venture capital in reinforcing the clustering of
venture capital investments is also discussed. Section 4 brings some of these earlier themes
together in the form of a short case study of Ottawa, Canada, a thriving technology
cluster. The intention is to show how economic activity is initially funded in emerging
high-tech clusters by a combination of ‘old economy’ business angels and the importing
of institutional venture capital from elsewhere, but over time, as it develops successful
technology companies so a technology angel community emerges and it also develops its
own indigenous supply of institutional venture capital funds. Section 5 draws the chapter
to a conclusion with some thoughts on future research directions and a brief consider-
ation of the implications for policy. A fuller discussion of policy issues can be found by
Murray in Chapter 4 of this volume.
Geographical aspects of the informal venture capital market

Business angels are very difficult to identify. They are not listed in any directories and their
investments are not recorded. Consequently, research has generally been based on
samples which are too small to be spatially disaggregated. Moreover, the identification of
business angels is often based either on ‘snowballing’ or samples of convenience which
have an in-built geographical bias. This has severely restricted the ability of researchers to
explore either the geographical distribution of business angels and their investment activ-
ity or to compare the characteristics of business angels and their investment activity in
different regions and localities. Some studies do make comparisons with findings from
independent studies conducted in other regions and countries but the lack of consistency
in methodologies, sampling frames and definitions renders such comparisons highly
suspect. However, since the majority of business angels are cashed-out entrepreneurs (up
to 80 per cent according to some studies) and other high net worth individuals, the size of
the market in different regions is likely to reflect the geography of entrepreneurial activ-
ity and the geography of income and wealth, both of which have been shown to be
unevenly distributed within countries (for example Davidsson et al., 1994; Keeble and
Walker, 1994; Reynolds et al., 1995; Acs and Armington, 2004).
The location of business angels

The only study which has looked at the geographical distribution of business angels is by
Avdeitchikova and Landström (2005). Based on a ‘large’ (n = 277) sample of informal
investors in Sweden (defined as anyone who has made a non-collateral investment in private
companies in which they did not have any family connections) they suggest that both
investments (52 per cent) and the amounts invested (77 per cent) are disproportionately
concentrated in metropolitan regions (which comprise 51 per cent of the total population).
However, this is a less geographically concentrated distribution than is the case for institu-
tional venture capital fund investments.
Regional comparative studies suggest that business angels also differ by region. For
example, a study that was based on a large sample of Canadian business angels (n = 299)
(Riding et al., 1993) noted that business angels in Canada’s Maritime Provinces (Nova
Scotia, Prince Edward Island and New Brunswick) are distinctive in terms of the typical
size of their investments, sectoral preferences, rate of return expectations and expected
time to achieve an exit (Feeney et al., 1998). Investors in Atlantic Canada and Quebec are
also the most parochial (63 per cent and 58 per cent of investments within 50 miles of
home compared with a national average of 53 per cent) (Riding et al., 1993). Johnstone
(2001) makes an important contribution, suggesting that remote and declining industrial
regions are likely to suffer from a mismatch between the supply of angel finance and the
demand for this form of funding. He demonstrates that in the case of Cape Breton, in the
province of Nova Scotia in Canada, the main source of demand for early stage venture
capital is from knowledge-based businesses started by well-educated entrepreneurs
(mostly graduates) with formal technical education and training who are seeking value-
added investors with industry- and technology-relevant marketing and management skills
and industrial contacts. However, the business angels in the region have typically made
their money in the service economy (retail, transport, and so on), have little formal edu-
cation or training, are reluctant to invest in early stage businesses and are not comfortable
with the IT sector. Moreover, their value-added contributions are confined to finance,
planning and operations. This suggests that the informal venture capital market in
‘depleted communities’ is characterized by stage, sector and knowledge mismatches.
There is rather more evidence on the role of geography – specifically the distance
between the investor’s location and that of the investee company – in the business angel’s
investment decision. This literature has looked at three issues: (1) the locational prefer-
ences of business angels; (2) how location is handled in the investment decision; and
(3) the locations of actual investments.
Locational preferences
Various survey-based studies in several countries have asked business angels if they have
any geographical preferences concerning where they invest. These studies reveal that some
angels have a strong preference to make their investments close to home while others
impose no geographical limitations on where they will invest. In the USA Gaston (1989)
reported that 72 per cent of business angels wished to invest within 50 miles of home and
only 7 per cent had no geographical preferences. However, other US studies – based on
smaller sample sizes and confined to specific regions – report that well under half of all
business angels will limit their investing to within 50 miles of home (Table 3.1). Studies in
other countries are equally inconsistent in their findings. For example, in Canada, a study
of Ottawa angels reported that 36 per cent imposed no geographical limits on their
investments (Short and Riding, 1989). In the UK, Coveney and Moore (1997) reported
that 44 per cent of angels would consider investing more than 200 miles or three hours’
travelling time from home, compared with only 15 per cent whose maximum investment
threshold was 50 miles or one hour. Scottish business angels are rather more parochial,
but even here 22 per cent would consider investing more than 200 miles or three hours
Table 3.1 Locational preferences by business angels: selected studies
Connecticut and
Massachusetts
(Freear et al., 1992; 1994)
New California
England (Tymes and USA Active Virgin
(Wetzel, 1981) Krasner, 1983) (Gaston, 1989) angels angels
(all figures in percentages)
Less than 50 miles 36 41 72 32 25
50–300 miles 17 – 10* 20 25
Over 300 miles – – – 19 12
Outside USA – – – 5 0
Other geographical 7 13 11 – –
restriction
No geographical 40 33 7 24 38
preference
100 87 100 100 100
Note: * 50–150 miles
from home, compared with 62 per cent wanting to invest within 100 miles of home (Paul
et al., 2003).
The role of location in the investment decision

Studies of how business angels make their investment decisions suggest that the location
of potential investee companies is a relatively unimportant consideration, and much less
significant than the type of product or stage of business development (Haar et al., 1988;
Freear et al., 1992; Coveney and Moore, 1997; van Osnabrugge and Robinson, 2000). A
more nuanced perspective is offered by Mason and Rogers (1996). Their evidence suggests
that most angels do have a limit beyond which they prefer not to invest, but – to quote
several respondents to their survey who used virtually the same phrase – ‘it doesn’t always
work that way’. In other words, the location of an investment in relation to the investor’s
home base appears to be a compensatory criterion (Riding et al., 1993), with angels pre-
pared to invest in ‘good’ opportunities that are located beyond their preferred distance
threshold.
Locations of actual investments

Studies which have focused on the actual location of investments made by business angels
reveals a much more parochial pattern of investing (Table 3.2). The proportion of invest-
ments located within 50 miles of the investor’s home or office ranges from 85 per cent
amongst business angels in Ottawa to 37 per cent amongst business angels in Connecticut
and Massachusetts. In the UK, Mason and Harrison (1994) found that two-thirds of
investments by UK business angels were made within 100 miles of home. In other words,
the actual proportion of long distance investments that are made is much smaller than
might be anticipated in the light of the proportion of investors who report a preference
for or willingness to consider long distance investments.
Table 3.2 Location of actual investments made by business angels: selected studies
Connecticut and
New England Massachusetts Ottawa (Short Canada (Riding
(Wetzel, 1981) (Freear et al., 1992) and Riding, 1989) et al., 1993)
(all figures in percentages)
Less than 50 miles 58 37 85 53
50–300 miles 20 28 4 17
Over 300 miles/ 22 36 (28+8) 11 29
different country
Total 100 100 100 100
Reasons for the dominance of short distance investments This dominance of local
investing reflects several factors. First, it arises because of the effect of distance on an
investor’s awareness of potential investment opportunities. Information flows are
subject to ‘distance decay’, hence, as Wetzel (1983, p. 27) observed, ‘the likelihood of an
investment opportunity coming to an individual’s attention increases, probably
exponentially, the shorter the distance between the two parties.’ Indeed, in the absence
of an extensive proactive search for investment opportunities, combined with the lack
of systematic channels of communication between investors and entrepreneurs, most
business angels derive their information on investment opportunities from informal net-
works of trusted friends and business associates (Wetzel, 1981; Haar et al., 1988; Aram,
1989; Postma and Sullivan, 1990; Mason and Harrison, 1994), who tend to be local
(Sørheim, 2003).
Second, business angels place high emphasis on the entrepreneur in their investment
appraisal – to a much greater extent than venture capital funds do (Fiet, 1995; Mason and
Stark, 2004). Their knowledge of the local business community means that by investing
locally they can limit their investments to entrepreneurs that they either know themselves
or who are known to their associates and so can be trusted. This point is illustrated by one
Philadelphia-based angel quoted by Shane (2005, p. 22): ‘we have more contacts in the
Philadelphia area. More of the people we trust are here in the Philadelphia area. So there-
fore we are more likely to come to some level of comfort or trust with investments that are
closer.’
A third reason is the tendency for business angels to be hands-on investors in order to
minimize agency risk (Landström, 1992). Maintaining close working relationships
with their investee businesses is facilitated by geographical proximity (Wetzel, 1983).
Landström’s (1992) research demonstrates that distance is the most influential factor in
determining contacts between investors and is more influential than the required level of
contact. This, in turn, suggests that the level of involvement is driven by the feasibility of
contact rather than need. Furthermore, active investors give greater emphasis to proxim-
ity than passive investors (Sørheim and Landström, 2001). Proximity is particularly
important in crisis situations where the investor needs to get involved in problem-solving.
As one of the investors in the study by Paul et al. (2003, p. 323) commented ‘if there’s a
problem I want to be able to get into my car and be there in the hour. I don’t want to be
going to the airport to catch a plane.’
Finally, angels need to monitor their investments. This is often done by serving on the
board of directors. It is desirable that the angel can travel to, attend and return in a day
in order to minimize their travel costs. Some angels prefer to monitor their investments by
making frequent visits to the businesses in which they invest, described by one angel in
Shane’s study as ‘seeing them sweat’ (Shane, 2005, p. 22). This is much easier to do if the
investment is local. Avdeitchikova and Landström (2005) provide statistical support for
these explanations. In their study of Swedish informal investors, they found that investors
who rely on personal social and business networks as their primary method for sourcing
deals, and active investors who provide hands-on support to their investee businesses, are
the most likely to invest close to their home/office.
Some studies have further observed that experienced angels have the greatest awareness
of the benefits of investing close to home. Freear et al. (1992; 1994) noted that whereas
38 per cent of virgin angels had no geographical restrictions on where they would be pre-
pared to invest, this fell to 24 per cent amongst active angels (see Table 3.1). In a study of
UK investors, Lengyel and Gulliford (1997, p. 10) noted that whereas the majority (67 per
cent) of investors gave preference to investee companies which were located within an
hour’s drive, actual investors placed an even bigger emphasis on distance in their future
investments, with 83 per cent indicating that they would prefer their future investments to
be within 100 miles of where they lived.
The characteristics of long distance investments Nevertheless, long distance investments

do occur. In studies of New England (Wetzel, 1981; Freear et al., 1992) and Canada
(Riding et al., 1993) between 22 per cent and 36 per cent of investments were over 300
miles from the investor’s home or office (see Table 3.2). In the UK, Mason and Harrison
(1994) found that one-third of investments were in businesses located more than 100 miles
from the investor’s home. Even in studies that have reported very high levels of local
investing, at least 1 in 10 investments were over a long distance. For example, 11 per cent
of investments made by Ottawa-based business angels were over 300 miles away (Short
and Riding, 1989), while in Finland, 14 per cent of investments were over 300 miles away
from the investor’s home (Lumme et al., 1998).
Long distance investing is distinctive in several respects. First, in terms of investors,
those who have industry-specific investment preferences (including technology prefer-
ences) are more willing to make long distance investments, and the pattern of their actual
investments supports this preference (Lengyel and Gulliford, 1997). Paul et al. (2003)
suggest that the willingness of angels to make non-local investments is related to the funds
that they have available to invest and the number of investments that they have made.
They note, for example, that distance is not an issue for ‘super-angels’ with more than
£500 000 available to invest. Such investors are also more likely to be well-known and so
more likely to be approached by entrepreneurs in distant locations. The ‘personal activity
space’ of angels is also relevant. Investors with other interests elsewhere in the country
will look for additional investments in these locations in order to reduce the opportunity
costs of travelling. Second, certain deal characteristics are associated with long distance
investing. Size of investment is important, with angels willing to invest further afield when
making a £100 000 investment than a £10 000 investment (Innovation Partnership, 1993).
The amount of involvement required is also relevant, with one angel observing that an
investment requiring ‘a one day a week involvement is going to be closer than [one which
requires] a one day a month involvement’ (Innovation Partnership, 1993). Third, angels
will make long distance investments if someone from the location in which the business
is based that they know and trust is co-investing with them.
From this fragmentary literature it can be concluded that there is not a national infor-
mal venture capital market. Rather, in view of the dominance of short distance investing
it is best described as comprising a series of overlapping local/regional markets. Localities
and regions differ in terms of both the numbers of business angels and their investment
capabilities. There are also more subtle, but equally significant, differences in terms of the
characteristics of investors, their investment preferences and the nature of the hands-on
support which they can provide to investee companies. It follows from this that informal
venture capital is not equally available in all locations. Nevertheless, some long distance
investing does occur. However, there is little support from the available evidence to suggest
that regions with a deficiency of informal venture capital can import their capital needs
from elsewhere. Indeed, in their exploratory study of long distance investing by business
angels in the UK Harrison et al. (2003) suggest that investors in the South East of
England – the most economically dynamic and most entrepreneurial region in the UK –
are the least likely to make long distance investments, and long distance investments in
technology businesses are most likely to flow from economically less dynamic regions and
into the South East region (which contains the major technology clusters).
Institutional venture capital: a geographical analysis
Definitions
Whereas the informal venture capital market comprises high net worth individuals invest-
ing their own money in unquoted companies, the formal, or institutional, venture capital
market consists of venture capital firms – in other words, professional fund managers who
are investing other people’s money. Most venture capital firms are ‘independents’ who
raise their finance from financial institutions (for example banks, insurance companies,
pension funds) and other investors (for example wealthy families, endowment funds, uni-
versities, companies). The investors in the funds managed by venture capital firms (termed
‘limited partners’) are attracted by the potential for superior returns from this asset class
but lack the resources and expertise to invest directly in companies themselves. Moreover,
as they are only allocating a small proportion of their investments to this asset class (typ-
ically a maximum of 1–2 per cent) it is more convenient to invest in funds managed by
venture capital firms (who are termed the ‘general partners’) who have specialist abilities
in deal selection, deal structuring and monitoring. This enables venture capital firms to
deal more efficiently with asymmetric information than other types of investor. Venture
capital firms also have skills in providing value-adding services to their investee businesses
and securing an exit for the investment which maximizes returns. The other, much smaller
category of venture capital firm is ‘captives’. These are venture capital firms that are sub-
sidiaries of financial institutions (especially banks) or non-financial corporations and
who raise their investment funds from their parent organization. (See Cumming, Fleming
and Schwienbacher in Chapter 5 for a more detailed discussion).
Three smaller types of institutional investors are also of note. First, some non-financial
corporations make venture capital investments for strategic reasons associated with R&D
or market considerations, an activity which is termed corporate venturing. Second, some
countries have venture capital funds that are funded entirely by investments by private indi-
viduals and who qualify for tax incentives. Examples include the UK’s Venture Capital
Trusts and Canada’s Labor-Sponsored Venture Capital Funds (Ayayi, 2004). Third, in
many countries there are government-funded venture capital funds which have been estab-
lished for economic development reasons usually in regions which lack private sector
venture capital funds (Hood, 2000).
Location of investments
The availability of information on the geographical distribution of venture capital invest-
ing is rather poor. The main source of information is in the form of highly aggregated
statistics produced annually by national venture capital associations or by organizations
acting on their behalf. However, this simply records the location of investments by region,
offers limited disaggregation by type of investment and provides no information on
investment source. A further concern relates to the comprehensiveness of the coverage
(Karaomerlioglu and Jacobsson, 2000). Members of national venture capital associations
tend to be skewed towards larger investors, including those which might not be regarded
as belonging to the venture capital industry,1 whereas many small-scale local investors are
not members and so are excluded. Investments by most corporate investors (that is non-
financial companies making strategic minority investments in small firms) and business
angels, including business angel syndicates, are also not covered. There are some com-
mercial sources of data which do provide deal-specific information (including locations
of investor and investee business). However, these suffer from a lack of comprehensive
coverage, being biased towards larger deals.
In the USA venture capital investments are highly concentrated at all spatial scales:
regional, state and metropolitan area. The pattern at the regional scale is bi-coastal,
with venture capital investing concentrated in California, New England and New York
(Table 3.3). Within individual states venture capital is concentrated in cities. At the met-
ropolitan area scale just 10 such areas attracted 68 per cent of all investments in 1997–98,
with just two – San Francisco and Boston – accounting for 39 per cent (Zook, 2002).
Equally, there are large swathes of the USA, including much of the south and mid-west,
which have attracted relatively little venture capital investing. The geography of venture
capital investing closely relates to the locations of high-tech clusters (Florida and Kenney,
1988a; 1988b; Florida and Smith, 1991; 1992).
In Canada venture capital investments are concentrated in Ontario and Quebec at the
provincial scale, with the Atlantic and Prairie provinces having the smallest amounts of
activity (Table 3.4). At the metropolitan area scale venture capital is concentrated in The
Greater Toronto Area (24 per cent), Montreal (20 per cent) and Ottawa (16 per cent) (2004
figures) which together account for just 28 per cent of total population. Indeed, underly-
ing the metropolitan focus of venture capital investing, just nine cities2 accounted for
82 per cent of all venture capital investments in Canada by value.
Turning to Europe, it should first be noted that the definition of venture capital is rather
broader than is the case in North America, and includes private equity firms which invest
in corporate restructuring situations such as management buy-outs, institution-led buy-
outs and public-to-private deals. These deals are typically very large, usually well in excess
of £10m. The geographical distribution of venture capital investing in the UK favours
London and the South East (Table 3.5) (Mason and Harrison, 2002). These regions have
Table 3.3 The location of venture capital investments in the USA, 2005
$ % number %
Alaska/Hawaii/Puerto Rico 17 044 900 0.1 5 0.2
Colorado 618 597 900 2.8 80 2.6
Washington DC/Metroplex 966 841 500 4.3 194 6.4
Los Angeles/Orange County 1 501 132 000 6.7 176 5.8
Mid West 773 419 400 3.5 147 4.8
New England 2 672 148 900 12.0 398 13.1
North Central 319 268 200 1.4 60 2.0
North West 964 114 500 4.3 156 5.1
NY Metro 1 865 528 600 8.3 168 5.5
Philadelphia Metro 580 389 900 2.6 90 3.0
Sacramento/N. California 80 262 200 0.4 15 0.5
San Diego 1 035 312 000 4.6 125 4.1
Silicon Valley 7 901 433 500 35.4 939 30.9
South Central 54 604 000 0.2 4 0.1
South East 1 219 747 600 5.5 204 6.7
South West 590 206 100 2.6 79 2.6
Texas 1 103 720 900 4.9 167 5.5
Upstate NY 59 391 300 0.3 30 1.0
Other US 57 099 000 0.3 2 0.1
Grand Total 22 380 262 400 100 3039 100
Source: PriceWaterhouseCoopers/National Venture Capital Association Money Tree™ Report

(www.pwcmoneytree.com/moneytree/index.jsp)
the largest location quotients – a simple statistical measure to show whether a region has
more, or less, than its ‘expected’ share of venture capital investments by dividing this
figure with some measure of the region’s share of national economic activity (in this case
the business stock). The only other regions with more than their expected shares of
venture capital investments by amount invested (indicated by a location quotient greater
than unity) are the East Midlands and West Midlands. Regions with the lowest location
quotients are in the ‘north’, notably Wales, Northern Ireland, Yorkshire and The Humber,
the North West and North East. Because of the dominance of MBO investments in the
UK there is a much weaker relationship between venture capital investing and high-tech
clusters (Martin et al., 2002). However, early stage investments continue to be dispropor-
tionately concentrated in London, the South East and Eastern regions and are more
closely linked to high-tech clusters (such as Cambridge) and more generally to the loca-
tional distribution of high-tech firms (Mason and Harrison, 2002).
A number of other West European countries, notably France, also exhibit high levels
of geographical concentration of venture capital investments in just one or two regions
(Martin et al., 2002). In Germany, 65 per cent of total investment in 2003 and 2004 was
concentrated in just three of the 15 federal states – Bavaria, Baden-Wurttemberg
and North Rhine-Westphalia (Fritsch and Schilder, 2006). Nevertheless, venture capital
investments are less geographically concentrated in Germany than in other countries, with
five states having location quotients greater than unity (Martin et al., 2005).
Table 3.4 Location of venture capital investments in Canada, by province, 2005
Companies Total
Amount invested financed Financings* investments
Province $m % No. % No. % No. %
British Columbia 225.7 12.3 58 9.8 69 10.8 198 12.9
Alberta 64.3 3.5 22 3.7 23 3.6 41 2.7
Saskatchewan 30.9 1.7 17 2.9 18 2.3 32 2.1
Manitoba 10.9 0.6 18 3.0 18 2.3 39 2.5
Ontario 751.0 41.1 156 2.6 170 26.6 510 33.3
Quebec 709.8 38.8 297 49.7 313 49.0 675 42.9
New Brunswick 15.6 0.9 13 2.2 16 2.5 30 2.0
Nova Scotia 17.2 1.0 6 1.0 8 1.3 16 1.0
Prince Edward 2.8 0.1 2 0.3 2 0.3 6 0.4
Island
Newfoundland 0.2 0.0 1 0.2 1 0.2 1 0.1
Territories 0.3 0.0 1 0.2 1 0.2 1 0.1
Total 1828.9 591 639 1531
Note: * companies may receive more than one investment in a year, hence the number of financings exceeds
the number of companies raising finance
Source: Thomson Macdonald (www.canadavc.com)
Little attention has been given to the extent to which these patterns of investing exhibit
stability over time. In the UK the regional distribution of venture capital investments
became less unevenly distributed during the 1990s compared with a decade earlier. The
dominance of London and the South East was reduced (declining location quotients),
while the older industrial regions, such as the East and West Midlands and Yorkshire and
The Humber, increased their shares of venture capital investments. However, this gain was
mainly in the form of management buy-outs; early stage investments continue to be con-
centrated in London and the South East (Mason and Harrison, 2002). In the USA the
investment ‘bubble’ of the late 1990s – caused by a large inflow of capital into the venture
capital sector, resulting in more, and larger, investments – did lead to a short-lived spatial
diffusion in investment activity as venture capital firms had to look further afield for
investment opportunities. However, in the subsequent investment downturn post-2000
venture capital firms quickly reversed this geographical expansion in investment activity
to re-focus on investments closer to home (Green, 2004). Indeed, the share of investing
by value in the top three states of California, Massachusetts and Texas has increased from
54 per cent in the pre-‘bubble’ period (1995–98) to 55 per cent in the ‘bubble’ years
(1999–2000) and to 61 per cent in the immediate ‘post-bubble’ period (2001–2002).
Explaining the geographical concentration of venture capital investments

This uneven geographical distribution of venture capital investments arises from the com-
bination of the clustering of the venture capital industry in a relatively small number of
cities, and the localized nature of venture capital investing.
Table 3.5 Location of venture capital investments in the United Kingdom, by region,
2001–2003 inclusive
Early stage
All investments – All investments – investments –
companies amount invested amount invested
Region Number % LQ* £m % LQ £m % LQ
South East 758 20.1 1.27 3.063 23.0 1.46 238 25.8 1.64
London 830 22.0 1.38 4031 30.3 1.91 229 24.9 1.56
South West 210 5.6 0.60 664 5.0 0.54 26 3.9 0.42
Eastern 413 10.9 1.08 827 6.2 0.62 216 23.5 2.32
West Midlands 262 6.9 0.84 1374 10.3 1.24 17 1.8 0.22
East Midlands 147 3.9 0.47 1147 8.6 1.27 22 2.4 0.35
Yorkshire and The Humber 191 5.1 0.72 319 2.4 0.34 10 1.1 0.16
North West 304 8.0 0.84 641 4.8 0.50 54 5.9 0.61
North East 117 3.1 1.24 194 1.5 0.58 6 0.7 0.26
Scotland 301 8.0 1.14 820 6.2 0.88 64 6.9 0.99
Wales 116 3.1 0.71 126 0.9 0.22 31 3.4 0.78
N. Ireland 128 3.4 1.06 100 0.8 0.25 25 2.7 0.85
Total 3777 13306 921
Note: * Location quotient (LQ) divides a region’s share of total venture capital investment by its share of
the total population of businesses registered for VAT. A value of greater than one indicates that venture
capital investments are over-represented in that region. A value of less than one indicates that venture capital
is under-represented in that region
Source: British Venture Capital Association, Report on Investment Activity
The spatial clustering of venture capital firms Venture capital firms are clustered in just
a small number of cities, typically major financial centres and cities in high-tech regions.
Since most venture capital firms have only a single office, including branch offices has only
a minor effect in reducing this high level of spatial clustering. In the USA venture capital
offices are concentrated in San Francisco, Boston and New York. In Canada the main
centre for venture capital firms is Toronto (59 per cent), with smaller concentrations in
Calgary, Montreal (both 9 per cent) and Vancouver (8 per cent). In the UK 71 per cent of
venture capital firms have their head offices in Greater London. There is greater dispersal
in Germany. Munich is the biggest single host to venture capital firms but accounts for
less than 20 per cent of the total (Fritsch and Schilder, 2006). In total, six cities account
for 65 per cent of venture capital firms: nevertheless, all of them are major banking and
financial centres (Martin et al., 2005).
The concentration of venture capital firms in financial centres reflects the origins of
many of them as offshoots of other financial institutions (notably banks). It also offers
access to the pools of knowledge and expertise that venture capital firms require to find
deals, organize investments and support their portfolio companies. Hence a location in a
financial centre enables appropriately qualified staff to be recruited and provides proxim-
ity to other financiers, entrepreneurs, legal, accounting and consultancy firms and head-
hunters during the investment process. The USA is unusual in having such a large
proportion of venture capital firms located in Silicon Valley, a high-tech region. In

contrast to the venture capital firms in financial centres, these firms have typically been
started by successful technology entrepreneurs and raised a lot of their funding from local
high net worth individuals (particularly wealthy cashed-out entrepreneurs). Technology
regions in other countries – such as Cambridge in the UK and Ottawa in Canada –
typically have only a handful of local venture capital firms, and ‘import’ much of their
funding from venture capital firms based in the major financial centres (London, Toronto,
and so on). However, these local venture capital firms have often been established by suc-
cessful local technology entrepreneurs (for example Amadeus in Cambridge, started by
Hermann Hauser, and Celtic House in Ottawa, started and initially funded by Terry
Matthews), and illustrates how technology clusters benefit from the institution-building
activities of such individuals.
The localized nature of venture capital investing The clustering of venture capital offices
need not necessarily lead to the uneven geographical distribution of venture capital invest-
ments – the money could be invested in distant regions. But in practice venture capital
investing is characterized by spatial biases which favour businesses located close to where
the venture capitalists themselves are located. Florida and Smith (1991; 1992) have
observed that venture capital firms located in high-tech clusters tend to restrict their
investing to the cluster. Powell et al. (2002) report that just over half of all biotech firms
in the USA attracted venture capital investment from local sources. This proportion was
even higher amongst smaller, younger, more science-focused firms and amongst firms in
the main biotech clusters (Boston, San Francisco and San Diego). Moreover, the tendency
for venture capital firms to invest locally increased during the 1990s. In the case of
Internet investing, Zook (2005) points to a strong statistically-significant correlation
between the offices of venture capital firms and the number of investments at all spatial
scales from five-digit zip code to metropolitan statistical area, with the strongest correl-
ation for early stage investments. Martin et al. (2005) similarly report a strong tendency
for German venture capital firms to invest locally, with most Länder dependent on local
venture capital firms for investment. On average nearly half of all firms raising venture
capital have been funded by local investors, with this proportion rising to 68 per cent in
the case of the Bayern region which is centred on Munich.
This strong spatial proximity effect arises because of the absence of publicly available
information on new and young businesses. Their unproven business models, untested
management teams, new technologies and inchoate markets all represent key sources of
risk and uncertainty for investors (Sorenson and Stuart, 2001). Venture capitalists seek to
overcome this uncertainty about the future prospects of potential investee businesses by
information sharing with other investors, consultants, accountants and a wide range of
other actors. Information sharing of this type is built on mutual trust that has been earned
through repeated interaction, while the nature of this information flow tends to be per-
sonal and informal and therefore hard to conduct over distance. As a consequence, less
information is available about businesses in distant locations. Making local investments
is therefore one of the ways in which venture capital firms can reduce uncertainty, com-
pensate for ambiguous information and thereby minimize risk (Florida and Kenney,
1988a; Florida and Smith, 1991). This reliance on personal and professional contacts –
what one venture capitalist terms ‘Rolodex power’ (Jurvetson, 2000, p. 124) – can be seen
at every stage in the venture capital investment process: deal flow generation, deal evalu-
ation and post-investment relationships.
Deal flow. At the deal flow stage, venture capitalists rely on their connections and rela-
tionships to find the best deals (Zook, 2005). Most venture capital firms are inundated
with business plans and have to develop systems which allow them to quickly identify
and focus on those which have the best prospects for success. There are two sources of
deal flow: deals which come in cold and those which are referred by the venture capital-
ist firm’s network – for example, law firms, accountancy firms, other venture capitalists
and entrepreneurs. Venture capitalists are unable to rely on the information provided by
the entrepreneur in deals which come in without an introduction. Instead, they rely on
their networks – which tend to be local – as a means of receiving deal flow which has
already been screened for relevance and quality. As one venture capitalist quoted by
Zook (2005, p. 83) explained, ‘I depend on someone I know to alert me to good deals. If
I don’t know this person at all and if they’re coming in totally cold, they have to say some-
thing really compelling to get me to look at it.’ Moreover, venture capitalists can place a
high level of trust in the quality of these referrals because these organizations and indiv-
iduals concerned are putting their reputation on the line when they refer deals to venture
capitalists.
Deal evaluation. The outcome of the initial screening is a much smaller number of
opportunities which the investor thinks have potential. These undergo a detailed evalu-
ation. As Banatao and Fong (2000, p. 302) observe, ‘at this stage the venture capitalist’s
contacts in his Palm Pilot are his best friend.’ Venture capitalists use their extensive con-
tacts to research the background of the entrepreneurs, the viability of the market, likely
competition already in place or on the horizon and protection of the intellectual property.
At the start-up and early stages of investing, considerable emphasis is placed on the
people. What have they done? Are they credible? Do they have the right integrity and
ethics? This is particularly the case in situations where the investor believes in the tech-
nology but there is no industry and market (von Burg and Kenney, 2000). In such situ-
ations – before a dominant design or standard has emerged – venture capitalists ‘have to
bet on the entrepreneurs presenting the business plan’ (von Burg and Kenney, 2000,
p. 1152). It is easier and quicker for a venture capitalist to check an entrepreneur’s résumé
if he or she is local, by using their own knowledge and local connections. The quality of
information is also likely to be better (Zook, 2004). Several Ottawa-based venture cap-
italists commented on how easily due diligence could be done on a local entrepreneur
(Harrison et al., 2004, p. 1064):
This is a community where most of the people are spin-outs of spin-outs. Two phone calls and
I can find out everything . . . For the most part, you are dealing with teams and at least some of
the team members come from the Ottawa community . . . Because I have six or seven investments
in semiconductors, there are not many people in the Ottawa area in the semiconductor industry
that I don’t already know or know someone who knows them, or who has worked with them in
the past and so on.
Ottawa is a small town, so typically the individual worked at Nortel at some stage in his career
and you can find someone who worked alongside him at one point.
I look at where they worked . . . If they’ve worked at half a dozen places there’s got to be one of
those places where I know somebody.
So, as Zook (2005, p. 81) notes, ‘limiting investments to nearby firms produces easier
and faster access to an entrepreneur’s references, which can often be double-checked by a
venture capitalist’s own personal connections and knowledge.’
Post-investment relationships. The local focus becomes even more important once an
investment is made. Venture capitalists not only provide finance; they also monitor the
performance of their investee companies to safeguard their investment, usually by taking
a seat on the board of directors, setting goals and metrics for the companies to meet and
supporting their portfolio companies with advice and mentoring in an effort to enhance
their performance. They may even play a role in managing the company in the case of
scientist-led young technology businesses. Supporting and monitoring their investments –
which is an important part of managing the risk and accounts for a significant propor-
tion of a venture capitalist’s time – also emphasizes the importance of proximity. Even
though some forms of support do not require close contact there will nevertheless be
many occasions when face-to-face contact is required and the venture capital firm will
incur high costs each time a non-local firm is visited. It is undoubtedly the case that geo-
graphical proximity plays an important role in both the level and quality of support that
businesses are able to obtain from their venture capital investors (Zook, 2004; 2005). First,
venture capitalists can work more closely with their investee companies in their support
and advisory roles when they are located nearby. Second, venture capitalists have abun-
dant contacts and deep knowledge of particular industries: providing referrals to these
sources of expertise is an important value-added contribution that venture capitalists
make. This social network is more readily tapped when investee businesses are geograph-
ically proximate to the venture capitalist (Powell et al., 2002; Zook, 2005). Third, a further
benefit which accrues when the venture capitalists and investee businesses are geograph-
ically proximate is that ‘unplanned encounters at restaurants or coffee shops, opportun-
ities to confer in the grandstands during Little League baseball games or at soccer
matches, or news about a seminar or presentation all happen routinely . . .’ (Powell et al.,
2002, p. 294). In short, it is precisely because venture capital is more than just the provi-
sion of capital that geographical proximity is important (Hellman, 2000, p. 292).
Summary. In their efforts to minimize risk and uncertainty venture capitalists place a
heavy reliance on their network of contacts to source quality deals, evaluate these deals,
provide timely assistance to their portfolio companies and monitor their performance.
This favours local investing because all of these activities become increasingly difficult to
undertake over long distances (Zook, 2005).
Venture capital as a location factor

This strong emphasis on local investing by venture capital firms can also attract businesses
from other regions where venture capital is lacking and which are seeking to raise finance.
This is well illustrated by Zook (2002; 2005) in his account of the geography of Internet
businesses. He notes that the importance of obtaining venture capital, combined with its
limited mobility, was a significant factor in encouraging Internet entrepreneurs in other
parts of the USA to move to the San Francisco area during the emergent phase of the
industry in the 1990s, either prior to starting their business or soon after founding a busi-
ness elsewhere. A mix of both push and pull factors lay behind this trend. First, the
venture capitalists in San Francisco were very receptive to approaches for funding by
Internet entrepreneurs in this period: those ‘venture capitalists who had been scanning for
the next promising breakthrough jumped on the opportunity of the internet and began
to fund and be approached by a wide variety of internet entrepreneurs’ (Zook, 2002,
p. 162). However, venture capitalists in other locations often ‘didn’t get it’ – they did not
know, understand or believe in the Internet industry – and so were more likely to reject
funding proposals from Internet entrepreneurs. Second, the lesson from the successes of
Netscape and Yahoo! was the importance of speed to market in order to secure first-
mover advantages. Thus, the strategy of Internet entrepreneurs during the Internet frenzy
of the late 1990s was to ‘get big fast’. This required raising venture capital so that they
could quickly scale-up, hiring the resources, developing routes to market and so on in
order to gain competitive advantage. Internet entrepreneurs also recognized the value that
venture capital investors could add through their networks and knowledge. However,
‘smart money’ in particular invests close to home (Zook, 2005). Thus, location became a
strategic choice for Internet entrepreneurs: ‘entrepreneurs had to go to Silicon Valley
because that was where the money was’ (Zook, 2005, p. 61).
Demand-side factors
Until now the discussion has been considering supply-side factors as a reason for the
geographical concentration of venture capital investing. However, the presence or
absence of venture capital also influences the demand side. A further consequence of
the localization of venture capital firms and their investment activity is that knowledge
of venture capital investing varies from place to place (Thompson, 1989). This, in turn,
has implications for the demand for venture capital (Martin et al., 2005). Knowledge
and learning about venture capital will spread through the local business community in
areas where venture capitalists are concentrated. Thus, both entrepreneurs and inter-
mediaries, including accountants, bankers, lawyers and advisers, will have a greater
understanding of the role and benefits of venture capital, what types of deals venture
capitalists will consider investing in and the mechanics of negotiating and structuring
investments. And, as noted earlier, the connections that lawyers, accountants and others
have with venture capital firms means that the businesses that they refer for funding will
be given serious consideration. The overall effect is to raise the demand for venture
capital in locations where venture capital is already established. As Martin et al. (2002,
p. 136) observe:
A strong mutually reinforcing process seems to be at work: venture capitalists emerge and
develop where there is a high level of SME – and especially innovative SME – activity and this
in turn stimulates further expansion of the local venture capital market which in turn contributes
yet further to the formation and development of local SMEs, and so on.
In areas which have few or no venture capital firms, in contrast, knowledge amongst
entrepreneurs and the business support network will be weak and incomplete, intermedi-
aries will lack connections with venture capital firms and, perhaps most significantly of
all, will be less competent in advising their clients on what it takes to be ‘investable’. The
effect is to depress demand for venture capital.
Long distance investing

The discussion thus far has emphasized the localized nature of venture capital investing.
However, it is important to recognize that long distance investing also occurs.
The effect of long distance investing is actually to reinforce the geographical clustering
of venture capital investments, rather than producing a more dispersed distribution of
investments, because it ‘flow[s] mainly to areas with established concentrations of high
tech businesses’ (Florida and Smith, 1992, p. 192). The best evidence on venture capital
flows is by Florida and Smith (1991; 1992) for the USA. They note that venture capital
firms that are based in financial centres such as New York and Chicago make most of their
investments in distant places, typically high-tech regions. This contrasts with the venture
capital firms in these high technology regions which make a high proportion of their
investments locally, although some long distance investing occurs. Powell et al. (2002) sim-
ilarly note for the biotechnology industry that New York money invests in Boston, San
Diego and the rest of the country whereas both Boston and San Francisco investors tend
to invest within-state. Likewise, in Germany venture capital firms in the major clusters of
venture capital make a significant minority of their investments in the Bayern region,
centred on Munich which is a major technology cluster. Indeed, Bayern is the second most
important region, after their own local region, for investments by venture capital firms,
accounting for 29 per cent of investments by Hamburg-based venture capitalists and by
25 per cent of those based in Dusseldorf (Martin et al., 2005).
The key point is that long distance venture capital investments typically occur in the
context of the syndication of investments between non-local and local investors (see
Wright and Lockett, 2003 and Manigart et al., 2006 for discussions of syndication in
venture capital). Sorenson and Stuart (2001, pp. 1582–3) have observed that ‘venture
capitalists expand . . . their active investment spaces over time . . . primarily through
joining syndicates with lead venture capitalists in distant communities.’ Syndication
arises because young, growing businesses – particularly technology businesses –
typically require several rounds of investment before they are successful, with each
round involving larger amounts. However, venture capital firms seek to mitigate risk
through diversification, investing in a portfolio of businesses, some of which they hope
will be successful, offsetting the losses from unsuccessful investments. Clearly, the initial
investor would cease to have a diversified portfolio if it continued to provide all of the
funding that a business needed. Investee businesses also benefit from having additional
investors co-funding later rounds because they are able to access a wider range of value-
added skills. Indeed, their initial investor’s value-added skills may be more appropriate
to businesses at their start-up or early growth, whereas businesses which have success-
fully negotiated this stage will require a different set of value-added contributions which
their initial investor may not possess. Because of the presence of a local lead investor
distance is not important to these later stage co-investors, who themselves can either be
local or non-local. They are willing to trust the local venture capital fund to undertake
the deal evaluation, monitoring and support functions, including taking a seat on the
board, leaving them to take a purely passive role. If the long distance investors do con-
tribute value-added functions then they are of a type that does not require close con-
tacts with the investee business. There is a strong reciprocal effect in syndication, with
the local investor likely to be invited by the other venture capitalists into deals that they
lead, which serves to reinforce the trust factor. Thus, syndication is a particular feature
of longer established venture capital firms. Florida and Kenney (1988a, p. 47) suggest
that ‘investment syndication is perhaps the crucial ingredient in the geography of the
venture capital industry.’
Venture capital clusters and technology clusters: the case of Ottawa

It is widely thought that the local availability venture capital is critical in incubating and
sustaining entrepreneurially-based high-tech clusters. As DeVol (2000, p. 25, emphasis
added) comments: ‘by financing new ideas venture capitalists are catalysts instrumental
in building a cluster as they provide a means for new firms to be formed.’ In other words,
it is suggested that a well functioning venture capital infrastructure is required for a
regional technology cluster to develop. But this contradicts evidence from Silicon Valley
(Saxenian, 1994) as well as other clusters such as Ottawa (Mason et al., 2002), Washington
DC (Feldman, 2001) and Cambridge (Garnsey and Heffernan, 2005) that venture capital
lags rather than leads the emergence of entrepreneurial activity. However, venture capital
is needed for the sustained growth and development of a cluster (Llobrera et al., 2000):
without venture capital a cluster is likely to stagnate or decline (Feldman, 2001; Feldman
et al., 2005).
The Ottawa technology cluster: an overview

This process is illustrated by Ottawa, Canada’s capital city, which is one of the main
regions for venture capital investing in Canada. (See Shavinina, 2004 for an overview of
Ottawa’s technology cluster.) It currently has around 1500 technology companies which
employ around 70 000 workers (down from a peak of 85 000 at the peak of the technology
boom in 2000). Over 75 per cent of Canada’s telecoms R&D is undertaken in Ottawa. It
is the location for several of the federal government’s R&D facilities and is also the home
of many leading private sector technology companies, including Nortel Networks,
Newbridge Networks (acquired by Alcatel in 2000), Corel Corporation, JDS-Uniphase
and Mitel Corporation – although many of these companies underwent substantial
retrenchment during the post-2000 technology downturn. Nortel undertakes a large share
of its worldwide research in Ottawa. Recognition of Ottawa as a centre for telecoms tech-
nology has led to global companies such as Cisco Systems, Nokia, Cadence Design
Systems and Premisys Telecommunications seeking a presence in the region during the late
1990s either through greenfield site development or the acquisition of local companies.
Ottawa’s emergence as a high technology cluster is largely attributable to the start-up
and growth of entrepreneurial companies over the past 40–50 years. Its origins date back
to the early post-war period with the founding of Computing Devices of Canada Ltd in
1948 as a spin-out from the government’s National Research Council (NRC) Laboratories
to produce military computer hardware. Both NRC and other Government research labs
have been the origin of many other spin-outs since then. A further significant building
block was the decision of Northern Telecom (the forerunner of Bell Northern Research
and later Nortel Networks) to move its R&D facilities from Montreal to Ottawa in the
1950s. This facility has gone on to become one of the largest and most innovative telecom-
munications research centres in the world, although it has contracted since 2000. It has
also been a significant source of spin-outs over the years. A further boost to the cluster
occurred in the mid-1970s with the closure of Microsystems International – a subsidiary
of Northern Telecom – one of the earliest developers of semiconductor technology fol-
lowing a temporary downturn in the chip business. The company had attracted a large
number of highly skilled IT engineers and scientists to Ottawa. Following the closure
some of the redundant workers started their own companies. More than 20 start-ups can
be attributed to former Microsystems employees.
Venture capital in the early stages of cluster development

The key point is that the initial emergence and early growth of Ottawa’s technology
cluster occurred in the absence of local sources of venture capital. One observer noted
in 1991 that compared to technology clusters in the USA, ‘Ottawa is conspicuous by
its . . . low venture capital investment’ (Doyle, 1991). Indeed, prior to the 1990s the only
sources of venture capital in Ottawa were provided by Quebec lumber companies which
began to invest in local high-tech companies in the 1960s. One of these companies was
acquired by Noranda which went on to create Noranda Enterprises, Ottawa’s first
venture capital company, in the late 1970s. Noranda ‘participated in nearly every suc-
cessful high technology company that was ever formed in the Ottawa-Carlton Region’
(Doyle, 1993, p. 12). However, Noranda and the other investors provided expansion
capital. The only source of start-up finance was therefore from business angels.3 A
survey of high-tech start-ups founded since 1965 (but primarily between 1978 and 1982)
found that few had raised external finance, none had raised venture capital and the most
important source of funding was the personal savings of their founders (Steed and
Nichol, 1985).
As recently as 1996 the Canadian Venture Capital Association (CVCA) directory
listed just two venture capital companies in Ottawa: a branch office of the Business
Development Bank, a Crown Corporation which provides both debt and equity finance
to Canadian SMEs via a network of branch offices, and Capital Alliances, a Labor
Sponsored Venture Capital Fund, started by the former managing partner of Noranda
Enterprises which had closed in the early 1990s.4 Moreover, venture capital firms in other
parts of Canada and the USA showed no interest in investing in Ottawa. The 1997 Ottawa
Venture Capital Fair was the first to attract non-local investors. For much of the 1990s
the only significant supplier of venture capital in Ottawa was Newbridge Networks,
founded in 1986 by the entrepreneur Terry Matthews (who had previously co-founded
Mitel with Michael Cowpland who went on to found Corel). Newbridge was acquired by
Alcatel in 2000. The Newbridge Affiliates Programme was essentially a form of corporate
venture capital. The affiliates were companies developing products that were compatible
with Newbridge equipment and so could leverage Newbridge’s sales force. The affiliates
programme provided these companies with direct investment by Newbridge and also by
Matthews himself, as well as mentoring and ongoing support, including back office func-
tions. The affiliates programme was wound down in the late 1990s. However, Matthews
continued his involvement in venture capital by establishing Celtic House, initially with
offices in Ottawa and London, but it subsequently opened a further office in Toronto. He
was the only investor in the first fund but Celtic House’s second and third funds have
raised funding from a variety of investors.
The recent boom in venture capital investing

The availability of venture capital in Ottawa has been transformed since the late 1990s.
Indeed, $1.2 billion (Can) was invested in Ottawa-based businesses in 2000, equivalent to
25 per cent of the Canadian total, four times larger than the 1999 figure and seven times
bigger than in 1997. The post-2000 tech-downturn has seen a drop in the scale of venture
capital investment (in part linked to declining valuations). Nevertheless, even in the down-
turn Ottawa continued to attract a disproportionate share of Canadian venture capital
activity.
This growth in venture capital investing has two sources. First, there has been an
increase in the number of Ottawa-based venture capital funds, including several local
funds (in many cases started by ex-Newbridge staff who had been involved in the affiliates
programme) and branch offices of Canadian venture capital funds. In addition, other
Canadian and US venture capital firms put people on the ground to act as their ‘eyes and
ears’. Second, a number of investors based elsewhere in Canada and the US – notably in
Toronto and Boston – started investing in Ottawa-based businesses. In most cases – and
especially in the case of US investors – these investors have been brought in by the ori-
ginal investors to provide second or third round funding.
Accompanying this growth in venture capital investing has a significant expansion
in the population of business angels. This has been a direct consequence of the many
successful, cashed-out entrepreneurs since the mid-1990s and the large number of
senior executives from the large company sector (for example Nortel, Newbridge,
JDS-Uniphase) who have made significant money from stock options, Moreover, these
angels – unlike those who funded earlier generations of technology start-ups such as Mitel
and Lumonics – are technologically savvy and are investing in areas that they understand
so that they are able to bring commercial know-how to support the entrepreneurs that
they are funding. One of the value-added contributions that business angels can provide
is to make introductions to venture capital funds. Indeed, Madill et al. (2005) noted that
57 per cent of technology-based firms which raised angel financing went on to raise
finance from venture capital funds; in comparison, only 10 per cent of firms that had not
secured angel funding obtained venture capital. This reflects the role of business angels in
building up start-up companies to the point where they become ‘investor ready’. The repu-
tation of a business angel can also be a positive signal to venture capital funds. Indeed,
one local venture capitalist observed that he has invested in firms ‘largely because of the
quality of their angels’ (quoted in Mason et al., 2002, p. 267).
There are four interrelated factors which account for this recent interest amongst venture
capitalists in investing in Ottawa (Mason et al., 2002). First, several contextual factors
favoured Ottawa. The venture capital industry experienced a boom in fund raising in the
second half of the 1990s, fuelled by a ‘hot’ IPO market and an active takeover market for
young technology companies. Thus, there was plenty of money looking for profitable
opportunities. In particular, US venture capitalists were finding that the money they had to
invest was outstripping the investment opportunities available locally, so they began to look
further afield (cf. Green, 2004). One of the key sectors in which venture capitalists were
interested in was communications – voice, data, telephony and infrastructure businesses.
These were precisely the sectors in which Ottawa was strong. Venture capital firms which
specialized in communications technology recognized that Ottawa has an international rep-
utation for world class technology in this area and knew that they could not overlook the
region as a source of potential opportunities. Two of Ottawa’s own venture capital funds –
Celtic House and Skypoint Capital – also specialize in communications technology.
Second, the sale of three young venture capital-backed companies in 1997 and 1998 for
what at the time were extremely high valuations demonstrated to the venture capital com-
munity that, in the words of one local investor, ‘Ottawa is a great place to make money.’
A further important consequence was that the monetary rewards of the entrepreneurs and
staff in these companies (through stock options) had a dramatic effect on the attitude of
engineers in the large companies, making them much more positive about starting, or
working in, a young technology company. Hence, it became much easier for venture
capitalists to attract people from major local companies to build strong start-up teams.
Third, the success of global companies based in Ottawa, such as Nortel, JDS-Uniphase
and Newbridge Networks, gave the region high visibility for the quality of its technology
and engineers. This attracted the attention of US venture capitalists in particular, giving
Ottawa-based entrepreneurs the credibility to get a hearing from venture capitalists. One
former local economic development official responsible for Ottawa’s Venture Capital Fair
noted that ‘when [entrepreneurs] call and say, “we’re from Ottawa and we’re working in
this area”, they get attention . . . because Ottawa is now really on their map.’ He went on
to quote from a US venture capitalist who told him that ‘if you see a deal involving ex-
Nortel guys, I want to see it.’ Indeed, by the late 1990s US venture capitalists were visit-
ing Ottawa ‘looking for ex-Nortel engineers or whatever engineers and funding their
ideas.’ Interestingly, Boston-based venture capitalists have invested in Ottawa despite
having no physical presence there. However, the flight time is only an hour and a half –
and because of Ottawa’s small size could quickly get plugged into the local networks.
Finally, Toronto-based venture capitalists also invested in Ottawa from a distance.
Ottawa is an hour’s flying time from Toronto, close enough for Toronto-based venture
capitalists to do a day’s business. However, by the late 1990s many Toronto-based venture
capitalists were finding this model of investing to be problematic. They were unable to
match the valuations paid by US venture capitalists for young technology companies.
Moreover, the large size of many US funds meant that they did not need to syndicate the
deal, thus excluding Canadian venture capital funds from the investment. This prompted
the recognition amongst Toronto venture capitalists that they needed to invest at an
earlier stage, ahead of the US investors, and therefore to already be an investor in com-
panies when they raised a subsequent round of finance. To do this required a local pres-
ence in order to improve their deal referral sources.
The Ottawa example therefore suggests that a technology cluster requires a previously
established technology base comprising R&D activities, out of which emerge the first gen-
erations of technology companies which get funded by local, usually non-specialist,
investors. However, it takes time to build a technology cluster capable of generating
leading edge ideas, with an entrepreneurial culture and which can support the emergence
and growth of world class companies that will generate high returns for investors. But
once venture capitalists recognize this they will be attracted to invest.
Conclusion
Summary
This chapter has drawn attention to the strong geographical effects that characterize
venture capital investing, contradicting the economist’s concept of perfectly mobile
capital markets (Florida and Smith, 1991). Although venture capital firms can, and do,
raise their investment funds from anywhere, there are strong geographical constraints on
where they make their investments. First, investing locally is a way of minimizing uncer-
tainty and reducing risk in identifying and evaluating investment opportunities and sup-
porting their investee companies. In particular, the hands-on involvement of venture
capitalists encourages local investing. These considerations may also encourage the
relocation of new firms seeking finance from other regions which lack venture capital.
Second, a significant proportion of venture capital is invested over long distances.

However, because this investment is typically made alongside other venture capital firms,
and requires a local investor to coordinate the syndicate and undertake the distance sen-
sitive functions, it is highly constrained in where it can flow. Indeed, most long distance
venture capital investments flow to major high-tech clusters which already contain sig-
nificant clusters of venture capital firms and investment activity. The effect is therefore to
reinforce the geographical concentration of venture capital investing. It is for these same
reasons that regions which lack local venture capitalists will encounter difficulties in
accessing venture capital from afar. Third, the concentration of venture capital investing
creates a virtuous circle in which knowledge and learning about venture capital spreads
to local entrepreneurs and intermediaries, resulting in increased demand for venture
capital. The exact opposite occurs in venture capital deficient regions where knowledge
and understanding of this type of finance in the business community will be weak, so
entrepreneurs will be less inclined to seek it and intermediaries will be less competent in
getting their client’s investment ready.
Given the positive effect that venture capitalists have on new firm formation and
growth, as both capitalist and catalyst, the effect of the geographical clustering of their
investments, in turn, contributes to uneven regional economic development. In the case
of Silicon Valley, for example, proximity to abundant sources of venture capital enables
firms to raise finance at a younger age, complete more funding rounds and raise more
money at each round. This translates into better performance: faster growth, profitabil-
ity, greater employment and a high likelihood of achieving an IPO.5 By having early access
to venture capital this gives start-ups substantial first-mover advantages, enabling pioneer
firms to transform ideas quickly into marketable products and become industry leaders
(Zhang, 2006).
Future research directions

The geographies of venture capital have been largely ignored by those scholars who have
approached the topic from entrepreneurial and finance perspectives. The subject has also
attracted surprisingly limited attention from economic geographers despite the growing
interest in the geography of money (Martin, 1999; Pollard, 2003). Hence, many significant
research questions need to be addressed. It is inevitable that any research agenda is per-
sonal and idiosyncratic. Based on the material that has been reviewed in this chapter, five
topics are identified as priorities for further research.
First, considering business angels, there is a need for research which can ‘put bound-
aries on our ignorance’ (Wetzel, 1986, p. 132): for example, better quality statistical infor-
mation on the locational distribution of business angels, the characteristics of business
angels in different locations, the circumstances in which long-distance investments occur
(assessing the roles of investor characteristics, investment characteristics and local envir-
onment), and how angels who make long-distance investments mitigate the locational
challenges. These are fairly straightforward questions but pose considerable challenges
simply because of the difficulties in obtaining comprehensive statistical information on
business angels and their investment activity.
Second, most geographical analyses of venture capital investing have used highly aggre-
gate data. Future studies need to make use of databases, such as Thomson Financial’s
Venture Expert Database, which contains a range of information on companies which
have received venture capital, and their investors, thereby permitting a much greater range
of geographical questions to be explored.
Third, moving from the macro scale, and quantitative data, to the micro-scale and
qualitative data, there is a need for greater insights into the way in which both business
angels and venture capital firms factor location and distance into their investment deci-
sions. Even though most investors – particularly those who specialize in early stage invest-
ing – emphasize the importance of investing locally, ‘exceptions’ are not hard to find
(Mason and Rogers, 1996). This might suggest that the location of the potential investee
is a compensatory factor, waived if other aspects of the investment are particularly
favourable. This is likely to require ‘real time’ research methodologies. More generally,
there is a need to explore the spatial biases of investors which influence their attitudes to
investment opportunities in different locations.
Fourth, there is a need to tease out the connections between venture capital and tech-
nology clusters. There are two particular issues. The first concerns the popular view that
venture capital is a pre-condition for the emergence of technology clusters. This chapter
has highlighted the case of Ottawa, and cited several other studies, which clearly demon-
strate that venture capital lags cluster development, with the funding of the early genera-
tions of spin-off companies being undertaken by various actors, including business angels,
established companies and government, and subsequently may attract venture capitalists
located in other regions who make and monitor their investments on a fly-in, fly-out basis.
Local sources of venture capital only emerge when a critical mass of entrepreneurial
activity is reached, the cluster develops an identity of its own, entrepreneurial success
stories begin to emerge and the quality of the region’s technology is recognized. More
research is needed to explore these processes.
The second concerns the process of knowledge spillovers in clusters. Firms that are
located in clusters derive competitive advantages by gaining rapid access to knowledge on
innovation, production techniques and competitive strategies of other firms. This know-
ledge, which is tacit and therefore difficult to transfer, circulates mainly by inter-personal
contact. Research has tended to focus on three main processes: the mobility of technically-
qualified workers within the local labour market, the spin-off process, involving individu-
als or teams leaving their existing employers to start new businesses, and various forms of
cooperative behaviour between firms in the cluster (for example suppliers, sub-contractors,
strategic alliances). It has not considered the role of venture capitalists as either a genera-
tor or diffuser of information. However, as this chapter has emphasized, venture capital-
ists sit at the centre of an extended network in which they share information with other
investors, entrepreneurs, corporate financiers, head-hunters, consultants and experts. This
provides them with deep knowledge about likely technological and market trends in par-
ticular industries which they draw upon to make decisions on what to invest in and what
not to invest in, and supporting their portfolio of investee companies. How this shapes the
trajectory of technology clusters is an important issue for research.
Finally, the venture capital industry is dynamic and as it has matured it has become
more heterogeneous. Research therefore needs to avoid extrapolating from what happens
in Silicon Valley, or even the USA and to examine venture capital investing practices in
different regions. There is also a need to recognize that investment processes and practices
change over the course of the investment cycle and that this produces different geogra-
phies (as Green, 2004, demonstrated). Research must also distinguish between ‘venture
capital’ – which can be defined as investing in new and growing entrepreneurial

businesses – and ‘private equity’ – which involves investing in established companies which
typically require restructuring and often takes the form of management buy-outs (MBOs)
in which the incumbent management along with the investors purchase their division or
subsidiary from the parent group to become co-owners. Venture capital and private equity
have different geographies (Mason and Harrison, 2002) and their local and regional
impacts are also very different. Fundamentally venture capital is providing finance which
is used for investment in growth whereas private equity is providing finance to enable own-
ership change to occur. Moreover, private equity deals are typically highly leveraged – in
other words, they have a high long-term debt component which is secured against the
future cash flows of the business to pay shareholders. Such businesses have to generate
cash in order to service this debt. This might involve asset sales. If they are unable to
service the debt then they will have to cut back on investment which may lead to loss of
market share and, in turn, to a decline in operating efficiencies and ultimately to financial
distress. Wrigley (1999, p. 205) has shown in the case of the US retail sector that the trans-
formation of the capital structures of firms can have
vital implications for the economic landscape, both directly, through the spatial reorganisation
of the activities of the high-leveraged firm, and indirectly, through the restructuring of markets
by rival firms responding to the commitments implicit in those transformations. . . . Divestiture,
market consolidation and avoidance . . . spatial predation, market entry, expansion and exit . . .
and competitive price response by rival firms . . . are just some of the outcomes.
Researchers also need to be alert to the changing nature of the venture capital indus-
try. Two trends are particularly significant. First, venture capital has been growing in pop-
ularity as an asset class amongst financial institutions. One of the consequences is that
funds have substantially larger amounts of money under management. This, in turn, has
driven up both the minimum and average size of investments and led to an increasing
emphasis on later stage investments in established businesses which have larger capital
needs than start-ups. Second, there has been a shift from generalist to specialist investors
who focus on specific industry ‘spaces’ (either vertical or horizontal). Both trends can be
expected to have geographical consequences, notably a weakening in the significance of
local investing (Mason et al., 2002).
Policy implications
The evidence concerning the catalytic effect which venture capital has on business start-
up and growth has prompted governments to see venture capital as an essential ingredi-
ent in their efforts to promote technology-led economic development in lagging regions.
However, as Florida and Kenney (1988b, pp. 316–17) observed, ‘simply making venture
capital available will not magically generate the conditions under which high technology
entrepreneurship will flourish.’ In similar vein, Zook (2005) comments that ‘simply
pumping additional capital into a region will not necessarily produce the dynamism of
established venture capital centres.’ First, as Venkataraman (2004) notes, venture capital
needs to be combined with talented individuals – typically business executives who can
generate and develop novel ideas, start companies, make the prototype, obtain the first
customer, develop products and markets and compete in the rough and tumble of com-
petitive markets. This, in turn, will generate some successes which provide the role models
for others. Without such a flow of high risk–high return businesses, private sector venture
capitalists will not invest, and wealthy local investors will shun becoming business angels
and invest in other asset classes instead. Second, it has been repeatedly emphasized that
providing money is only part of the role of venture capitalists. Hence, using public money
to create ‘venture capital’ funds which are staffed by managers who lack the value-added
skills of venture capitalists will be ineffective. According to Venkataraman (2004, p. 154)
the money will flow ‘straight to low-quality ventures’. However, as the example of Ottawa
highlighted, regions which do offer good investment opportunities will attract venture
capital. The implication for venture capital-deficient regions is therefore clear. Trying arti-
ficially to create a regional pool of venture capital is likely to be ineffective. Venture capital
will only be attracted to places with novel ideas and talented individuals (Venkataraman,
2004). Instead, policy-makers should concentrate on developing the region’s technology
base, encourage business start-up and growth, and enhance the business support infra-
structure. Specifically this means investing in the region’s research institutions to develop
knowledge in which they have some comparative advantage – to attract talented indivi-
duals from other regions and generate a steady flow of novel technical ideas – and initia-
tives which enhance the entrepreneurial culture of the region and raise the entrepreneurial
competences of the population (Venkataraman, 2004). As one long-term participant and
latterly an observer of Ottawa’s high-tech cluster observed, referring to venture capital-
ists: ‘if you build it they will come’ (quoted in Mason et al., 2002, p. 277).
Acknowledgements
I am grateful to Hans Landström for his insightful comments on earlier drafts of this
chapter. It was completed while in receipt of a Visiting Erskine Fellowship at the
University of Canterbury, New Zealand. I am most grateful to the University of
Canterbury for the award of this Fellowship.
Notes
1. Notably private equity firms which invest in large companies to facilitate their restructuring.
2. Vancouver, Victoria, Kitchener-Waterloo, Calgary, Edmonton, Ottawa, Greater Toronto Area, Montréal
and Québec City. These cities accounted for 45 per cent of Canada’s population at the 2001 Census of
Population.
3. For example, Mitel was started with seed money from local lawyers while Lumonics raised its money from
local businessmen (‘retailers, lawyers and car lot owners’: Mittelstaedt, 1980).
4. Noranda Enterprises – the only Ottawa-based venture capital company listed in the 1992 CVCA directory –
was closed down in the early 1990s following acquisition of the parent company in the late 1980s. Its new
owners saw it as a resources company and so in 1992 closed its investment activities (despite having achieved
a 38 per cent compound rate of return to shareholders: Doyle, 1991; 1993).
5. However, venture capital-backed firms in Silicon Valley also have lower survival rates. Zhang (2006) sug-
gests this may reflect the lack of prudent screening. A more plausible explanation may be the competition
between venture capital firms for investment opportunities leading to over-investment in specific markets.
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4 Venture capital and government policy
Gordon C. Murray
Introduction
It is instructive to observe that all venture capital markets of which we are aware were initiated
with government support. These markets do not appear to emerge without some form of assist-
ance. This leads to the question as to what it is that requires the need for government support in
these markets, at least in their formative stages. (Lerner et al., 2005)
The above quote is taken from a contemporary evaluation of public venture capital activ-
ity in New Zealand. It is one of a number of formal reviews of early-stage venture capital
activity that have recently been concluded by government policy makers with the assist-
ance of academic researchers.1 The authors of the New Zealand evaluation suggest that,
despite venture capital being a financing instrument most widely associated with the
‘animal spirits’ of the free market and of entrepreneurial agents unrestricted by public
interference, the state may well have an important role in both initiating risk capital pro-
grams as well as providing a conducive environment for the seeding and commercial
growth of such activity.
This view of the importance of government commitment to entrepreneurial action,
particularly in nascent (usually new knowledge or new technology-derived2) industries,
has support from several academic researchers (Bottazzi and Da Rin, 2002; Lerner, 2002;
Gilbert et al., 2004; Page West III and Bamford, 2005) who see evidence of a significant
increase of public initiated and financed venture activity on an international scale.
Venture capital and the role of public actors may be seen as one part of such a wider move-
ment to support new enterprise. These authors suggest that the logic behind this growth
of activity is a widening appreciation of entrepreneurship policies ‘as one of the most
essential instruments from economic growth . . . for a global and knowledge-based
economy’ (Gilbert et al., 2004, p. 321). More tangible roles for public intervention are
given by, among others, Lerner, 1999; Jeng and Wells, 2000; Keuschnigg and Nielsen,
2001; 2002; Keuschnigg, 2003. They emphasize the importance of government in setting
the supportive legal and economic framework conditions necessary for risk capital activ-
ity to flourish. Similarly, Audretsch and Keilbach (2004) see the entrepreneurial catalyst
as the ‘missing link’ in endogenous economic growth theory. Entrepreneurs become the
critical conduit for knowledge spillovers and the subsequent creation of valuable new
products and services.
However, academic support for a public role(s) in developing early-stage venture capital
markets is, at best, conditional and cautionary (Lerner, 1998). Successful policy makers
will have to act with a deft hand. There is plentiful evidence that governments are at least
as likely to produce overall negative effects by their involvement in markets as they are
to engineer a lasting improvement in market conditions (Gilson, 2003; Armour and
Cummings, 2006). Economists are particularly circumspect regarding micro-policy inter-
ventions at the ‘black box’ level of the firm or venture capital fund. Their preferred
113
prescriptions are more anonymously concerned with removing market barriers that
impede individual agents (for example business angels, venture capital firms or entrepre-
neurs) from pursuing their own commercial interests. But the involvement of government
in risk capital markets presumes some form of serious and persistent market failure.
Determining the importance or even existence of market failures will, in turn, require a
view of both demand and supply-side efficiencies. The difficulty of determining market
failure, despite its widespread presumption in entrepreneurship finance policy initiatives,
is noted below.
Academic and policy interests closely reflect the rapidly growing importance of venture
capital activity at both national and international levels over the last 25 years.
Governments’ recent endorsement of venture capital’s status as an important instrument
of entrepreneurial and innovation policy has been particularly noteworthy in Europe
(EC, 1998; 2001; 2003a; 2003b; 2005b; 2006a; 2006b; Murray, 1998; Martin et al., 2003).3
A profusion of contemporary public schemes is also indicative of governments’ contin-
gent response to the rapid reduction in supply of early-stage risk capital after the year
2000 collapse in technology markets (Sohl, 2003). High potential young firms were among
the first casualties of the changing market conditions at the start of the present century.
In several European markets, publicly supported funds were quickly to become one of the
most important and continuing sources of risk capital for new enterprises in the hiatus
of privately-funded, institutional and informal venture finance following the dot.com
collapse (Auerswald and Branscomb, 2003; EC, 2004; NEFI, 2005; Small Business
Service/Almeida Capital, 2005).
It would be incorrect to assume that venture capital is exclusively Anglo-Saxon in its
nature or distribution although a strong association exists between countries in the
former British Empire and the international centers of venture capital activity. Nascent
or growing venture capital industries now exist in virtually all developed economies in
the world. They are frequently encouraged by government action. Similarly, policy
makers in the emerging economies of China, Russia, and Brazil are also now exploring
the development potential of risk capital.4 India already has an established venture
capital community.5
Despite the assumption that venture capital is a suitable subject for policy action,
surveys of SME finance repeatedly show that entrepreneurs’ receipt of risk capital from
professional investors is an extremely rare event. Reynolds et al. (2003) ‘guesstimate’ that
less than half a per cent of all nascent entrepreneurs receive either venture capital or busi-
ness angel finance at start-up. A 2004 survey of UK SMEs showed that less than 2 per
cent of respondents had ever raised institutional venture capital (Small Business Service,
2005). A similar percentage has been recorded in Europe (see European Commission,
2005a). Given that the UK has the largest and most advanced venture capital/private
equity industry in Europe, it is probable that other countries are unlikely to register sig-
nificantly greater risk capital activity among their young firms. European studies confirm
this reality of the scarcity of venture capital receipt (European Venture Capital
Association, 2005).
Early-stage (‘classic’) venture capitalists primarily target technology-based young firms
because of their potential for very rapid growth in attractive and immature markets. Yet,
in a 1997 survey of 600 high-tech start-ups in Germany and the UK (that is conducted at
the start of the technology bull market), Bürgel et al. (2004) found that only around 1 in
Venture capital and government policy 115
10 of UK firms had received venture capital. In Germany, this ratio went down to 1 in 14.
Even in the US, Auerswald and Branscomb (2003) note that the supply of institutional
venture capital finance for technology development trails significantly behind business
angels, corporations and the Federal Government. It is salutary to note that in 2005, the
US and UK venture capital industries invested collectively in only 412 seed and start-up
deals (BVCA, 2006;6 PricewaterhouseCoopers/National Venture Capital Association,
2006). This is from two major world economies where, collectively, over one million new
businesses are started every year. Thus, institutional venture capital still remains a spe-
cialist financing instrument of relevance only to a tiny percentage of the population of
new and growing enterprises in any economy. This continues to be the case even during a
bullish, new technology market.
This chapter will seek to summarize what consensus may be found in seeking an appro-
priate role and mode of action for government in the light of the evidence of both acad-
emic enquiry and policy experience. The question of why governments appear to be so
interested in venture capital will be addressed while also noting the considerable influence
of US experience. The circumstances under which government itself becomes involved in
either influencing or participating directly in risk capital investment will be explained. The
nature of policy instruments at governments’ disposal are subsequently catalogued
including the growing interest in ‘equity-enhancement’ programs that incentivize private
venture capital agents. The chapter will also seek to address why governments have also
become involved in the ‘alternative’ policy direction of supporting informal investors or
business angels. The chapter will conclude by suggesting future research questions of both
academic and policy import.
Why are governments so interested in venture capital?

The attraction of an established venture capital industry lies in its putative ability both to
help finance the creation of new industries and, in so doing, to transform and reinvigo-
rate mature and established economies (Apax Partners, 2006; European Commission,
2006a; 2006b). The joint application of risk capital and high levels of managerial and
entrepreneurial experience is seen as a particularly attractive resource combination
(Sapienza, 1992) which possibly explains venture capitalists’ popularly perceived ability
to both identify and nurture exceptional new and innovative enterprises.
It is evident that the venture capital experience of the United States in the second half
of the twentieth century has exerted a huge influence on the entrepreneurship policy
ambitions of the majority of developed and emerging economies alike. Above all, it
was America’s unique ability to generate a stream of new companies of enormous vigor
and global span from the nation’s advanced science and technology research centers.
American venture capital clusters, pre-eminently Silicon Valley and Route 128, are per-
ceived as the ‘gold standard’ of early-stage innovation finance systems (Bygrave and
Timmons, 1992). Venture capital – both in its institutional and informal variants – is seen
as part of the very fabric of the USA’s ability to remain at the forefront of knowledge pro-
duction and commercialization (Edwards, 1999) through risk capital’s contribution to the
entrepreneurship/economic growth link (Audretsch and Keilbach, 2004). Multi-country
findings from the Global Entrepreneurship Monitor (GEM) further validate venture
capital ‘as playing a central role in facilitating high growth entrepreneurship’ (Reynolds
et al., 2000).
Accordingly, policy goals are often crudely framed as ‘How does country X or region Y
create the necessary conditions to replicate a Silicon Valley’ (Armour and Cumming,
2006). As the emerging BIC economies7 grow their global share of the production of
manufactured goods of increasing sophistication, high value, knowledge-based goods
and services are seen to be of growing importance for the continued prosperity of devel-
oped economies. Thus, the question of how to emulate world-class examples of innova-
tive and entrepreneurial excellence remains an urgent policy goal for mature Western
economies as traditional markets erode (Archibugi and Iammarino, 1999). In Europe,
these concerns about regional competitiveness are exemplified by the Lisbon Agenda
which sought by 2010 to make Europe the most competitive world region in which to
establish and grow a new business (EC, 2004; Kok, 2004).
Despite the absence of a resolution of the question of how to create a new Palo Alto
in Bavaria or a Route 128 around Helsinki, governments’ concerns for the continued
support of the domestic science base (including the commercialization of intellectual
property from laboratory to successful enterprise) remain intertwined with a strong faith
in the value of venture capital finance. Venture capital is as much an instrument of innov-
ation policy as enterprise policy. That many governments recognize the importance of
venture capital finance is, of course, no argument that they should directly engage in such
commercial actions. Most free-market oriented, public administrations have considerable
reservations about direct state involvement in specialist financing activities. They would
prefer to remove themselves completely from this commercial role. None the less, gov-
ernments reserve the right to intervene if there is clear evidence that: 1) the supply of
appropriate finance is insufficient; 2) as a consequence, material economic and other bene-
fits from entrepreneurial actions are being lost to the domestic economy; and 3) no private
investors will independently increase the supply of risk capital. Thus, public intervention
is predicated on an ‘insufficient’ response from private capital markets.
Market failure
We have argued that, given the evolution of the venture capital industry, the competen-
cies and dynamism of its professional managers and the weight of institutional money
now at their disposal, there appears little direct role for the state. Yet, there exists a conun-
drum. As the size and scale of venture capital activity has grown internationally, govern-
ments have perversely become increasingly drawn into the investment process. The state
has become both a provider of public funds to private venture capital firms and, on occa-
sions, an active investor directly selecting new enterprises. Governments have by default
been obliged to assume responsibilities for early-stage enterprise financing activities that
many academic and industry observers believe should better be left to efficient capital
markets. Their involvement in the investment process is recognition that the institutional
venture capital industry increasingly believes that early stage investments are not
sufficiently attractive.
A market failure can be said to have occurred when the price mechanism fails to produce
a socially optimal outcome. In effect, rent-seeking investors8 being unable to capture the
full economic and social value of their investments provide less finance (venture capital)
than could effectively and profitably be employed in existing opportunities. In these cir-
cumstances, public intervention is one possible contingent response to private market
shortcomings (European Commission, 2001). At best, the public involvement is seen as
temporary and should be designed to be phased out as the venture capital market corrects
(OECD, 2004). Yet, the term ‘market failure’ is ambiguous at best. It is frequently used,
and mis-used, to argue the case for public intervention and state subsidy in areas where the
market appears to deliver less of a product or service than may be deemed desirable by
interested parties. Within the context of SME finance, there are repeated calls from entre-
preneurs, small enterprise owners and their lobbyists for the state to intervene in order to
encourage the providers of finance (typically banks or venture capital firms) to lend more
debt or invest more equity capital. These arguments frequently resort to some vague defin-
ition of ‘public good’ and are often linked, in the case of venture capital, with arguments
promoting internationally competitive, innovation and technology policies. Rarely do such
submissions acknowledge that a reduction in supply of finance may be an efficient market’s
reaction to an insufficient supply of attractive companies.
Thus, the term market failure is often used as a label rather than a serious argument.
The specific market(s) in which the problem occurs needs to be carefully defined. Repeated
surveys of finance for SMEs are ambiguous in their findings. For example, a large pro-
portion of small business owners do not require external finance (Small Business Service,
2005). A Eurobarometer survey found that over three-quarters of SMEs have sufficient
financing and only 14 per cent of respondents put easier access to finance as their primary
concern (EC, 2005a). However, it is the much smaller population of high potential and
rapidly growing young firms that are most likely to seek external finance. These immature
firms with, as yet, limited assets are also one group that is most likely to find finance is
problematic both in its supply and in the cost of access. This is particularly the case for
knowledge-based young firms with intellectual and experiential assets that are largely
intangible and tacit. (See, for example Bank of England, 1996; Storey and Tether, 1996;
OECD, 1997; Westhead and Storey, 1997; European Commission, 2003a; 2003b; Maula
and Murray, 2003; 2007.)
For policy makers, the quandary exists in determining when a constraint in the supply
of finance to a potential user is either: 1) an adverse outcome of an inefficient and/or ill-
informed market; or 2) a rational and well informed judgment by an efficient market on
an unattractively priced proposal. In the former case, often called ‘the equity gap’, there
may be an argument for publicly incentivizing either economic principles or agents to
provide a greater supply of debt or equity (Keuschnigg, 2003). In the latter case, the failure
resides in the entrepreneur’s inability to demonstrate the attractiveness of the business
proposal. In contemporary policy vocabulary, this venture is not yet ‘investment ready’
(Mason and Harrison, 2001). Here, the prescription is much more likely to be public inter-
ventions to improve human capital. A ‘supply-side’ response that seeks to manipulate
investors’ returns would not address the core ‘demand-side’ problem of poor quality
enterprises.
The longevity of the ‘equity gap’

The term ‘equity gap’ has entered the policy vocabulary. It was first used in an official British
governmental report in 1931 that looked at the availability and access of small and medium
sized businesses to sources of external finance. The Macmillan Report concluded that firms
were facing impediments in the search for capital that were not a function of their attrac-
tiveness as individual investment opportunities. Rather, because of their size and designa-
tion as small businesses, owners were facing discriminatory actions by the institutional
providers of business finance. Thus, the equity gap was conceived as a supply-side market
failure. Successive official reports in the UK (Bolton, 1971; Wilson, 1980; National
Economic Development Office, 1986; Williams, 1998; Pickering, 2002; HM Treasury and
Small Business Service, 2003) over the three-quarters of a century since the Macmillan
Report have broadly echoed its findings that the capital markets are frequently discrimina-
tory against smaller firms.9 However, the phenomenon is not unique to one nation but uni-
versal to market-based economies obliged to make judgments on partial information.
It is perhaps not the longevity of the gap that is surprising but, rather, its continuing
notoriety. That the gap remains an issue of substantive debate (HM Treasury and Small
Business Service, 2003) is in large part because of the changing nature of the enterprises
affected by capital constraints. The financing problems experienced by firms which could
be classified as ‘high-tech’ or ‘R&D intensive’ (Butchart, 1987; OECD, 1997) only gained
visibility in the latter quarter of the twentieth century. The use of the term ‘knowledge
economy’ with its implication of intangible (and thus un-bankable) intellectual assets is
similarly recent (Sweeney, 1977).
Murray (1995) and latterly Sohl (1999) have both argued that the use of the term ‘equity
gap’ in the singular is a misrepresentation of the harsher realities faced by the young and
growing firm in its vulnerable years prior to the accumulation of sufficient collateral-
based assets or reputation. They both suggest that there exists a second equity gap repre-
sented at the stage where seed or start-up capital had been exhausted and no additional
providers were prepared to ‘follow-on’ from the original external investor. For small early-
stage venture capital funds or business angels with limited resources to fund follow-on
rounds without the participation of new syndicate partners, the absence of external co-
funding also severely prejudices investment performance.
This discussion implies the delineation of a range of funding which is considered to be
within the equity gap problem. The UK government believes that the gap exists for small
firms seeking investments broadly between £500 000 to £2 million (HM Treasury and
Small Business Service, 2003). Yet, its exact quantification remains vague and inconclu-
sive. The term, and its estimation, is frequently anecdotal. More than one gap has been
identified for more than one reason (Lawton, 2002; Sohl, 2003). The institutional venture
capital industry largely denies the import of the gap arguing that there are few supply-side
constraints. Rather, they counter that the (demand-side) failure is in the quality of the
entrepreneurs seeking risk capital (Queen, 2002).
Causes of market failure when investing in knowledge-based industries

The term equity gap nicely describes a financing constraint affecting high potential but as
yet immature and vulnerable businesses. The actual reasons causing investors to provide
insufficient finance are embedded in the investment process and the risks and reward that
such investment decisions will incur. Further, there is an operational question of mater-
iality. The investment process has high sunk costs and often little advantages of scale. Thus,
small investments may incur transactions costs out of all kilter with the probable benefits
of the investment. In these circumstances, a rational and informed decision not to invest
in an early stage venture cannot be seen as a market failure. On the contrary, it is the market
working effectively. None the less, there are genuine sources of market failure affecting new
knowledge-based firms. Two are particularly pernicious: information asymmetries and
R&D spillovers.
Information asymmetries
In extremis, a highly innovative but immature technology employed to produce novel
products and services provided to new customers by a technically knowledgeable but com-
mercially inexperienced entrepreneur (possibly coming from a university environment)
and who is starting a new enterprise provides a full spectrum of the sources of potential
risk that the venture capital investor has to manage (NEFI, 2005). At its earliest stages,
the technology is not proven in its applications. Even if the technology works as it is envis-
aged, it will be used to create products and services which are not yet widely available nor
in some cases even fully comprehended by either future suppliers or users. In such cir-
cumstances, how does the firm or its investor(s) determine the attractiveness of products
or services that as yet do not exist? These information challenges will remain while the
company grows (see Box 4.1) up until that extremely unlikely event that the technology
attains a dominant position and becomes comprehensively understood as an industry
standard.
Thus, we can have simultaneously technology risk, market risk, managerial risk and
financial risk, each impacting on a new high-tech enterprise (Amit et al., 1990; Storey and
Tether, 1998). Multiple decisions have to be made, often very quickly, on highly imperfect
knowledge. As Amit et al. (1990) contend, less able entrepreneurs will choose to involve
venture capitalists, whereas the more profitable ventures will be developed without exter-
nal participation because of the adverse selection problem associated with asymmetric
information. Amit’s argument implausibly assumes that unknown entrepreneurs, regard-
less of skills, have alternative and sufficient sources of finance available.
BOX 4.1 INVESTMENT RISKS IN NEW TECHNOLOGY-

BASED FIRMS
● Exceptional technical entrepreneurs are rarely competent or experienced

business managers.
● Project assessment and due diligence are highly problematic in areas
concerning ‘leading edge’ technologies.
● Uncertainty is compounded by the need to analyze both technological
feasibility and the existence of a sufficiently large and attractive market
(often for a product which does not yet exist).
● The speed of the change and the threat of technological redundancy often
require an extremely rapid rate of commercial exploitation.
● Competitive response and the availability of alternative products/services
are likely to be rapid in dynamic and attractive new technology markets.
● Successful NTBFs need to grow, internationalize and develop second gen-
eration products in a very short time horizon.These imperatives place excep-
tional managerial, financial and technical demands on a new business.
● The scarcity of large, liquid and technologically informed capital markets
increases the uncertainty of the future financing of the investee firm and
the profitable ‘exit’ of the venture capital investor.
Risk is a computable state based on estimated probabilities. Thus, seed, start-up and
other early-stage investments in unique enterprises where no prior history exists are
particularly problematic. Without reference benchmarks, investors also face incom-
putable uncertainty of a Knightian nature (Knight, 1921). Audretsch and Keilbach
(2004), in referring to new technology environments, uses the term ‘hyper uncertainty’.
The use of quantitative approaches is effectively nullified in such a speculative and
volatile environment. The main implication of this situation is that the presence of non-
quantifiable uncertainty affects commercial decisions by amplifying their perceived
risk components (Einhorn and Hogarth, 1985; Kahn and Sarin, 1988; Ghosh and
Ray, 1997). As a result, early-stage venture capital investments may offer investors the
prospect of little confidence of higher returns but with a considerable likelihood of
project failure. In such circumstances, the abandonment of seed investments in favor of
later stage deals by commercial investors can be viewed as highly rational (Dimov and
Murray, 2006).
R&D spillovers
Audretsch (2004) also observes that it cannot be assumed that desirable spillover effects,
that is whereby society at large gains access to and benefits from the availability of a valu-
able new innovation, are automatic. The entrepreneur is a critical agent in the dissemina-
tion of innovative ideas. In early-stage classic venture capital activity, a majority of
investments in a portfolio will either fail or return (at best) a negligible net present value
when the time cost of money and an appropriate risk premium are computed (Fenn et al.,
1995; Murray and Marriott, 1998; Rosa and Raade, 2006). Where attractive net returns
are made by the fund, it is likely to result from the realization of a small minority of excep-
tional investments within the portfolio (Huntsman and Hoban, 1980; Bürgel, 2000).
Given these uncertainties, the venture capital investors will seek to ensure contractually
that when abnormal rents are generated they are owned by the investors (van Osnabrugge,
1999). Hence, the attention given by technology investors to ensure that they have strong
patent protection (Salhman, 1990; Kortum and Lerner, 2000). Indeed, the investors’
ability to appropriate the commercial benefits of their actions is likely to affect their ori-
ginal investment decision. None the less, the full value of a novel technology and the con-
sequent stream of new products and services are rarely harvested in their entirety by the
investors. Competitors may emulate and copy key attributes, both legally and illegally.
The bargaining power of suppliers or customers may also erode the innovator’s surplus
rents (Griliches, 1992). In a study of 600 high-tech start-ups in Germany and the UK,
Bürgel et al. (2004) found that the high-tech young firms experienced their first serious
competitive threat after a median period of 16 months of sales.
In these circumstances, both entrepreneurs and investors may well feel that the enter-
prise risks and uncertainties are too high and their ability to secure both full and attrac-
tive returns from successful technology enterprises are too doubtful. This is likely to result
in an undersupply of investment regardless of the fact that the existence of the innovation
has benefits to a wide range of parties. Griliches estimates that the gap between the private
and the social rate of return spans 50–100 per cent of the private rate of return. Small
firms because of their lesser market power and inability to finance the aggressive defense
of intellectual ownership infringements are particularly likely to see an erosion of their
returns (Mansfield et al., 1977).
Policy challenges in the venture capital arena

Based on a near universal admiration as to the vigor of the US innovation financing
system, several governments have sought to emulate elements of the American venture
capital system. The assumption is made, often implicitly, that elements of a system may
be isolated and applied within other different contexts. This raises a set of issues of both
theoretical and operational complexity that policy makers ignore at their peril.
The influence of a US exemplar

Given the noted hegemony of the USA innovation finance system, it is legitimate to ques-
tion what can be learned from the American experience of venture capital activity and
readily applied to other national economies both in the developed and developing world.
Yet the simplicity of the question betrays an ignorance of both ‘path dependency’
(Kenney and von Burg, 1998) or what it is that can actually be made transferable even
assuming that the environmental and institutional conditions (for example tax regimes,
legal and corporate governance structures, and so on) exist for such a transfer to be pos-
sible.10 Gilson (2003) is explicit in his assertion that others cannot follow USA experience
in order to reach ‘the holy grail’ of a flourishing venture capital market modeled on
Silicon Valley. He notes that because of the US industry’s highly idiosyncratic history, ‘the
manner in which the US venture capital market developed is not duplicable elsewhere’
(p. 3). He goes on to argue that other countries might be obliged to use public policy mea-
sures given the inability to copy another country’s history.11
State interest in entrepreneurial action has moved from exhortation to involvement
as many commercial investors have abandoned early-stage equity finance (Sohl, 2003;
Cumming et al., 2005; Coller Capital, 2006). General and limited partners’ actions are an
articulate judgment of the economic attractiveness of the early-stage market. Their deser-
tion has left a financing (equity) gap that governments have felt obliged to try and fill. This
move from early to later stage deals (‘style drift’) is most evident in European venture
capital markets. However, it is not an exclusively European phenomenon. Gompers (1998)
shows that US investors also moved to later stage deals as the size of the finance under
management by venture capital general partnerships increased rapidly in the late 1990s.
This same phenomenon was earlier described by Bygrave and Timmons (1992) and more
recently by Branscomb and Auerswald (2003).
The specific problem of minimum fund scale

‘Ask an LP what he thinks of investing in European venture tech and he is likely
to respond “what is European venture tech”?’ (European Venture Capital Journal,
November 2004).
The single biggest problem – facing both governments keen to encourage early-stage
investment in new technology-based firms as well as for general and limited partnerships
prepared to consider early-stage risk capital investment activity – is simply put. With very
few exceptions, the investment record of early-stage funds worldwide has been very poor
(European Venture Capital Association, 2005). The general exceptions to this rule over
the long term have been from the upper quartile of US technology investors. The consist-
ency of poor venture capital returns in Europe has been so uniform as to make a number
of institutions question whether Europe actually has a viable, early-stage technology
investment activity (Ernst and Young, 2004).
Table 4.1 Long-run investment returns to venture capital and private equity in Europe
European private equity funds formed 1980–2005. Net returns to investors from inception to
31 December 2005
Pooled Upper Top Quarter
Stage IRR Quartile IRR*
Early stage 0.1 2.3 13.6
Development 9.2 9.0 18.8
Balanced 8.3 8.5 23.7
All venture 6.3 6.2 17.1
Buyouts 13.7 17.8 31.8
Generalist 8.6 8.8 10.3
All private equity 10.3 10.6 22.9
Note: * The top quarter IRR is the pooled return of funds above the upper quartile
Source: Thomson Financial (venturexpert database)
The pooled IRR statistic of all ventures for Europe of 6.3 per cent p.a. in Table 4.1
can be compared to the US equivalent of 16.5 per cent p.a. for the period 1986–2006
(both sets of statistics are from Thomson). Söderblom and Wiklund (2005), in
seeking to determine robust reasons for the apparent consistent difference in perform-
ance between US and European early-stage venture capital funds, reviewed over 120
academic papers. They concluded that the following venture capital firm-related
variables appeared to be repeatedly associated with successful professional equity
investments:
● Industry specialization (knowledge effects);

● Large fund size (scale effects);
● Strong syndicated deal flow (network effects);
● Management and technical competence (human capital effects); and
● Large and rapid investments per successful enterprise (implementation effects).
Collectively, these firm-level influences can be interpreted as the positive application of

‘scale and scope economies’ to the risk capital investment process.
Murray and Marriott (1998), in a simulation of early-stage venture capital fund activ-
ity, showed that fixed costs have a severe effect on the net performance of small funds.
Excess costs particularly fell on the venture capital firm or general partner (Figure 4.1).
This view is also corroborated by Dimov and Murray’s (2006) analysis of the supply
determinants of seed capital in their investigation of seed capital fund activities from
1962 to 2002. They showed that the most active seed investors over time were almost
exclusively large and well established US funds. The top five venture capital
investors active in seed capital which were all US based12 had, on average, made 92 seed
investments from total funds under management of nearly $4 billion per venture
capital firm.
50
40
30 Limited
I
R 20 Partners’ IRR
R Management
% 10 IRR
0
7.5 10 15 20 25 30 35 40 45 50
–10
–20
Fund size £ million
Figure 4.1 Simulation model of the effect of fund size on management’s and private
partners’ returns (Murray and Marriott, 1998)
Small is not beautiful

The most conspicuous outcome of these studies is to challenge the apparent willingness
of policy makers to create and to support programs which encourage the formation of
sub-optimal, and ultimately non-viable, seed capital funds. Here, the state can be seen as
both part of the problem as well as a possible solution to financing constraints. In the
state’s absence, few private investors would have participated in such funds. Small, early-
stage funds have a series of structural weaknesses that serve to undermine the probabil-
ities that these funds will earn an acceptable risk adjusted return on the finance under their
management (Box 4.2). One effect of this sub-optimal fund size is a particularly damag-
ing inability to recruit experienced professional investment executives in a highly com-
petitive market for talent (European Investment Fund, 2005).
Insufficient fund size similarly reduces its attraction to institutional investors. These
investors including pension funds, insurance companies and other money managers
become limited partners in venture capital funds in order to add some controlled expo-
sure to high risk/high reward opportunities (Bürgel, 2000; BVCA, 2000). Because of the
multi-billion dollar global reach of these institutional investors, asset allocation has to be
material in order to have any effect on the performance of their investment portfolio. In
these circumstances, a minority position for a limited partner demands involvement in a
fund of sufficient scale in order to influence the institution’s overall performance. For all
but the smallest institutional investors, a minority position in a closed venture capital fund
of under US$100 million is likely to be irrelevant.
Thus, a small seed fund’s circumstances often describe the worst of all worlds. It has
modest funds to invest and little income with which to execute a strategy of finding and
evaluating potential investee firms. It is unlikely to be fully diversified. Investee firms, par-
ticularly at start-up, are costly in their urgent need for advice, and the fund has little
money to provide follow-on finance for the most attractive prospects in its portfolio. The
lack of finance results in either impeding the portfolio firm’s growth plans and/or in the
rapid dilution of the fund’s ownership share as syndication finance is arranged. These
conditions are very likely to lead to a sustained poor investment record which will severely
BOX 4.2 NEGATIVE CONSEQUENCES OF SMALL VENTURE

CAPITAL FUND SIZE
Small, early-stage venture capital funds bear disproportionately the following

dis-economies:
● The high costs of reducing information asymmetries in immature, complex

and dynamic markets
● The high levels of management support & guidance required by early-
stage investees
● The limited ability to attenuate project risks by fully diversifying the venture
capital fund
● The limited ability to invest large sums early in the life cycle of the investee
firm
● The skewed risk/return profile resulting in the need for an exceptional
success by the venture capital fund
● The long NTBF cycle and its implications on fixed term, fund
structure/conduct/performance
● The limited ability to provide follow-on financing in a successful NTBF
● The danger of excessive dilution of ownership for the original investors in
deal syndication
reduce the fund’s ability to survive by attracting subsequent follow-on funds from private
sector investors. In these circumstances, policy makers outside the elite technology clus-
ters of the USA are likely to see the earliest and most uncertain stages of equity invest-
ment virtually abandoned by commercial venture capital firms. Governments are obliged
to come to a view as to their own response to such a withdrawal of private, early-stage
funding sources to priority (new technology) young enterprises. Almost universally, they
have considered the reduction (or absence) of support for such firms to be strategically
and politically unacceptable.
Government instruments to promote institutional venture capital finance

Government’s influences on the entrepreneurial vigor of a national economy are mani-
fold. For example, the institutional legal and fiscal frameworks (Fenn et al., 1995; La
Porta et al., 1997; 1998), the incentive structure of personal and corporate tax systems,
the regulatory regime’s impact on business, and the efficiency of the market for corporate
control will each have profound (albeit not easily predicted) effects on the incentives for
entrepreneurial risk taking. As such, these influences also affect the demand for venture
capital as an important source of entrepreneurial finance.
The eclectic nature of popular policy recommendations (see Box 4.3) reflects the wide spec-
trum of important influences on venture capital activity. Further, such conditions in order to
be effective will in turn have to be embedded in, and legitimized by, a culture of opportunity
recognition and entrepreneurial endeavor (Shane, 2003). However, given the dynamic and
linked nature of investment activities to both micro- and macro-economic variables, it is not
BOX 4.3 VENTURE CAPITAL POLICY RECOMMENDATIONS

Investment regulations:
● Ease quantitative restrictions on institutional investors to diversify sources
of venture funds
● Support the development of a private equity culture among institutional
investment managers
● Facilitate creation of alternative investment pooling vehicles, such as
funds-of-funds
● Improve accounting standards and performance benchmarks to reduce
opacity of venture capital funds and protect investors
● Remove barriers to inflows of foreign venture capital finance
Taxation
● Reduce complexity in tax treatment of capital from different sources and
types of investments
● Decrease high capital gains tax rates and wealth taxes which can deter
venture capital investments and entrepreneurs
● Evaluate targeted tax incentives for venture capital investment and con-
sider phasing out those failing to meet a cost–benefit test
Equity programs
● Use public equity funds to leverage private financing
● Target public schemes to financing gaps, e.g. for start-up and early stage
firms
● Employ private managers for public and hybrid equity funds
● Consolidate regional and local equity funds or use alternative support
schemes
● Focus venture funding on knowledge-based clusters of enterprises, uni-
versities, support services, etc.
● Evaluate public equity funds and phase-out when private venture market
matures
Business angel networks
● Link local and regional business angel networks to each other and to
national initiatives
● Ensure linkages between business angel networks and technology incu-
bators, public research spin-offs, etc.
● Provide complementary support services to enhance investment-
readiness of small firms and increase demand
Second-tier stock markets
● Encourage less fragmentation in secondary-stock markets through
mergers, e.g. at pan-European level
● Enhance alternative exit routes such as mergers and acquisitions (M&As)
necessarily easy to determine what factors are most important at any one time. Factors that
constrain entrepreneurial activity (for example legal and regulatory compliance) may not by
their removal necessarily act as an accelerator for greater entrepreneurial endeavor.
A full treatment of environmental conditions conducive to venture capital finance is
inappropriate in this chapter. Accordingly, we will focus specifically on what measures the
state may employ directly to support the actions and effectiveness of both the institutional
and informal venture capital industries.
The growing status of entrepreneurial activity

The late twentieth century saw a coming together of two related trends of 1) an increas-
ing awareness of the importance of small and young firms to the wider economy after
Birch’s seminal MIT study (1979), and 2) an appreciation of the changing nature of eco-
nomic value as represented by the growing importance of innovation via knowledge-
based goods and services in mature and developed economies (Nonaka, 1994;
Grant, 1996; Spender, 1996). Young high-tech firms were increasingly seen as an impor-
tant conduit for continuing innovation particularly in fostering disruptive and non-
incremental, technology developments (Drucker, 1985; Storey and Tether, 1998;
Audretsch and Acs, 1990; Audretsch, 2002; Branscomb and Auerswald, 2003). Incumbent
large firms were all too often seen as reactionary and thus vulnerable to adept new com-
petitors (Christensen, 1997). The confluence of these new understandings meant that it
was highly unlikely that governments could envisage not supporting entrepreneurial
young firms. The ‘political stock’ of small firms increased throughout the 1980s and
1990s. The technology and Internet-related bull markets of the latter part of the 1990s,
with their focus on young knowledge-based firms, further fueled public and government
interest in entrepreneurial activity. Accordingly, the specific financial constraints faced by
young firms in their attempts to grow, and particularly the appropriateness of risk capital
finance to high potential, new enterprises, became an increasing focus of policy interest.
Despite setbacks, there is also evidence that governments can and do learn over time.
The environmental preconditions to effective entrepreneurial action including its financ-
ing are increasingly being recognized in policy circles (OECD, 2004; Small Business
Service, 2005; US Department of Commerce and European Commission Directorate
General for Enterprise and Industry, 2005). Thurik (2003) summarizes Europe’s eclectic
policy needs in order to stimulate greater entrepreneurial activity (Box 4.4).
Thurik’s span of policy prescriptions reflects closely both the EC’s 2003 document
Green Paper: Entrepreneurship in Europe and similarly the UK government’s own 2004
policy roadmap for a more entrepreneurial Britain (Figure 4.2). These enabling environ-
mental conditions set a context in which venture capital programs can operate. The UK
model is interesting for its belief in entrepreneurial activity and its comprehensive linking
to government departments with both a commercial (for example DTI, Treasury and
Inland Revenue) as well as a social mandate (Home Office). The encouragement of new
enterprises in economically disadvantaged communities borrows from earlier experiences
of immigration into both the British and US economies.
The two above illustrations raise an important issue of policy priorities and focus.
Venture capital is an important instrument for promoting enterprise.13 But as the US
experience has also shown us, risk capital has played a critical role in the emergence of
technology hubs on the East and West coasts. Thus, venture capital is additionally seen
BOX 4.4 FIVE AVENUES TO STIMULATE

ENTREPRENEURSHIP
1. Demand side intervention

R&D expenditure, stimulating competition
2. Supply side intervention
Labor mobility, regional development
3. Influencing input factors
Higher education, venture capital market
4. Influencing preferences
Attitude/mindset, image of entrepreneurship
5. Individual decision making process
Taxes, social security, level of benefits
Drivers of Policy Government Vision 7 National Strategies

Many more people
have the desire
Building an Enterprise Culture
skills and
Encouraging a more dynamic
opportunity to start
start-up market
Productivity a business
Building the capability for small
Everyone with the
business growth
ambition to grow
Improving access to finance for
their business is
small businesses
helped and
Encouraging more enterprise in
supported
disadvantaged communities
A supportive
Enterprise Improving small businesses’
business
for all experience of government
environment makes
services
it easy for all small
Developing better regulation and
businesses to
policy
respond to
government and
access to its services
Source: Small Business Service (2004a)
Figure 4.2 UK government’s model of building an enterprise economy
as a major instrument of innovation policy. The conflation of the two policy goals is likely
to result in some contradictions. Entrepreneurship is largely about mass activity includ-
ing a wider interest in new enterprise at all levels of the citizenry. In contrast, innovation
policy is frequently much more meritocratic in nature and seeks the promotion of tech-
nologies and enterprises of world-class competitive status. However, as the ‘TrendChart
Innovation Policy in Europe’ (European Commission, 2004) report notes, priorities on
innovation among EU states include ‘fostering an innovation culture’ and ‘building
innovative capacity in smaller enterprises’. These instruments and goals of both innova-
tion and entrepreneurship policies often appear remarkably similar.
Venture capital intervention typologies

As noted earlier in this chapter, governments have restricted their direct financial involve-
ment in venture capital to the more problematic investment stages of seed, start-up and
early firm growth (OECD, 2004). Their interventions are premised on a belief of the key
role that professional risk capital can make to the innovative capacity of an economy.
Hence their near exclusive focus on supporting seed, start-up and early growth stages. In
these earliest and most speculative stages, it is still not fully evident that specialist early-
stage venture capital investment is an activity than can be effectively mediated through a
market mechanism as apposed to directed grants or subsidy alternatives. As noted, this
uncertainty is exacerbated by the historically poor returns to early-stage venture capital
activities. Outside the special case of the United States ‘high-tech’ industries prior to the
year 2000, risk-return characteristics have consistently been unfavorable for investors
wishing to engage in early-stage ventures (Murray and Lott, 1995; Murray and Marriott,
1998; Lockett et al., 2002; Rosa and Raade, 2006).14 In direct contrast, the later stages of
venture capital and private equity have been consistently profitable with management
buy-outs becoming the European industries’ dominant product (Wright et al., 1994;
EVCA, 2005). Private equity does not exhibit comparable problems of insufficient scale
or information asymmetries. Thus, government involvement in such later-stage actions
is rare other than in the setting of the appropriate enabling legislation (Wright and
Robbie, 1998).
Having made the decision to intervene in the market for early-stage venture capital, the
state has to decide what form of intervention will be most effective for what purpose.
While there are a number of national studies of venture capital programs (Lerner, 1999;
Dossani and Kenney, 2002; Maula and Murray, 2003; 2007; Ayayi, 2004; Lerner et al.,
2005), the value of such precedents is in part obscured by the specificity of the programs
to their national context (Jääskeläinen et al., 2006). None the less, the risk capital deci-
sions of government can be pared down to two generic choices:
1. Direct intervention – government as venture capitalist. Government may elect to

become its own venture capitalist and undertakes all the roles that would otherwise be
the responsibility of a rent-seeking, market intermediary. Here, the government run,
venture capital firm has to undertake all the selection and due diligence, governance
and nurturing duties incumbent on an early-stage risk capital investor. Given that the
government is investing public finance in order to fulfill its role, the state assumes
simultaneously both the roles of general and limited partner in the public fund.
2. Indirect intervention – private venture capital firms as agent of government.
Alternatively, government can delegate executive responsibility to a private venture
capitalist fund manager. This is often done on the assumption that the state has neither
the professional skills nor the experience to be a ‘direct’ risk capital investor. Once
operational responsibility has been assumed by a private general partner agent, the
position of the state becomes analogous to that of a limited partner in a traditional
limited liability partnership (LLP) fund. Limited partners are not able to intervene in
the operations of the fund manager at the risk of losing tax status privileges. Similarly,
the government’s operational involvement ceases once the focus and mode of opera-
tion of the fund has been agreed and public monies committed. Indirect intervention
via equity enhancement schemes is becoming the dominant contemporary mode of
public involvement as the importance of highly skilled, and properly incentivized,

investment managers is recognized (Gilson, 2003; OECD, 2004).
Government uses multiple incentives with which to encourage the involvement of

private venture capital agents. It will exploit the power of the state to provide additional
and cheaper finance to the fund thereby allowing a leverage affect to increase ‘up-side
returns’. Government may further reduce the costs of the venture capital fund by con-
tributing to a proportion of the operating costs of the fund. However, such operating
subsidies are less common than alternative measures with a direct incentivizing effect on
the fund’s performance. Finally, the state may change the risk/reward profile of the fund
by underwriting part or all of the risk of financial loss to the limited and general
partners.
Direct public involvement

The state as a direct investor creates some challenging issues. First, there is the question
as to whether government has appropriate personnel capable of carrying out such com-
mercially sophisticated activities as equity investment in early-stage firms. It is unlikely
that such persons are widely available as civil servants. Secondly, the state by its size and
influence inevitably will create an impact – for good or ill. Thirdly, that the state has to
assume the role of a direct investor may be seen as a consequence of its failure to incen-
tivize a private market to take on this largely commercial role. A number of countries
do have direct investment via public bodies. The Finnish Investment Industry program
with civil servants investing public money directly into young enterprises primarily to
fulfill government policy goals would meet this definition (Maula and Murray, 2003).
Similarly, the Danish government financed VaekstFonden (Business Development
Finance) also has a direct venture capital investment activity.15 Yet these programs
raise some very considerable issues regarding the conflict between policy and commer-
cial goals.
As noted, direct involvement in new venture investment by government agencies carries
a material risk of market disruption through the potential misallocation of capital and
the possible ‘crowding out’ of private investors (Leleux and Surlemont, 2003). These
undesired effects can be due to both the commercial involvement of inexperienced public
service personnel, who may often control substantial levels of finance relative to the total
supply of early-stage venture finance in a market. In addition, there may be differing
return requirements of public investors (OECD, 1997; Manigart et al., 2002; Armour and
Cumming, 2006). Government funding can further distort private markets by offering
finance which does not fully reflect the appropriate risk premium (Maula and Murray,
2003; 2007). Venture capital is a ‘learned’ activity (Bergemann and Hege, 1998; Shepherd et
al., 2000; De Clercq and Sapienza, 2005). General partnerships often need the experience
of managing and investing multiple funds before they have accumulated sufficient tech-
nical and market knowledge to provide their investors with acceptable returns (Gompers
and Lerner, 1998). Many public programs have recognized the possible adverse effects of
government inexperience on market outcomes. None the less, government’s direct inter-
vention in the supply of venture capital has frequently been defended on market failure
arguments without reference to the efficacy of such actions. It is perhaps inevitable that
criticisms of market distortion have been leveled at such public programs. For example,
the Canadian Labor-Sponsored Venture Capital Corporations – a program with both

commercial and social goals and made attractive to individual investors via substantial
federal tax breaks – have been accused of crowding out private venture capital activities
(Cumming and MacIntosh, 2003).
Indirect or ‘hybrid’ public/private venture capital models

The OECD has used the term ‘hybrid’ to describe the structures where government and
private interests work in concert as co-investors, that is limited partners, in a fund. Such
structures are seen as an element of ‘best practice’ (OECD, 1997; 2004; US Department of
Commerce and the European Commission, 2005). In effect, the venture capital firm or
general partner is acting as an ‘agent’16 for a group of principals (limited partners), one of
which is the state using public monies. Governments’ history as active investors selecting
commercially attractive projects is problematic at the very least with many illustrations of
adverse selection. ‘Spotting winners’ among young and growing companies is fraught with
danger (Hakim, 1989) and denies the stochastic nature of the firm formation process. A
general conclusion from the last half a century is that government would do well to avoid
placing itself in a position where it has to make nominally economic decisions that are
bounded by other, usually political, conditions (OECD, 1997; Modena, 2002; Gilson,
2003). There appears to be a growing consensus on the limited role of government as a
direct investor. Contemporary venture capital programs in, for example, the USA, the UK,
Australia, New Zealand and Germany have each used private venture capital firms to invest
on behalf of government in areas of new enterprise deemed important for policy reasons.
The parallel involvement of both public and private investors can be seen in Figure 4.3.
That the state would wish the participation of private investors to support its policy
goals is self-evident. But why commercial investors would be prepared to be involved as
limited partners in such a hybrid activity needs further explanation. Such an arrange-
ment may do little to alter expected outcomes that led to the supply side, market failure
in the first place. Thus, the involvement of the GP and any private sector LPs17 in the
fund will frequently require the engineering of more attractive profit expectations in
order for them to participate (Gilson, 2003; Maula and Murray, 2003; Hirsch, 2005;
Jääskeläinen et al., 2006).
Private Loan or
Private investors Investment Equity Government
‘Uncapped’ Early-stage ‘Capped’

Profit share fund Profit share
Start-up &
growing SMEs
Source: Small Business Service (2004b)
Figure 4.3 Generic ‘hybrid’ venture capital model

In discussing the evolution of different incentive structures in government’s support of

venture capital, it is important to acknowledge the contribution of the Small Business
Investment Company program created by the US Government’s Small Business
Administration.18 The basic model of an ‘equity enhancement’ program by which the
state’s involvement (either by direct investment or acting as a guarantor to other fund
providers) enables additional and cheaper funds to be raised – thereby creating a leverage
advantage to private investors – has been reflected in venture capital programs worldwide.
It should be stressed that the full value of the Small Business Investment Company
program in its various forms (that is bank owned, debenture and participating securities
funds) was not restricted to the net returns generated by the funds. Indeed, the investment
performance of these funds has been highly variable over time (Small Business
Administration, 2002; 2004). Rather, the value of the program has been in the espousing
of novel public–private experiments used to address the problem of the inadequate sup-
plies of risk capital for young firms across a range of communities. Of critical importance,
the Small Business Investment Company program also enabled a generation of US invest-
ment managers to obtain their first commercial experience of venture capital activity via
government supported funds. There is an ‘infant industry’ argument for interceding in
immature markets (Baldwin, 1969; Irwin and Klenow, 1994). In the UK, the government-
conceived venture capital firm, 3i plc and its predecessor ICFC, performed a similar
industry development role from 1946 until the late 1980s (Coopey and Clarke, 1995).
Public-funded incentives in hybrid funds

Hybrid funds illustrate the imperative of government action in strategically important
investment categories where consistently poor returns have precipitated a major reduction
in private finance for young enterprises. Such structures also acknowledge that good
investment managers will rarely tolerate the state having an executive role in their funds.
This impasse is resolved by the use of government finance to incentivize private managers
to engage in more risky, early-stage funds. It is the ‘hands-off’ provision of government
leverage finance that has appealed to professional investment managers mindful of the
need to increase fund scale in the challenging early-stage markets and frequently faced
with private investor indifference.
The term ‘equity enhancement’ is accurate. The state needs to incentivize the general
and limited partners to be prepared to engage in a fund that includes public welfare goals
as part of its raison d’être. In the absence of explicit economic incentives, there is little
logic for profit maximizing, private agents to become involved. Pari passu funding,
whereby the state and private investors provide investment finance on equal terms, only
works where the returns to private investors are attractive enough without needing to skew
the return distributions to private limited partners’ advantage. The state is obliged to
enhance the returns to the general partner and to the other commercially motivated
limited partners in order to attract private investors’ commitment to the co-investment
model. Essentially, the public investor forgoes some of its rights to a pro rata share in the
economic returns of the fund. Given that the state is often the largest single investor in
the fund, a reduction of its share of any net capital gain can leverage a material increase
to the other parties’ returns in the event of a moderately successful fund. In all cases, the
state as a ‘special’ limited partner does not influence the commercial and executive deci-
sions of the fund managers once the investment criteria of the fund are determined.
Relative distributions of surplus are agreed ex ante. Hybrid funds commonly employ one
or more of a range of incentive structures:
1. Capped returns to the state: the public limited partner invests at a rate which is com-
monly fixed at approximately the government’s cost of capital.19 Once this return
threshold has been met from the proceeds of the sale of any portfolio companies, any
further positive cash flows are exclusively shared between the other commercial LPs
and the GP via its ‘carried interest’.
2. Differential timing of limited partners’ cash flows (‘first in and last out’): for the
general partners of the venture capital firm, their performance will be largely mea-
sured and communicated by one universal metric – the Internal Rate of Return of the
fund.20 When the state is the first investor to have its committed finance fully drawn
down and the last investor to have its monies returned with any associated surplus,
the shorter investment period of the other private LPs directly benefits their returns.
Again, the performance enhancement of the private or commercial partners is at the
direct cost of the public partner.
3. Guaranteed underwriting of investment losses incurred by the limited partners: gov-
ernment may seek to influence the investment decision by removing all or a large part
of the costs of portfolio failure. Usually, a percentage of committed investments is
guaranteed which may often vary from 50–75 per cent of investors’ costs. The guar-
antee may be on a fund or on individual portfolio investments. However, the guaran-
tee schemes do not, in themselves, improve the returns to investors but rather cap
losses. Thus, it is common for a guarantee to be put in place in addition to some other
incentive which leverages the upside of a successful investment.
4. Buy-back options: buy-back options give the private investors the opportunity to
purchase the entirety of government’s interest in a program at a pre-determined time
during the public/private program. The terms of the exchange are arranged ex ante
and thus present the private investors with a clear incentive and opportunity for an
early exit of the state as co-investor. Essentially, the facility is a purchase ‘option’
which may be exercised at some stipulated future date when economic future of the
investment is possibly indicated but not fully known. One of the most admired of
such programs was the Israeli Yozma program (1993–98). Seven countries have sub-
sequently modeled programs on this Israeli experience.21
A list of a number of existing government-supported venture capital structures that

have adopted one or more of the four described incentives programs is given in Table 4.2.
Despite the increasing popularity of government involvement in hybrid, venture capital
funds, rigorous evaluation of their effects is limited. Evaluations have been undertaken on
such schemes in the UK, New Zealand and Australia.22 However, unabridged evaluations
are rarely available in the public domain.23 Thus, while we may assume that subsequent
program rounds have learned from policy experience, our overall knowledge of contem-
porary venture capital policy actions and outcomes is limited. Agreed evaluation method-
ologies and the ability to compare and contrast across program and country are each
urgently required in an area of government interest and action of increasing scale
(Lundström and Stevenson, 2005).
Table 4.2 Publicly financed venture capital ‘equity enhancement’ schemes
Examples (present
Feature Description Incentive effects & past)
Public Government Helps in setting up a fund. Also 50% of the fund:
investor matching the helps to build a sufficiently big Europe/EIF
co-investing investments by fund to benefit from economies Finland/FII
with private private investors of scale Israel/Yozma
investors However, investing in pari passu 50% of the fund:
with private investors does not Australia/IIF and
have direct incentive effects i.e. it Pre-seed Fund
does not improve the expected USA/SBIC and
returns for private investors in SSBIC UK/regional
market failure segments such venture capital funds
as early stage
Capped After all the Capped return for the UK/regional venture
return for investors (including government increases the capital funds
public the public investor) expected IRR for private Australia/IIF and
investors have received certain investors. The incentive effect is Pre-seed fund
IRR (e.g. interest such that it increases the
rate perhaps some compensation for good Chile/CORFU
risk premium) the performance. This in turn creates
rest of the cash flows a strong incentive for the private
are distributed to investors to incentivize the
private investors only general partners to make
successful investments and add
value to portfolio companies
Buy–out Private investors are The effect of buy-out option on Israel/Yozma
option for given the option to the IRR of private investors is New Zealand/New
private buy the share of the quite similar as the effect of Zealand Venture
investors government at (or ‘capped return’ of public Investment Fund
until) a specific point investor. However, there are two
of time at additional benefits:
predetermined price 1) The buy-out option gives
(typically nominal both the public investor and the
price interest rate) private investors an opportunity
to demonstrate success earlier
and more visibly than in the
capped return alternative
2) In the case of success,
government gets a quick exit
from the fund and can put the
money to work again instead of
waiting for the returns on fund
termination
Downside Downside protection Downside protection has a Germany/WFG
protection means the negative effect from the incentive Germany/tbg &
government perspective. While downside KfW France/
Table 4.2 (continued)
Examples (present
Feature Description Incentive effects & past)
underwriting losses protection helps support the IRR, SOFARIS Denmark/
from the portfolio it decreases the difference in Vaekstfonden
returns for private investors and (Loan Guarantee
the management company Scheme)
between successful and
unsuccessful investments. The
effects of good selection and
value-added efforts have a lower
impact on the performance of
the fund
Fund Government gives a The fund operating costs are Europe/European
operating subsidy for the neutral from the perspective of Seed Capital Scheme
costs management incentives to fund management
company to cover or LPs while increasing the IRR
some of the costs of the fund
from running the
fund
Timing of Ordering of the cash The IRR of the private investor UK/Regional
cash flows flows so that public can be enhanced through timing Venture capital Funds
investor puts the of cash flows improving the
money in first and attractiveness of the fund
gets the money
out last
Government’s role in venture capital ‘funds of funds’

The hybrid venture capital fund structure assumes that government is the co-partner and
limited partner to an individual fund. In the ‘fund of funds’ option, the government does
not signal preference for any one fund but supports investments in a range of funds that
are sanctioned by the general partner management. The fund of funds manager, acting as
an allocator of limited partners’ commitments, allocates finance to specific venture capital
funds, not to individual investments. While several such fund of funds exist, governments
tend to invest only in such groupings that specifically target young and high potential
firms of policy interest. In France, the Fund for the Promotion of Venture capital (Fonds
de Promotion pour le Capital Risque – FPCR) was set up in 2001. With €150 million,
including European Investment Bank support, at its disposal, the FPCR has invested in
10 French venture capital funds. Investments are geared towards innovating companies
less than 7 years old in sectors where it is difficult to mobilize private funding, that is life
sciences, ICT, electronics, new materials and environment and sustainable development.
The UK equivalent is the UK High Technology Fund. This fund of funds, set up by gov-
ernment in 2000 and managed by a commercial investment company, has raised £126
million, of which £20 million only came from government. It invests exclusively in spe-
cialist technology venture capital funds located in the UK. This fund of funds also
attracted EC assistance via the co-investment of the European Investment Fund. It is as

yet too early to appraise the performance of either of these programs.
Government policy and informal investors (business angels)

So far in this chapter, discussions have focused on policy actions in the institutional market
for risk capital. Thus, the unit of analysis has been the established, and often very visible,
venture capital firms or general partnerships. Yet, advocates of the importance of business
angels have repeatedly noted that the scale of the informal supply is likely to dwarf that of
the institutional venture capital in all developed risk capital markets. There is clear evi-
dence of this disparity in the US and the UK where both types of investor co-exist. This
argument regarding the scale, and thus potential for economic transformation via business
angels, is strongly made and mutually re-enforced by authors Mason, Kelly, Riding,
Madill, Haines and Sohl writing in this book. Accordingly, governments concerned at the
effective supply of financial and business-related support to young and growing companies
have increasingly become interested in informal investors or business angels.24 As Kelly
rightly notes, government interest in these ‘publicly hidden’ investors was materially influ-
enced by the work of pioneering academic researchers both in the USA and Europe.
Given that three chapters in this book are devoted to different aspects of business angel
research and practice, this author will not repeat the analysis of acknowledged experts in
the field. Rather this section will remain exclusively within the policy focus of the chapter
and will look at how governments have sought to promote a vigorous and successful busi-
ness angel sector.
Investors of first resort

Van Osnabrugge (1999) ‘guesstimates’ that business angels provide between 2–5 times the
amount of finance to entrepreneurial firms in the US and possibly invest in up to 40 times
the number of portfolio companies compared to institutional venture capital firms.
Bygrave et al. (2003), using GEM data on 15 nations, subsequently offer more modest
differences in business angels’ favor of 1:1.6 in respect of funds allocated. Sohl (1999)
argues that the ratio of understanding of business angels compared to their impact on the
economy is lower than just about any other major contributor. Bygrave et al. (2003)
support this view noting that entrepreneurs – and policy makers – should pay far less
attention to institutional venture capital activities. They observe that new enterprises,
including those involved in the commercialization of revolutionary research, are much
more likely to be self-financed or gain support from business angels rather than from
classic venture capital firms. In an international venture capital and private equity indus-
try which is becoming increasingly dominated by scale, those parochial investors that are
prepared to undertake local investments within the equity gap spectrum are an increas-
ingly valued asset. The overall trend is for an increase in size, and thus concentration of
venture capital funds, that continues to militate strongly against small investments.25
A complement to institutional investors

In an ideal policy maker’s world, one might envisage informed and highly experienced
business angels being the predominant seed capital providers to nascent businesses.
Through their own commercial experience in allied sectors or activity, they would be able
to offer the new enterprise valuable practical experience of running a young company. Of
equal value, they can provide a ‘certification effect’ allowing fledgling entrepreneurs access
to valuable commercial networks (Birley, 1985; Stuart et al., 1999; Steier and Greenwood,
2000), as well as offering timely and pertinent advice on markets, production and so on.
As the investee firm starts to grow and to demonstrate a major economic opportunity, the
business angel could be the conduit to institutional venture capital. With firm growth
accelerating, the influence of the business angel would give way to the more structured
and ‘enterprise nurturing’ skills of the venture capital firm (Harrison and Mason, 2000).
However, as with formal investing, practice is likely to fall short of idealized expect-
ations. The business angel invests his/her own money and thus does not need to meet
external regulatory standards. The venture capital firms are handling investors’ monies
and must therefore be registered with the appropriate financial regulators. The former can
act as idiosyncratically as they wish. Hunch, gut feel and subjective stimuli are all found
to be important investment decision criteria. The institutional venture capital manager is
much more likely to undertake industry-specific training and to have clear guidelines from
both the general partners of the fund as well as industry guidance from the national
venture capital industry association on due diligence, deal pricing, use of share structures,
legal contracts and so on. Accordingly, unless well known and trusted by the venture
capital investor, the idiosyncratic and untrained business angel is likely to be viewed with
mistrust as an investment syndicate partner. As Kelly wisely notes: ‘complementarity’
does not presume ‘compatibility’.
Business angels as a policy focus

The three writers on business angels in this volume each make some brief observation on
the policy implications of business angel activity. Mason, looking at the spatial dimensions
of investment, argues that a supply of attractive investments will generate the supply-side
response of adequate investments funds. His argument strongly reflects the venture capital
communities’ argument that effective demand (that is quality of proposals) is the greatest
constraint to early-stage financing. Perhaps more interestingly Mason and Harrison (2003)
have argued that the UK government, by promoting the Regional Venture Capital Funds
program to address both spatial and early-stage inequities, have misunderstood both the
nature of the problem and its prescription. They make a telling argument that business
angel finance could be a much more appropriate response to such problems. Kelly men-
tions the three related problems of an excess demand for business angels’ equity finance
from would-be entrepreneurs; the information asymmetry or search problem of investors
and firms not knowing that each other exists; and the incentives problem of getting ‘virgin’
business angels to turn intention into tangible investment activity. Finally, Sohl addresses
four areas of policy including promoting better linkages, sponsoring research in the field,
more education of business angels, and unambiguous incentives for business angels to take
the risks of equity finance. How government has actually sought to tackle the issue of
stimulating informal investment will be addressed in the following sections.
Targeting business angels as individuals

Government has generally adopted a two-pronged strategy to facilitate the supply of
informal investors in the national and local market. Firstly, they have had to address the
‘indirect measures’ (OECD, 2004) of taxation in order to ensure that the incentives avail-
able to private investors are commensurate with the level of (undiversified) risk that they
have to assume. The major suppliers of venture capital at the institutional level are
frequently tax exempt in the most developed venture capital economies, that is pension
funds, insurance companies and university or family trusts.26 But for informal investors,
the means by which successful investments are made and recouped are profoundly influ-
enced by the detail of the prevailing personal taxation regimes. The OECD’s view is that
it is counter-productive for a private investor to incur such high taxation and other costs
that they reduce the underlying logic for making the original investment. It is difficult to
argue with this orthodoxy.
A number of countries have ‘front end’ incentives that give significant income tax shel-
ters for bearing the cost of entrepreneurial activity. In the event of a successful investment
realization, Capital Gains Tax may be delayed or removed from investments held for spe-
cific lengths of time. Such fiscal incentives exist in, for example, the US, the UK, France,
Ireland, Belgium and Canada. Because business angels are usually relying on their own
personal income and wealth for investment activity, the system seeks to incentivize them
to remain active investors by improving (and protecting) their returns compared to those
parties not involved in the incentive schemes. However, as the OECD also acknowledges,
while sophisticated changes to the tax system for high net worth individuals may prompt
them to make more investments and/or retain their investments in growing companies for
a longer period, it may also confuse other less sophisticated, informal investors.
The UK has been one of the developed economies most interested in using fiscal incen-
tives to encourage ‘virgin’ angels. In 1981, the Business Start-Up Scheme was announced.
This program, which was the first to offer entrepreneurial investor incentives, evolved over
time to become the Business Enterprise Scheme. This was established to enable investors to
obtain tax relief when purchasing ordinary shares in unquoted firms seeking seed-corn
funds for development.27 It ran ten years from 1983 to 1993. In turn, the Business Enterprise
Scheme metamorphosed into the Enterprise Investment Scheme in 199428 in order to
provide a revised program that would incentivize individual investors to provide more risk
capital funds for the UK’s SME sector.29 In a review of the efficacy of this latter and extant
program (Boyns et al., 2003), its authors concluded that the schemes had created significant
‘additionality’, thereby improving the resources available to young firms while increasing
investors’ returns. The simplicity of the Enterprise Investment Scheme is particularly attrac-
tive to business angels as it makes no attempt to determine investment eligibility other than
stipulating the qualifying and non-qualifying categories of investment (see Box 4.5).
BOX 4.5 ENTERPRISE INVESTMENT SCHEME (UK):

INVESTOR TAX BENEFITS
● income tax relief – 20% of amount invested in terms of tax – period to hold
shares of 3 years
● exemption from capital gains tax on shares held for the 3-year period
● capital losses on shares treated as income losses
● deferral of chargeable gain on any asset
● maximum invested per tax year for income tax relief is now £400 000
(€589 000)
The UK scheme is not unique but rather is more established than many similar pro-
grams. It may be seen as an archetype or model given that it replicates the key criteria
evident in most programs, namely:
● Higher risk, young companies clearly targeted and specified by age, economic size
and type of activity;
● total tax forgone is capped for both the recipient company and the individual
investor;
● ex ante tax relief given on investors’ income when equity investment made in target
business;
● investment losses can be used in further personal tax computations; and
● ex post Capital Gains Taxes either avoided or reduced after a minimum holding
period.
Based on several countries’ experiences, a European-wide program, the Young

Innovative Company Scheme is currently evolving (EuropaBio, 2006). It is proposed that,
for eligible investments, no tax is levied on capital gains realized or stocks that have been
held for a minimum of three years. The French equivalent of the Young Innovative
Company program (that is Jeune Entreprise Innovante) was adopted by the French
Parliament in the 2004 Budget Bill. A similar bill, HR 5198, the Access to Capital for
Entrepreneurs Act of 2006, was presented to the US Congress in April of this year.
Targeting business angels as co-investors

These above schemes are directed at incentivizing the individual to invest directly or via a
tax efficient, trust fund structure. Government has also increasingly seen the business
angel community as an entity that may be incentivized collectively at the fund level in a
potentially similar fashion to institutional venture capital businesses. To date, the tax
transparency attractions of the Limited Liability Partnership structure have largely been
irrelevant to the private investor. Yet, a syndicate of business angels investing co-
operatively on projects where the due diligence and other investment costs has been
shared, as well as any eventual capital gains, is broadly equivalent to the established prac-
tices of the established venture capital industry. In recognition of this reality, the UK gov-
ernment has tried to find means by which it can invest alongside informal investors. Such
leverage initiatives have had to address and accommodate the legal issue that the business
angel is a personal investor rather than an institutional investor. However, as business
angel networks or bespoke syndicates start to manage external funds, these differences
begin to blur.
A number of recent developments are noteworthy. Governments may invest as a public
limited partner in a fund specifically made up of business angels investors. The UK’s 2004
scheme, the Enterprise Capital Fund, is designed in such a manner as to accommodate
both institutional and informal investor groups. The bringing of business angel investors
into a legal identity as a group or fund is relatively novel. It addresses the common
problem of business angel investors being severely curtailed in the size of personal invest-
ments. Historically more common, the state may be a co-investor at the level of individ-
ual projects. Such a scheme has been in operation for several years in a primarily
institutional venture capital context in Germany via the BTU program. An informal
investor equivalent is seen in New Zealand’s Seed Co-investment Fund. This latter
program that has been designed in the light of UK experience via the publicly co-funded
Scottish Co-Investment Fund and the London Business Angel program.
These schemes each bear common criteria of informal investor/government interaction:
● State acts as a co-investor increasing scale of investment available;

● once conditions of investment eligibility met, the state is passive;
● criteria of eligible investment defined by age, size and economic activity; and
● state’s position as an investor is usually subordinate to private investors.
Networks, portals, match-makers and information asymmetries

The institutional venture capital industry, like many professional services, may be seen as
a dense network of complementary actors associated in the common delivery of special-
ist financial products and sharing critical information. Overlapping venture capital net-
works may, for example, be classified by stage of investment, types of opportunity, or
location. Issues of access and preference determine a pecking order of venture capital
firms and partners efficiently calibrated by industry reputations. The intensity of the
venture capital locations or clusters in a relatively small number of major cities across
Europe, America or Asia further increases the ability to communicate effectively and
quickly between interested parties. To date, the venture capital industries have been
broadly characterized as country-specific. However, as the venture capital industry
matures and leading players grow and expand their locus of operations at the expense of
less successful partnerships, the incidence of internationalization has increased markedly
(Mäkelä and Maula, 2005; Deloitte and Touche, 2006).
Communications between informal investors or business angels compares poorly to
the small number of well organized venture capital firms located within the umbrella of
an efficient and highly representative industry association. Gilson’s (2003) ‘simultaneity
problem’ exists but is much more acute in an informal venture capital environment. A
business angel has to signal to would-be investee businesses that he or she is interested in
receiving business proposals. At the same time, the informal investor may wish to inform
other angels of his/her30 presence and willingness to participate in syndicated invest-
ments. This lack of preceding contact, the diverse personal histories of the investors and
the absence of physical market places each serve to confound efficient communication.
In the absence of such communication, it is similarly difficult to ensure that investment
proposals are fairly appraised and sensibly priced. It is not uncommon for an inexperi-
enced investor to face an equally inexperienced entrepreneur with neither party able to
assess the quality or the credibility of the business proposal or the financing offered. Such
circumstances are very vulnerable to inefficient (or disastrous) outcomes either by chance
or design. It is for these reasons that many in the insitutional venture capital industry
remain highly ambivalent as to the involvement of business angels in professional
venture capital investment deals. The cost of sorting out badly constructed or poorly
priced financial arrangements previously arranged between an inexperienced business
angel and entrepreneur may be sufficiently time consuming for the venture capitalist to
walk away from providing follow-on finance. As Gifford (1997) has noted, the con-
straining resource for many general partners is management time rather than the flow of
opportunities or finance.
In these circumstances, the involvement of government in activities which increase the

information available to investors and/or investees is likely to be productive at modest
cost. Similarly, the powerful national venture capital associations also have an interest in
ensuring that informal investors looking for early-stage deals that might lead on to insti-
tutional venture capital activity are also sensibly advised, financed and structured. The
policy benefits of reducing information asymmetries and ensuring deals are properly com-
municated to an active and deep market appear universally accepted. Accordingly, busi-
ness angels networks on a local, national and (on occasions) international basis have been
supported by both government and institutional venture capital associations. Sohl uses
the generic term ‘portal’ to describe this interface between investors and entrepreneurs.
Public transfers have also allowed the networks to be sufficiently well financed to ensure
the recruitment of appropriate management and training resources.
A dissenting voice
Lerner (1998) turns a refreshingly skeptical eye on business angel activity. This is a useful
antidote as the business angel literature is often highly evangelical in its arguments. Lerner
asks two questions that he contends are too often assumed rather than posed: 1) do private
capital markets provide insufficient capital to new firms; and 2) can governments better
identify future winning businesses in which to invest? In the absence of robust empirical
examination31 of both the contribution of angels and the value-added role of govern-
ment, Lerner remains a skeptic. Picking up a major theme of this chapter, he notes that
the importance of scale is clear, but business angels, with very few exceptions, are com-
monly characterized by their modest investment resources. Even when bandied together
in investment syndicates, they are seldom likely to create an aggregate fund size of >$50
million. In classic venture capital terms, such a small fund size would now widely be seen
as uneconomic. Lerner’s concern is that new enterprises of insufficient potential to be
financed by institutional venture capital firms are then taken up by sub-optimally sized
business angel networks where the range and level of investment skills and experience are
highly variable. In effect, the informal investor network is both ‘second best’ in its
resources and in the potential assistance that it can offer entrepreneurial firms. Business
angels are also far less regulated for minimum quality practices than their institutional
equivalents. In Lerner’s arguments, there is an implied ‘trickle down’ process with classic
venture capitalists first reviewing prospects and the huge majority they reject becoming
part of the raw material of informal investors. Accordingly, he argues that we have at
present little proof that fiscal incentive programs funded by the state are necessary to
increase business angel activity, nor do we have a clear understanding as to how such pro-
grams may best be structured in order to realize policy goals (Lerner, 2002). While
Lerner’s argument remains cogent, the assumption that business angels are second best to
institutional venture capitalists when appraised by early-stage investment performance
remains hotly debated.
Lerner is supporting those academics who argue that there exists a failure in quality
demand (‘investment readiness’ argument) rather than a lack of available risk capital for
nascent enterprises (the ‘equity gap’ argument). Yet, in practice, the minimum size thresh-
olds for new investments imposed by the majority of professional venture capitalists are
now so high that it is highly unlikely that they would consider investing in a seed or start-
up investment other than for the most interesting opportunity in a new technology. Such
speculative and exploratory investment could be viewed as placing a ‘put’ option on

potentially important future developments (McGrath and MacMillan, 2000; Miller and
Arikan, 2004). Yet, as Dimov and Murray (2006) demonstrate, such an integrated, market
intelligence strategy is rarely undertaken by professional venture capital investors outside
the largest US firms.
Business angels – future policy interest

Business angels by their very scale and ubiquity remain a focus of considerable interest to
governments. Ironically, it is their lack of activity that makes them so enticing. A modest
increase in informal investment activity is likely to have a much larger impact than an
equivalent increase in institutional venture capital given the business angels’ predominant
focus on early-stage investment. Accordingly, it is likely that business angels will increas-
ingly feature in the enterprise policy activities of developed economies. Countries that
facilitate and incentivize personal investment activity via generous fiscal incentives are
likely to have an important head start. A number of trends will reinforce the growing
policy interest in business angels. As the maturing, venture capital industry gets larger in
terms of funds managed (rather than the numbers of venture capital general partner-
ships), a number of traditional venture capital funds will continue to withdraw from the
earliest stage activities as partners experience the need to invest large amounts of fund
monies quickly. The relative performance advantages of later stage funds, including
private equity investments, will exacerbate this long term trend in Europe. In order to
support this rational trend by their venture capital firm members, national venture capital
industry associations will increasingly work with government to ensure that business
angels receive public support.
Such a cooperative industry stance supports the supply of potentially attractive busi-
nesses to their venture capital firm members (at later rounds of finance) as well as deflect-
ing government concern of the limited impact of institutional venture capital on national
innovation and entrepreneurship programs. Business Angel Networks will be able to
exploit this opportunity to argue successfully for greater support (operating grants, co-
investment schemes, and so on) for individual investors and (increasingly) legally defined
angel groups. Programs supporting networks’ development, information exchange and
investor training, are likely to continue to attract public support at regional, national and
international levels. Yet, few public-supported programs are likely to invite independent
academic evaluation and scrutiny de novo. Hence the importance of Sohl’s call for more
support for empirical research into a major financing activity that, in comparison to its
institutional venture capital equivalent, can still reasonably be viewed as terra nullis.
What have we learned from public involvement in private venture capital activity?
One can argue with some authority that the evidence of government learning in the arena
of early-stage risk capital finance is rather poor. Detractors of government’s role could
repeatedly point to unviable small fund sizes in public supported programs; the willing-
ness of governments still to manage their own business angel programs outside the incen-
tives and disciplines of the market; the imperfect integration between governments’
entrepreneurial agendas, their fiscal programs and investors’ interests;32 the still under-
developed role of informal investors; and the poor financial returns on public supported
funds. The vigorous growth over the last quarter of a century when venture capital has
grown to become a major asset class is not reflected in equal successes for public involve-
ment in new enterprise financing.
However, the choices which government faces are not often easy or unambiguous.
Governments with responsibilities for departmental portfolios of often competing inter-
ests have to determine if they wish to intervene in order to correct market imperfections
or to realign incentives in a manner congruent with their policy goals. They have to decide
how attractive a flourishing venture capital industry would be to the domestic economy,
and what can sensibly be done to promote its realization. Yet, while there is considerable
and growing governmental activity in the arena of early-stage risk capital investment, the
body of knowledge on which this activity is based remains sparse. Lerner (1999) has com-
mented on the absence of theory in guiding public venture capital activity. Similarly, Jeng
and Wells (2000) note that just as later and early-stage venture capital investment behav-
iors are different and not necessarily influenced by the same factors, so likewise are public
and private venture capital activities different. These authors note that we are still rela-
tively poorly informed as to the appropriate role of government in venture capital activ-
ity. We lack both a canon of theoretical understanding (and guidance) as well as a
diversity of exemplar programs from which we can benchmark progress.
Gilson (2003) takes a similar view that governments often undertake programs without
a clear understanding as to the full consequences of their actions. In addition, political
cycles and investment cycles are rarely likely to be synchronized. There appears a growing
academic consensus that sanctioning government intervention is a decision that should
only be taken with considerable caution, and perhaps only when private venture capital
markets are patently failing. Circumstantial evidence of the large number of sub-optimal,
publicly supported venture capital programs operating across the world including the US
would suggest that academics’ concerns with the logic of public intervention have fre-
quently been ignored by policy makers (Bazerman, 2005; Rynes and Shapiro, 2005).
Yet, to suggest little has been learned and acted upon would be too pessimistic a diagno-
sis. The ubiquity of entrepreneurial finance programs at local, regional, national and,
increasingly, international levels of government are now so omnipresent that some learning
is inevitable. There is a burgeoning corpus of research knowledge from scholars based in the
entrepreneurship, innovation, management and economics subject areas.33 However, the
communication and accommodation of research lessons into contemporary policy actions
at national level is still capable of considerable improvement (Söderblom and Murray, 2006).
Further, and of equal importance, government usually works in the least attractive
areas of a financial market. The public exchequer becomes involved because of the
absence of private investors. Accordingly, the situation of difficult investment choices and
poor returns is virtually guaranteed. Governments should not be criticized for poor
returns per se. Rather, a more apposite question is whether they should rationally hazard
public monies by attempting to undertake investment activities in areas so commonly
abandoned by informed, experienced and profit-seeking commercial interests.
These comments should not be seen as an apologia for harassed policy makers. There is
regrettably little evidence that robust research findings are acted upon in new policy for-
mation and execution. It is inevitable that partially informed program designs will have real
(and avoidable) costs. Sometimes, in the absence of institutional venture capital research
programs, government may too readily accept the convenient results of management
consultants or venture capital industry association.34
To summarize the factors that policy makers may consider in their efforts, a set of broad
guidelines based on our imperfect contemporary knowledge is offered:
● Institutional or informal venture capital programs should harness private investors’

interests and experience as agents of government program goals. Any deviation
from this norm should be rigorously evaluated prior to agreement.
● There are trade-offs between venture capital or business angel program outcomes.
Policy makers should be explicit as to the ‘value’ of different objectives, for example
return on capital, innovation, employment, regional investment and so on in both
launching and evaluating programs.
● There are major economies of scale and scope in venture capital fund activities.
Program outcomes should be modeled and simulations tested prior to committing
public funds to unviable fund structures.
● The levels of unmanageable uncertainty at the very earliest stages of venture capital
investment in novel technologies may be such that it may not be sensible to allocate
resources by markets alone. Venture capital should be seen as only one of a range
of financing options that may also include merit-based grants and other support.
● The premium for managerial and investor experience is high in informed, profes-
sional labor markets. Program designers need to reflect on how such tacit know-
ledge may be best harnessed to address the challenges of early-stage investment.
● The USA has provided venture capital communities worldwide with a huge stock
of experience and expertise. Much of this learning may be valid and relevant
outside North America. Some of it will be usable in other and different national
contexts. It is implausible that a globalizing venture capital industry will, over time,
be reliant on one absolute and exclusive model of success.
● All new venture capital programs involving public funds should have a formal (and
independently validated) evaluation model built into the program design stage.
Future academic research opportunities

Venture capital studies have reached their adolescence – a period of rapid but awkward
growth. In a subject area originally colonized by entrepreneurship and small business
scholars, the field has burgeoned (in parallel with a wider interest in entrepreneurship
since the early 1980s) to include other managerial disciplines and, above all, economics.
While venture capital studies embrace the theories and methodologies of economics,
finance, organizational behavior and so on, policy studies by their very nature are prag-
matic in purpose. Governments wish to know how to change or improve systems to
achieve tangible and cost effective outcomes – preferably quickly and by incremental and
non-disruptive changes. Such utilitarianism still sits uncomfortably with some scholars
holding purely theoretical interests in venture capital finance. This is not unreasonable.
However, for others, the ability to research and influence the actual processes of govern-
ment in an area with little established public expertise provides both intellectual and pro-
fessional rewards. With this latter group in mind, the following questions are presented as
some domains in which our research knowledge is still wanting.
● Does the equity gap actually exist? If so, at what levels of finance, who is affected,
and are the adverse consequences material?
● Measured by the criteria of venture capital fund survival and acceptable investment
returns, are early-stage (seed and start-up) activities a long term viable proposition
both within and outside the USA? What policy and operational conditions need to
be in place to secure such desired commercial outcomes?
● Business angels are seen as an alternative to institutional venture capital providers
at the earliest stages of investment. Is such an assumption empirically valid? By
what means can business angels succeed in early-stage market conditions that are
presently hostile to venture capital success?
● What actions under governments’ control (for example tax incentives, equity
enhancement, investor training, network support, and so on) are most effective in
stimulating the investment activities of current and potential business angels?
● By what means can business angels and venture capital firms most effectively work
together to support high potential young firms?
● By what means should public/private ‘hybrid’ venture capital programs be evalu-
ated in order to both capture the economic and social objectives of all participat-
ing investors and to allow meaningful cross-program comparisons?
● Venture capital has evolved to become one of a range of ‘alternative asset classes’
by which financial institutions may seek to engineer the risk/reward profiles of their
investment portfolios. The actors involved and the decision processes by which such
institutional portfolios are designed remains a ‘black box’. How may researchers
address the dearth of empirical studies focusing on the nature of institutional
investor decision making?
● As venture capital activity has internationalized so has the policy response. How
may academics best respond collectively to international and comparative studies
of venture capital activity?
● We now have an international and multi-disciplinary body of research into venture
capital studies that has chronicled the introduction and growth of risk capital activ-
ity across a large number of developed economies in Europe, North America and
beyond. Emerging economies in Asia, South America and Eastern Europe are
showing considerable interest in the putative role of venture capital in supporting
the genesis and growth of new enterprises and industries. How may academics
feature in the processes by which emerging economies learn effectively from extant
venture capital experience?
While academic scholars have much to offer their policy colleagues, it cannot be
assumed that the potential complementarity of their interests will guarantee research
access or funding. Scholars will have to earn policy makers’ respect and active support.
Experience shows that this is not an easy task. Similarly, while academics are often tribal
in their disciplinary interests (see Sapienza and Villanueva’s chapter), policy clients fre-
quently prefer inter-disciplinary teams that will address big issues with strong evaluation
and execution recommendations. The skill for the academic is to be able to meet legiti-
mate executive needs while still being able to undertake studies capable of scholarly vali-
dation via peer review. Arriving at such mutually acceptable outcomes is not easy and will
require a level of trust building and mutual understanding between academics and policy
makers that is still largely in its infancy. Entrepreneurship and venture capital scholars are
going to have to be equally as entrepreneurial in the crafting of venture capital policy
research ideas as the creators and funders of the new enterprises on which their discipline
is founded.
Notes
1. Contemporary venture capital evaluations by government have included programs in Finland (2002; 2006),
UK (2003), and Ireland (2005) as well as New Zealand in 2005. Only the Finnish and New Zealand eval-
uation is in the public domain (Maula and Murray, 2003; 2007; Lerner et al., 2005).
2. We have tended to use the terms ‘knowledge-based firms’ and ‘new technology-based firms’ interchange-
ably. While this is a sensible shorthand in the context of this chapter, new technology-based firms should
be seen as a specialist category of knowledge-based firms. They both share a reliance on tacit and intan-
gible assets for their competitive advantage.
3. As Lerner (2002) has noted, the US similarly has financed a considerable amount of public venture capital
actions both at federal and state levels. This involvement continues to be material.
4. Each of these economies has already experienced considerable inward investment by private venture
capital and private equity firms. However, these commercial interests are rarely at the level of new
enterprises.
5. See www.indiavca.org.
6. BVCA statistics only record start-up deals and not seed investments: 208 companies received start-up
investment in 2005.
7. Brazil, India and China.
8. In practice, early stage investors rarely seek interest payments but if successful are (ultimately) rewarded
by a significant capital gain multiple at exit.
9. See Pickering (2002) for a valuable government policy maker/insider’s view of six UK reports on funding
tech-based Small and Medium Sized Enterprises.
10. While senior policy makers are usually very aware of the limitations of transferring models to new con-
texts, this complexity does not stop politicians framing the question as noted.
11. The statement is curious in that it implies a modest historic role for public policy in the US experience.
12. If funds are ranked by the proportion of seed investments to total investments, a UK fund does not appear
until position 59.
13. The Directory of Support Measures (EC, 2003c) lists seven measures by which the state can assist SMEs:
Reception, facilities and basic information, referral; Professional information services; Advice and direct
support; SME-specific training and education; Finance; Premises and environment; Strategic services.
14. There is some more encouraging evidence that early-stage investing in Europe after 2001 is showing more
positive returns and that performance is not affected by location once fund structural characteristics are
controlled (Lindstrom, 2006).
15. Over the last 25 years, Northern European countries have arguably had a stronger tradition of direct
investment activity via public agencies than the more market-driven Anglo-Saxon models of the US and
the UK.
16. Despite Rocha and Ghoshal’s (2006) concern with the adversarial presumption of agency theory, it is a
powerful concept that has considerable salience to venture capital studies.
17. The managers of a venture capital fund which is structured in the industry standard format of a Limited
Liability Partnership are called ‘general partners or GPs. Similarly, the investors into such a fund are called
the ‘limited partners’ or LPs. Both parties have a range of specific rights and responsibilities which are the
subject of considerable, and complex, legal documentation.
18. Over the period 1959–2002, this program was responsible for raising $37.7 billion for some 90 000 busi-
nesses (US Small Business Administration, 2003).
19. See the Small Business Services’ notes for the proposed Enterprise Capital Fund www.sbs.gov.uk/
SBS_Gov_files/finance/waterfall.pdf.
20. European Venture Capital Association valuation guidelines exist to set a basis for objective performance
comparison between funds.
21. Communication with Yigal Erlich, the Government Chief Scientist of Israel at the time of the program’s
inception and now CEO of the Yozma Group, Tel Aviv. The seven emulating countries cited by Mr Erlich
are: Australia, Czechoslovakia, Denmark, Korea, New Zealand, South Africa and Taiwan.
22. Finnish 2003 and Irish 2005 evaluations were on venture capital programs that, while involving state invest-
ment, could not easily be classified as hybrid funds using the term as understood by the OECD.
23. The public access of Finnish evaluations is an honorable exception to the rule.
24. In this chapter no difference will be drawn between business angels and informal investors on the simplis-
tic assumption that they are both categories of private individual who provide risk capital (and loans) for
non-family enterprises.
25. In Europe in 2006, a private equity fund, Permira, launched an international fund of approximately €10
billion. At least four venture capital funds of over $10 billion are scheduled for launch in 2007.
26. University endowment programs and investment trusts for high net worth family dynasties have played an
important early role in the development of the US venture capital industry (Bygrave and Timmons, 1992).
27. See http://www.lse.co.uk/financeglossary.asp?searchTerm&iArticleID1646&definitionbusiness_exp
ansion_scheme.
28. The Venture Capital Trust program which allowed retail investors to access venture capital funds and pro-
vided another source of capital for young businesses was similarly launched in April 1995 (see http://www.
hmrc.gov.uk/guidance/vct.htm).
29. The Netherlands had a broadly similar tax incentive program for private investors starting in 1996 and
known as the ‘Aunt Agatha scheme’.
30. Research suggests that male informal investors outnumber female investors by about 5:1.
31. There is a dearth of large scale, quantitative ‘matched sample’ empirical studies whereby the outcomes of
BA investment on recipient firms can be compared to the outcomes of alternative investment channels on
comparable enterprises.
32. Government’s low interest policies have helped fuel a property boom that has arguably been a direct substi-
tute for personal investors to informal investments in new enterprise. See, for example, the contemporary UK
and Irish economies.
33. See the international Norface program on Venture Capital Policy Research Seminars (www.norface.org)
instituted by Murray in 2005.
34. Most national venture capital associations have research departments producing analyses of the benefits
of venture capital activities albeit from a clearly articulated position of interest.
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PART II
INSTITUTIONAL VENTURE
CAPITAL
5 The structure of venture capital funds
Douglas Cumming, Grant Fleming and
Armin Schwienbacher
Introduction
Venture capital funds perform a vital intermediary role in the financing of entrepreneur-
ial firms and the spurning of new technology and knowledge in an economy. These funds
can take a variety of different organizational and legal forms, including limited partner-
ships, investment trusts, corporate subsidiaries, financial institution subsidiaries and gov-
ernment funds. The variety of forms is reflective of the way in which the venture capital
market has developed over the last forty years, becoming increasingly institutionalized
and internationally active. Academic research has followed these market developments in
a quest to analyse and explain how institutional markets emerge, what structures charac-
terize them, and how venture capitalists behave.
The research literature on the structure of venture capital funds is still relatively young.
And yet the topic is important because the structure of venture capital funds lies at the
heart of the way in which the institutional venture capital market works. The institutional
market involves professional venture capitalists investing on behalf of their investors in
entrepreneurial firms. The structure of these relationships is a combination of explicit and
implicit contracts that regulate and guide how venture capital finance, skills and expertise
is delivered to entrepreneurs. In some cases, venture capitalists are loosely governed by
covenants through limited partnerships, and ‘live or die’ by their investment success. In
other cases, more formal bureaucratic structures impinge on the delivery of venture
capital. Our review of the research on the structure of venture capital funds brings
together theoretical and empirical studies in analysing and explaining how these struc-
tures are designed, and vary across geographical markets. As we shall describe, the earli-
est literature in this area focused largely on explaining how and why venture capital funds
were structured as limited partnerships. The focus in this work was on the USA and was
driven by empirical observations. Only later have we witnessed the literature deepen
through empirical work on markets outside the USA, and through research on the
economic–theoretic foundations of the structure of venture capital funds. The literature
on contract design as it pertains to venture capital fund structure now makes an impor-
tant contribution to a range of disciplines including economics, finance and organiza-
tional theory.
The structure of venture capital funds also impacts how venture capitalists go about
their craft. Important issues include: to what extent does structure influence a venture cap-
italist’s strategy and the type of businesses receiving finance? And what if the structure of
venture capital funds leads to different behaviour by rational venture capitalists? Is there
more or less risk taking, willingness to add value to companies, or indeed, investment
success? Important policy and economic lessons can be gleaned from studying how
venture capital fund structures vary within a country and between countries, and the
implications for the delivery of finance to entrepreneurial firms.
155
This chapter reviews literature on the structure and governance of different types of
venture capital funds with a focus on the institutional structures designed to alleviate
agency problems associated with financial intermediation in venture capital finance. As
venture capital limited partnerships (VCLPs) are the most common type of venture
capital fund in many developed economies, our analysis uses the VCLP structure as a
benchmark upon which other types of venture capital funds are compared. It is import-
ant to note here, however, that the VCLP structure is not necessarily the best type of struc-
ture in all situations. Seminal papers on the VCLP structure describe the role of venture
capitalists as financial intermediaries between investors and entrepreneurial firms. As
investors do not have the time and skills to structure venture capital contracts, screen
potential investees, and add value to investees so that they are brought to fruition in an
initial public offering (IPO) or acquisition exit, investors contract with venture capitalists
such that venture capitalists act on their behalf in carrying out the process of entrepre-
neurial investment. We examine research on this process and contrast VCLPs with other
structures. We then turn to review literature and evidence on why fund structure matters.
As discussed above, fund structure may impact strategy, types of firms receiving finance,
incentives for venture capitalists, the venture capitalist’s behaviour in the investment selec-
tion and management process, and investment returns. The variation in structural forms
observed in the market are due, in our view, to the way in which contracting parties solve
agency problems given differentiated objective functions. The relationship between the
structure of venture capital funds and behaviour of venture capitalists is fundamental to
our understanding of the nature of the venture capital market.
This chapter is organized as follows. The next section provides a short history of the
development of institutional venture capital markets, with particular attention to the
change in fund structures. Next, we will review research surrounding the structure and
governance of venture capital funds, and then our attempt is to show evidence on why
venture capital fund structure matters, in terms of the types of investments made and the
returns to such investments. Finally, we will present our conclusions and offer some areas
of future research.
The development of institutional venture capital markets

Research on the structure of venture capital funds has always been motivated by the
empirical observations that venture capital markets around the world were using various
organizational forms to finance entrepreneurial firms. The growth in the body of litera-
ture on the subject can best be understood in the context of how markets themselves
developed. Research did not emerge due to a paradigmatic shift in economics and finance,
the development of new research techniques, or cross-fertilization of ideas from related
disciplines. Rather, it was impetus to understand the increasing importance of profes-
sional venture capital firms in the economy, and the way in which parties contract between
each other to create new businesses that characterized the seminal articles.
The history of institutional venture capital markets has been well documented by Fenn
et al. (1997) and Gompers and Lerner (2001a). The literature focuses on the emergence of
venture financing in the post-second world war period in the USA through American
Research and Development (ARD), listed closed-end funds spawned by the ARD, the
first limited partnerships in the late 1950s, and federally supported Small Business
Investment Companies (SBICs). Even today, the historiography provides few insights into
The structure of venture capital funds 157
the institutional developments in non-US markets, or of the experiments in corporate

venturing that were to become important developments in the venture capital industry in
later years.
While the lineage of institutional markets is not well developed in the literature, all
researchers point to marked changes in the level of capital committed to the US venture
capital markets in the 1970s and early 1980s that form the basis of today’s industry. The
consensus is that this change was motivated predominately by the changes to legislation
in the US pension system in 1979 permitting pension fund managers to invest in riskier
assets such as venture capital (Gompers and Lerner, 1998). For Europe, the entry of new
venture capital firms from the 1970s (the founding rate of firms) has been positively
related to density, suggesting that a critical mass is also needed to spurn industry growth
(Manigart, 1994).
The growth and development of venture capital markets is illustrated best through data
on venture capital. The capital committed data in Figure 5.1a shows the total amount of
capital committed to venture capital funds in the three major regions – USA, Europe and
the Asia-Pacific.
The US venture capital industry has always dominated global capital available from
institutional venture capital funds. Figure 5.1a shows total capital committed each year
between 1968 and 2005 for the three major regions – USA, Europe and the Asia-Pacific.
There were steady commitments to US funds in the 1980s, and a noticeable increase from
the mid-1990s. International markets in Europe and the Asia-Pacific only increased in
importance in the late 1990s. Capital commitments peaked in 2001 in all three regions. The
information technology ‘bubble’ and associated venture capital overshooting (Gompers
and Lerner, 2000) led to large falls in new capital flowing into the industry until 2004–2005.
Figure 5.1b measures the relative development of institutional venture capital markets
using USA as the benchmark. The graphs express capital committed per year in Europe and
110 000
100 000 USA Europe Asia-Pacific
90 000
80 000
70 000
US$m
60 000
50 000
40 000
30 000
20 000
10 000
0
1968
1974
1980
1986
1992
1998
2004
Figure 5.1a Total venture capital commitments 1968–2005: USA, Europe and
Asia-Pacific
0.60
Europe Asia-Pacific
0.50
0.40
0.30
0.20
0.10
0.00
1980
1985
1990
1995
2000
2005
Source: Thomson Venture Economics; Authors’ calculations
Figure 5.1b Relative venture capital market development 1980–2005: Europe and
Asia-Pacific vs USA
Asia-Pacific as a percentage of US capital raisings. The European market grew rapidly in

the 1980s to be almost 50 per cent of US raisings, although it has fallen recently to 30 per
cent. The Asia-Pacific has shown steady increase to 30 per cent of the US market per year.
The data in Figures 5.1a and 5.1b illustrate that institutional venture capital markets
have become larger in each of the three major world regions since the 1980s (note that the
data here is annual capital commitments, not cumulative assets under management).
Another notable trend has been changes in the way in which venture capital funds are
structured. Contracting out investment management to third party venture capitalists (via
VCLPs) uniformly became the dominant form of venture capital fund structure. Table 5.1
provides summary statistics on this trend, by showing the relative importance of, and
changes in, different types of venture capital funds in the US, Europe and Asia-Pacific
countries between 1980 and 2004.
The data illustrate several trends that are insightful in explaining how the research
has developed. First, from the 1980s VCLPs raised by independent venture capital firms
have been the most common structure in the market. It is not surprising then that this
form has attracted substantial research attention. VCLPs were 75 per cent of the new
funds formed in the USA in the 1980s, with this increasing to 84 per cent by 2002 to 2004.
Even today, we know much more about the operations of VCLPs operated by independ-
ent venture capital firms than we do about any other structure, although we have only
recently seen research on non-US VCLPs. Second, the late 1990s witnessed corporations
and financial institutions establishing venture capital funds to a much greater extent than
previously. These ‘captives’ were part of the venture capital fund-raising ‘bubble’ of the
period, and although their proportion of all funds raised did not change greatly, the
Table 5.1 Venture capital fund structures around the world
United States All European Countries All Asia-Pacific Countries

Vintage Year
(Aggregated All IND CORP FIN All IND CORP FIN All IND CORP FIN
in Periods) Funds Funds Funds Funds Funds Funds Funds Funds Funds Funds Funds Funds
Total Number of New VC Funds by Period:
1980–1989 957 661 76 91 236 135 3 43 112 85 – 12
1990–1996 718 543 30 51 274 170 8 32 391 279 8 54
1997–2001 1804 1342 120 94 1152 703 80 134 856 595 54 116
2002–2004 376 317 13 12 225 150 8 29 150 90 12 27
Relative Importance of Different VC Fund Types (in Per cent of all New VC Funds) by Period:
1980–1989 1.000 0.691 0.079 0.095 1.000 0.572 0.013 0.182 1.000 0.759 – 0.107
159
1990–1996 1.000 0.756 0.042 0.071 1.000 0.620 0.029 0.117 1.000 0.714 0.020 0.138
1997–2001 1.000 0.744 0.067 0.052 1.000 0.610 0.069 0.116 1.000 0.695 0.063 0.136
2002–2004 1.000 0.843 0.035 0.032 1.000 0.667 0.036 0.129 1.000 0.600 0.080 0.180
Average Number of New VC Funds per year by Period:
1980–1989 96 66 8 9 24 14 2 4 14 11 – 2
1990–1996 103 78 4 9 39 24 2 5 56 40 2 8
1997–2001 361 268 24 19 230 141 16 27 171 119 11 23
2002–2004 125 106 4 4 75 50 8 10 50 30 4 9
Note: This table describes the relative importance of different types of VC fund structures over time. IND: independent fund (VCLP), CORP: corporate VC
fund, FIN: financial-affiliated VC fund. ‘All VC funds’ include all 3 types as well as others. Time periods are based on vintage year; i.e., year funds were
established.
Source: Thomson Venture Economics; Authors’ calculations

number of venture capital funds in the category increased between 400–600 per cent. Now
researchers were faced with a new structural form whereby venture capital was provided
to firms through more bureaucratic structures. Thirdly, the internationalization of
venture capital has prompted research on the ways in which legal systems, culture and
institutions impact structure. While the USA continued to be the home of the most new
funds raised each year, Europe and Asia has increased in importance. Indeed, there are
now more funds raised outside the USA than inside the USA, providing impetus to cross-
country research and the arrival of new researchers from various nationalities contribut-
ing to the literature.
There is no doubt that new developments in the venture capital market will, over time,
have additional stimulatory impact on the growth of the literature. To date, the market
trends described above have meant that research covers three major types of venture
capital fund structure: VCLPs, captive funds (financial institutions and corporate venture
capital funds), and government funds (under the guise of government venture capital
support programmes). We will examine each of these structures in turn.
The structure of venture capital funds

The development of institutional venture capital markets and the rise of venture capital
as an important form of finance provided researchers with a fertile topic of analysis. Of
particular importance was the way in which parties contracted to solve agency problems
in the investment management process. In this section we review the work that pioneered
our understanding of fund structures. We first discuss research examining venture capital
limited partnerships. We then turn to more recent work on captive venture funds and gov-
ernment sponsored funds. An overview of the research discussed in this section is pro-
vided in Table 5.2.
Venture capital limited partnerships (VCLP)
The characteristics of VCLP Venture capital limited partnerships are the contractual
outcome of negotiations between the general partner (the venture capital firm run by
investment professionals) and the limited partners (investors). Two features of the for-
mation of a VCLP have been documented – fund raising and contract negotiation. In
terms of fund raising, limited partners are institutional investors that invest in a range of
assets across the risk spectrum (depending upon their asset–liability structure). Venture
capital and private equity forms a relatively small part of institutional investors’ asset
portfolio. Investors (typically) aim to have up to 10 per cent of their capital to the venture
capital (funds focused on early stage investments) and private equity (funds focused on
late stage, turnaround and buy-out investments) asset class, depending on economic and
institutional conditions (Gompers and Lerner, 1998; Jeng and Wells, 2000; Mayer et al.,
2005). Endowments and foundations (long term, intergenerational asset pools) have trad-
itionally allocated much higher proportions of their assets (often above 25 per cent) to
venture capital and private equity. Gompers and Lerner (1998) and Jeng and Wells (2000)
show that pension funds are dominant investors, while other investors include life insur-
ance companies, corporations, commercial and investment banks, universities, endow-
ments, foundations, and wealthy individuals. In an international study, Mayer et al. (2005)
focus on fund raising in Germany, Israel, Japan and the UK, and show that banks are the
Table 5.2 Key features of the structure of venture capital funds
Type of VC fund & Typical ownership of

structure the firm Source of funds Objectives Contract features
Independent VC firm Individual partners Third party investors Financial returns Limited life; multiple fund
(VCLP) through a private company including pension funds, (return on investment, raisings; contract
endowments, fund-of- IRR) covenants; limited liability
funds, life insurance
companies, individuals
Captive (division/business Publicly owned Balance sheet funds; Strategic goals including Unlimited life; formal
unit) corporation business development or access to new technologies administrative control and
R&D budgets and/or products; limiting informal control through
161
competitive threats; corporate culture
financial returns
Government sponsored Individual partners Government finances (and Public policy goals Limited life; single fund
fund (various structures) through a private sometimes matching including development of raising; contract
company, endorsed private sector capital from the local venture capital covenants often with
by a government third party investors) industry; accelerating geographic, company type
programme economic growth and and investment stage
employment; restrictions
commercialization of
technology
major source of funds in all considered countries, but particularly in Germany and Japan.
Pension funds are more important in the UK than elsewhere.
The motivation for limited partners to invest in VCLPs derives from portfolio theory.
Gompers and Lerner (2001a) and Lerner et al. (2005) found that investors can increase
overall portfolio return through a justifiable increase in associated risks so long as they
select venture capitalists that perform, over their life time, above the observable median
fund return. Obtaining the required allocation and exposure, however, is not a simple
matter. While institutional investors desire a set exposure to venture capital, this exposure
is not achieved immediately upon committing capital to a venture capital fund (Cumming
et al., 2005). Capital commitments are drawn down over time through capital calls when
the fund managers have selected entrepreneurial firms to invest in, and as such, it typically
takes a number of years before an institutional investor has reached their targeted expo-
sure to venture capital and private equity. Once exposure is achieved the investor must
continue to commit new capital to venture capital in order to maintain a ‘steady state’
exposure position. Institutions with long term, steady state programmes have been shown
to outperform other investors in achieving returns (Lerner et al., 2005).
The second feature of the formation of a VCLP is the negotiation of covenants in the
partnership agreement. This area was first studied by Sahlman (1990) and Gompers and
Lerner (1996; 1999). The structure of VCLPs is designed to mitigate information asym-
metries and agency problems associated with fund managers investing money in entre-
preneurial firms on behalf of institutional investors. The VCLP is structured as a
contractual relationship between limited partners and the general partner under partner-
ship law, although it should be noted that not all countries around the world have codi-
fied partnership laws conducive to venture capital. The VCLP has a finite horizon of
(typically) 10 years, with an option to continue for 1–3 years (if the remaining companies
need to be exited). This contractual arrangement is efficient, as it facilitates the time
required to select entrepreneurial firms in which the VCLP will invest and bring that
investment to fruition (either in the form of an IPO or an acquisition). The time of first
investment until exit in an entrepreneurial firm can take between 2–7 years. Venture
capital fund managers start fund raising for subsequent funds in the later part of the life
of their existing fund(s), and may operate more than one VCLP simultaneously (subject
to covenants, as discussed below). In industry practice, the collection of funds that com-
prise a venture capital organization is sometimes referred to as a ‘venture capital firm’
(whereas a ‘venture capital fund’ is a single fund that is part of a venture capital firm).
The economics associated with VCLPs are designed to secure interest alignment under
conditions of hidden information and hidden action. Venture capital fund managers are
compensated in a way that provides them with a fixed management fee (1–3 per cent of
committed capital per year) and a carried interest performance fee (20–30 per cent of
profits over return of capital). The fixed management fee is designed to provide enough
capital to run the fund and pay the fund manager prior to any exit. The performance fee
is designed to align the incentives of the VCLP managers with their institutional investors.
Gompers and Lerner (1999) show younger inexperienced fund managers typically negoti-
ate higher fixed fees at the expense of lower performance fees, as their ability to earn per-
formance fees is uncertain. Moreover, more recent studies have evidenced deviations from
the ‘2 and 20 rule’ of venture capital manager compensation (that is 2 per cent manage-
ment fees and performance fee of 20 per cent of the profits) in recent years (Litvak, 2004b).
VCLPs have three key legal advantages. First, they avoid (or at least mitigate) double
taxation of profits as would take place if the structure were a corporation. Second, they
allow for unlimited liability of the fund managers (the general partner), while allowing for
limited liability of the institutional investors (the limited partners). The fund manager is
involved in the day-to-day operation of the fund, and can make decisions without inter-
ference from the institutional investors (or otherwise the institutional investors risk losing
their limited liability status). This autonomy is a marked advantage over corporate
venture capital funds, as discussed below. Third, unlike a corporation (where covenants
are imposed by statute), VCLPs are structured by contract, which is completely flexible
and negotiated to specifically suit the best interests of the parties.
Covenants governing the VCLPs The covenants contained in VCLP set out the ‘rules of
behaviour’ for long term relationships. Theory on the design of these covenants is in its
infancy. Lerner and Schoar (2004) examine the extent to which venture capital managers
may want to include specific covenants in the LP agreements in order to screen better
investors for their fund (that is more ‘liquid’ investors that are long term oriented, with
secure sources of capital). The central hypothesis is that the manager benefits from having
their investors participate in follow-up funds, since it provides a signal to other investors
that LPs are happy with the manager. Therefore, the latter may prefer to keep out liquidity-
constrained investors in early funds, since these investors may not participate in follow-up
rounds for reasons other than how well the fund performed. Their study leads to empirical
predictions with respect to the particular design of partnership agreements.
In terms of empirical studies on covenants, the seminal work was undertaken by
Gompers and Lerner (1996; 1999), who analyse the covenants used to govern VCLPs in
the US. Subsequent work (Schmidt and Wahrenburg, 2003; Cumming and Johan, 2005)
considers similar evidence in an international context. One type of covenant among
VCLPs is the restriction on the fund manager regarding investment decisions. First, fund
managers are restricted on the size of investment in any one portfolio company. Without
such a restriction, a fund manager might lower his or her effort costs associated with diver-
sifying the institutional investors’ capital across a number of different entrepreneurial
firms. It also limits excessive risk-taking by venture capital managers as it forces them to
diversify. Second, fund managers are typically restricted from borrowing in the form of
bank debt, as it would increase the leverage of the fund and impose extra risks on insti-
tutional investors. Third, there are restrictions on co-investment by another fund
managed by the same fund manager, as well as restrictions on co-investment by the fund
investors, which limit conflicts of interest managing the fund. Fourth, there are restric-
tions on the re-investment of capital gains obtained from investments brought to fruition
to ensure realized capital gains are returned to institutional investors.
A second category of covenants relates to types of investment and ensures that the insti-
tutional investors’ capital is invested in a way that is consistent with their desired
risk/return profile. Restrictions include investments in other venture funds, follow-on
investments in portfolio companies of other funds of the fund manager, public securities,
leveraged buy-outs, foreign securities, and bridge financing. Without such restrictions, the
fund manager could pursue investment strategies that better suit the interests of the fund
managers regardless of the interests of the institutional investors. In practice, covenants
tend to be defined in relatively broad language in order to give flexibility to venture capital
managers. However, private equity offering memoranda used by venture capital firms to
raise funds typically include more detailed investment objectives in terms of stage of
development, industry focus and geographical scope. Any deviation from these invest-
ment objectives is traditionally called ‘style drift’. Cumming et al. (2004) study such style
drifts in a sample of US data, and show drifts are related to fund age (first-time fund man-
agers are less likely to drift due to potential reputation costs), and to changes in market
conditions between the time funds were raised and funds are invested. Other forms of
covenants are discussed in Gompers and Lerner (1996; 1999), Litvak (2004b), Lerner and
Schoar (2004) for US evidence, and Schmidt and Wahrenburg (2003) and Cumming and
Johan (2005) for international evidence.
Overall, the flexible nature of contractual covenants used to govern VCLPs, and the
autonomy of VCLP managers vis-à-vis their institutional investors, are viewed to be a
major reason behind the successful development of the US venture capital market
(Gompers and Lerner, 1996; 1999). Lerner and Schoar (2004) show that an effective way
to punish venture capital managers is to not participate in follow-on funds of a venture
capital firm. This provides an adverse signal to other fund providers about the quality of
the venture capital firm. The manager then faces a ‘lemons’ problem when he has to raise
funds for a subsequent fund from outside investors. New investors cannot determine
whether the manager is of poor quality. Where prior institutional investors no longer par-
ticipate in follow-on funds of the venture capital firm, other potential institutional
investors of the fund may infer that the existing investors believe that the venture capital
fund managers are of low quality. Thus, VCLP covenants bind the behaviour of the
venture capitalist but it is rare for the sanctions involved in VCLPs to be invoked by
investors. Punishment is more likely to take place through the investor exiting the rela-
tionship when the next fund is offered for investment.
Captive venture capital funds

Captive venture capital funds are funds that are partly or wholly owned by parties other
than the venture capital professionals. Captives may be affiliated to banks, securities firms,
larger diversified financial institutions or a division/unit of a corporation. The ownership
structure of the captive venture capital fund means that its legal and organizational struc-
ture differ from VCLPs in several crucial ways. First, captive funds primarily derive capital
from their parent and invest on behalf of the parent. There is no limited life fund struc-
ture in the agency relationship. Second, governance of venture capitalists within the
captive fund is materially different from governance as contracted through the covenants
in the VCLP. Rather, the company acts as a large (and often sole) shareholder controlling
the fund. Third, venture capitalists invest in entrepreneurial firms in order to satisfy objec-
tive functions that may contain financial and non-financial goals. Finally, the behaviour
of venture capitalists is influenced by the structure of the fund in terms of risk investing,
portfolio construction and effort (we examine this last difference later on in this chapter).
Research on bank venture capital funds is still in infancy. Banks supply their venture
capital divisions with capital from the balance sheet of the bank, allocating a notional
commitment amount (for example capital per year to be invested). Thus, fund raising is
different in process to professional venture capital firms under the VCLP structure
(Gompers and Lerner, 1999; Cumming et al., 2005; Dushnitsky and Lenox, 2005;
Cumming and MacIntosh, 2006). Banks intermediate between depositors and private
companies requiring longer term debt and equity. The investment objective for banks is to
match longer term liabilities in their capital structure with debt and equity investment in
private equity. As the major, or only capital provider to an entrepreneurial firm, there is no
conflict between debt and equity in the bank’s view. Also, banks aim to sell additional ser-
vices into the portfolio company (for example advisory services, capital raising and arrang-
ing fees) in order to ‘service’ their client and generate income from the investment. Thus,
the investment objectives are measured through a range of key performance indicators that
may include non-return variables. Again, this is in stark contrast to VCLPs where return
maximization is the sole objective. Banks establish venture capital companies as separate
divisions providing development capital to clients/prospective clients. Governance takes
place through the internal administration process that is used by the corporation in all divi-
sions (rather than having governance tailored to the venture capital fund and its particu-
lar circumstances). Deviations from the venture capitalist’s role and responsibilities inside
the bank venture capital fund (for example conflicts of interest, hidden action) are dealt
with like any other cases in the bank, as venture capitalists are employees governed by
labour contracts. Given hierarchical internal labour markets it is less likely to see oppor-
tunistic behaviour in the venture capital unit (the payoff to such behaviour is low), and it
is less costly for the bank to sanction inappropriate behaviour (implying for the venture
capitalist that the probabilistic costs of detection and punishment are high).
Corporate venture capital companies are organized to provide corporations with
balance sheet investments for strategic advantages (see Gompers and Lerner, 1999;
Hellmann, 2003; Riyanto and Schwienbacher, 2005). In the late 1960s and 1970s, more
than 25 per cent of Fortune 500 companies attempted to create corporate venture capital
programmes. Corporate venture capitalists comprised 12 per cent of all US venture capital
investment in 1986; 5 per cent of all US venture capital in 1992, 30 per cent of all US
venture capital in 1997 (Gompers and Lerner, 1999), 15 per cent of all US venture capital
in 2000 (Dushnitsky and Lenox, 2005), and 6 per cent of all US venture capital in 2003
(VC Experts, 2003). Similarly, corporate venture capital comprised approximately 5 per
cent of the Canadian venture capital market in 2003 (Cumming and MacIntosh, 2006).
Large corporations use separate entities such as corporate venture capital funds (as a
wholly-owned subsidiary) to structure such operations (see for example Chesbrough,
2002). Like banks, corporations usually establish a division/unit to invest committed
amounts into venture capital investments. The investment objective is to maximize a
widely defined objective function that relates to broad corporate goals, the securing of
new technologies for competitive advantages (real options), and controlling competitive
threats. Captive venture capitalists are paid less, and have less pay-per-performance sen-
sitivity than limited partnership venture capitalists (Gompers and Lerner, 1999;
Birkinshaw et al., 2002). Captive venture capitalists also have much less autonomy than
limited partnership venture capitalists (Gompers and Lerner, 1999). As such, captive
venture capital managers that show signs of success are often recruited away from the
captive venture capital organization to work for limited partnerships.
Government venture capital funds
Government venture capital programmes Government-backed venture capital company

programmes have been popular around the world as governments support the development
of national venture capital markets servicing all stages in the entrepreneurial investment
process (see for example programmes operating in the USA (SBIC), the UK, Israel
(Yozma), Scandinavia, Belgium (SRIW and GIMV), Australia (Innovation Investment
Fund), and New Zealand (Venture Investment Fund)). Typically, these programmes
provide government funding alongside private sector funding (sometimes with an option
to ‘buy out’ the government at a lower rate of return, providing a leverage effect). The
investment objective is usually to alleviate perceived market failure in the supply of
seed/early stage venture capital, where information asymmetries are highest and sub-
optimal capital is allocated by private sector investors (Jaaskelainen et al., 2004).
Government venture capital funds are often driven by policy objectives associated with
welfare outcomes to enhance the market structure, improve financing options to younger
firms, increase employment, foster innovation and support economic growth (Kortum and
Lerner, 2000; Jaaskelainen et al., 2004). From a theoretical perspective, government pro-
grammes have been shown to be Pareto improvements, leading to net positive economic
benefits to an economy (Keuschnigg, 2003; Kanniainen and Keuschnigg, 2004). The struc-
ture of government funds involves covenants on the sector/stage geographic conditions, on
investment behaviour (for example regional, state or country limitations, technology focus,
stage focus), a commitment to wider policy goals such as knowledge transfer, commercial-
ization of technology from universities, encouraging international linkages with compa-
nies, and development of local venture capital industry.
Public policies towards venture capital Broadly classified, public policies towards venture
capital come in one of two primary forms: (1) law, and (2) direct government investment
schemes. Capital gains taxes are widely recognized as being one of the most important
legal instruments for stimulating venture capital markets (Poterba, 1989a; 1989b;
Gompers and Lerner, 1998; Jeng and Wells, 2000) (but there are other legal instruments
for venture capital markets; see Armour and Cumming, 2005). Poterba (1989a; 1989b)
shows US venture capital fund raising increased from $68.2 million in 1977 to $2.1 billion
in 1982 as there was a reduction in the capital gains tax rate from 35 per cent in 1977 to
20 per cent in 1982. Venture capitalists invest with a view to exit. As entrepreneurial firms
typically do not have cash flows to pay interest on debt and dividends on equity, venture
capitalists invariably invest with a view towards an exit and the ensuing capital gains. The
most profitable forms of exit for high quality entrepreneurial firms are typically IPO and
acquisitions (Gompers and Lerner, 1999; Cumming and MacIntosh, 2003b; Cochrane,
2005). Therefore, tax policy in the area of capital gains taxation is particularly important
for venture capital finance (for theoretical work on tax policy, venture capital and entre-
preneurship, see Keuschnigg and Nielsen, 2001; 2003a; 2003b; 2004a; 2004b; Kanniainen
and Keuschnigg, 2004; Keuschnigg, 2003; 2004). Da Rin et al. (2005) and Armour and
Cumming (2005) examine the effectiveness of several public policy measures. As conjec-
tured by Black and Gilson (1998), the creation of active IPO markets in Europe appears
to be an important measure for fostering an effective venture capital market. Other mea-
sures that increase the extent to which venture capital flows to high-tech and early-stage
investment opportunities are tax benefits and reduced labour and bankruptcy regulation.
A second form of government support is via direct government created venture capital
funds. Lerner (1999; 2002) discusses the ways in which government funds can be success-
fully implemented to work alongside private venture capitalists. One of the most important
items identified by Lerner (2002) is the need for government funds to partner with, and
not compete with, private venture capital funds. It is also important for government funds
to work towards areas in the market where there exists a clear and identifiable market
failure in the financing of companies due to, for example, structural impediments in the
market that have given rise to a comparative dearth of capital. Further, Lerner (2002) sug-
gests it is useful for government funds to be structured in ways that minimize agency costs
associated with the financing of small and high-tech firms. For example, it is useful for
fund managers to have covenants controlling investment mandates and compensation
incentives to add value to all of their investee companies; such covenants and compensa-
tion mechanisms have worked extremely well in mitigating agency problems among
private limited partnership venture capital funds (Gompers and Lerner, 1996; 1999).
Government programmes around the world Countries around the world have adopted
different forms of direct government investment programmes in venture capital and
private equity. For example, the US has adopted the Small Business Innovation Research
(SBIR) Programme, administered by the US Small Business Administration (SBA). The
SBIR programme is the largest government support programme for venture capital in the
world. SBIRs have invested over $21 billion in nearly 120 000 financings to US small busi-
nesses since the 1960s. Investee companies include such successes as Intel Corporation,
Apple Computer, Federal Express and America Online. SBIRs are operated like private
venture capital funds and are operated by private investment managers. The difference
between a private venture capital fund and an SBIR is that the SBIR is subject to statu-
tory terms and conditions in respect of the types of investments and the manner in which
the investments are carried out. For example, there is a minimum period of investment for
one year, and a maximum period of seven years for which the SBIR can indirectly or
directly control the investee company. The SBIR does not distinguish between types of
businesses, although investments in buy-outs, real estate, and oil exploration are prohib-
ited. Investee companies are required to be small (as defined by the SBA) which generally
speaking is smaller than those firms that would be considered for private venture capital
financing. SBIRs also face restrictions as to the types of investment in which they may
invest. Capital is provided by the SBA to an SBIR at a lower required rate of return than
typical institutional investors in private venture capital funds. Excess returns to the SBIR
flows to the private investors and fund managers, thereby increasing or leveraging their
returns. Lerner (1999) shows early stage companies financed by the SBIR have substan-
tially higher growth rates than non-SBIR financed companies. This programme has been
quite effective in spurring venture capital investment and creating sustainable companies
(Lerner, 1999). A key feature of this programme is that it complements and partners with,
and does not compete with, private sector venture capital investment.
Similarly, the Government of Australia adopted the Innovation Investment Fund (IIF)
Programme in 1997. As in the US SBIR programme, a key feature of the Australian IIF
programme is that it operates like a private venture capital fund. There have been nine
IIFs created in Australia, for which the ratio of government to privately sourced capital
must not exceed 2:1. Investments will generally be in the form of equity and must only be
in small, new-technology companies. At least 60 per cent of each fund’s committed capital
must be invested within five years. Unless specifically approved by the Industry Research
and Development Board of the Government of Australia, an investee company must not
receive funds in excess of $4 million or 10 per cent of the fund’s committed capital,
whichever is the smaller. Prior to the introduction of the IIF programme in 1997, there
was scant start-up and early stage venture capital investment in Australia. Cumming
(2006a) finds that IIFs are fostering the development of the Australian venture capital and
private equity industry in a statistically and economically significant way. In short, the US
SBIR and Australian IIF are indicative that there is tremendous potential for govern-
ments to foster innovation and economic development through public subsidization of
venture capital.
Policy makers in Canada have adopted a unique form of government venture capital
fund known as the Labour Sponsored Venture Capital Corporation, or LSVCC
(Cumming and MacIntosh, 2006). The UK has adopted a similar type of fund known as
the Venture Capital Trust (VCT) (Cumming, 2003). Both the Canadian LSVCC and the
UK VCT are mutual funds listed on stock exchanges, and not operated like private
venture capital funds as in the case of US SBIRs and Australian IIFs. The LSVCC and
VCT investors are individuals, and they receive substantial tax incentives to contribute
capital to this class of funds (by contrast, a mix of government and private funds are used
in partnership to support Australian IIFs and US SBIRs). In exchange for the tax subsidy,
LSVCC and VCT managers agree to adhere to a set of statutory covenants that constrain
their investment decisions and activities. The dominant presence of government subsi-
dized LSVCC funds in Canada is in sharp contrast to the US venture capital market. Prior
work has shown that LSVCCs distort efficient venture capital investment duration
(Cumming and MacIntosh, 2001) and efficient exit strategies (Cumming and MacIntosh,
2003a; 2003b) in Canada relative to the US. Further, LSVCCs crowd out private venture
capital funds (Cumming and MacIntosh, 2006). LSVCCs have much larger portfolios of
investee companies per fund manager than private independent venture capitalists in
Canada (Cumming, 2006b), and distort the selected security in Canada (Cumming,
2005a; 2005b).
Overall, government support programmes for venture capital have had mixed success.
In countries where the government venture capital fund competes with private venture
capital funds (as in Canada), the policy objectives of the government programme has not
been met. Where the government programme complements the private market and fills a
gap in the private provision of capital (as in the US and Australia, for example), the pro-
grammes have been quite successful.
Summary
Research on the structure of venture capital funds is consistent with the view that VCLPs
are the most appropriate structure for the financing of entrepreneurship and innovation in
most areas of venture capital (Gompers and Lerner, 1996; 1999; Schmidt and Wahrenburg,
2003; Cumming and Johan, 2005). As we showed in Table 5.2, these venture capital funds
are owned by the individual investment professionals and make contracts (VCLPs) with
third party investors. The delineation of activities between the parties is well laid out, and
the goals are clear. Entrepreneurial firms receive finance from venture capitalists who are
motivated to help the company to grow in order to maximize shareholder value and invest-
ment returns. Indeed, the continuation of the venture capitalist’s franchise depends upon
successful support of entrepreneurial companies. The structure of the VCLP facilitates long
term autonomous investment structures and appropriate compensation arrangements.
Captive venture capitalists, by contrast, are structured in a more bureaucratic way with spe-
cific corporate objectives given that they are located within a different ownership structure
(for example publicly traded corporations). The captive venture capital division provides
venture capitalists with little autonomy and the organizations are much less stable. Goals
may be unclear, conflict, and include the potential negative effects of limiting entrepre-
neurial company growth to protect the competitive position of the corporation. Finally, the
ownership of the venture capital fund by a corporation means that while its structure is
open-ended (which is more suitable than a VCLP for long term risk capital), there may be
less certainty over the life of the fund as the corporation changes strategy or faces financial
pressures in other areas of the business. Government venture capital funds have had mixed
success depending on the design of the programme, which varies significantly across coun-
tries. Successful government programmes take the best structural characteristics from
VCLPs and complement this with specific features to minimize market distortions.
Why venture capital fund structure matters

We have seen that venture capital fund structures vary within a market, and across geo-
graphies. In this section we review the theoretical literature on why venture capital fund
structure matters for the value-added provided by venture capitalists to investee firms, as
well as for generating returns. We then examine empirical evidence.
Theoretical research on venture capital fund structure and venture capital behaviour
The main strand of theoretical research focuses on micro-level analysis and uses agency
theories and mechanism design to produce insights into the functioning of venture capital
markets. Venture capital-specific theories are relatively new, and the first ones certainly
were written after empirical research on venture capital started. The functioning of the
venture capital market has been used as motivation ground for many analyses in incom-
plete contracting and control theories (for example Hellmann, 1998). The theoretical
research in venture capital has largely focused on the relationship between the venture
capital fund manager and the entrepreneur, taking a single investment perspective. Only
recently has there been attention directed to the relationship between limited partners
(LPs) and the venture capital fund manager (general partner, GP). A small number of the-
oretical works have contributed to a better understanding of tradeoffs that a venture
capital fund manager faces, and how these are resolved in order to align the manager’s
incentives with LPs’ interests. This is particularly important for venture capital funds since
LPs cannot easily liquidate their positions once they have invested (or only at very high
costs). This reason, and the fact that LPs by definition cannot interfere in the day-to-day
process of the fund, makes the contract design of partnership agreements a crucial aspect
of a well-functioning fund.
When examining decisions made by venture capital managers, a number of papers
utilize information economics theories such as the signalling and learning hypotheses.
These are especially useful when examining the decisions made by venture capitalists
when approaching the fund raising process for their next fund (for example Gompers,
1996; Cumming et al., 2005). The signalling hypothesis refers to fund manager actions
that seek to demonstrate to institutional investors that they are of high quality. A central
variable along these lines is the degree to which the manager (or the firm she runs) is
already well-established or still young. In the latter case, it is assumed that fund providers
have little information about the true quality of the manager and try to infer her quality
from information signals. Two possible signals that have been investigated are exit deci-
sions (‘grandstanding effect’ as examined in Gompers, 1996) and investment decisions
(that is whether the manager style drifted while investing, as examined in Cumming et al.,
2004). For the context of establishing fund compensation arrangements, Gompers and
Lerner (1999) find evidence in favour of learning. However, other evidence shows sig-
nalling is important for both exits (Gompers, 1996) and investment decisions (Cumming
et al., 2004).
Investment decisions are also closely tied to the structure of a venture capitalist’s port-
folio. Recent papers have therefore moved from a single investor model to take a portfolio
perspective of venture capital investments. Kanniainen and Keuschnigg (2003; 2004) and
Keuschnigg (2004) examine the tradeoff between the number of portfolio companies (that
is portfolio size) and the amount of effort each investment receives. Clearly, a manager
that needs to monitor more companies has less time for each of them. Their resulting com-
parative static analysis provides a clear departure from earlier papers (for example
Gompers and Lerner, 1999) that did not consider the number of portfolio companies.
Similarly, examination of the interaction between portfolio companies within a venture
capital fund shows that venture capital managers do not choose each company individu-
ally but may have incentives to take a portfolio perspective. Fulghieri and Sevilir (2004)
argue that venture capital fund managers may let related projects compete in their early
stages, and stop the less promising one afterwards so that resources and human capital
can be redeployed to the most promising one. Under certain conditions, this provides
better incentives to entrepreneurs and venture capital fund managers. Their work has
empirical implications for size and focus on venture capital funds. Along similar lines,
Kandel et al. (2004) study the inefficiency arising due to the limited duration of funds.
This forces the venture capital fund manager to liquidate the fund’s asset at a given time
in the future. Given that LPs cannot observe the quality of the venture capital manager’s
investments, they may not reward the manager appropriately at liquidation time of the
fund. This in turn provides incentives to the GP to favour short-term projects at the
expense of value maximization of the fund.
Other papers have expanded the standard principal–agent framework to two-side
moral hazard. This strand of the literature recognizes the fact that both players, entre-
preneur and venture capital manager, need to bring in effort (for example Casamatta,
2003; Schmidt, 2003; Repullo and Suarez, 2004). Among other things, this extension has
led to a better understanding of the widespread use of convertible securities in venture
capital finance.
In sum, theoretical work is consistent with the view that venture capital fund structure
is important for the screening of new potential investments and the governance provided
by venture capitalists to the investee firms. The next subsection describes empirical evi-
dence consistent with this view.
Empirical research
Empirical research has found that the structure of venture capital funds and the contracts
that govern the relationship with suppliers of capital influence the behaviour of profes-
sionals and their investment strategy and style. While the next chapters of this book focus
on investment decisions by venture capital companies, we emphasize here some research
findings specific to differences in the structure of venture capital funds. Research on how
structure influences behaviour has been organized into a small number of themes, as
detailed below.
Fund structure, types of investment and value-added advice The first set of evidence on
how structure matters relates to the effect that the source of funds has on the use of funds
by the venture capital. The basic proposition derives from the fact that as agents, venture
capitalists are often contracted to invest to provide defined investment outcomes that may
yield both financial and non-financial benefits to the capital provider. The differences in
venture capital behaviour driven by structure include types of entrepreneurial firms sup-
ported, portfolio structure, governance and value-added by the venture capital. As
pointed out by Mayer et al. (2005), in principle the source of funds is irrelevant to the
investment decision (similar to Modigliani and Miller’s irrelevance theorem) as long as all
venture capital funds pursue a sole objective of maximizing profits of their own funds.
Mayer et al. (2005) provide evidence from a large cross-country data set (Germany, Israel,
Japan and the UK) that the use of venture capital varies by source, attributable in large part
to differentiated objective functions. Venture capitalists sourcing capital from banks and
pension funds invest in ‘low technology’ entrepreneurial firms in later stages (that is more
established firms) than individual and corporate backed venture capitalists. Similarly,
Cumming et al. (2007) show that Japanese bank venture capitalists act differently from inde-
pendent VCLPs by investing in later stage companies. The structure of venture capital com-
panies also impacts the governance structure of portfolio companies. Cumming et al.’s
study shows that individual owner-manager structures (typically VCLPs) give rise to much
smaller portfolios of entrepreneurial firms and more advice to entrepreneurs. In contrast,
bank affiliated funds hold larger portfolios (measured by number of entrepreneurial firms
per manager) and provide investees with less value-added advice. This negative link between
value-added per investee and number of firms in the portfolio is examined theoretically by
Kanniainen and Keuschnigg (2003) and empirically by Cumming (2006b). Because venture
capitalists invest time and effort in advising their portfolio firms, as opposed to just pro-
viding funds, increasing the number of firms in the portfolio dilutes the quantity and quality
of the advice provided. The relation between portfolio size per manager and venture capital
advice, however, is not linear. Complementarities among venture capital and entrepreneur
effort, and complementarities among different entrepreneurial firms in the portfolio, among
other things, make the relation between portfolio size and advice rather complex (see also
Kanniainen and Keuschnigg, 2003; 2004; Fulghieri and Sevilir, 2004; Keuschnigg, 2004;
Cumming, 2006b).
Our discussion so far has looked at the variation across types of venture capital fund
structure. But even within structures differences in behaviour are evident, most clearly
seen in VCLPs operated by venture capitalists of varying experience. Gompers (1996)
shows that younger funds tend to exit through an IPO earlier as a way to signal their
quality to fund providers prior to raising a new fund. Moreover, Cumming et al. (2004)
find that the VCLP structure and the need for independent venture capital funds to raise
capital every few years affect the investment decisions of managers, not only exit deci-
sions. Their analysis shows that younger funds are less likely to deviate from their stated
objectives (that is style drift less) prior to raising a new fund in order to signal their man-
agerial quality. Incomplete information from the arm’s length relationship between
capital suppliers and the venture capital means that both grandstanding and style drift
act as a signalling device.
Fund structure and financial returns (direct and indirect) The financial returns to venture
capital investing have been most commonly linked with the state of finance markets and
the legal conditions underpinning the structure of VCLPs. The stronger public finance
markets and legal protection for investors are in the VCLP, the higher are financial returns
to investment. Black and Gilson (1998) argue that there is a strong link between active
stock markets and active venture capital markets, as the former allow investors to divest
their most successful deals. An international study of venture capital in the Asia-Pacific
region by Cumming et al. (2006) provides evidence that a more important factor than
active stock markets is the quality of a country’s legal system, which is a central mech-
anism to mitigate agency problems between outside shareholders and entrepreneurs.
Legality affects exits because legality affects the new owners’ ability to resolve problems
resulting from information asymmetries in the sale of the firm (consistent with La Porta
et al., 1997; 1998; Shleifer and Wolfenzon, 2002). The venture capitalist’s goal is to maxi-
mize capital gains upon sale of the entrepreneurial firm. All else being equal, the new
investor(s) will pay the most when information asymmetries are lowest. IPOs are less
costly exit routes relative to private exits (acquisitions, secondary sales and buybacks)
among countries with a higher legality index and stronger investor protections, and should
therefore be observed more frequently in countries with higher legality indices (Cumming
et al., 2006). Hege et al. (2003) find a significant performance gap (measured by IRR of
individual investments) between Europe and the United States. US venture capital funds
outperform their European counterpart in the financing of entrepreneurial firms funded
at the early stage. Their analysis is consistent with the idea that either European ventures
are of lower quality or US venture capitalists are better at screening business plans.
Indirect financial benefits to venture capital funds are more important in non-VCLP
structures. Studies have shown that, for instance, large corporations set up their own funds
for strategic reasons (Siegel et al., 1988; Winters and Murfin, 1988; Yost and Devlin, 1993;
Chesbrough, 2002; Santhanakrishnan, 2002) so that the companies financed by the cor-
porate venture capital fund fit within the corporation’s objectives. Some studies document
that the use of corporate venture funds is most likely when complementarity gains are
highest (Lemelin, 1982; Dushnitsky and Lenox, 2005; Dushnitsky, 2004). Gompers and
Lerner (1998) find that corporate venture capital fund investments in companies with
‘strategic fit’ to the mother company perform at least as well as investments by indepen-
dent venture capital funds. Moreover, Riyanto and Schwienbacher (2005) develop a the-
oretical framework where they study the incentives of large corporations to set up
corporate venture capital funds in order to generate demand for their own products. The
article also mentions a number of real cases where this indeed took place. Given these posi-
tive externalities for corporate investors, they need to be taken into account in investment
decisions of corporate funds. Hellmann (2002) analyses the strategic role of venture
investing, that is either a corporate venture financing or an independent venture financ-
ing. The use of corporate venture capital mitigates the potential hold-up problem at the
R&D stage. In contrast, Riyanto and Schwienbacher (2005) take another perspective.
They focus on the corporate investor’s active role in utilizing corporate venture financing
strategically as a commitment to compensate the entrepreneur for potential opportunistic
behaviour in the product market. It therefore helps to avoid a potential ex post hold-up
problem in the product market (instead of at R&D stage).

This chapter has examined the structure and governance of different types of venture
capital organizations, including limited partnerships, captive venture capitalists and gov-
ernment venture capital programmes. This chapter has also examined the relation
between organization structure and governance provided by venture capitalists to investee
firms, and has shown that prior research is consistent with the view that returns are
affected by venture capital fund structures. Agency relationships between capital pro-
viders and venture capitalists are solved efficiently through a range of organizational con-
figurations. We have reviewed the state of research on these forms of venture capital. We
offer here our views on future research directions.
1. Internationalization of venture capital

The past ten years has witnessed the increased internationalization of the venture capital
industry, especially given the presence of large institutional investors (see Megginson,
2004, for a review of work on non-US markets). Work on Europe and the Asia-Pacific
(Lockett and Wright, 2002) show the potential provided by analysis of the international
aspects of venture capital. The internationalization phenomenon raises a number of new
research questions, listed below:
● How have, and how will, venture capital markets evolve around the world? Will
there be a convergence towards a single venture capital model?
● How will increasing financial integration affect the structuring of transactions in
venture capital-backed companies?
● How does internationalization impact venture capital firm structure and its man-
agers’ investment decisions?
● Will the growth of new markets with different legal systems (such as China and
India) lead to different styles of venture capital investing?
2. Single VCLPs versus fund-of-funds

The professionalization of venture capital investing has led to new structures being
adopted by institutional investors to access quality venture capitalists. To date there has
been little research on the venture capital fund-of-funds industry, although Lerner et al.
(2005) discuss variations in investment returns across different types of limited partners.
The research on hedge fund-of-funds has led academic attention on the intermediation
process in newer asset classes.
● How do venture capital fund-of-funds invest?

● How are venture capital fund-of-funds managers incentivized?
● Do funds-of-funds produce better returns than building a portfolio as a single investor?
3. Listed venture capital funds

Financial innovation in the retail funds management sector has led to listed venture
capital funds (and fund-of-funds) providing investment options for retail investors. Listed
venture capital funds face a different set of information and liquidity factors. Research
could examine:
● Are venture capital outcomes different when the vehicle is listed?

● What is the impact of listed structures on the types of venture capital investments,
venture capital behaviour and investment returns?
4. Business culture and venture capital fund structure

The international growth of venture capital has seen traditional ways of venture capital
investing merge with non-Western business cultures. Indeed, family-controlled venture
capital has been a feature of the development of many economies (for example northern
Italian business groupings, Chinese business diaspora). We have seen that the research on
captive venture capital funds is still in its infancy. Culture is also important in this area,
and future work should look towards disciplines such as psychology, organizational
behaviour, anthropology and economic/business history.
● How does organizational culture impact venture capitalist behaviour?

● Are non-Western venture capital firms different in their outcomes? Approach to
investing? Use of non-contractual aspects (for example trust) of transactions?
● How does the Western style of venture capital become integrated into the new
global venture capital world?
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6 The pre-investment process: Venture capitalists’
decision policies
Andrew Zacharakis and Dean A. Shepherd
Introduction
The venture capital process can be thought of as a series of activities or stages that each
new venture works through from the time the venture is first proposed up until the time
when the venture capital firm successfully exits from the venture and takes its profit. For
example, Tyebjee and Bruno (1984) proposed a model of the venture capital process with
five such stages: (1) deal origination – seeking potential investments; (2) deal screening –
quick review of business plans and/or oral proposals, both solicited and unsolicited;
(3) deal evaluation – for those deals that pass the screen, more in-depth due diligence to
validate business model and prospects; (4) deal structuring – establishing and negotiating
the terms of the investments; and (5) post-investment – value-added activities such
as serving on the board, assisting with follow-on investment and liquidity events. Pre-
investment activities refer to all venture capital tasks up to and including the signing of
an investment contract: soliciting new venture proposals for submission to the venture
capital firm, determining whether these proposals meet the firm’s broad screening criteria,
conducting due diligence (more extensive research to determine the likely success of the
venture), and then negotiating and structuring a relationship with the entrepreneur. In
this chapter we focus on the screening phase of the pre-investment process – specifically,
what decision criteria are important to the investment decision and how this decision
process works – while post-investment activities will be discussed in detail in the next
chapter by De Clercq and Manigart (Chapter 7).
The venture capitalist’s most valuable asset is his time. Gorman and Sahlman (1989)
find that venture capitalists spend 60 per cent of their time on post-investment activities.
On average, a venture capitalist commits 110 hours per year to assisting and monitoring
one venture investment (Gorman and Sahlman, 1989). While venture capitalists spend
most of their time and effort on post-investment activities, that time and effort is inefficient
if the venture capitalists make investments in marginal ventures. In fact, Roure and Keeley
(1990) assert that success can be predicted from information contained in the business
plan. Therefore, improving the investment decision can improve the venture capitalist’s
performance. Better understanding how venture capitalists make decisions and more
importantly, how they can improve their decision process will lead to more efficient use of
their time and higher overall returns (Zacharakis and Meyer, 2000). Thus, the vast major-
ity of research on the pre-investment process has focused on how venture capitalists select
those ventures that they back. Deal flow and due diligence are under-researched (see
Smart, 1999, for one of the few studies on due diligence) and while work on valuation (for
example Keeley and Punjabi, 1996; Kirilenko, 2001; Seppä and Laamanen, 2001) and con-
tracts is common (for example Gompers and Lerner, 1996; Kaplan and Stromberg, 2004;
Cumming, 2005), it views the topic from an economic rational perspective (that is what is
177
the optimal valuation to motivate and align the entrepreneur’s efforts with the venture cap-
italist’s objective of achieving high ROI and deriving an appropriate contract to minimize
the threat of opportunism). While we limit the scope of this chapter to the investment deci-
sion, we do believe that the decision process during the selection phase impacts both due
diligence and negotiation. As such, there is room to explore how venture capital decisions
influence these phases.
Venture capitalists differ in the screening criteria they use to select ventures including
type of industry, company stage of development, geographic location, and size of invest-
ment required. For example, venture capitalists often specialize by industry (Sorenson and
Stuart, 2001). A venture capitalist interested in biotechnology will look at criteria
differently than venture capitalists interested in retail; proprietary protection may be of
more importance for instance. Likewise, venture capitalists focused on early stage deals
may place more emphasis on the team – can the entrepreneur execute on the opportunity –
since there is little past history of the venture to evaluate. Later stage venture capitalists
can assess the team’s capabilities based upon what the venture has achieved in its earlier
stages. While venture capitalists with different objectives emphasize different criteria, the
basic categories still hold (the entrepreneur, the market size and growth, the product, the
competition, and so on), but how the criteria are used or weighted differs.
The primary goal of this chapter is to review the progression of venture capital research
on investment selection in the screening phase and primarily takes an information pro-
cessing perspective to do so. It is our belief that the field is becoming more sophisticated
in both its methods and questions asked. We have moved beyond simple surveys and inter-
views asking venture capitalists how they select which ventures to back, to tests of how
venture capitalists actually make decisions and how contextual and process factors influ-
ence that decision. As is true with all fields of inquiry, the more we learn, the more ques-
tions that arise. Thus, this chapter not only looks backwards, but suggests ways forward.
The chapter progresses as follows: first, we review the early research on venture capital
decision making followed by an overview of how verbal protocols and conjoint analysis
have helped us answer basic questions, such as what criteria do venture capitalists use in
the decision and how do they use those criteria. The following section looks at context of
the decision. Industrial organization economics, the resource based view and institutional
theory suggest how context might influence the decision. Next, we examine how biases
and heuristics impact the venture capital process. The basic question underlying process
is whether biases and heuristics are efficient means for boundedly rational decision makers
to pick the best ventures, or whether they lead to sub-optimal decisions. Much of the
research to date assumes that venture capital decision making is relatively homogeneous,
but more recently researchers are looking at factors that lead to heterogeneity in the deci-
sion process. At the end of each of the major sections of our review, we raise several new
research questions and avenues to explore them.
The evolution of research on pre-investment venture capital

Venture capital research has progressed and become more sophisticated. This section
highlights the move from simple surveys and interviews which rely on accurate introspec-
tion to verbal protocols and conjoint analysis. Verbal protocols are real-time ‘think aloud’
observations of the venture capitalist screening a potential deal. As such, they allow
researchers to track what and when information is used in the decision. Conjoint analysis
The pre-investment process 179
moves beyond verbal protocols to a controlled experiment which allows researchers to

capture the relative importance of different decision criteria.
Venture capitalists’ espoused decisions

Venture capitalists are conspicuously successful at predicting new venture success (Hall
and Hofer, 1993; Sandberg, 1986) and numerous studies have investigated their decision
making. The majority of research on venture capitalists’ decision making has produced
empirically derived lists of venture capitalists’ ‘espoused’ criteria which are the criteria
venture capitalists report they use when evaluating new venture proposals, including early
seminal articles by Tyebjee and Bruno (1984) and MacMillan and colleagues (MacMillan
et al., 1985; 1987). Tyebjee and Bruno (1984) articulated four categories – market poten-
tial, management, competition and product feasibility – and MacMillan et al. (1985)
grouped their 27 criteria into six categories – the entrepreneur’s personality, experience,
characteristics of product/service, characteristics of market, financial considerations and
venture team. This early research consistently finds that the entrepreneur and team are the
most important decision criteria in distinguishing between successful and failed ventures.
For example, MacMillan et al. (1985) find that 6 of the top 10 criteria relate to the entre-
preneur and team. The findings of these early studies fit the mantra espoused by Georges
Doriot, the father of venture capital and founder of the first modern venture capital firm
ARD, that he’d rather ‘invest in an “A” team with a “B” idea than a “B” team with an “A”
idea’ (as noted in Timmons and Spinelli, 2003). This early research provided a context in
which to understand and evaluate venture capitalists’ decision making, but it was prone
to recall and post hoc rationalization biases (Zacharakis and Meyer, 1995). Zacharakis
and Meyer (1998) find that venture capitalists aren’t accurate in self-introspection. In
other words, post hoc studies may not truly capture how venture capitalists use decision
criteria.
Verbal protocol analysis of venture capitalists’ decisions

Next there were studies by Sandberg et al. (1988), Hall and Hofer (1993), and Zacharakis
and Meyer (1995) that attempted to overcome prior post hoc study flaws by using verbal
protocols. Verbal protocols are real time experiments where venture capitalists ‘think
aloud’ as they are screening a business plan (Ericsson and Crutcher, 1991). Thus, venture
capitalists aren’t required to introspect about their thought processes which removes recall
and post hoc rationalization biases (Sandberg et al., 1988). Moreover, the verbal protocol
approach provides richer understanding of the decision process whereas post hoc
methods focus on the decision outcome (Hall and Hofer, 1993). Verbal protocols, for
instance, not only allow the research to capture what criteria venture capitalists use, but
in which order they consider different criteria and how much time they spend evaluating
each criterion, which gives us a relative sense of the importance of different criteria.
Results from verbal protocol studies suggest that venture capitalists’ insight into their
decision processes may be less than perfect. For example, Hall and Hofer (1993) find that
the venture capitalist pays relatively little attention to entrepreneur/team characteristics
and even less attention to strategic issues of the new venture proposal. Instead, the most
important factor centred on the market and product attributes, which is congruent with
the findings of Zacharakis and Meyer (1995). Such findings appear to contradict most
post hoc studies which find that the entrepreneur is typically the most important factor.
Zacharakis and Meyer (1995) suggest that the discrepancy may be attributable to the
screening stage on which verbal protocol research has focused. Specifically, venture capi-
talists may assess whether the entrepreneur meets minimum qualifications during the
screening stage, and reserve final judgment for later evaluation (see Smart’s, 1999 study on
how venture capitalists evaluate the entrepreneur during due diligence).
While verbal protocols are rich in the amount of data collected from each venture cap-
italist, they are time consuming as the researcher needs to observe each venture capitalist
as he actually reviews a plan. As such, these studies are limited by the small sample sizes
that can be easily accommodated. Nonetheless, the discrepancy between verbal protocols
and earlier post hoc studies spurred a new wave of real time experiments that can more
efficiently manage larger samples.
Conjoint analysis and policy capturing of venture capitalists’ decision policies

Conjoint analysis and policy capturing move beyond survey methods used to identify deci-
sion criteria and verbal protocols used to assess how and when criteria are used. Conjoint
analysis is a ‘technique that requires respondents to make a series of judgments, assessments
or preference choices, based on profiles from which their “captured” decision processes can
be decomposed into its underlying structure’ (Shepherd and Zacharakis, 1997, p. 207).
Policy capturing is a type of conjoint analysis. The research supports the notion that venture
capitalists aren’t very good at introspecting about their decision process (Zacharakis and
Meyer, 1998). Conjoint studies (Zacharakis and Meyer, 1998) support verbal protocol
research (Hall and Hofer, 1993; Zacharakis and Meyer, 1995) indicating that market issues
might be more important than entrepreneur characteristics. In general, real time studies find
that venture capitalists tend to overweight less important factors and underweight more
important factors when they ‘espouse’ lists of decision criteria they say they use in their
assessments (Zacharakis and Meyer, 1998; Shepherd, 1999). Furthermore, the accuracy of
introspection decreases the more information that the decision maker faces (Zacharakis and
Meyer, 1998). This leads venture capitalists to remember more salient information as being
more important than it actually was. The finding is particularly pertinent to the venture
capital process as information inundates the venture capital decision context. For example,
there is information about the entrepreneur (for example entrepreneur’s industry and start-
up experience), market (for example size and growth), product/service (for example propri-
etary protection), among other categories. Not only is there a lot of available information,
but much of it is of a subjective nature. For example, venture capitalists often discuss the
‘chemistry’ between themselves and the entrepreneur. The deal often falls through if the
chemistry is not right. Such intuitive, or ‘gut feel’ (MacMillan et al., 1987; Khan, 1987),
decision making is difficult to quantify or objectively analyse. The added complexity from
subjective information further clouds the decision making process and invites decision
makers toward more biases that impede their ability to introspect accurately. Due to the
complexity of the decision and the venture capitalists’ intuitive approach, venture capital-
ists have a difficult time introspecting about their decision process (Zacharakis and Meyer,
1998). In other words, venture capitalists do not have a comprehensive understanding of
how they make the decision. This lack of understanding may lead to sub-optimal decision
strategies and subject venture capitalists to biases that may lead to sub-optimal decisions.
Conjoint analysis and policy capturing allows us to gain a deeper understanding of the
venture capital decision process (Shepherd and Zacharakis, 1999). Not only can researchers
capture how important each decision criterion is to the decision relative to other decision
criteria (Zacharakis and Meyer, 1998), but it also allows for examining contingent deci-
sion processes (Zacharakis and Shepherd, 2005). Thus, the research in venture capital
decision making has followed a natural progression from identifying decision criteria
through post hoc surveys (for example Tyebjee and Bruno, 1984; MacMillan et al., 1985)
to understanding how that information is utilized during the actual decision via verbal pro-
tocols (Sandberg et al., 1988; Hall and Hofer, 1993; Zacharakis and Meyer, 1995) to con-
trolled experiments which can pull out the similarity/differences between venture capitalists
(Zacharakis et al., 2007), the relative importance of different decision criteria (for example
Muzyka et al., 1996) and more complex, contingent decision policies (Shepherd et al., 2000;
Zacharakis and Shepherd, 2005). The following sections will elaborate on how the venture
capital decision making research has used experiments to test theory on both the content
venture capitalists’ decision policies and the decision process.
Theory development and experiments for empirical testing

In this section we continue our review of conjoint analysis and focus on the theory devel-
opment in increasing our understanding of both the content of venture capitalists’ deci-
sion policies and the process by which they make those decisions.
Theory development and content tested using experiments

Riquelme and Rickards (1992) pioneered conjoint analysis in the study of venture capital
decision making. They ran a series of pilot tests on 14 venture capitalists and concluded
that conjoint analysis is an effective means of studying the venture capital process. Shortly
thereafter, Muzyka et al. (1996) used conjoint experiments to explore the importance of
a long list of criteria (35 investment criteria) that venture capitalists had identified as being
important when making their decisions. They used a conjoint experiment that required 73
venture capitalists to each make 53 pair-wise trade-offs with multiple levels. The criteria
fell into seven groupings: (1) financial; (2) product-market; (3) strategic-competitive; (4)
fund; (5) management team; (6) management competence; and (7) deal. They found that
venture capitalists ranked in the top seven criteria all five management team attributes,
product market criteria appeared to be only moderately important, and fund and deal cri-
teria were at the bottom of the rankings. This study led Muzyka and his colleagues (1996,
p. 274) to conclude that the venture capitalists interviewed would
prefer to select an opportunity that offers a good management team and reasonable financial
and product-market characteristics, even if the opportunity does not meet the overall fund and
deal requirements. It appears, quite logically, that without the correct management team and a
reasonable idea, good financials are generally meaningless because they will never be achieved.
While pair-wise conjoint studies identify which criteria might be more important than
other criteria, it still suffers post hoc recall biases as the venture capitalists are not making
real time investment decisions, but thinking about how they believe they used the criteria
listed on past decisions.
More recently, experimental methods such as metric conjoint analysis and policy cap-
turing have been used to test theoretically derived hypotheses on the content of venture cap-
italists decisions in a real time investment decision. For example, Shepherd and colleagues
used an industrial organization economics (IO) perspective of strategy to investigate the
types of information venture capitalists utilize when evaluating new ventures (including its
strategy and experience) and how venture capitalists use this information to assess new
venture survival (Shepherd, 1999) and profitability (Shepherd et al., 2000). Specifically,
Shepherd (1999) used the IO strategy and population ecology literatures to develop a model
of new venture survival that centred on the importance of uncertainty. This study found
that in assessing the probability of survival venture capitalists consider the new venture’s
timing, lead time, educational capability, industry related competence and the nature of the
environment in terms of stability of the key success factors and competitive rivalry. These
results suggested considerable consistency between the proposed theoretical framework and
the decision policies of venture capitalists. In investigating venture capitalists’ assessments
of profitability, the theory development work of Shepherd et al. (2000) suggested contin-
gent relationships between the criteria that were previously used to explain the probability
of survival. Specifically, they found that the relationship between timing of entry and
venture capitalists’ assessment of profitability is moderated by key success factor stability
(environmental stability), lead time and educational capability.
Zacharakis and Shepherd (2005) used theory from the resource-based view (RBV) of
strategy to hypothesize that venture capitalists use non-additive decision policies when
making their investment decision – interactions between leadership experience and other
internal resources, and between leadership experience and environmental munificence are
reflected in venture capitalists’ decision policy. A policy capturing experiment found that
although venture capitalists always prefer greater general experience in leadership, they
value it more highly in large markets, when there are many competitors, and when
the competitors are relatively weak. It also found that previous start-up experience of the
venture’s management team may substitute for leadership experience in venture capital-
ists’ decision policy.
The above research has used theory to hypothesize content that is then tested using
experiments to understand whether venture capitalists’ decision policies are consistent
with theory, or if they deviate, what the nature of that deviation is. These studies are illus-
trative of the increasing sophistication in venture capital decision making research.
Specifically, these studies go beyond the simple main effects studies of the past and ask
not only what criteria venture capitalists use, but how these criteria interact with other cri-
teria in the venture capitalist’s decision. These investigations produce a decision policy for
the sample as a whole yet there are theoretical reasons that under certain circumstances
venture capitalists should differ in their decision policies. The next level of sophistication
moves beyond building base models that describe the general venture capital decision, to
when venture capitalists might deviate from this base model. In other words, newer
research needs to examine the heterogeneity of venture capital decision making.
Recent experimental research on the content of venture capitalists has focused on
explaining variance in the decision policies across venture capitalists. Based on institu-
tional theory that various economic institutions structure the incentives of human
exchange differently, Zacharakis et al. (2007) proposed that venture capitalists from
different countries (US – mature market economy, South Korea – emerging economy, and
China – transitional economy) would use different information when formulating their
decisions. Using policy capturing experiments on 119 venture capitalists across these three
countries, they found that venture capitalists in rules-based market economies rely upon
market information to a greater extent than venture capitalists in emerging economies,
and also found that Chinese venture capitalists more heavily weigh human capital factors
than either US or Korean venture capitalists. We expect that more research will use theory
to explain variance in decision policies across venture capitalists.
Future research opportunities into venture capital decision making content Beginning with
Riquelme and Rickards (1992) and Muzyka et al. (1996), there has been substantial
progress in theoretically based conjoint experiments that allow us to understand the
extent to which our theories are reflected in the way that venture capitalists make deci-
sions. The theoretical approaches to date have relied heavily on strategy research to derive
criteria. This makes sense because both are interested in assessing firm performance.
However, we believe that there are opportunities to move beyond theories of strategy to
drive theory-based conjoint studies intent on better understanding the content of venture
capitalists’ decision policies. For example, much has been made about the management
team. There are likely opportunities to explore theories of psychology and team behav-
iour to derive criteria which we believe that venture capitalists may use in assessing the
‘quality of the management team’. How motivated are entrepreneurs? Will they maintain
their motivation and effort when things get tough? How do they handle stress? Perhaps
theories from economics will provide the opportunity for more fine-grained experimental
work to understand how venture capitalists assess potential competition. Are venture cap-
italists always equally concerned about competition? Do venture capitalists weigh the risk
of new entrants less heavily in their investment decisions when the potential portfolio
company is in a highly munificent and/or highly dynamic environment? Is competition
sometimes viewed positively, such as with new entrants legitimating an emerging market?
There are ample opportunities to take one of the criteria that have been tested above and
use theory to explore it in finer detail and then test it using conjoint analysis.
To date, research has focused primarily on the screening stage and venture capitalists
looking at early stage deals. There is reason to expect that decision criteria, or at least the
relative importance of decision criteria, might differ across both venture capital process
stage and the venture’s development stage. For example, Smart (1999) finds during the due
diligence stage that venture capitalists quiz entrepreneurs on a number of ‘what if’ sce-
narios to see how they might react to different situations new ventures are likely to face,
especially for early stage ventures. For later stage ventures, Smart finds that venture cap-
italists spend more time evaluating the entrepreneur’s achievements within the current
venture to that point in time. Research along these lines could be expanded and tied to the
type of entrepreneur content venture capitalists explore at different stages of the venture
capital process. Likewise, the relative emphasis on other content areas may change based
upon the venture capitalist’s process stage and the venture’s development stage. There is
also reason to expect that venture capitalists’ criteria differ based upon the venture’s
industry. These avenues of future research extend the base model of venture capital deci-
sion making and are the next logical step in the development of this line of research.
Theory development in process and experiments

Using information processing theory (Anderson, 1990; Lord and Maher, 1990) has helped
the venture capital decision making stream to develop by allowing us to predict and
understand how venture capitalists make decisions, and when those decisions may be sub-
optimal, biased and contain errors. The following sections delineate why we need to
understand the ‘process’, how information processing theory helps us understand the
process, especially as it pertains to mean for managing all the information, potential biases
to the process and so on.
Why understanding process is important While understanding the content of the venture
capitalist’s decision is crucial to improving those decisions, it is also critical to understand
the process by which venture capitalists make decisions. Decision makers are not perfectly
rational, but boundedly rational (Simon, 1955; Cyert and March, 1963). It is impossible
for venture capitalists to evaluate all information fully as their decision environment is par-
ticularly rich in information (Zacharakis and Meyer, 1998) and highly equivocal in nature
(Moesel et al., 2001). Venture capitalists must interpret information at the environmental
level (industry trends, economic conditions, and so forth), the business model level (can
the venture capital financing enable the company to grow to a point where the venture
capital can extract a return on investment), and the team level (can the entrepreneur team
execute). Information richness, or as Zacharakis and Meyer (1998) call it, ‘information
noise’, leads venture capitalists to economize on their decision process in order to manage
the sheer volume of information. Thus, venture capitalists will use heuristics, both con-
sciously and unconsciously, that filter out certain information and allow the venture cap-
italists to focus on other information. However, what information venture capitalists pay
attention to impacts their decision process and may result in decision biases.
Information processing theory Cognitive science, the study of how people make deci-
sions, has provided a fruitful source for theories that have been applied to the venture
capital decision process. Barr et al. (1992) delineate a simple information processing
model that describes decisions as a function of what information attracts the manager’s
attention, how that information is interpreted, and what actions follow from that inter-
pretation. The expert decision making model (Lord and Maher, 1990) best fits the venture
capital environment (Shepherd et al., 2003). Expert models can be characterized as fitting
between a truly rational decision model where all information and alternatives are con-
sidered and evaluated to a limited capacity model which recognizes the cognitive limits of
decision makers (Cyert and March, 1963). Experts learn which factors best distinguish
between successful and unsuccessful ventures (Shepherd et al., 2003), although this is
often on an unconscious level (Zacharakis and Meyer, 1998).
Venture capitalists possess a multitude of mental models which can be called into action
depending upon the situation (that is based on past experience with industry, or past
experience with lead entrepreneur, and so on (Zacharakis and Shepherd, 2001)). Thus,
when the venture capitalist perceives a somewhat familiar situation which requires action,
an appropriate mental model is summoned from long term memory (Moesel et al., 2001).
In unfamiliar situations, the venture capitalist uses an evaluation strategy (a mental model
of how to approach new situations) to formulate the information into a mental model
which is then manipulated to make a decision. However, the venture capitalist’s mental
model of the situation influences what and how the information surrounding the situation
is perceived; the mental model acts as a filter which preserves limited cognitive processing
capacity (Moesel et al., 2001; Zacharakis and Shepherd, 2001). An example might better
illustrate the mental model concept. Imagine two venture capitalists examining the same
proposal. The first venture capitalist is very familiar with the industry and, in fact, also
has extensive knowledge of the team. As such, the venture capitalist is likely to base her/his
judgment on these two chunks of information. Other important information that doesn’t
fit neatly within this configuration receives limited consideration. The second venture cap-
italist, on the other hand, is not familiar with the industry or the entrepreneurial team. In
this case, the venture capitalist doesn’t possess a mental model based on the larger chunks
of information. The venture capitalist assesses the entire array of information and uses
various decision strategies to make her/his decision. For example, s/he may use a satisfic-
ing strategy (Simon, 1955) and assess whether the proposal meets the minimum criteria on
each decision factor.
With information processing theory as a theoretical lens, a number of pertinent issues
have been studied in the venture capitalist decision process. Primarily, what heuristics do
venture capitalists employ to make decisions in an information rich environment? And,
what factors might bias venture capitalist decision making? It is our estimation that we
have only begun to scratch the surface on these issues.
Heuristics Heuristics, or ‘rules of thumb’, are sub-optimal decision strategies in that the
decision maker does not fully utilize all available information (Tversky and Khaneman,
1974; Simon and Houghton, 2002). Since decision makers have limited cognitive capacity,
they rely on heuristics to conserve cognitive resources (Simon, 1981). Whereas biases
impact decision effectiveness by directing the decision maker’s attention to salient infor-
mation, heuristics provide a ‘road map’ on how and which information is used to make a
decision. Eisenhardt (1989) suggests that heuristics allow decision makers to derive deci-
sions based upon fragments of information about various attributes and alternatives sur-
rounding the decision. In other words, heuristics are mental models that make certain
information factors more salient than others. Therefore, while heuristics ‘are always
efficient, and at times valid, these heuristics can lead to biases that are persistent, and
serious in their implications’ (Slovic et al., 1977, p. 4). Hitt and Tyler (1991) add that
although heuristics ease cognitive strain, they often lead to systematic biases.
The new venture environment encourages heuristic use as entrepreneurs and venture
capitalists face information overload, high uncertainty regarding success, novel situations,
and time pressure (Baron, 1998). Baron (1998) points out that under certain contextual
factors, such as time constraints, heuristic strategies may lead to better decisions than
would occur under the rational model. Busenitz (1999) adds that speed may be critical in
an entrepreneurial environment where a new venture needs to launch while the ‘window
of opportunity’ is open. Although heuristic research has focused mostly on entrepreneur
decision making, much of it is relevant to venture capitalists as they participate in a
similar environment (Moesel et al., 2001). The underlying principle is that heuristic
effectiveness is a question of cost versus benefit (Fiske and Taylor, 1991). Is the time spent
reaching an optimal decision more valuable than the approximate decision reached by
using a time saving heuristic? Part of the answer depends on which heuristic the decision
maker is using.
Based upon Payne et al.’s (1988) categories, it is likely that venture capitalists use non-
compensatory strategies (that is they don’t evaluate all the information surrounding an
alternative when making a decision); they do not have the time, or the cognitive capacity
to use all information surrounding a proposal (Moesel and Fiet, 2001). Venture capitalists
are also likely to use an alternative versus an attribute-based approach (Payne et al., 1988)
as they typically review ventures as they are presented to them. Under an alternative
approach, the venture capitalist evaluates each proposal in isolation, typically looking to
reject the venture idea because it fails on one or more of the attributes. Since each proposal
is evaluated in isolation, the venture capitalist may be inclined to compare it to past ven-
tures. Comparing the current venture to other transacted deals is a representative heuris-
tic; the tendency to generalize from small, non-random samples (Busenitz, 1999). In the
venture capitalists’ case, they tend to compare current ventures under consideration to
deals that they have made (or passed on) in the past (Zacharakis and Meyer, 2000). While
using a representative heuristic saves time, it can lead to sub-optimal decisions in that the
decision maker generalizes from a small, non-random sample and thereby is likely to
underestimate the risk of failure (Busenitz, 1999; Keh et al., 2002). The underestimation
risk is heightened in conjunction with the recall bias in that people tend to recall past suc-
cesses and forget past failures (Dawes et al., 1989).
Venture capitalists also tend to use satisficing heuristics (Zacharakis and Meyer, 2000)
which means that as they evaluate a venture they are looking for reasons to quickly dis-
patch it as a poor investment choice. The rationale for such a heuristic is quite simple as
most venture capitalists are inundated with entrepreneurs seeking funding. Quickly
screening out deals allows venture capitalists to spend more time on other activities that
can increase returns, such as post-investment work with portfolio companies. Thus, con-
sidering the time constraints that venture capitalists face, satisficing is both efficient and
effective by enabling venture capitalists to focus their time on those ventures that have the
greatest perceived potential. The downside of satisficing and representative heuristics is
that they may lead to a ‘herding’ phenomenon (Gompers et al., 1998). Venture capitalists
may chose to invest in those ventures which are most like the ventures that other venture
capitalists have funded, such as was the case in the dot.com boom and bust. This can lead
to overcrowding in the market space with lots of ‘me-too’ competitors that damage the
overall sector dynamics and increase the failure rate within that space.
Biases Biases are those salient factors that cause the venture capitalist to evaluate situ-
ations differently by affecting which mental models are used for any particular decision
(Zacharakis and Shepherd, 2001). For example, a venture capitalist’s experience within an
industry may cause the venture capitalist to evaluate available industry information more
rigorously because s/he knows the industry well (that is industry indicators and bench-
marks); an availability bias. On the other hand, it may cause the venture capitalist to
evaluate the other aspects of the proposal less rigorously such as product and entrepre-
neur attributes. The point is that such knowledge biases the venture capitalist; the venture
capitalist evaluates or uses different mental models for this proposal than a venture capi-
talist who is unfamiliar with the industry. In other words, the venture capitalist deviates
from his/her base decision model.
Just because mental models bias decisions does not mean that they result in errors (Barr
et al., 1992). However, these biases most likely prevent decision makers from reaching
optimal solutions (in the rational model sense) because they may reduce the amount of infor-
mation and alternatives considered. The number of potential biases to any decision is enor-
mous. Table 6.1 lists several biases that affect decision making effectiveness. Only a few of
the listed biases have received attention in the venture capital literature. The others provide
an opportunity to research their impact, if any, on venture capitalist decision making.
Table 6.1 Biases to decision making
Bias Description
Availability Easy recall of well-publicized or chance events which means that
decision maker focuses more on available events in the decision
process, and neglects unavailable information
Selective perception Problems structured by an individual’s prior experience
Frequency Absolute cue frequency is used versus the relative occurrence
Concrete information Concrete data dominates abstract data
Illusory correlation Belief that two variables covary when in fact they do not covary
Data presentation Evaluation biased by sequence, presentation mode, qualitative
versus quantitative mixture, perceived display ‘logic’, and context
Inconsistency Inability to apply judgments consistently
Conservatism Failure to revise decisions when presented with new evidence
Non-linear extrapolation Underestimation of joint probabilities and growth rate
Habit Previously successful alternatives are applied to solve a problem
Anchoring/adjustment Prediction results from upward or downward adjustment of a cue
value
Representativeness Evaluation based upon a similar class of events
Law of small numbers Small samples are believed representative
Justifiability A rule can be used if it can be ‘justified’
Regression bias Predictions fail to recognize regression toward the mean
Best guess strategy Simplification and ignoring data
Complex environment Information overload and time pressures reduce consistency
Overconfidence Belief that your decisions are correct more often than is actually
the case
Emotional stress Induces panic judgments or reduced attention
Social pressures Conformity or distortion of judgments
Consistent data sources Increase decision confidence but not accuracy
Question format Judgment process requirements or choice affects outcome
Scale effects Measurement scale affects response perceptions
Wishful thinking Preferences affect the assessment of events
Illusion of control Perceived control resulting from activity concerning the outcome
Outcome irrelevant Observed outcomes provide incomplete feedback for correction
‘Gambler’s fallacy’ Higher probability of event following unexpected similar chance
outcomes
Success/failure attributions Success is attributed to skill; failure to chance
Recall fallacies Failure to recall past details leads to logical reconstruction
Hindsight bias Plausible explanations can be found for past surprises
Source: Adapted from Hogarth and Makridakis, 1981.
Overconfidence is one bias that has received attention in the venture capitalist realm.
Using a conjoint experiment, Zacharakis and Shepherd (2001) find that venture capital-
ists are overconfident (96 per cent of the 51 participating venture capitalists exhibited sig-
nificant overconfidence) and that overconfidence negatively affects venture capitalists’
decision accuracy (the correlation between overconfidence and accuracy was 0.70). The
experiment controlled for the amount of information each venture capitalist reviewed and
the type of information reviewed. The study finds that more information leads to
increased overconfidence. What this means is that venture capitalists believe more infor-
mation leads to better decisions, yet they don’t necessarily use all that information and
their overall decision accuracy is lower. Likewise, venture capitalists’ confidence increases
when they view information criteria with which they are more familiar and comfortable.
Finally venture capitalists are more overconfident in their failure predictions than success
predictions. As such, Zacharakis and Shepherd (2001) posit that overconfident venture
capitalists may limit their information search (although they believe that they are fully
considering all relevant information) and focus on salient factors (for example how similar
this deal is to a past successful deal) despite other information factors that would suggest
this deal might fail. Unlike Busenitz and Barney (1997) who suggest that overconfidence
can have positive ramifications for entrepreneurs – they will launch the venture in the
first place and then work harder to make sure the venture succeeds – overconfidence in
venture capitalists is likely to be mostly a negative in that it is overconfidence in decision
making ability and it may not lead to increased effort to help failing ventures succeed,
especially when venture capitalists often attribute failure to outside, uncontrollable events
(Zacharakis et al., 1999).
Future research opportunities on the venture capital decision process Beyond the above
studies, there does not appear to be much other work on heuristics and biases that impact
the venture capital decision process. Research on heuristics in the entrepreneurship liter-
ature, however, has focused on those used by entrepreneurs, and has relatively ignored
venture capitalists’ decision making. Although only a small number of heuristics have
received the attention of entrepreneurship scholars, there are others that may be pertinent.
We suggest these as a source of future research. Finally, heuristics can have both positive
and negative outcomes. Much more research, along the lines of Baron (1998) and
Busenitz (1999), can shed light under which conditions heuristics are better or worse.
The topic of biases has received more attention when looking at entrepreneurs’ deci-
sion making. As noted above, Baron (1998) asserts that the new venture context creates
an environment ripe for decision biases. Baron (1998) suggests that entrepreneurs are
prone to counterfactual thinking; the tendency to think about ‘what might have been’. He
proposes that entrepreneurs are more likely to regret actions not taken (for example a
missed opportunity), rather than the mistakes they may have actually made. A counter-
factual bias may also have a strong impact on venture capitalists. Anecdotally, we read
about venture capitalists who bemoan passing up investments in big winners, such as
Amazon or Google. This regret may increase the tendency to take bigger risks without
fully evaluating all the information around a venture decision because the venture cap-
italist doesn’t want to miss out again. It may also lead to chasing bubbles, as venture cap-
italists see others succeed in a particular space and feel that they need to get in there or
lose out (for example the dot.com bubble). This counterfactual thinking and any number
of the biases listed in Table 6.1 provide fertile ground for extending our knowledge of
venture capital decision making.
Future research opportunities to examine heterogeneity in venture capital decision policies

Now that the field has a strong grasp of the core venture capital decision making process,
it is time to dig into aspects that lead to variance from that core process, such as heuristics
and biases. For instance, we suspect that there are a number of demographic and psycho-
graphic factors that might lead to difference susceptibility to use certain heuristics and
biases. For example, Shepherd et al. (2003) find that experience has a curvilinear impact
on decision accuracy. After 14 years of venture capital experience, decision accuracy
declines. Shepherd et al. (2003) suggest this is likely to be due to a number of biases that
lead to venture capitalists economizing their decision process; relying more on gut feel
(Khan, 1987).
Simon and Houghton (2002) find that smaller, younger entrepreneurial firms exhibit
more biases than larger more established firms. It is reasonable to assume that size and
age factors might cause venture capital firms to act differently. For example, Gompers
(1996) argues that younger venture capital firms push ventures to IPO or other liquidity
events prematurely – called grandstanding – in order to gain credibility in the eyes of
potential limited partners when raising another follow-on fund. We propose that new
research start digging into these biases and heuristics to paint a deeper picture of the
venture capital decision process.
There is also room to examine how context affects venture capitalist biases. Einhorn
(1980) highlights a number of factors that can hinder effective decision making:
1. Information from the environment which is not clean; environmental noise disguises
information relevance;
2. feedback on past decisions which is often incomplete or distorted;
3. the relationship between decision rules and their outcomes which is frequently
non-linear;
4. placing information into an appropriate category which can be difficult due to ‘fuzzy’
category definitions;
5. the need to consider several decision rules at once;
6. decision rules which often have counterintuitive or unexpected relationships with the
outcome;
7. certain actions by that person, after the decision has been made, which influence the
outcome of his/her decision; and
8. judgments which, at times, must be made under pressure.
All of these factors are prevalent in the venture capital decision domain and create an
opportunity to assess how they impact the venture capitalist decision. For example, are
venture capitalists differently susceptible to these conditions? Are these conditions
stronger in certain industries than others? Do they differ across countries?
Conclusion
This chapter focuses on venture capitalists’ pre-investment activities, namely, their assess-
ment and investment decisions. The implications from the research to date are many. For
example, we have learned that venture capitalists are poor at introspecting about their own
decision processes (Zacharakis and Meyer, 1998). This lack of insight makes it difficult
for venture capitalists to learn from past decisions and to improve future decisions.
Moreover, it is difficult to articulate and train junior associates if the venture capitalist
doesn’t understand his own decision process. Shepherd and Zacharakis (2002) suggest
that modeling a venture capitalist’s decision process can help him gain this insight and can
also be used as a training tool. Zacharakis and Meyer (2000) find that models of the
venture capital process, or actuarial aids, improve the venture capitalist’s decision accu-
racy. They suggest that such actuarial aids can be used by junior associates to screen ven-
tures, thereby freeing up the venture capitalist’s time for other activities.
We have also called for more research into decision heuristics. Heuristics can be efficient
and effective especially for time constrained venture capitalists. Yet, venture capitalists
need to understand which heuristics they use and when different heuristics are most
effective. While a satisficing heuristic allows venture capitalists to screen proposals
quickly, strictly following the heuristic may mean that venture capitalists reject potentially
attractive deals because they fail to pass a hurdle on a relatively minor attribute. Creating
a venture ‘scorecard’ where the venture capitalist rates and records each proposal on the
attributes that they believe to be most pertinent helps ensure that venture capitalists don’t
overweight the importance of a negative evaluation on a relatively minor attribute or
underweight a positive evaluation on a relatively more important attribute. The scorecard
also creates a history that minimizes post hoc recall and rationalization biases and thereby
provides a feedback source that can help venture capitalists learn and improve their deci-
sion process (Zacharakis and Meyer, 1998).
While some research has investigated potential biases and their impact (Zacharakis and
Shepherd, 2001), more research into biases will further benefit venture capitalists. The key
implication is that venture capitalists should be aware that they, as is true for all decision
makers, are prone to biases that might lead to sub-optimal decisions. Venture capitalists
can take steps to minimize the potentially negative impact of biases. Some methods, such
as the weekly partners meeting, are built into the venture capital process (Shepherd et al.,
2003). During such meetings, a venture capitalist should articulate why they like a particu-
lar venture and the other partners should challenge some of the underlying assumptions.
This will help all the venture capitalists identify areas where they might be biased, such as
overweighting a salient attribute like the entrepreneur. Unfortunately, this meeting only
helps venture capitalists avoid biases that might incline them to back a venture that isn’t
as attractive as it seems. Venture capitalists should consider also presenting a deal that
they didn’t like and to articulate why. While it is true that venture capitalists reject far too
many deals to present all of them to the partner’s meeting, picking an occasional rejec-
tion will help them learn if they have any biases that are causing them to reject potentially
promising ventures prematurely.
In conclusion, this chapter has presented a historical perspective of research in the area
with pioneering works interviewing and surveying venture capitalists to gain deeper
insights into their reported decision policies. With more sophisticated methods, more
recent research has focused on real time methods of data collection from which decision
policies can be composed (for example verbal protocol analysis) or decomposed (for
example conjoint analysis and policy capturing). Along with the use of experiments to
decompose venture capitalists’ decisions into their underlying structure, research has been
more theory driven. Theory has been used to hypothesize which attributes are used in
venture capitalists’ decision policy and how they are used, to hypothesize differences in
decision policies across venture capitalists; and to better explain the process of con-
structing a decision policy. In a short period scholars of venture capitalists’ pre-invest-
ment activities have made great strides, but there is much still to learn. We look forward
to reading future research on this important topic.
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7 The venture capital post-investment phase:
Opening the black box of involvement
Dirk De Clercq and Sophie Manigart
Introduction
It is well documented that venture capital is a special form of financing for an entrepre-
neurial venture, in that the venture capital firm is an active financial intermediary. This is
in sharp contrast with most financial intermediaries such as banks, institutional or stock
market investors that assume a passive role. Once the latter invest in a company, they may
monitor the performance of the company periodically but they seldom interfere with the
decision making. In order to overcome the huge business and financial risks and the
potential agency problems associated with investing in young, growth oriented ventures
(often without valuable assets but with a lot of intangible investments), venture capital
firms specialize in selecting the most promising ventures and in being involved in the ven-
tures once they have made the investment. In this chapter we focus on the post-investment,
but pre-exit phase of the venture capital cycle. More specifically the principal theme of
this chapter is to provide an overview of relevant aspects and research findings pertaining
to the period after the venture capital firm (or venture capitalist) has made the decision
to invest in a particular portfolio company (or entrepreneur). We hereby focus on the
interaction between a venture capitalist and the entrepreneur, rather than on financial
events as follow-on financing rounds or exit. In essence, this overarching theme involves
two important issues that will be addressed.
A first objective of this chapter pertains to categorizing the existing literature
into research that has focused on venture capitalists’ involvement in monitoring activities
vis-à-vis entrepreneurs and research on the potential for venture capitalists to add value
to their investees. Once an investment is made, the venture capitalist monitors the entre-
preneur in order to reduce the chance that the latter appropriates the funds to pursue her
personal interests. Next to monitoring, the venture capitalist helps in the decision making,
so as to enhance value creation in the venture. In the earlier studies on venture capitalist
involvement in portfolio companies, no clear distinction was made between monitoring
and value adding, however. Research focused on understanding what venture capitalists
do (for example Tyebjee and Bruno, 1984; MacMillan et al., 1988; Rosenstein, 1988),
defining their roles and extent of involvement. Early evidence showed that there was a lot
of variation with respect both to what venture capitalists do (that is content-related) and
the extent of their involvement (that is process-related) (Gorman and Sahlman, 1989;
MacMillan et al., 1988), without explaining the difference. Subsequent research examined
the conditions under which venture capitalists become more involved in their portfolio
companies, especially with respect to variations in the characteristics of the portfolio com-
panies. For example, the impact of greater agency risk (Barney et al., 1989; Sapienza and
Gupta, 1994; Sapienza et al., 1996), business risk (Barney et al., 1989), and task uncer-
tainty (Sapienza and Gupta, 1994) on venture capitalists’ interactions with the CEOs of
193
their portfolio companies was acknowledged. More recently, research acknowledges that
the extent and impact of venture capitalists’ monitoring and value adding is not only
driven by portfolio company characteristics, but also by the venture capitalists’ charac-
teristics. The resource dependence theory, and the resource endowments of both venture
capitalists and entrepreneurs, such as their human, social or intellectual capital (for
example Baum and Silverman, 2004; Dimov and Shepherd, 2005) have been used to
explain the nature, level and effectiveness of the interaction between venture capitalists
and entrepreneurs. Recently, attention has also been paid to the nature and intensity of
venture capitalists’ involvement in different parts of the world, showing that their behav-
ior shows commonalities, but differences as well (for example Sapienza et al., 1996;
Bruton et al., 2005). In this chapter, we summarize some of the major research findings
with regard to the monitoring and value-adding role played by venture capitalists.
A second objective of this chapter pertains to highlighting recent research that has
started to open the ‘black box’ of the venture capitalist – entrepreneur relationship. More
specifically, while early research discussed how entrepreneurs can benefit from their
venture capital providers, and how venture capitalists attempt to maximize the returns
from their investments, the specific question of how value added is created between the
two parties was somewhat under-studied, both with respect to what type of information
is exchanged (that is content-related issues), and how the parties interact with one another
(that is process-related issues). In this chapter, we will therefore include the findings from
some recent research on the type of interactions that take place between venture capital-
ists and entrepreneurs. We emphasize that we will neither discuss how venture capitalists
decide to invest in a venture (see Chapter 6 by Zacharakis and Shepherd), nor what the
outcome of their monitoring and value adding activities is in terms of venture capitalists’
exit routes and investment performance, nor the return to the entrepreneur (see Chapter 8
by Busenitz and Chapter 9 by Leleux).
The chapter is structured as follows. In a first section, we compare the literature that
describes the role of monitoring and value adding in venture capitalist–entrepreneur rela-
tionships. More specifically, we discuss the research that focuses on the importance for the
venture capitalists to monitor their investments, thereby relying on the agency framework.
We also discuss the research on the importance of value added in the post-investment
process, and describe the various value-adding roles that can be played by investors. In the
subsequent section, we report the findings from research that attempts to open the ‘black
box’ of how value is added, and we focus on several issues pertaining to the content and
process of the interactions that take place between venture capitalist and entrepreneur.
With respect to content, we report research findings pertaining to the role of venture cap-
italists’ experience, the knowledge exchange between venture capitalists, and the know-
ledge exchange between venture capitalist and entrepreneur. With respect to process, we
discuss research findings pertaining to the role of trust, social interaction, goal congru-
ence, and commitment, and we show in particular how these components have been
applied to the context of venture capitalist–entrepreneur relationships. Figure 7.1 pro-
vides an overview of the different issues that are discussed in this chapter.
The role of monitoring and value added in venture capitalist–entrepreneur relationships

The early research on the post-investment relationship between venture capitalist and
entrepreneur has pointed to the undertaking of monitoring and value adding activities by
The venture capital post-investment phase 195
Monitoring
Venture capitalist Entrepreneur

Value added
Content: Process:
– VC experience – Trust
– Knowledge – Social interaction
exchange between – Goal congruence
VCs – Commitment
– Knowledge
exchange between
VC and entrepreneur
Figure 7.1 Conceptual framework
venture capitalists. Whereas these two broad types of activities overlap with one another,
and in fact may represent complementary roles, the assumption underlying these activi-
ties is quite different. More specifically, the focus on monitoring relates to venture cap-
italists’ attempt to correct potential harmful behavior by entrepreneurs, and the focus on
value added relates to venture capitalists’ attempt to increase the upside potential of their
investments. In the following paragraphs, we provide an overview of the literature on
monitoring and value added.
Monitoring and information asymmetry

Prior research has indicated that an important aspect of the venture capitalist–entrepre-
neur relationship pertains to the former’s monitoring of the latter’s actions. Monitoring
pertains to the procedures that are used by the venture capitalist to evaluate the entrepre-
neur’s behavior and performance in order to keep track of her investment (Sahlman, 1990;
Sapienza and Korsgaard, 1996; Wright and Robbie, 1998). Given their equity ownership,
venture capitalists have strong incentives to monitor entrepreneurs’ actions, as entrepre-
neurs’ and venture capitalists’ goals are not always perfectly aligned. Venture capitalists
therefore receive strong control levers, sometimes disproportionate to the size of their
equity investment (Lerner, 1995). For instance, venture capitalists often receive convert-
ible debt or convertible preferred stock that carries the same voting rights as if it had
already been converted into common stock (Gompers, 1997), or they receive a relatively
great board representation in order to allow the replacement of the entrepreneur as chief
executive officer if performance lags (Lerner, 1995).
The venture capitalists’ involvement in monitoring activities stems from the presence of
goal incongruencies coupled with information asymmetry between the two parties. First,
venture capitalists and entrepreneurs may not always have the same goals. For example,
firm survival or generating a personal income, rather than value creation, may be of
primary importance for the entrepreneur, but not for the venture capitalist. Alternatively,
venture capitalists aim for early exit, while entrepreneurs may have more long term aspi-
rations. Moreover, information asymmetries mean that the venture capitalist and entre-
preneur have access to private information that is not available to the other party. For
example, entrepreneurs often have a better insight into their own capabilities and the level
of effort they want to put in the venture, compared to external investors. Also, entrepre-
neurs often have a good insight into the nature of technological developments. Venture
capitalists, on the other hand, may have a better insight into the potential market accept-
ance and competition, given that they invest in a portfolio of companies (Cable and
Shane, 1997).
Goal incongruencies, together with unequal distribution of information, may lead to
agency problems of adverse selection or moral hazard (see hereafter). They are thus
important when both parties negotiate about establishing an investment agreement (see
Chapter 8), as well as after the investment decision has been made (Sapienza and Gupta,
1994). The presence of information asymmetry may be particularly high in the case of
high-tech investment deals in which the entrepreneur has an in-depth knowledge about
the specifics of an innovative technology. Given the information opaqueness surrounding
technological ventures and the intangibility of most of their investments, close monitor-
ing by venture capitalists is, albeit not easy, essential in order to understand the actions
of the entrepreneur (Sapienza and De Clercq, 2000).
In order to explain the impact of information asymmetry on venture capital behavior,
agency theory has been used by many early researchers as their central framework to
explain venture capitalist behavior (for example Sapienza and Gupta, 1994; Lerner, 1995;
Sapienza et al., 1996). The center of agency theory is the agency relationship in which one
party (the principal) delegates work to another party (the agent), who performs that job
as defined in a contract (Eisenhardt, 1989). Interestingly, recently researchers have argued
that both the entrepreneur and venture capitalist can play the role of ‘agent’. In the fol-
lowing paragraphs we provide an overview of this research.
Entrepreneur as agent Most early research on venture capitalist behavior has depicted the
venture capitalist as the principal and the entrepreneur as the agent (Eisenhardt, 1989;
Sapienza and Gupta, 1994). That is, from the venture capitalist’s perspective, an important
question may evolve from the question of how to ensure that entrepreneurs do not take
actions that jeopardize the venture capitalists’ chances to generate maximum financial
returns. According to agency theory, two types of agency problems may arise, that is
‘adverse selection’ and ‘moral hazard’. First, the term ‘adverse selection’ pertains to the
uncertainty the venture capitalist faces with respect to the entrepreneurs’ capabilities to
meet pre-set expectations (Eisenhardt, 1989), and therefore is an important issue in the
venture capital selection process (see Chapter 6). For instance, an entrepreneur may end
up not having the required competencies to grow her venture successfully (Wright and
Robbie, 1998). Second, and more importantly in terms of the post-investment relationship,
‘moral hazard’ problems pertain to a party’s potential shirking behavior and unwillingness
to make sufficient efforts, even if it has the capability to meet pre-set expectations
(Eisenhardt, 1989). For instance, from the venture capitalist’s perspective, there is a danger
that the entrepreneur, once she has received the money, may alter her behavior in ways that
mislead the investor. The entrepreneur, being an inside member of the company as well as
the controlling officer, has access to company information that is not necessarily readily
available to the venture capitalist (Cable and Shane, 1997). Many aspects may be hidden
from the venture capitalist, such as the actual progress of product development or even the
entrepreneur’s hidden motives for having created the company. Other examples of entre-
preneurs’ defective behavior might be their purchasing of a larger than necessary computer
for their enjoyment, charging personal trips to the company, or even activities that might
be business related (for example product decisions) but not consistent with the venture cap-
italist’s wishes (Cable and Shane, 1997; De Clercq and Sapienza, 2001).
In other words, this stream of research explains that opportunities abound for the entre-
preneur to act in a manner that increases her personal wealth or that is consistent with
her personal goals, but jeopardizes the company’s well-being, whereby the venture cap-
italist’s money is not utilized as desired. This behavior will lead then to higher costs for
the venture capitalist, since she needs to supervise and monitor the entrepreneur’s activi-
ties. One possibility for the venture capitalist to reduce moral hazard problems is by
writing appropriate contracts at the time of investment, thereby aligning the interests of
the entrepreneur and the venture capitalist (Kaplan and Strömberg, 2003). One example
is to use convertible securities, such as convertible debt or convertible preferred equity
(Gompers, 1997; Cumming, 2005). The use of staged investing, where venture capitalists
have the opportunity to withdraw from an investment and thus motivate the entrepreneur
to behave ‘honestly’, is also a commonly used method (Sahlman, 1990; Wright and
Robbie, 1998).
Given that contracts are inherently incomplete and cannot foresee all future states of
nature, venture capitalists closely monitor their portfolio companies formally by taking a
seat on the Board of Directors of their portfolio companies (Rosenstein, 1988; Rosenstein
et al., 1993), and informally through periodical check-ups of the day-to-day activities and
through interim financial reports (Gompers, 1995; Mitchell et al., 1995). Interim financial
reporting by the entrepreneur is indeed an important monitoring device, included in the
investment agreement (Rosenstein, 1988). Informal control may also include the use of
codified rules, procedures and contract specifications that specify desirable patterns of the
entrepreneur’s behavior.
The Board of Directors is the formal governance mechanism utilized by venture cap-
italists in most countries. Boards of Directors can vary widely in their size and operation,
however. There is evidence that Asian boards are, on average, larger in size, and have a
larger percentage of insiders compared to US boards, while Continental European boards
are smallest (Bruton et al., 2005). Furthermore, Kaplan and Strömberg (2003) showed
that US venture capitalists have on average a quarter of all board seats, but they control
the board in 25 per cent of their portfolio companies. Control over the board is more
common when the business risk is higher, that is when the company has no revenues yet
or when the company operates in a volatile industry (Kaplan and Strömberg, 2003).
Interestingly, it has also been found that venture capital board members are, on average,
not of better quality than other external board members, except if the lead venture capital
investor is ‘top quality’ (Rosenstein et al., 1993).
Evidence on the nature, extent and impact of monitoring activities of venture capitalists
is surprisingly scarce, however. There is some evidence that venture capitalist monitoring is
an attempt to reduce agency problems, as monitoring intensity is highest for companies with
high information asymmetries and potential agency problems. For example, companies that
just entered the venture capital portfolio and poorly performing companies are followed
more closely by venture capitalists (Beuselinck et al., 2007). Furthermore, it appears that
the agency framework may be more applicable in the context of Anglo-Saxon compared to
Continental European venture capital investments, as recent research has indicated that
venture capitalists exert more monitoring efforts in the former case than in the latter case
(Beuselinck et al., 2007). Finally, the importance of monitoring has also been discussed in
the context of venture capitalists’ syndication, that is the simultaneous investment by at
least two venture capitalists in the same entrepreneur (for example Lockett and Wright,
2001). For instance, it has been shown that lead investors exert more monitoring effort in a
syndicate than non-lead investors (Lockett and Wright, 2001). The last finding opens an
avenue of further research, namely how non-lead syndicate investors monitor the lead
venture capitalist.
Understanding the monitoring process is important not only from an academic per-
spective. From the venture capitalist’s perspective, more monitoring not only reduces
agency problems, but also entails larger costs with respect to time allocation (Barney
et al., 1989; Gorman and Sahlman, 1989; Gifford, 1997). Greater governance may
therefore not always be cost-efficient (Sapienza et al., 1996). MacMillan et al. (1988,
p. 37) already observed that ‘a relevant issue in need of examination is the opportunity
cost of [greater] involvement.’ We believe that the research to date has not yet fully
addressed the trade-off between greater monitoring and cost efficiency. Furthermore, it
is possible that post-investment monitoring by the venture capitalists may be substi-
tuted by more rigid contractual arrangements or equity control as agreed upon prior
to the investment decision (Beuselinck and Manigart, 2007). From the entrepreneur’s
perspective, more monitoring by venture capitalists increases the information produc-
tion of the portfolio firm, leading on the one hand to enhanced decision making but
on the other hand also to increased information reporting costs. Research indicates that
venture capitalist monitoring has positive outcomes for portfolio companies and their
stakeholders. It leads to the establishment of more effective corporate governance rules
in portfolio companies and subsequently to a higher quality of reported accounting
figures both in the US (Hand, 2005) and in Europe (Mitchell et al., 1995; Beuselinck
and Manigart, 2007). Venture capitalists’ monitoring effects are especially beneficial for
more mature portfolio companies. From the perspective of external parties such as
banks, employees, suppliers and customers, enhanced monitoring leads to qualitatively
improved and more extensive external reporting of portfolio companies (Beuselinck
and Manigart, 2007).
Venture capitalist as agent Alternatively, some researchers have suggested that venture
capitalists can be the agents of entrepreneurs. For instance, Cable and Shane (1997) crit-
icized the representation of the venture capitalist–entrepreneur dyad as an agency
problem, in that this framework ‘does not incorporate the possibility of opportunistic
behavior by the principal’ (Cable and Shane, 1997, p. 147). Also, Sahlman (1990) reported
that a venture capitalist is often responsible for almost nine investments and sits on five
boards of directors. Therefore, post-investment activities – such as the search for further
financing, or assistance in strategic decision making – that venture capitalists undertake
for one portfolio company, cannot necessarily be undertaken for all portfolio companies,
such that venture capitalists are often not able to allocate an optimal amount of time to
each entrepreneur (Gifford, 1997).
It has furthermore been suggested that venture capitalists are sometimes inclined to
‘under-invest’ in their portfolio companies. That is, venture capitalists often prefer to stage
their investments because this reduces the amount of money invested at the earliest stages
of venture development when investment risk is highest. This practice may not necessar-
ily be bad for entrepreneurs as it enables them to retain a higher fractional ownership. It
nevertheless poses the risk that if their venture does not develop as planned, entrepreneurs
may run out of money and be in a poor negotiation position to raise additional money
(De Clercq et al., 2006), thereby potentially facing high levels of dilution. Furthermore,
it has been argued that venture capitalists may sometimes be inclined to distribute a firm’s
profits rather than to reinvest these profits in the company as limited partners have the
right to get returns on their investments before venture capitalists can secure a profit
(Sahlman, 1990). This venture capitalist behavior can prevent an entrepreneur from bring-
ing her company to a next growth stage.
Finally, prior research has shown that some venture capitalists may seek a premature
IPO in their portfolio companies in order to gain reputation and report enhanced
performance when raising new funds. This ‘grandstanding’ behavior is more likely to
happen among young venture capitalists that want to establish a reputation in the venture
capital community (Gompers, 1996). Also, venture capitalists are inclined to take com-
panies public near market peaks, even if this is not necessarily the optimal timing for the
entrepreneurial company (Lerner, 1994).
In short, it has been argued that venture capitalists’ actions can be contradictory
to the best interests of an entrepreneur in terms of their allocation of time and effort,
re-investment decisions, or the timing of a portfolio company going public.
Concluding note Some researchers have suggested that the literature on venture capital
monitoring and its assumptions regarding information asymmetry and opportunism,
should be complemented with research that views the venture capitalist–entrepreneur
relationship from a more positive angle (Sapienza and De Clercq, 2000; Arthurs
and Busenitz, 2003). For instance, it has been suggested that stewardship theory may
provide a framework complementary with agency theory for examining the venture cap-
italist–entrepreneur relationship (Davis et al., 1997; Arthurs and Busenitz, 2003). The
starting point in this alternative approach is the identification of situations in which the
interests of the venture capitalist and the entrepreneur are aligned, and both parties
commit themselves to the development of a trustful relationship. In other words, the
application of agency theory to the venture capitalist–entrepreneur relationship may be
appropriate only when the two parties have diverging goals (Arthurs and Busenitz, 2003).
Furthermore, the fact that both venture capitalist and entrepreneur hold informational
advantages over one another may be related to the very nature of, and difference in, the
activities these parties engage in. That is, venture capitalists and entrepreneurs essentially
specialize in the development and contribution of different types of knowledge (Cable
and Shane, 1997). By virtue of their repeated experience with the monitoring of start-ups
and growing companies, venture capitalists may often have a better idea of their portfo-
lio companies’ value than the entrepreneurs themselves. Alternatively, entrepreneurs are
specialized in detecting new opportunities in the environment and combining resources

to exploit these opportunities in an original fashion (Kirzner, 1973). For instance, high-
tech entrepreneurs may possess specialized technical knowledge and skills that are
difficult if not impossible to be replicated.
Although entrepreneurs’ wish to hide negative information from their investors com-
bined with their superior insight into the viability of new technology may make defective
behavior appear to be a likely option, the wisdom of hiding information for opportunis-
tic purposes is of questionable practical value, since doing so directly threatens the via-
bility of the company itself as well as the venture capitalist’s trust and support (Sapienza
and Korsgaard, 1996; Cable and Shane, 1997). Furthermore, although information asym-
metry may lead to defective behavior, it also includes the potential for benefits to be
derived for both parties. This issue will be discussed later in this chapter.
Value adding
Whereas venture capitalists’ monitoring activities mainly focus on how venture capital-
ists can minimize potentially harmful behavior by entrepreneurs, venture capitalists may
try to increase the value of their portfolio company through value-adding activities after
the investment decision has been made. The literature on the post-investment process
starts from the dominant assumption that venture capitalists do add value and highlights
the question of how they increase the upside potential of their investments. An early
stream of research has emphasized the value-adding activities venture capitalists engage
in with respect to their investment deals. More specifically, this research has discussed the
beneficial role of the value-adding beyond financial capital that is provided by venture
capitalists to their portfolio companies (Sapienza, 1992; Fried and Hisrich, 1995;
Sapienza et al., 1996; Busenitz et al., 2004). From the entrepreneur’s point of view, the
presence of added value beyond pure financial support compensates for the high cost of
venture capitalist money (Manigart et al., 2002). Interestingly, Seppa (2002) and Hsu
(2004) showed that entrepreneurs are willing to accept significantly lower valuations and
thus face higher dilution when they expect that the venture capitalist will contribute more
to the development of their venture, more specifically when the venture capitalist has a
better reputation.
In early research on value added, all venture capitalists were treated homogeneously or,
if differences between venture capitalists were acknowledged, they were not clearly
explained (for example MacMillan et al., 1988). For example, a distinction was made
between three categories of venture capitalists, the ‘inactive’ investors, the ‘active advice
givers’, and the ‘hands-on’ investors (MacMillan et al., 1988; Elango et al., 1995), with the
latter category attaching most importance to value-adding activities. In contrast,
other research has emphasized that ‘not all venture capital is the same’, and has started
to explain the differences in venture capitalist value-adding behavior. It has been sug-
gested that the roles venture capitalists play in their portfolio companies differ depending
on the characteristics of the venture capitalist or venture capital firm itself (for example
reputation – Gompers, 1996) or of the portfolio company (for example its stage of
development – Sapienza, 1992). In the following paragraphs we give a short overview of
what we believe are two important sub-streams in the value added literature, that is
research on the ‘classic’ value-adding roles, and research on how venture capital reputa-
tion may influence venture capitalist involvement.
Value-adding roles Providing non-financial assistance to portfolio companies and

thereby improving the risk–return mix, is an essential task of a venture capitalist as a
financial intermediary (Gupta and Sapienza, 1992; Amit et al., 1998). Research consis-
tently stresses three key roles played by venture capitalists in their relationship with
entrepreneurs: (1) a strategic role as generators of and sounding boards for strategic ini-
tiatives, (2) an operational role as providers of key external contacts for locating man-
agerial recruits, professional service providers, key customers, or additional financing,
and (3) a personal role as friends, mentors and confidants (Sapienza et al., 1994).
Venture capitalists see their strategic roles as having the greatest importance (Fried et al.,
1998), their interpersonal roles as next in importance, and their operational roles as
being relatively less important to helping their portfolio companies realize their full
potential.
Interestingly, some conflicting results have been found with regard to the value added
proposition. Whereas some researchers have found support for the non-financial value
added by venture capitalists (for example MacMillan et al., 1989; Sapienza, 1992;
Hellman and Puri, 2000; 2002), other research has suggested that venture capitalists may
not necessarily add value (for example Gomez-Mejia et al., 1990; Steier and Greenwood,
1995; Manigart et al., 2002). One of the reasons for the inconsistency of findings may be
that many studies examining venture capitalist value added have a survival bias in that the
surveyed samples contain relatively more success stories (Manigart et al., 2002; Busenitz
et al., 2004).
Furthermore, it has been suggested that the value-adding intensity varies across venture
capitalists, across portfolio companies or across regions of the world. For instance, as can
be expected, venture capitalists related to a financial institution or with a financial back-
ground have been found to place more emphasis on their financial role (Bottazzi and Da
Rin, 2002). Furthermore, venture capital managers with business rather than financial
experience spend more time with their portfolio companies, and especially with com-
panies with high business and agency risk (Sapienza et al., 1996). Also, a study examin-
ing the level and nature of European venture capital involvement in their portfolio
companies found that venture innovativeness and stage had a consistent impact such that
greater value added involvement by the venture capitalist occurred for highly innovative
ventures and for early stage ventures (Sapienza et al., 1994). Finally, venture capitalists’
value adding behavior may differ depending on the part of the world and therefore the
institutional context they operate in (Sapienza et al., 1994; Bruton et al., 2005). For
instance, Sapienza et al. (1994) found that venture capitalists in the Netherlands were less
involved with experienced CEOs than anticipated, while venture capitalists in the UK
were more involved with experienced CEOs. In France, involvement varied less and did
not follow a consistent pattern. It has also been found that more value adding is provided
by American venture capital managers than by their European or Asian counterparts
(Bottazzi and Da Rin, 2002; Bruton et al., 2005).
In sum, while the literature generally suggests that venture capitalists do add value, and
that this value added is contingent upon factors related to the venture capitalist, entre-
preneur or external conditions (for example geographical region), the majority of
research to date has to a great extent treated the value-adding role played by venture
capitalists as a black box, whereby it is not clear what factors influence the degree to which
value is (potentially) added, or even whether value is added. As will be explained later
in this chapter recent research has begun to open this black box by probing the role
of content and process-related issues in fostering the creation of value in venture
capitalist–entrepreneur relationships.
Venture capital and reputation A more indirect but nevertheless important aspect of
venture capitalists’ value-adding potential pertains to their reputation, in that for the
entrepreneur the venture capitalist’s reputation may be a critical point in gaining legiti-
macy in the market place (Gompers, 1996; Black and Gilson, 1998). That is, next to
money, monitoring and value adding, venture capitalists may provide enhanced credibil-
ity to their portfolio companies, especially when they are highly respected players in the
venture capital industry. The venture capitalist’s reputation can have a positive effect on
the entrepreneur because a company backed by a venture capitalist with an outstanding
reputation may be more capable of attracting customers, suppliers and highly-talented
managers (for example Davila et al., 2003) as venture capitalist performance and experi-
ence are associated with a greater likelihood of success.
Furthermore, venture capitalists’ role as reputational intermediary may be comple-
mentary with their role as financier, monitor and provider of value added in that reputa-
tion enhances the credibility of the information that the venture capitalist provides and
therefore yields a positive signal, not only in the eyes of third parties but also of the entre-
preneurs themselves. Prior research has indeed argued that entrepreneurs are more willing
to accept the advice from highly esteemed investors (Busenitz et al., 1997; Hsu, 2004).
Interestingly, it has also been argued that venture capitalist reputation may potentially
have a negative effect for entrepreneurs. More specifically, because of the time constraints
venture capitalists are confronted with (Gifford, 1997), some venture capitalists may be
inclined to treat their own reputation as substitutes for their value-adding services. That
is, all else being equal, some venture capitalists with high reputational capital may devote
less effort to their investments compared to their less well-known rivals because they –
perhaps falsely – assume that their mere reputation will be sufficient to create value,
regardless of their post-investment effort (De Clercq et al., 2003).
For the venture capitalists themselves, reputation may be important because it gives
great market power in their ability to close attractive deals, as entrepreneurs of start-up
companies are more likely to accept a financing offer made by a venture capitalist with a
high reputation, even at lower valuations (Seppa, 2002; Hsu, 2004). Reputation also pro-
vides the venture capitalist with the ability to raise new funds and certify ventures to third
parties (Gompers, 1996). The consequences of losing a good reputation can therefore be
significant. For example, in the aftermath of the market crash in 2001, a number of well-
established venture capitalists damaged their reputation by over-investing in marginal
ventures, and subsequently were unable to raise new funds and were forced out of busi-
ness (Lerner and Gompers, 2001). Furthermore, because venture capitalist reputation is
highly valued by the market, venture capitalists attempt to gain reputations as soon as
possible. A primary vehicle for building reputation is going public with a portfolio
company because an IPO may serve as a visible (if somewhat imperfect) signal of the
venture capitalists’ prowess in selecting, developing, and cashing out of high potential
ventures (Stuart et al., 1999). Another way to build reputation is to syndicate with
respected venture capitalists (Sorenson and Stuart, 2001), which venture capitalists may
seek out of their own interest, rather than in the venture’s best interest.
Concluding note Overall, prior empirical studies on venture capitalists’ value added have
shown that both venture capitalists and entrepreneurs perceive value in active venture
capitalist presence in entrepreneurial ventures. The importance of venture capitalists’
value-adding potential has been illustrated by the fact that successful venture capitalists
have been found to use a ‘hands-on’ approach on a discriminating and exceptional basis
rather than in a universal manner, in that successful venture capitalists intervene in areas
where they believe they can make an important economic contribution to their portfolio
companies (for example Murray, 1996). However, and as mentioned earlier, despite the
empirical evidence that venture capitalist value added is an important aspect of the post-
investment relationship, the literature to date has to a great extent considered the venture
capitalist–entrepreneur relationship as a ‘black box’. That is, the notion that value can be
added is expected as ‘a fact of venture capitalist practice’, and no clear explanation is
given of how exactly value is created. In the next section, we highlight some recent
research that has attempted to focus more closely on the type of interactions that take
place between the venture capitalist and entrepreneur. In essence, two categories of issues
arise with respect to the dynamics that occur between the two parties: (1) the content of
the interactions; and (2) the process through which these interactions take place.
The role of content and process in venture capitalist–entrepreneur relationship
Content-related issues
As indicated above, venture capitalists’ active involvement in their portfolio companies
represents an important path through which entrepreneurs can benefit. In the following
section, we focus on research that has looked particularly at the role of knowledge and
learning in venture capital investments. More specifically, we discuss the role of venture
capitalists’ experience and knowledge, the importance of knowledge sharing between
venture capitalists (either within a given venture capital firm or within an investment syn-
dicate), and the communication that takes place between the venture capitalist and entre-
preneur (Figure 7.1).
Venture capitalist experience Whereas some venture capitalists may prefer to diversify
their portfolio in order to decrease their financial risk, others prefer to specialize and focus
on developing specific expertise within a given domain (for example in terms of industry
and/or development stage) in order to reduce the uncertainty embedded in their invest-
ments (for example Gupta and Sapienza, 1992; Norton and Tenenbaum, 1993; Lockett
and Wright, 1999; De Clercq et al., 2001). More specifically, it has been argued that while
financial risk management may help reduce a venture capitalist portfolio’s downside,
knowledge management may help increase its upside (Dimov and Shepherd, 2005). De
Clercq and Dimov (2003) found that investors’ specialization in terms of industry and
development stage has a positive effect on their overall portfolio performance. Venture
capitalists’ specialized knowledge may make it more difficult for entrepreneurs to hide
issues of management incompetence, misbehavior or other crucial information regarding
company performance due to the investor’s more in-depth understanding of the
company’s business. Furthermore, a positive relationship between specialization and per-
formance may also suggest that specialized venture capitalists may be more efficient in
detecting and providing adequate resources (for example potential customers, employees
or other investors) to portfolio companies depending on their particular industry and

stage of development.
Other research has suggested that the advantages stemming from investment special-
ization may be particularly strong in the case of high-tech investments. As high-tech
investments are characterized by high levels of informational asymmetry and opacity,
specialized venture capitalists may be in a better position to reduce the uncertainty
stemming from this asymmetry (Henderson, 1989). It has even been argued that the high
informational asymmetries typical for high technology investing create a competitive
advantage for venture capitalists if they decide to specialize in these firms (Sapienza and
De Clercq, 2000). Going one step further, Hurry et al. (1992) found that Japanese venture
capital investments often serve as a learning mechanism to carry the venture capitalist to
a new technology, and the success of this learning transition may take precedence over the
success of the portfolio company or the goal to produce immediate financial returns to
the venture capitalist.
In short, prior research suggests that investment specialization may facilitate the acqui-
sition of specific information by the venture capitalist, and this in turn may enable the
investor to become more effectively involved in the key decision-making processes of her
ventures. Experienced venture capitalists may thus be better equipped to detect deficien-
cies (to monitor) and to deliver sound advice (to add value) to the entrepreneur.
Interestingly, one study found that a venture capitalist’s overall experience is negatively,
rather than positively, related to how much the investor learns from a particular portfolio
company (De Clercq and Sapienza, 2005). This counter-intuitive finding needs further
investigation in terms of what some of the boundary conditions are for venture capital-
ists to learn from their prior investment experience and how exactly to apply this experi-
ence in a constructive manner toward future investments. For instance, it could be that,
in some cases, experienced investors adopt dominant logics that filter out new informa-
tion and are guilty of assuming that their experience obviates the need to communicate
with the entrepreneur or other investors (Prahalad and Bettis, 1986).
Knowledge exchange between venture capitalists In addition to the knowledge held by an

individual venture capitalist, the communication that takes place between venture capital-
ists may also play an influential role in generating positive investment outcomes. First, the
communication between investors working for one and the same venture capital firm may
be important. Venture capital firms indeed consist of several general partners and a staff
of associates who function as apprentices to the general managers (Sahlman, 1990). As the
partners and associates have to some extent varying backgrounds and skills, and each may
hold different ‘chunks’ of knowledge, entrepreneurs may benefit from investors who foster
effective communication routines with their colleagues within the venture capital firm. For
instance, intensive knowledge exchange among individual venture capitalists regarding a
particular portfolio company may give the venture capital firm as a whole broader access
to and deeper insight into knowledge that is important to assist a portfolio company suc-
cessfully (De Clercq and Fried, 2005). As such, in order for a venture capital firm to exploit
its knowledge base optimally, it benefits from combining and integrating knowledge from
among various individuals (that is venture capitalists) within the firm.
Furthermore, there is an increasing body of research that addresses the importance of
knowledge exchange that takes place within venture capital investment syndicates, that is
the cooperation between individual venture capitalists working for different venture capital
firms (Lockett and Wright, 2001; De Clercq and Dimov, 2004; Dimov and De Clercq, 2006;
Manigart et al., 2006). At a conceptual level, an important aspect of the beneficial effect
of syndication pertains to the productive interactions that may take place among syndi-
cate partners (for example Bygrave, 1987; 1988; Lerner, 1994; Brander et al., 2002). From
a knowledge perspective, there may be two principal positive outcomes resulting from
venture capitalists’ syndication. First, syndication may help facilitate venture capitalists’
selection process in that venture capital syndicates may find better investment targets than
each individual venture capitalist would find on her own (Lerner, 1994). Second, syndica-
tion may increase the venture capitalists’ value-added potential after the investment deci-
sion has been made since syndicate partners can bring complementary knowledge to the
table (Brander et al., 2002) and are heterogeneous with respect to their resources (Lockett
and Wright, 2001). That is, as different syndicate members may have different skills rele-
vant to a particular portfolio company (for example detecting new customers, filling top
management team vacancies, or bringing the entrepreneur in contact with additional
investors), investment syndicates represent a rich variety of knowledge relevant to the
entrepreneur. Interestingly, Dimov and De Clercq (2006) found a positive, rather than neg-
ative, effect of syndication on the proportion of portfolio company defaults in a venture
capitalist’s portfolio. One explanation of this finding is that once a portfolio company loses
its promise of high returns, venture capitalists involved in a syndicate may feel a lower
responsibility vis-à-vis a prior investment decision when this responsibility is shared with
other investors. This may not necessarily be a bad thing as this practice diminishes the like-
lihood of ‘living dead’ investments in a venture capitalist’s portfolio (Ruhnka et al., 1992).
In this regard, further investigation is necessary to examine how venture capitalists’ esca-
lation of commitment, that is their continued involvement with a portfolio company with
a disappointing performance, may be attenuated when venture capitalists are being part of
a group of investors (Birmingham et al., 2003).
Knowledge exchange between venture capitalist and entrepreneur Recent research has sug-
gested that venture capitalists and entrepreneurs are involved in a learning relationship,
and that both sides may play alternatively the role of ‘student’ and ‘teacher’ (De Clercq
and Sapienza, 2001; Busenitz et al., 2004). More specifically, the potential outcomes from
the relationship between venture capitalist and entrepreneur may be highest when the two
parties hold complementary knowledge that enforces the other party’s expertise and skills
(Murray, 1996). A specific manifestation of the complementarity between the venture cap-
italist and entrepreneur pertains to the parties’ undertaking of relation-specific invest-
ments, that is investments that are specifically targeted at their mutual relationship (Dyer
and Singh, 1998). Relation-specific investments by the venture capitalist for example may
be to devote considerable time and energy with an entrepreneur to learn the nuances and
potential of a specific technology. Likewise, the entrepreneur may develop and utilize
reporting procedures specifically aimed at fitting the venture capitalist’s timing and report-
ing requirements. De Clercq and Sapienza (2001) argued that both venture capitalist and
entrepreneur can benefit from such relation-specific investments since these investments
enable them to access information and capabilities not widely available in the market. That
is, the complementary skills of venture capitalist and entrepreneur can result in an
extremely potent combination that leads to enhanced learning for both parties.
In addition to the nature of the knowledge that is held by venture capitalist and
entrepreneur, effective knowledge sharing routines have to be established between the two
parties. Communication between venture capitalist and entrepreneur may occur in a
variety of formal and informal forms, such as through telephone, email, voice mail,
formal meetings and board meetings (Gorman and Sahlman, 1989; Sahlman, 1990).
When effective board knowledge-sharing routines are in place, the interaction between
venture capitalist and entrepreneur may lead to an improved capacity for both parties to
exchange and process knowledge, and this may then lead to optimal learning outcomes
(De Clercq and Sapienza, 2005). Furthermore, personal contacts outside board meetings
may allow for easier exchange of information, in that such contacts may allow the venture
capitalist and entrepreneur to learn more about the other’s idiosyncrasies and to develop
a mutual understanding of each other’s goals. Also, the employment of frequent interac-
tion routines between venture capitalist and entrepreneur enhances access to each other’s
knowledge base and increases the capability of processing complex knowledge (Sapienza,
1992). More generally, effective communication between venture capitalist and entrepre-
neur stimulates a greater understanding between the two parties, and ultimately enhances
the potential for favorable investment outcomes.
Concluding note An important aspect of how venture capitalists add value to their port-
folio companies, or how entrepreneurs benefit from their venture capital providers, per-
tains to the content of the interactions that take place between the two parties. As
illustrated in the research cited above, the knowledge held by the individual venture cap-
italist, the aggregated knowledge held by multiple venture capitalists belonging to the
same or different venture capital firms, as well as the combined knowledge of investor and
entrepreneur all play an important role in the effectiveness of venture capital investments.
Overall, the literature indicates that the knowledge-based view and learning theory are
appropriate frameworks that help explain why certain venture capitalist–entrepreneur
relationships are more effective than others. However, although the literature mentioned
above suggests that venture capitalists and entrepreneurs should work together in a com-
plementary fashion in order to more fully exploit their respective knowledge bases, the lit-
erature falls short of describing how exactly these advantages could happen. Therefore,
more research is needed on the actual activities and procedures that are maintained by the
two parties, for example, what are the specific task descriptions outlined for the venture
capitalist during and outside board meetings, or what is the content and frequency of the
feedback that entrepreneurs provide to their investors?
Process-related issues
Whereas the previous section focused on the role of knowledge in venture capital finance,
we now turn our attention to process-related aspects of the relationship between venture
capitalist and entrepreneur. We draw hereby on the increasing body of venture capital
research that recognizes the importance of establishing strong social relationships
between the two parties rather than focusing solely on behavior based on self-interest and
opportunism as advanced by the agency framework.
Various theoretical frameworks In essence, the assumptions underlying agency theory

deny the establishment of a trusting relationship between exchange partners, and the
theory is predicated on an extreme form of self-serving behavior (Eisenhardt, 1989).

Given the shortcomings related to the agency framework, alternative theories such as
game theory (Cable and Shane, 1997) and procedural justice theory (Sapienza and
Korsgaard, 1996), have been applied to the context of venture capitalist–entrepreneur
relationships. Cable and Shane (1997) argued that the relationship between venture cap-
italist and entrepreneur can be described as two parties locked together in a game, which
if successfully and rationally played together, will yield rewards greater than if appreci-
ated in a contested and untrusting fashion. The authors’ application of game theory to
venture capitalist–entrepreneur dyads is interesting in that it explains why the two parties
may be motivated towards cooperative behavior, despite their different goals. However,
this emphasis on the play of games still assumes economic gain as the exchange partners’
sole motivator, and does not take into account the principles underlying relational
exchange and trust development.
Other studies have included trust as an important construct for describing the governance
of venture capitalist–entrepreneur relationships (Sapienza and Korsgaard, 1996; Fiet et al.,
1997). The core idea of procedural justice theory is that regardless of the outcome of certain
decisions, individuals react more favorably when they feel the procedure used to make the
decisions is fair. For instance, it has been suggested that a regular provision of information
by the entrepreneur to the venture capitalist may be perceived as a fair component of the
investment agreement by the latter, which will subsequently increase the investor’s trust in
the entrepreneur. However, whereas procedural justice theory does take into account the
role of non-economical aspects in the venture capitalist–entrepreneur relationship, the
underlying assumption is still one of protection against each other’s opportunistic behav-
ior.
In the following sub-sections, we focus on recent venture capital research that has
applied a social exchange perspective for describing venture capitalist–entrepreneur rela-
tionships, and we also refer to the broader sociological and management literature from
which the application of this framework has been derived. More specifically, we will
discuss the importance of the following four process-related components of venture
capitalist–entrepreneur relationships: trust, social interaction, goal congruence and com-
mitment (Figure 7.1). The first three components represent key dimensions of the social
capital that is potentially embedded in venture capitalist–entrepreneur relationships
(Nahapiet and Ghoshal, 1998). More specifically, ‘trust’ pertains to expectations one
party has vis-à-vis the other’s behavior (relational dimension), ‘social interaction’ pertains
to the overall pattern of connections and the tie strength (structural dimension), and ‘goal
congruence’ pertains to the presence of shared interpretations between the parties (cog-
nitive dimension). The fourth dimension, commitment, reflects the relational intensity of
the cooperation between two parties, and hence represents a dimension deeper than social
capital (Morgan and Hunt, 1994). The importance of the hereafter described research on
process-related issues lies in its close connection with the role played by learning and
knowledge in venture capitalist–entrepreneur relationships (as pointed out earlier). More
specifically, prior research on social capital suggests that knowledge is essentially embed-
ded in a social context, and that knowledge is created through ongoing relationships
among economic actors (Nahapiet and Ghoshal, 1998). As such, the literature on process-
related issues provides additional insights into how the outcomes of the venture capital-
ist–entrepreneur relationship can be further enhanced.
The role of trust Given the high importance accorded to trust in the dynamics of inter-
firm relationships (Ring and Van de Ven, 1992; Zaheer et al., 1998), we discuss the role of
trust as the first process-related aspect characterizing venture capitalist–entrepreneur
relationships. The presence of ‘trust’ has for long been considered an essential determin-
ant of the performance of exchange relationships since the willingness to interact with
others is often contingent on the prevalence of trust (Ring and Van de Ven, 1992). From
a social exchange perspective, trust involves the presence of positive expectations about
another’s motives in situations entailing risk, that is, ‘to trust another party’ essentially
means to leave oneself vulnerable to the actions of ‘trusted others’ (Boon and Holmes,
1991). Although the early research in the venture capital area did not explicitly focus on
the importance of trust in venture capitalist–entrepreneur relationships, trust has gener-
ally been considered as being an important aspect of relationships between investor and
investee. For instance, Sweeting (1991) noted that venture capitalists are often quite con-
cerned with whether entrepreneurial team members can be trusted. Further, Sapienza
(1989) showed that successful venture capitalists try to build social, trusting relationships
with their entrepreneurs.
The potential value of trust in venture capitalist–entrepreneur relationships has been
argued to derive from the more effective knowledge exchange that takes place between the
two parties. For instance, De Clercq and Sapienza (2006) found a positive relationship
between the venture capitalists’ trust in their portfolio companies and their perception of
the companies’ performance. The authors reasoned that the presence of trust between
venture capitalist and entrepreneur creates a context in which both parties are willing to
open themselves to the other since the likelihood that the other will act opportunistically
is diminished.
Interestingly, there is also some evidence that, in some cases, too much trust in venture
capitalist–entrepreneur relationships may potentially have a negative side effect. More
specifically, at extremely high levels of trust there may be less need felt by the two parties
to engage in penetrating discussions and information exchange. In other words, there
may be a danger that they scrutinize the other’s decisions less (De Clercq and Sapienza,
2005). This suggests that venture capitalist and entrepreneur should be wary not to
develop a level of trust that actually reduces the intensity of processing information in
their relationship.
The role of social interaction The level of social interaction that takes place between the
venture capitalist and entrepreneur (or exchange partners in general) pertains to the social
contacts and personal relationships that exist among the parties. The notion of social
interaction is not necessarily synonymous with that of trust in that the venture capitalist
and entrepreneur may have confidence that the other will not engage in opportunistic
behavior, but that they will still interact with one another in a formal rather than infor-
mal manner. Prior research has suggested that strong personal contacts between exchange
partners may be beneficial as these contacts increase their willingness to be involved with
the other for a long period of time (Morgan and Hunt, 1994). Similarly, recent research
in the venture capital area has found empirical evidence for a positive relationship
between the extent to which venture capitalist and entrepreneur interact with one another
in social occasions and the performance of venture capitalist investments (De Clercq and
Sapienza, 2006). The rationale for this positive relationship is that thanks to strong social
contacts the investor may become more motivated in assisting the entrepreneur for
reasons different from economical ones (Zaheer et al., 1998). Social interaction between
venture capitalist and entrepreneur can also expand the nature of the knowledge
exchanged in the relationship, in that social interaction increases the transfer of complex,
tacit knowledge (Nonaka, 1994). In the venture capital context, tacit knowledge may
pertain to the venture capitalist’s ability to detect the knowledge needs of her portfolio
companies, or to the entrepreneur’s ability to detect hidden value-adding skills held by the
venture capitalist.
An implication from this stream of research for entrepreneurs is that their willingness
to develop close social relationships with their investors may affect their standing within
the venture capital community. That is, an entrepreneur’s reputation with respect to their
willingness to engage in open relationships with external partners may function as a signal
to the venture capitalist that cooperation with the entrepreneur will be efficient and
effective. Put differently, entrepreneurs may increase their potential access to additional
needed funding by building a track record of strong social relationships with investors
and other exchange partners.
The role of goal congruence Goal congruence refers to the degree to which two exchange
partners hold common beliefs regarding their relationship (Nahapiet and Ghoshal, 1998).
The notion of goal congruence, or goal incongruence, is closely related to the presence of
information asymmetry as described in agency theory (Eisenhardt, 1989). Goal congru-
ence extends the idea of economic actors’ self-interest in that it speaks to the compatibil-
ity between two parties’ vision of how their relationship will evolve in the future (Davis
et al., 1997). The broader literature on inter-firm relationships has argued for a positive
relationship between goal congruence and relationship outcomes in that higher goal con-
gruence facilitates the ability of the partners to interact effectively with one another
(Larsson et al., 1998). That is, if two parties share similar goals, they will be more moti-
vated to give the other full access to the own knowledge base because such access will
potentially help the other in better achieving the common goals.
In the context of venture capital financing, the venture capitalist and entrepreneur may
each have unique skills and capabilities, and therefore, differ in terms of their orientation,
activities and goals (Cable and Shane, 1997). Several types of goal conflict may hamper
the extent of the information exchange between venture capitalist and entrepreneur, and
the resulting poor communication may ultimately reduce the potential of the entrepre-
neur to benefit optimally from the venture capitalist’s input. For instance, a possible goal
conflict between the venture capitalist and entrepreneur pertains to the venture capital-
ist’s expectation that the entrepreneur is willing to give up her absolute independence in
order to maximize the expected shareholder wealth through corporate growth (Brophy
and Shulman, 1992). However, when the entrepreneur’s main objective is not just future
wealth maximization, but also meeting other personal needs, such as approval and inde-
pendence (Birley and Westhead, 1994), she may not be willing to provide the venture cap-
italist with useful information that would facilitate high company growth. Furthermore,
although both parties may believe to hold similar goals at the time of the investment deci-
sion, they may fail to honor their commitment to these goals in the post-investment phase
because of divergent interpretations, which may then lead to mutual disappointments and
conflict (Parhankangas et al., 2005).
From a more positive angle, high levels of goal congruence between venture capitalist
and entrepreneur should stimulate the parties’ ability to interact effectively with one
another. There is indeed empirical evidence for the existence of a positive relationship
between the level of goal similarity between the venture capitalist and entrepreneur and
the performance of the venture capitalist’s investment (De Clercq and Sapienza, 2006).
When the venture capitalist and entrepreneur share the same goals and expectations, it is
more likely that they engage in more effective communication because each party has a
better understanding of which information is important for each, and how this informa-
tion may benefit the other’s objectives.
The role of commitment Prior research has also emphasized the importance of commit-
ment for relational outcomes. For instance, research on inter-firm relationships has shown
that relationship commitment represents an important driver for success in that commit-
ted partners exert extra effort to ensure the longevity of their relationship with others, and
they engage in closer cooperation (Morgan and Hunt, 1994). In the context of venture
capital financing, the commitment of venture capitalist and entrepreneur to their mutual
relationship may manifest itself in specific behaviors that reflect the partners’ willingness
to invest highly in the relationship, that is their commitment may be reflected in their will-
ingness to undertake significant efforts (Gifford, 1997). For instance, venture capitalists
may devote more or less time and energy in consulting their network of business rela-
tionships aimed at getting specific advice for the entrepreneur. Alternatively, entrepre-
neurs may show varying efforts in reporting performance data to their investor. In
addition, the level of commitment in venture capitalist–entrepreneur relationships may
not only pertain to the actual efforts that are undertaken on behalf of the relationship,
but also to one’s identification with and feelings vis-à-vis the other (De Clercq and
Sapienza, 2006). Commitment therefore also reflects the affective or emotional orienta-
tion by the venture capitalist and entrepreneur to their mutual relationship.
Signals of commitment by the venture capitalist may increase the value that is created
in the venture capitalist–entrepreneur relationship for two reasons. First, a deep commit-
ment held by the venture capitalist vis-à-vis a particular investment can reflect itself in the
venture capitalist spending more time in executing various value-adding roles (Sapienza
et al., 1994), which may then increase the likelihood that the entrepreneur will benefit from
the venture capitalist’s assistance. Second, prior research has indicated that entrepreneurs
may be resistant to the advice provided by their venture capital providers. This resistance
may be explained by the entrepreneur’s unwillingness to give up control over her company
(Sahlman, 1990). However, when the venture capitalist shows a deep concern about and
interest in the entrepreneur’s well-being, the latter may be more likely to believe in the
loyalty and motives of the venture capitalist, and therefore be less resistant in accepting
the offered advice. It has indeed been shown that entrepreneurs are more receptive
for the venture capitalist’s advice when the venture capitalist is a highly involved member
of the board of directors (Busenitz et al., 1997). Also, De Clercq and Sapienza (2006)
found empirical support for the positive relationship between a venture capitalist’s com-
mitment to a particular investment and her perception of success of that investment.
Overall, this stream of research shows that venture capitalists benefit from convincing
entrepreneurs that they are ‘in the game’ for the long run and are willing to function as
committed insiders.
Interestingly, although there is an important advantage related to venture capitalists’

commitment, the reality does not always allow a venture capitalist to maximize her com-
mitment for each single investment. In this regard, Gifford (1997) explained that venture
capitalists face a serious time allocation dilemma with regard to the myriad of activities
they are involved in, that is devoting attention to their existing portfolio companies,
locating and closing new investment deals, and raising new funds. This author argued
that venture capitalists often economize on allocating their effort across these activities
in ways that are optimal for the venture capitalist herself, but not necessarily optimal for
the portfolio companies. More specifically, given that venture capitalists have a tendency
to devote as much time as possible to those deals that generate the majority of their
returns (Sahlman, 1990; Sapienza et al., 1994), entrepreneurs who are in the highest need
for venture capitalist advice may in fact be left in the cold. Ultimately, this conscious
choice of reduced involvement may have gruesome consequences for the individual
entrepreneur.
Concluding note An important aspect of how venture capitalists add value to their
portfolio companies, in addition to the content of the knowledge that is exchanged
between the venture capitalist and entrepreneur, pertains to the social dynamics that
take place in the interactions between the two parties. The literature suggests that
process-related issues, such as trust and commitment, may facilitate venture capitalists’
ability to aid a particular entrepreneur through an improved understanding of the entre-
preneurs’ operations and needs. That is, good relationships between venture capitalist
and entrepreneur may lead to more specific insights into how an investment deal can be
optimized, and therefore enhance the potential that the venture capitalist adds value.
Also, process-related issues may increase venture capitalists’ value-adding potential
because these issues increase the receptivity of the parties vis-à-vis the other’s input and
advice. Finally, whereas the literature cited above appeals to the intuitive notion
that venture capitalists and entrepreneurs will benefit from more trustful, socially ori-
ented, congruent and committed relationships, further examination is needed with
respect to whether in some cases close relationships may actually hurt rather than help.
For instance, it is possible that high-quality relationships may lead to groupthink in
which the scrutiny with which the two parties judge each other’s actions is diminished.
This may then potentially lead to poor decision making (Janis, 1972; De Clercq and
Sapienza, 2005).
Future research
In this chapter we have provided an overview of prior research on the post-investment
phase of venture capital investing. We first discussed the literature on the monitoring
and value-adding activities undertaken by venture capitalists vis-à-vis their portfolio
companies. We then turned our attention to the literature that attempted to better
explain the mechanisms underlying the question of how value is added in venture cap-
italist–entrepreneur relationships. Two types of issues relevant to better understanding
value-added were discussed, that is issues pertaining to the content and issues pertain-
ing to the process of the exchange relationship. In the remaining paragraphs, we give
some indications of how future researchers can further extend the literature highlighted
in this chapter.
Heterogeneity of monitoring and value-adding activities

First, future research should further elaborate on how the heterogeneity of venture cap-
italists’ monitoring and value-adding activities depends on the combination of venture
capitalist characteristics, characteristics of the entrepreneur and venture, and the institu-
tional and social environment in which both parties are embedded. More specifically, a
comprehensive framework could be developed and empirically tested in which the various
antecedents of venture capitalists’ monitoring and value-adding activities are examined
at the same time. For instance, the following venture capitalist characteristics should be
included:
● The type of investors in the venture capital fund (for example independent venture
capitalists compared to venture capitalists related to a financial institution or a
corporate),
● the structure of the venture capital fund (for example open ended versus
closed; quoted or not; the nature of the compensation of the venture capital
managers),
● the investment strategy of the venture capital fund (for example generalist versus
specialist; early stage versus later stage or mixed),
● the human capital of the (team of) venture capitalists, and
● characteristics of other investors (that is syndicate members).
Furthermore, monitoring and value-adding activities may further be influenced by

characteristics of the portfolio company and entrepreneur:
● The business or financial risk of the venture (for example level of innovation; per-
formance level, stage of development),
● the agency risk (for example depending on information asymmetries),
● the human capital of the entrepreneur (for example her general or specific human
capital),
● the complementarity and completeness of the entrepreneurial team, and
● the initial resource endowments of the entrepreneurial venture (for example intel-
lectual capital).
Finally, the institutional and social environment may have an impact on venture capital-
ist behavior. While institutional forces enforce some broad common ways of working in
the venture capital industry worldwide, specific settings and social norms and behavior in
different parts of the world mean that the US model is not universal. More research is
needed to fully understand the specific behavior of venture capitalists depending on insti-
tutional and cultural aspects of their environment:
● The development of financial markets,

● the overall level of (minority) shareholder protection,
● the legal enforceability of contracts,
● the role of government in economic life,
● the tolerance for ambiguity, and, in general, the prevailing social norms, and
● the prevailing norms with respect to inter-firm co-operation.
Content and process-related issues

Future research should also further build on the literature pertaining to how value is
added in the venture capitalist–entrepreneur relationship. It could hereby be examined in
more detail how the exchanges of specific knowledge and the process of such exchanges
affect investment outcomes. For instance, the following topics could be examined in terms
of content-related issues:
● A longitudinal examination of venture capital performance and organizational learn-

ing across a variety of portfolio companies could answer the question of how venture
capitalists are able to transfer knowledge from one venture to another. Furthermore,
a related question that needs further investigation is: at what point does extensive
communication between the venture capitalist and entrepreneur become a burden for
learning given the costs associated with extensive information processing?
● It is well-established that venture capitalists stage their investment across subse-
quent investment rounds (Sahlman, 1990). The time period in which the undertak-
ing of an additional investment round takes place may be particularly important in
terms of the intensity of the interactions that take place between the venture cap-
italist and entrepreneur. It could be examined how the nature of communication
between the two parties differs and evolves across subsequent investment rounds.
● Another topic pertains to how venture capitalists are better able than others to
create conditions and mechanisms that encourage quality interactions with their
portfolio companies. For instance, what is the importance of establishing know-
ledge-sharing routines before the initial investment is made? How can the venture
capitalist motivate the entrepreneur to provide useful inside information in a con-
tinuous and spontaneous manner, especially when the entrepreneur has not been
able to achieve pre-set performance targets?
In terms of process-related issues, the following research questions could be examined:
● What is the combined effect of various process-related factors (for example trust,
commitment) and issues related to the knowledge exchange itself (for example the
cost, intensity, frequency, openness, or variety of communication) on the learning
outcomes that are generated in the dyad. Also, what factors determine the timing
for the exchange of information. How does the quality of the venture capitalist–
entrepreneur relationship (for example reflected in the level of trust) affect the
parties’ willingness and capability to plan early on in the relationship which type of
information needs to be exchanged in the subsequent stages of the relationship?
● It could also be explored how venture capitalists commit their time across the myriad
of ventures in their portfolio. Also, how do venture capitalists divide their emotional
involvement across multiple portfolio companies based on their perception of how
well the portfolio companies have performed? Are venture capitalists always better
off by focusing their efforts on those companies with a high upside-potential rather
than on companies which just need lots of hands-on attention and guidance. Which
criteria do venture capitalists use to allocate their time optimally across multiple port-
folio companies? Also, how do the venture capitalists’ background and experience
affect how they allocate their time and resources?
Classic venture capitalists versus other investor types

Finally, whereas the primary focus in this chapter was on the classic (or institutional) venture
capitalist, as opposed to the business angel (see Chapters 12 to 14) or corporate venture cap-
italist (see Chapters 15 and 16), we believe that the literature would also benefit from com-
paring how the content and process-related issues discussed in this chapter may differ across
different investor types. In essence, classic (institutional) venture capitalists, business angels
and corporate venture capitalists represent complementary sources of finance for entrepre-
neurs, and each type of investor may have specific characteristics that reflect on the nature
of the relationship between investor and entrepreneur (De Clercq et al., 2006).
First, given that business angels tend to be more willing than institutional venture
capitalists to invest at the very earliest stages (Benjamin and Margulis, 2005), their invest-
ments may be characterized by more uncertainty. Consequently, business angel invest-
ments may provide a higher opportunity for entrepreneurs to benefit from the knowledge
provided by the investor, yet the uncertainty involved in such investments may make the
establishment of stable, trustful relationships more challenging. Furthermore, since busi-
ness angels, compared to institutional venture capitalists, may be more motivated by the
intrinsic reward of their involvement in a portfolio company and often do not have a wide
portfolio of companies, the time allocation dilemma as described above (Gifford, 1997)
may be less relevant for business angels. Also, due to the informal nature of angel financ-
ing, entrepreneurs who have angel financiers may not enjoy as many reputational benefits
as entrepreneurs who have institutional venture capitalists or corporate venture capital
investors on board.
Furthermore, the nature of possible goal incongruence between investor and entrepre-
neur may depend on the investor type. For instance, classic (institutional) venture cap-
italists (and to a lesser extent business angels) may be primarily concerned about
increasing the realizable trade value of their ventures since a substantial portion of their
compensation is based on capital gains. When harvesting is an important short-term
objective, the investor will want to collect as much information as possible that is useful
for presentation to potential buyers of the venture. However, the entrepreneur may not be
willing to provide the institutional venture capitalist with such information if she has
different goals for the company. In contrast, a relevant goal for a corporate venture cap-
italist may be to utilize the portfolio company as an external research and development
resource, or to direct the company’s research towards the mother company’s strategic
goals (Siegel, 1988). In that case, possible goal conflict between the corporate venture cap-
italist and entrepreneur may pertain more to how autonomous the entrepreneur can be in
terms of the strategic direction in which her company is going. This type of goal incon-
gruence is of a very different nature and calls for different action, which in turn presents
a further route for fruitful research.
Acknowledgement
We thank the editor (Hans Landström), Lowell Busenitz and participants of the State-
of-the-Art workshop (Lund) for helpful comments on earlier drafts of this chapter.
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8 Innovation and performance implications of
venture capital involvement in the ventures
they fund
Lowell W. Busenitz
Introduction
When entrepreneurs choose to take on venture capital funding, the life and dynamics of a
venture change substantially. One of the first structural changes to occur is the implemen-
tation of a board of directors of which the founding team usually plays a minority role
(Rosenstein et al., 1993). There tends to be a fair amount of interaction between venture
capitalists and entrepreneurs that may allow venture capitalists to intervene in various
capacities to build and protect an entrepreneurial venture. Venture capitalists may help the
venture make key links to customers and suppliers, monitor venture performance, act as a
sounding board as well as assist with strategic issues (Timmons and Bygrave, 1986;
MacMillan et al., 1989; Fried and Hisrich, 1995; Manigart et al., 2006). Research has only
begun to explore whether venture capital involvement beyond their financial involvement
adds value to the ventures in which they invest as well as the broader economic development.
One impetus for the emergence of the venture capitalist–entrepreneur relationship is
that it may enable firms to create value by the sharing of knowledge, combining or gaining
access to critical resources and decreasing the time required for a new venture to market
its products. Venture capitalists spend approximately one-half of their time monitoring
an average of nine funded ventures (Gorman and Sahlman, 1989). A venture capitalist’s
ongoing involvement with the entrepreneurial team and the venture will generally impact
on the venture in a variety of ways. Some research has found support for a venture cap-
italist’s non-financial input adding value (MacMillan et al., 1989; Sapienza, 1992) whereas
other research suggests that venture capitalists do not tend to add value (Gomez-Mejia
et al., 1990; Steier and Greenwood, 1995; Manigart et al., 2002). This chapter presses
forward with the following question: does venture capital involvement impact on venture
innovation and performance?
At least two fundamental issues are embedded in answering this question. First, in
addressing whether venture capitalists add value to the ventures in which they invest,
earlier research suggests multiple areas of venture capital involvement. For example, does
frequency of interaction between venture capitalists and the entrepreneurs that they fund
add value? Do venture capital-backed firms perform better during the IPO process? While
there are contributions that earlier research has made on this subject, I will argue that
future inquiry needs to move beyond these broad questions. More specifically, it is time
for research to press forward with governance arrangements, compensation systems, and
obtaining follow-on rounds of funding. It is argued that these areas represent promising
areas for future research and can help resolve some of the mixed results from earlier
research. It seems apparent that venture capitalists do not always add value as the research
findings seem quite mixed.
219
Second, this chapter examines the broader impact of venture capitalist investments.
The presence of venture capitalist investing should enhance the overall level of innov-
ation. Whole new industries have been reported to emerge because of venture capitalist
investments. While past research has started to probe this area, there is much work that
needs to be done here.
Finally, this chapter addresses performance issues that come with studying venture
capital funding. Given that these ventures are private firms, obtaining legitimate financial
numbers clearly represents unique challenges. Given that investors such as venture cap-
italists look to exit a venture after a season of involvement and, hopefully, growth (venture
capital exits are generally projected at approximately 5–6 years), organizational outcomes
or exit modes represent a viable metric for analyzing performance. Furthermore, venture
capital involvement often involves interactions and relationships with individuals inside
the venture, making the evaluations of both venture capitalists and entrepreneurs import-
ant. The final section explores these various measurement alternatives and addresses the
strengths and limitations of these alternatives.
This chapter will proceed in the following manner. The next section addresses activities
in which venture capitalists typically get involved with a venture and how they may help
or hinder the development of the venture. Second, we discuss the impact that venture cap-
italists have on innovation and the development of new industries. Third, we will explore
performance measurement issues as they relate to venture capital-backed ventures. In so
doing, we will address the types of phenomena being researched and the type of perform-
ance that is likely to be most appropriate as the dependent variable.
Venture capital impact on venture development

Venture capitalists are known for potentially adding value to ventures through their
knowledge and contacts to enhance supplier and customer relationships, through offering
strategic and operational advice, and helping recruit key managers (MacMillan et al.,
1989; Sapienza, 1992; Barney et al., 1996). Furthermore, venture capitalists have often
established relationships with underwriters (Bygrave and Timmons, 1992) and certify the
value of their ventures to those underwriters (Megginson and Weiss, 1991). Thus, venture
capital involvement in ventures may represent an important asset that allows for a
resource advantage in subsequent phases such as acquisitons and IPOs. In sum, the con-
tributions of venture capitalists to the ventures that they back has found positive support
(Sapienza, 1992) as well as little or no support (Daily et al., 2002). Given the mixed find-
ings from previous research, it is time to probe some new areas for future research. We
now develop research opportunities for addressing the potential impact that venture
capital involvement can have in the form of the governance oversight that they bring to
the venture, the financial accountability, the certification of venture capital backing and
managing positive exits. By addressing these issues, we seek to provide direction to future
research where venture capitalists may add value to the ventures in which they invest
through governance and reputation effects.
Governance
Some venture capital research is addressing internal governance issues in venture capital-
backed ventures (for example Amit et al., 1990; Sahlman, 1990; Bruton et al., 2000). When
the entrepreneur (for example the agent) contracts with the venture capitalist (for example
Innovation and performance implications 221
the principal) for funding, an agency problem can arise as a result of incongruent goals
and potentially different risk preferences (Eisenhardt, 1989; Bruton et al., 2000). Because
of information asymmetry and the venture capitalist’s bounded rationality (Amit et al.,
1990; 1993; 1998; Bohren, 1998), the entrepreneur may engage in opportunistic behaviors
that would benefit the entrepreneur at the expense of equity investors such as venture cap-
italists (Gompers and Lerner, 1996). Particularly in US studies, agency theory has
emerged as the central paradigm for understanding the venture capitalist–entrepreneur
relationship (De Clercq and Manigart address this paradigm more extensively in the pre-
ceding chapter).
From an agency perspective, the venture capitalist–entrepreneur dynamic does not
directly mirror the principal–agent relationship. Rather, it is more like a principal (venture
capitalist)/principal and agent (entrepreneur) relationship. In other words, while entre-
preneurs are agents of the venture capitalists (principals) who invest, they are also holders
of equity and thus principals themselves. With the onset of venture capital investments,
the entrepreneur moves from being the sole principal to a partially diluted ownership pos-
ition. With their investments, venture capitalists are eager to monitor the progress of the
venture and the performance of the entrepreneurial team, both from a moral hazard and
adverse selection perspective (Barney et al., 1989; Sahlman, 1990). Given their substan-
tial ownership stakes, venture capitalists tend to be heavily involved in governance activ-
ities such as board involvement and face-to-face interaction. Research across many
countries seem to bear this out (Sapienza et al., 1996). Consequently, venture capitalists
tend to have extensive experience in aligning the goals of managers with owners, and given
that they spend a fair amount of time monitoring firms in their portfolio, they are likely
to be able to provide greater protection compared to those ventures without venture
capital backing. On the other hand, we suspect that ventures without venture capital
backing will not be as closely monitored and will not have the same level of protection
against potential adverse selection and moral hazard type situations.
Only a few studies to this point have specifically addressed board of director and gover-
nance issues associated with the onset of venture capital investments (for example
Rosenstein et al., 1993; Lerner, 1995; Filatochev and Bishop, 2002). This is an under-
researched area that needs much more inquiry. The make-up of the board of directors in
venture capital-backed versus non-venture capital-backed ventures is proposed as a poten-
tially important area of further inquiry. For example, boards of non-venture capital-backed
firms are likely to be dominated by the founding team and perhaps associates or family
members. In contrast, venture capital-backed firms are likely to have boards where the
founding team and insiders are likely to play a much smaller role. As a condition of invest-
ing in the venture, venture capitalists typically want the right to replace members of the
existing entrepreneurial team. Should such action be necessary, this can be accomplished
by having a greater portion of outsiders on the board. Furthermore, CEO duality (the pos-
itions of CEO and Chairman of the Board held by the same individual) are likely to be far
less common in venture capital-backed firms than non-venture capital-backed firms. Both
the number of outsiders on the board and CEO duality serve as signals of power to correct
moral hazard and adverse selection issues in a venture should they arise. In sum, better gov-
ernance and board of directors should lead to greater venture performance.
Regarding the composition of venture capital-backed boards, we also expect that there
will be more homogeneity in the boards of non-venture capital-backed firms than venture
capital-backed firms. More specifically, I suspect that there is more industry experience
and more diversity in venture capital-backed boards. Venture capitalists are adamant
about moving a firm towards commercialization as soon as possible and generally want
as much experience on the board as possible. Non-venture capital-backed ventures tend
to attract ‘likes’ and more family members to their boards whereas venture capitalists in
and of themselves typically represent significant deviations from founder norms and char-
acteristics. Furthermore, an increase in the equity held by one or two members of the
founding team is likely to be associated with insider domination on the board, and the
board may be less diverse (Filatochev and Bishop, 2002). In sum, we believe that the gov-
ernance mechanisms put in place by the boards of venture capital-backed ventures will
significantly differ from those of non-venture capital-backed ventures. More importantly,
stronger governance should lead to better venture performance. These arguments lead to
the following propositions:
Proposition 1: Venture capital-backed ventures will have substantially better governance

mechanisms in place than will non-venture capital-backed ventures.
Proposition 2: Because of the repetition and skill that venture capitalists have in moni-
toring entrepreneurial ventures, there will be significantly less variance in
the governance mechanisms in venture capital-backed ventures than in
ventures with non-venture capital-backed ventures.
Proposition 3: Stronger governance mechanisms in venture firms will lead to better

venture performance.
Venture team compensation

When entrepreneurs start their ventures, compensation and pay-off issues are almost
always assumed to be at some distance into the future. Often little compensation is taken
by the founders from the venture in the early months with the assumption that their
‘sweat’ equity will be rewarded by the long-term success of the venture. Consequently,
near-term compensation tends not to be much of an issue until venture capitalists invest.
A reduction in the equity stake of the venture and the implications of needing to share
the long-term rewards of the venture are projected to create substantial compensation
issues. While it seems that this subject has received at best minimal research attention, it
is an important issue.
I first turn to the research on executive compensation as a platform into this new area
for venture capital research. Research on managerial pay has shown how monitoring and
reward mechanisms can help to align the interests of managers and shareholders (Jensen
and Murphy, 1990; Barkema and Gomez-Mejia, 1998). Furthermore, contingent pay, such
as stock options, may motivate managers differently than non-contingent pay, such as salary
and other annual cash compensations (Daily et al., 1998). The use of contingent pay mech-
anisms more closely aligns managerial incentives with those of investors because managers
have a substantial position in the firm whose value is contingent on firm performance
(Jensen and Murphy, 1990). In addition, as noted above, the presence of venture capital-
ists tends to reduce managerial equity stakes in the company. This reduction in equity own-
ership can lead to less incentive alignment for managers (Fama and Jensen, 1983).
Non-contingent pay is also a part of the compensation scheme and may be more
salient with the advent of venture capital investments. Venture capitalists can realign the
entrepreneurial team through greater use of contingent pay mechanisms. Contrary to
contingent pay, non-contingent pay is normally expected to generate managerial inter-
est in the shorter term, although the empirical evidence for the effectiveness of cash
compensation on increasing firm performance tends to be relatively weak (Jensen and
Murphy, 1990; Balkin et al., 2000). Cash compensation provides a stable income stream
and mitigates compensation-based risk or rewards (Daily et al., 1998). Thus the incen-
tive effects of non-contingent pay may not help to reduce managerial opportunism.
However, Balkin and colleagues (2000) found that non-contingent pay was positively
related to firm performance in high technology industries. In reality, too much contin-
gent pay may result in the transfer of too much risk to managers (Beatty and Zajac,
1994) such that they reduce their level of risk-taking (Gray and Cannella, 1997). This
may be a particular problem in entrepreneurial ventures. With the onset of venture
capital funding, non-contingent pay may represent a mechanism through which man-
agers can be rewarded without transferring too much risk. Furthermore, at lower levels
of non-contingent compensation, managers may feel that their income is inequitable
and not commensurate with the amount of effort and time that they expend. As a result,
lower levels of this type of compensation may encourage undesirable behavior (Kidwell
and Bennett, 1993), or the pursuit of excessive perquisites (Jensen and Meckling, 1976)
or other utility-maximizing behavior to the detriment of the firm. On the other hand,
higher levels of non-contingent pay can help soften the impact of having to give up a
significant equity stake in the venture in exchange for venture capital funding. Future
research should explore the use of compensation in venture capital versus non-venture
capital-backed ventures as well as the importance of each with the advent of venture
capital funding.
Proposition 4: Venture firms with venture capital backing will have greater protection
against managerial opportunism compared to those new ventures
without venture capital involvement as evidenced by the greater use of
contingent and non-contingent compensation.
Proposition 5: Entrepreneurs will view the giving up of partial venture equity more
favorably with higher levels of non-contingent pay.
It is also likely that compensation schemes will affect the performance of venture
capital-backed ventures. Greater contingent pay helps to soften the impact of decreased
equity that entrepreneurs are likely to feel with the advent of venture capital funding,
leading them to work harder for the overall well-being of the venture. Contingent pay
in the form of stock options is also likely to increase long-term venture performance.
While the equity portion of entrepreneur ownership contracts with venture capital invest-
ments, the availability of stock options potentially increases their stake in ownership.
Proposition 6: Greater use of both non-contingent and contingent pay in venture

capital-backed ventures will increase the long term performance of the
venture.
Reputation and certification

Since entrepreneurs usually start firms in turbulent environments with an unproven product
market, a great deal of uncertainty typically surrounds these ventures. Furthermore, there
is usually little or no historical information giving a venture little or no ‘track record’ on
which to base future projections. It is in this type of context that venture capitalists have the
potential to add to the stature and credibility of a venture. Megginson and Weiss (1991)
examined venture capital backing in IPO firms and found that their presence lowered both
underpricing and the gross spread paid to underwriters. Dolvin (2005) also found support
for the certification hypothesis with IPO firms, as venture capital-backed firms had lower
issuance costs, increased upward price adjustments, and shorter lock-up periods. Dolvin
also found support for venture capital certification among penny stocks.
While this prior research on certification in the IPO process is helpful, venture capital
certification may also have implications in the earlier days of a venture. Venture capital
involvement and certification may make it easier for the venture to establish a relationship
with critical buyers and suppliers, obtain additional financing, and develop a better
reputation with external constituents. Given the importance of credible commitments
(Williamson, 1983; 1991), we argue that the presence of venture capital investments and
positions on the venture board of directors will serve in this manner. For example, venture
capitalists will not want to harm their reputation in the industry of the new venture (Amit
et al., 1998) and will take steps to improve any difficulties between transacting parties. This
in turn will act to reduce the potential transaction costs (Williamson, 1985) for the parties
involved, and will provide additional benefits for the new venture. Thus, we should expect
to see greater efficiency, especially as it relates to governance costs (Williamson, 1991) in
venture capital-backed firms.
Proposition 7: Venture capital-backed ventures will have higher levels of credible com-
mitments with transacting parties such as buyers and suppliers than non-
venture capital-backed ventures.
We also suspect that venture capitalists will have a significant effect with follow-on
investors. Given that venture capitalists typically invest in stages or rounds providing
enough money for venture firms for roughly a year before additional financing is needed,
follow-on investors are critical. The amount of financing needed in subsequent rounds
usually increases and if credible investors have been involved in earlier rounds and they
continue to support the venture in subsequent rounds, this sends a positive signal and par-
tially certifies the venture as a credible investment for follow-on financing. On the other
hand, non-venture capital-backed ventures are likely to have to find a whole new set of
investors. This is almost always a very time consuming process.
Proposition 8: Once venture capitalists have invested in a venture, the entrepreneurs will
spend less time obtaining subsequent rounds of financing than non-
venture capital-backed ventures.
Reputation and certification characteristics are also likely to lead to performance

effects. When quality venture capitalists invest in a venture, this will add to their reputa-
tion in a positive way, thus enabling the venture to develop alliances and relationships with
higher quality firms. The enhanced reputation is also likely to allow the entrepreneurs to
spend more time on their own ventures instead of making and further establishing con-
tacts. These issues should have positive effects on venture performance.
Proposition 9: Venture capital-backed firms will have better reputations leading to

higher venture performance.
Concluding remarks
One of the longest standing assumptions in the research literature on venture capital
involvement is that they add value to the ventures that they invest in. Unfortunately,
empirical findings have been quite mixed thus far. This does not mean that venture cap-
italists do not add value and that researchers should stop examining this area. Rather, the
essence of the above arguments is that we need to focus our research in the areas argued
above. I have developed arguments for more specifically examining governance arrange-
ments, the compensation of founders and the top management teams as well as the repu-
tation and certification implications of venture capital funding. More focused research
should enable us to better address this critical issue.
Venture capital impact on innovation

With venture capital backing as an alternative becoming more common across the globe,
it is often assumed that the presence of venture capital investments is an important con-
tributor to the advancement of innovation and even economic development. The major-
ity of the employment growth of even the most developed economies is coming from
smaller and start-up firms, and much of this growth involves technological innovations
(Tyebjee and Bruno, 1984). Venture capital is a common source of funding for these ven-
tures that have high-growth potential (Bygrave and Timmons, 1992). However, we still
know very little about the impact that venture capitalists have on the ventures they back
individually as well as the more collective impact. This section examines exploration and
exploitation at the firm level as well as the development of new industries and how venture
capitalists impact these issues.
Exploration and exploitation

Venture capital funding is often closely linked with the pursuit of innovative technologies,
with this probably being particularly true in the US. Of course innovation can occur in
larger corporations as well as in smaller firms without venture capital funding, but venture
capitalists are almost always associated with the funding of innovative ventures. The
involvement of venture capitalists in such ventures stems at least in part from the issue
that newer technology-based ventures have few funding sources since they do not have an
established financial history nor fixed assets on which to anchor their funding. Venture
capitalists also invest with a relatively limited time frame. Successful exits (IPOs or acqui-
sitions) have to be anticipated within about five years to be considered for venture capital
funding because of the funding cycle of their own limited partners. So while they tend to
prefer innovative ventures, they are also very much concerned about their own returns and
the quick commercialization or exploitation of the innovations that they are funding. By
exploitation, we have reference to implementation, efficiency, production and market
development (March, 1991; He and Wong, 2004).
The development of the exploration and exploitation literature has shown that these two
approaches to learning and organizational growth can be quite different. The strategies,
capabilities, organization structures, organizational cultures and the like tend to be quite
different for the pursuit of exploration versus exploitation. For example, exploration is
associated with organic and loosely coupled systems, emerging markets, flexibility and path-
breaking strategies (Brown and Eisenhardt, 1998). Venture capital backing is virtually syn-
onymous with high growth potential ventures, and consequently, with innovative technol-
ogy seeking to be exploited in the market place. This raises an interesting question: does the
pursuit of exploitation when the venture was founded on an innovative idea and has explor-
ation competencies, really enhance the value of the venture or does it pressure a venture to
seek capabilities in areas that they will never be able to sufficiently obtain? It might be that
moving from exploration to exploitation may create a conundrum for the venture firm.
While venture capitalists mostly prefer to invest in technology-based ventures pursuing
an innovation versus an imitator strategy, there is some variance in the stage1 of the venture
at which venture capitalists start to get involved (Hellmann and Puri, 2000). Venture
capital funding also tends to accelerate the time a venture takes in getting their product to
market. In a similar study, Timmons and Bygrave (1986) found that venture capitalists
seem to be increasingly interested in funding highly innovative technology ventures versus
less innovative technology ventures and that their returns on the highly innovative tech-
nology ventures tended to be superior. By extension, venture capital funding may also lead
to significantly higher patenting rates (Kortum and Lerner, 2000). Without patenting, the
product may be threatened as it seeks to move quickly into the marketplace. These find-
ings indicate that venture capitalists tend to favor innovative ventures as is widely perceived
but there is variance on this. In a study of venture capitalists across Austria, Germany and
Switzerland, Jungwirth and Moog (2004) found that venture capitalists did vary in their
preference for investing in technology-based firms. Venture capital firms that were pursu-
ing a generalist strategy tended to invest in lower technology firms while those venture cap-
italists pursuing a specialist strategy preferred to invest in high technology firms.
On average, the evidence seems to link venture capitalists with technology-based ven-
tures. However, that does not mean that they prefer to back exploration. While ventures
pursuing such innovation often hold the most promise, it appears that most venture cap-
italists tend only to get involved in the later stages where capital requirements are quite
large and the distance to successful exits and pay-offs is quite narrow. However, if the
opportunity is at too great a distance (roughly five years), they are unlikely to pursue
it. Therefore, I argue that venture capitalists are much more likely to be interested in
technology-based ventures with exploitation and commercialization already starting or
close at hand. If the innovation still requires much work and substantial time before
exploitation can be pursued, most venture capitalists will tend to pass on the investment.
Most of the exploration will tend to have already been accomplished. This leads to the
following proposition:
Proposition 10: Venture capitalists tend to invest in technology-based ventures that

either have or are ready to develop an exploitation strategy.
Consistent with the above proposition, I argue that venture capitalists, on average, tend
to be best at helping firms transition from exploration to exploitation. While ventures
often start with exploration, developing exploitation strategies is likely to be critical for
long-term success. In this sense, they may need to become ambidextrous or multi-faceted
in their capabilities (He and Wong, 2004). Most organizations struggle with transitions
and change. Newer and smaller organizations tend to do it better than anyone else but
they can struggle as well. The infusion of venture capital funding along with more intense
board involvement that is typically associated with outside funding comes with an infu-
sion of added human capital assets in addition to other changes and dynamics. The net
effect is that venture capital funding may well bring with it a growing ability for ventures
to pursue exploration issues more quickly.
Proposition 11: Ventures receiving venture capital funding will make the transition to
the exploitation stage more quickly than non-venture capital-backed
ventures.
In going a step further, we again suspect that there will be performance implications.
Venture capital backing brings with it the urgent need to move ventures towards com-
mercialization so that a successful exit can be obtained within 5–6 years. Furthermore,
venture capital involvement can bring with it the ability and attention to the skills associ-
ated with commercialization. These issues lead to the following proposition:
Proposition 12: Ventures receiving venture capital funding will become profitable faster
and move towards successful exits sooner than non-venture capital-
backed ventures.
Development of new industries

Given that venture capitalists often invest in the commercialization of technological
innovation, they are often credited with being central to the development of entirely new
industries. Bygrave and Timmons (1992) and others have discussed their involvement in
the development of the biotechnology, hard disk drives, relational databases, worksta-
tions and minicomputers, to name a few. Von Burg and Kenney (2000) have explicitly
studied the role of venture capitalists in the development of the local area networking
(LAN) industry. In sum, the default assumption seems to be that venture capitalists are
intimately involved with the development of entirely new industries. Without venture
capital involvement, these industries would not have developed.
In their in-depth study of the development of LAN networks, von Burg and Kenney
(2000) carefully chronicled venture capital involvement in the early stages of this indus-
try. At one point very early in the development of this industry, a venture capitalist actu-
ally became involved in helping to write a business plan (venture capital involvement at
this level is the exception and is probably even less likely today than it was 25 years ago).
However, they had a very difficult time finding other venture capitalists to collaborate in
the investment, a requirement of most venture capitalists. Most venture capitalists ‘could
not envision the economic space and could not believe that a startup could construct such
a market’ (p. 1142). It was noted that virtually every venture capitalist in the world was
contacted with little success. While the von Burg and Kenney article notes that several
venture capitalists ultimately did invest in the venture, it was rejected by the vast major-
ity of venture capitalists.
On average it seems that the venture capitalists are extremely reluctant to get involved
in funding new ventures that are not a part of an industry that is perceived to be devel-
oping. While venture capitalists are often characterized as investors who pursue
risky opportunities, such opportunities seem to be true to the extent that the risk can be
managed and minimized. When there are no industry benchmarks, no established
ventures in a specific industry and there is no clear market, most venture capitalists seem
to be very reluctant to pursue such opportunities. An exception has been the online
grocery business where venture capital invested hundreds of millions of dollars in the late
1990s and very early 2000s. Here venture capitalists invested in an industry that was
clearly ahead of its time. Given the tight networks that venture capitalists are typically
involved with, they will tend to be persuaded by fellow venture capitalist decisions and a
‘who is investing where’ mentality. This herding influence and the syndicated investment
approach is constructive for minimizing risk (Gompers and Lerner, 2000), but it does not
contribute to the pursuit of ‘new industry’ type investments. This conclusion leads to the
following propositions:
Proposition 13: Venture capitalists tend not to make investments in ventures that are in
unproven industries.
The risk associated with new ventures is one of the critical factors that outside investors
consider. A solid entrepreneurial team is one of the most important factors in obtaining
venture capital funding because an experienced team is believed to be able to mitigate at
least some of the risk that a venture is likely to encounter (for example Komisar, 2000;
Timmons and Spinelli, 2004). Drawing from the von Burg and Kenney study, it seems that
only when a venture capitalist has had a unique experience with a linking technology or
has a special relationship with the entrepreneurs involved will they ever consider invest-
ing in a start-up in a new industry.
Proposition 14: When venture capitalists do invest in new industries, it will likely be
mediated by the strength of the entrepreneurial team and their experi-
ence with previous start-ups in related technologies.
Counter to the assumption that venture capitalists regularly help develop new indus-
tries is the possibility that venture capitalist investments are sometimes counterproduc-
tive. The venture capital community is widely regarded as tightly knit with investments
commonly occurring in syndicates (Lerner, 1994). Furthermore, venture capital invest-
ments typically occur in cycles based on the financial markets (number of successful IPOs
and capital inflow to venture capitalists) as well as by which industries are in an aggres-
sive growth phase. Given venture capitalists’ interest in investing in ‘hot’ deals and the
herding behavior (Gompers and Lerner, 2000) that can so easily occur given the tighter
circles that venture capital tend to run in, I suspect that venture capitalists often over-
invest in some industries and this over-investment comes after it has become evident that
a given industry is indeed emerging. For example, there were multiple venture capital
investments in the computer disk drive industry prior to a shakeout in the market occur-
ring, and many venture capital investments came up short. It seems that once an indus-
try starts to emerge and it appears to be a major growth area, venture capitalists tend to
over-invest in a specific market with capital rather than pull off and look to fund the next
industry in the nascent stage.
Proposition 15: Venture capitalists make investments in industries after it becomes

evident that it is a growth area.
Proposition 16: Venture capitalists invest in new industries only after a top venture cap-
italist has decided first to invest.
Proposition 17: Venture capital investments made in new industries will be negatively
related to venture capital firm performance.
Concluding remarks
Venture capitalists have a widespread reputation of funding risky ventures generally stem-
ming from technology. While venture capitalists are often credited with starting new
industries, this rarely seems to be the case. On average, it seems much more accurate to
say that venture capitalists help to finance newer industries that are on the rise and
showing promise but are rarely involved in funding ventures that actually give birth to an
industry. It tends to be only after it becomes evident that a given technology is viable and
that it holds great promise in the marketplace that venture capitalists tend to get involved.
It appears that one of the greatest places that venture capitalists can add value to the ven-
tures that they back and to the development of newer innovations, is by funding ventures
that are ready to exploit their innovations and helping to move the venture into these new
territories. It is not easy for any organization to transition from one phase into another
or to become ambidextrous. Furthermore, economic development in today’s world fre-
quently involves having a global awareness, if not presence. Most entrepreneurs and
founding teams in themselves are unlikely to have the vision and capabilities to appropri-
ately expand firms beyond the exploration phase. Venture capitalists can provide the
impetus for such transitions.
Measuring venture performance

To this point, this chapter has discussed venture capital involvement in the ventures that
they fund along with the broader impact that venture capitalists have on venture devel-
opment and innovation. Furthermore, arguments and propositions have been developed
regarding the potential performance effects that these various dimensions are likely to
have on venture firms. The intent has been to constructively push forward an agenda for
future research. However, one of the major challenges of research regarding venture
capital involvement is data collection, and particularly the measuring of firm perform-
ance. Measuring firm performance in a way that accurately represents the development
and life of the firm is a substantial challenge as reflected by various discussions in the
strategy literature (see Barney, 2001, for a review).
The measurement of performance in entrepreneurial firms is compounded by several
additional issues. First, performance indicators vary substantially across the industries of
start-up firms. For example, ventures in the bio-technology industry rarely show any sales
until the firm is 5–10 years old, often after it has gone public or is acquired. Second, private
firms are typically very reluctant to disclose objective financial information that publicly
traded firms are required to do. Unless private ventures are required by law (as is the case
in Canada), it is highly unlikely that private entrepreneurial ventures will disclose accurate
financial indicators of firm performance. Third, there is substantial variation in the way
accounting data are recorded (while this is also true for publicly traded firms, it is even more
so for newer entrepreneurial ventures). Accounting for all these differences in the way these
data are recorded and then used for empirical research represents a substantial challenge.
Given these issues, collecting meaningful data for venture capital-backed firms represents a
substantial challenge for future research (Chandler and Hanks, 1993). The purpose of this
section is to address some of the alternatives and challenges of measuring the performance
of venture capital involvement and the investments that they make. Different types of per-
formance indicators will be discussed along with their potential for future use. The various
performance measures along with their advantages and challenges are summarized in
Table 8.1. This section does not deal with IPOs and publicly traded firms where perform-
ance data is much more widely available. Rather, addressing the strengths and limitations
of performance data of publicly traded firms reaches beyond the scope of this chapter.
Accounting measures of performance

In thinking of performance, one typically first thinks of common financial measures
involving growth in sales and revenue. A variety of financial measures and ratios have
been developed with return on sales, return on equity and return on income being of the
most common. Given that there are biases that come with each accounting measure, more
than one indicator of performance is often encouraged so as to correct for firms that
operate with relatively low levels of capital or whose sales are not likely to reflect the true
growth and value of the firm for years to come. The typical limitations and shortcomings
of these accounting measures become particularly problematic in entrepreneurial ven-
tures. For example, many innovative ventures do not experience their first sales until years
of research and testing are completed. Similarly, some ventures tend to be very capital-
intensive while others are not creating substantial disparity in measures reflecting finan-
cial equity. Given these issues, it is not surprising that I was unable to locate any studies
of venture capital firms or the ventures that they back (pre-IPO) using accounting meas-
ures of performance.
Subjective measures of performance

It seems that the most common type of performance measure used in venture capital
studies involves subjective measures where entrepreneurs or venture capitalists (or both)
respond to questions with Likert-type scales to indicate their own evaluations of the
venture and the venture capitalist–entrepreneur relationship. The advantage of these
types of measures is that they can at least start to capture some of the depth and richness
of the relationship. Furthermore, self-report measures of performance should allow for
better comparison of ventures across industries. Of course, as noted in Table 8.1, prob-
lems and biases exist with such measures and I suspect that it is very challenging to get
research with such measures published in top-tier journals without at least some data col-
laboration from additional sources.
In their study of subjective measures of performance, Chandler and Hanks (1993) found
that (1) venture growth and (2) business volume measures have the best in terms of relevance,
availability, reliability, and validity. Furthermore, they were found to be superior to measures
Table 8.1 Performance measurements in venture capital-backed ventures
Performance
Measures Characteristics Advantages Challenges Examples
Entrepreneur and/or • Case studies. • Can capture relationship • Generalizability issues. • Steier and Greenwood
Venture Capital • In-depth interviews. • depth and intangibles. • Addressing multiple • (1995)
Evaluations • Exposes the richness of • performance measures • von Burg and Kenney
(small numbers) • multiple dynamics. • simultaneously. • (2000)
• Addresses the • Communicating the • Ruhnka, Feldman and
• multi-dimensional nature • complexities of • Dean (1992)
• of performance. • performance in a
• meaningful manner to the
• research community.
Entrepreneur and/or • Large scale surveys. • Can capture relationship • Hindsight bias. • Tyebjee and Bruno (1984)
Venture Capital • Development of • depth and some • Performance is usually • Amit, Brander and
Evaluations • performance scales. • intangibles. • measured cross- • Zott (1998)
231
(large numbers) • Exposes the richness of • sectionally. • Sapienza (1992)
• multiple dynamics. • Hard to obtain venture • Wang and Ang (2004)
• Rigorous measurement of • capital and entrepreneurs’ • DeClercq and
• specific constructs. • perspectives simultaneously. • Sapienza (2006)
• Accommodates large • Performance is still
• number of statistical • cross-sectional.
• analysis.
Venture Outcomes • Since venture capitalists • A positive venture • Hard to control for all the • Busenitz, Fiet and
• investments demand • outcome is the ultimate • intervening factors to • Moesel (2004)
• exits to satisfy their own • goal. • influence a venture over • Manigart, Baeyens and
• investors, a change in • Tracks definable events • time. • Van Hyfte (2002)
• organizational ownership/ • over time. • Specific outcome types • Dimov and Shepherd
• form is very typical. • Longitudinal in nature. • (IPOs and mergers) are • (2005)
• The four most common • not equal. For example,
• outcomes include: out- • there are good and bad
• of-business, still-private, • acquisitions.
• acquired, and IPO.
Performance
Measures Characteristics Advantages Challenges Examples
• The seasonality of the
• IPO market alters the exit
• types over time.
Accounting • Financial returns • Common performance • The meaning of financial • There are several
Measures of • produced by venture • language. • returns. • studies that use private
Financial • capital-backed ventures: • Can look at the venture • Accuracy of reports are • data from Venture
Performance • Return on sales, return • capitalist–entrepreneur • self-report and can be • Economics (e.g. Kaplan
• on investment, return on • relationship over time. • misleading. • and Schoar, 2005),
• equity, etc. • Financial snap shots can •• but this data seems to
• be misleading. • have very limited
• Data tends to be very • accessibility.
232
• hard to get from these
• mostly private venture
• capital firms.
Venture Capital • Examines the combined • Provides feedback on the • Performance in the • Gompers and Lerner
Fund Returns • returns for specific • outcomes of ventures • industry tends to be very • (1999)
• venture capital funds. • across multiple • cyclical.
• investments. • Data tends to be very hard
• Helps identify the ‘top’ • to get from these mostly
• venture capital firms / • private venture capital
• those ventures that are • firms.
• consistently making • Such data does not
• better decisions. • distinguish between lead
• and co-investors’
• approaches.
that captured respondents’ satisfaction with performance and performance relative to com-
petitors’ scales. Measures of growth that have broad appeal and meaning include growth in
market share, cash flow and sales. Measures often used to measure business volume include
earnings, sales, and net worth. A study addressing the determinants of venture performance
used these measures of performance (Wang and Ang, 2004). Others such as DeClercq and
Sapienza (2006) have adjusted and developed their own subjective measures of performance.
In spite of the limitations of subjective measures, ongoing research using such measures
seems to provide a legitimate window into the performance of privately held ventures.
Venture outcomes as measures of performance

A unique opportunity that comes with the study of venture capital-backed ventures is the
pending change in firm status. Venture capitalists virtually always invest with a successful
exit strategy clearly in mind and a 4–7-year time horizon (venture capitalists are typically
committed to returning to their limited partners their principal and earnings within 8–10
years). With ventures that are successful, the exits typically take on the form of an IPO or
an acquisition. Ventures that are not successful typically end up in bankruptcy and
closure or they squeeze out a meager existence from which the venture capitalists at some
point divest themselves (typically referred to as ‘living dead’). By example, Busenitz et al.
(2004) used IPO, acquisition, living dead, and out-of-business as four distinct categories
as their performance variable. More recently, Dimov and Shepherd (2005) contrasted IPO
firms with those that went bankrupt as their dependent variable. This performance
measure shows particular promise because venture capitalists invest with an exit in mind
and a limited time horizon.
While these outcomes provide four relatively clear and observable changes in organ-
izational status, they are not without some caveats. The IPO market is clearly cyclical, with
sometimes only the best of the best going public like in the early to mid-2000s. At other
times, as in the late 1990s, some relatively poor performing ventures were able to go public.
The IPO cycles undoubtedly impact the variance of the value that is placed on the acqui-
sitions. Furthermore, variance in the value of an acquisition can be quite mixed since
occasionally such an exit can be used to liquidate a venture. In an overall sense, venture
outcomes hold much promise for future venture capital-based research. Furthermore,
there are ways to potentially improve on acquisition outcomes being sharper and more
representative of positive or negative exits.
Concluding remarks
In sum, performance measures for venture capital-backed ventures are critical for future
research to make progress in advancing our understanding of this critical area. While per-
formance measures are virtually always a challenge in business research, they represent
some unique challenges in entrepreneurship and venture capital research. There is clearly
no one right answer to this dilemma, although venture outcomes, as discussed above, rep-
resent a particularly encouraging approach. Furthermore, future research should seek to
use multiple measures of performance wherever possible.
Note
1. Venture capitalists invest in what is widely known as stages: seed, start-up, first round, second round,
mezzanine, and so on. While venture capitalists do invest in all the rounds with some even specializing in
early-stage or later-stage funding, venture capitalists on average are increasing the financial size of their
rounds of funding and generally moving towards later rounds. This chapter assumes the average position
while considering the differences in the various stages (for example Manigart et al., 2006).
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9 The performance of venture capital investments
Benoit F. Leleux
Introduction
Venture capital is an interesting industry in which at least 75 per cent of the players you talk to
are top quartile performers . . .
This tongue-in-cheek reference by a leading institutional investor (who preferred to

remain anonymous) points not only to many venture capitalists’ tendency for self pro-
motion but also to a more fundamental issue the industry has struggled with since its
inception, namely the best metrics to use to report its financial performance. The issue has
proven a very difficult one to tackle by the academic and the professional communities
alike, due to a unique combination of factors such as: (1) the basic difficulties in valuing
venture capital investments (mostly minority stakes in restricted stocks of early stage,
technology-rich companies), which test the limits of standard valuation techniques;
(2) IRR-boosting cash flow management techniques, such as the progressive drawdown
of the fund commitments; and (3) the very private nature of the industry, where reported
numbers are often aggregations of self-reported rates of returns.
In this chapter, we offer to review the documented drivers of venture capital perform-
ance and the issues related to financial metrics in the venture capital industry, offering a
critical perspective on the limitations inherent in the system. The ultimate objective is to
develop a grounded understanding of the performance dilemmas in the venture capital
industry, more than it is to ‘explain’ variations in performance. While no comprehensive
study exists to ‘explain’ fund performance, a growing body of evidence points to key
drivers, both endogenous and exogenous.
Performance in venture capital: a four-level approach

The literature on the drivers of venture capital fund performance has been relatively
scarce, partly due to the difficulty to access the fund-level data, which is normally only
provided to limited partners in the funds and, partially, to national venture capital asso-
ciations. On the other hand, a rich literature has developed to examine the performance
of venture capital-backed companies, as well as the determinants of successful venture
capital investing, including the structural conditions in which it would thrive and the ben-
efits as seen from the entrepreneurial perspective.
We use four complementary approaches to address the performance issue. First, at a
micro (deal) level, we review the literature on key drivers of venture capital performance.
This literature focuses mostly on how venture capitalists add value to entrepreneurial ven-
tures. Second, we take a fund-level perspective and investigate the evidence regarding per-
formance there. Third, we take a macro perspective (industry level) and review the
evidence as to actual aggregated industry performance. Finally, we review generic issues
with performance measurement in the venture capital context.
236
The performance of venture capital investments 237
The key messages in the critical review fall into three categories. First of all, the nature
of the industry, and in particular the types of deals done, puts severe constraints on the
very ability to measure value creation and hence performance over time. These factors are
ingrained in the mesh of the industry, and thus to be taken as invariable. Second, struc-
tures have emerged to deal with the nature of the deals, themselves contributing to the
variability of the returns. Finally, while the limitations inherent in performance reporting
in this context are material, they do not prevent an efficient functioning of the industry.
An expected contribution of this chapter is to highlight the conditions precedent to indus-
try practices and hopefully to provide a solid basis for the necessary interpretation of the
numbers provided by the industry. This re-balancing of expectations is a pre-requisite for
a healthy, sustainable venture capital industry.
Value drivers in venture capital deals

The largest part of the venture capital literature actually investigates key drivers of per-
formance in venture capital-backed deals. We separate the presentation into three cate-
gories: (1) venture capital-controlled investment factors; (2) environmental factors; and
(3) decision making processes.
Venture capital-controlled investment factors
Deal flows, screening and syndication Rigorous company and investment selection
processes, including proprietary deal flows, deal flow quality and quantity, screening and
syndication abilities are said to impact the performance of funds positively.
Birkshaw and Hill (2003) support the view that syndication may allow investors to make
decisions regarding investments based on multiple judgements by other parties, thereby
(potentially) enhancing the accuracy of screening through the incorporation of greater
experience and impartiality into the process. Corporate venture units may be able to more
greatly diversify their risk by utilizing co-investment tactics for a defined amount of finan-
cial investment. Active participation in a community of investors may allow corporate
venture units to avoid problems of adverse selection and to attain access to an enhanced
deal flow. Involvement in a community of investors may provide a corporate venture unit
with the opportunity to search more distant knowledge domains with reduced transaction
costs, thereby accessing a greater volume of novel investment opportunities.
Hochberg et al. (2004) show that venture capitalists tend to syndicate their investments
with other venture capitalists rather than investing alone. Once they have invested in a
company, venture capitalists draw on their networks of service providers – head hunters,
patent lawyers, investment bankers and so on – to help the company succeed. The two
main drivers of venture capital performance are the ability to source high quality deals
and to nurture the investments. Syndications support both critical activities. Syndication
networks facilitate the sharing of information, contacts and resources amongst venture
capitalists. Strong relationships with other venture capitalists are likely to improve the
chances of securing follow on venture capital funding for portfolio companies, and may
indirectly provide access to other venture capitalists’ relationships with service providers
such as head hunters and prestigious investment banks.
Controlling for other known determinants of venture capital fund performance such as
fund size as well as the competitive funding environment and the investment opportunities
facing the venture capitalist, the authors find that venture capitalists that are better net-
worked at the time a fund is raised subsequently enjoy significantly better fund perfor-
mance, as measured by the rate of successful portfolio exits over the next ten years. Perhaps
the leading alternative explanation for the performance enhancing role of venture capital-
ist networking is simply experience. It seems plausible that the better networked venture
capitalists are, also the older and more experienced venture capitalists. Venture capital
funds whose parent firms enjoy more influential network positions have significantly better
performance as well. Similarly, the portfolio companies of better networked venture
capital firms are significantly more likely to survive to subsequent rounds of financing and
to eventual exit. Interestingly, once network effects are controlled for in the models of fund
and portfolio company performance, the importance of venture capitalist prior experience
is reduced, and in some specifications, eliminated. Given the authors’ documented large
returns to being well networked, enhancing a network position should be an important
strategic consideration for an incumbent venture capitalist, while presenting a barrier to
entry for new venture capitalists.
Engel (2004) stresses the value of syndication as a successful strategy to overcome prob-
lems of information asymmetries. A public promotion of syndication can be helpful for
supporting the learning process of venture capitalists, for increasing the quality of the
value chain process and hence for pushing up the capital inflow by investors. Gompers
and Lerner (2001), for their part, argue that by syndicating investments, venture capital
firms can invest in more projects and largely diversify away firm-specific risk. Involving
other venture firms also provides a second or third opinion on the investment opportun-
ity, which limits the danger that bad deals will get funded.
Control mechanisms Venture capitalists have developed over time a sophisticated

toolbox of structural and contractual arrangements to help manage difficult features of
their transactions, such as high levels of uncertainty about future outcomes and large
information asymmetries between the parties involved. Contingent control rights, which
include continuous monitoring processes (such as positions on the Board, reporting
requirements, and so on), the ability to replace the entrepreneur, powerful stock option
compensations, investor liquidation rights, and the use of convertible securities have all
been presented as critical drivers of performance in individual deals.
Hege et al. (2003) focus on the significant performance gap between US and European
venture capitalists, both in terms of types of exits and of rates of return realized. The
authors partly attribute the gap to differences in the contractual terms of the relation-
ship, like the frequency and effectiveness of the use of instruments asserting an active
role of venture capitalists in the value creation process. Venture capitalists in the US
assert vigorously contingent control rights, through systematic use of financial instru-
ments that convey residual control rights in case of poor performance, such as convert-
ible securities, and they activate these controls more frequently, as measured by the
replacement of entrepreneurs. Also, US venture capitalists exhibit sharper screening
skills than their European counterparts. A better average quality of selected projects in
the US is said to be consistent with the finding that a larger fraction of the total
investments occur there in the initial round. Finally, there is some evidence for a more
effective management of financing relationship and participation of different groups of
investors in the US. Interestingly, the results also suggest that relationship financing,
which is more pronounced for European companies, does not have any significant
impact on performance.
Kaplan and Strömberg (2003) focus on the agency problems inherent in contract
design. The external risk results suggest that risk-sharing concerns are unimportant rela-
tive to other concerns, such as monitoring. Venture capitalists expect to take actions with
their investments and those actions are related to the contracts. Venture capital manage-
ment intervention is related to venture capital board control while venture capital support
or advice is shown to be more related to venture capital equity ownership.
Gompers and Lerner (2001) investigate the tools used by venture firms to address the
information issues. These are said to include intense scrutiny before and after the provi-
sion of capital. The monitoring and information tools used include meting out financing
in discrete stages over time, syndicating investments with other venture capital firms,
taking seats on a firm’s board of directors, and compensation arrangements including
stock options. Lerner (1995) similarly found evidence that board service is driven by a
need to provide monitoring, showing that geographic proximity is an important determi-
nant of venture board membership. Another mechanism utilized to influence managers
and critical employees is to have them receive a substantial fraction of their compensa-
tion in the form of equity or options.
General partner experience The industry knowledge and experience of the General
Partners (GP), including access to and degree of implicit and tacit knowledge as well as
the degree of specialization has been shown to impact the performance of funds.
Gompers (1994) shows that unseasoned venture capital firms (those that have been in
existence five years or less) are under tremendous pressure to perform during the initial
stages of their first fund. These inexperienced venture capitalists have an incentive to
‘grandstand’, or to bring firms from their first fund to the public market sooner than
would otherwise be optimal. On average, young venture capitalists lose almost $1 million
on each initial public offering because they bring the companies to market too early.
Kaplan and Schoar (2005) show that venture capital returns persist strongly across
funds raised by individual private equity partnerships. Performance increases (in the cross
section) with fund size and with the GPs’ experience. The relation with fund size is
concave, suggesting decreasing returns to scale. Similarly, a GP’s track record is positively
related to the GP’s ability to attract capital into new funds. This is also supported by
Gottschalg et al. (2004) who show that the main drivers of underperformance are funds
that are small, European and run by inexperienced GPs. Engel (2004) similarly finds that
large, older venture capital companies with access to implicit, tacit knowledge have a
higher quality of the value chain process.
Persistence of performance, timing and investment durations Kaplan and Schoar (2005)
document substantial persistence in leverage buy-out (LBO) and venture capital fund
performance. General partners whose funds outperform the industry in one fund are
likely to outperform the industry in the next, and vice versa. Persistence is found not
only between two consecutive funds, but also between the current fund and the second
previous fund. These findings are markedly different from the results for mutual funds,
where persistence has been difficult to detect, and when detected, tends to be driven by
persistent underperformance rather than over-performance. Fund flows are positively
related to past performance, however the relationship is concave in private equity.

Similarly, new partnerships are more likely to be started in periods after the industry has
performed especially well. But funds and partnerships that are raised in boom times are
less likely to raise follow-on funds, suggesting that these funds perform poorly. A larger
fraction of fund flows during these times, therefore, appears to go to funds that have
lower performance, rather than top funds. Not only do more partnerships decide to
start up after a period in which the industry performed well, but also, first time funds
tend to raise bigger amounts of capital when the private equity industry performed well.
Funds raised in boom years are more likely to perform poorly and therefore are
unable to raise a follow-on fund. In sum, it appears that the marginal dollar invested in
boom times goes towards financing funds which are less likely to be able to raise a sub-
sequent fund. In periods of increased entry of funds into the industry overall, the
authors observe a larger negative effect on the young funds, than on the older, more
established funds.
Reputation of fund and general partners Nahata (2004) shows that venture capitalist
reputation has a positive impact on the profitability of harvesting venture investments –
as venture capitalists are able to attract higher tier underwriters, and companies backed
by reputable venture capitalists are able to time IPOs near stock market peaks. High
quality affiliation also has a strong and positive effect on young companies’ valuations at
the time of IPO.
Kaplan and Schoar (2005) base their analyses on the premise that the underlying het-
erogeneity in general partners’ skills and competences should lead to heterogeneity in per-
formance and to more persistence if new entrants cannot compete effectively with existing
funds. Several forces make it difficult to compete with incumbents. First, many practi-
tioners assert that unlike mutual fund and hedge fund investors, private equity investors
have proprietary access to particular transactions, that is ‘proprietary deal flow’. In other
words, better GPs may find better investments. Second, private equity investors typically
provide management or advisory inputs along with capital. If high quality general part-
ners are scarce, differences in returns between funds could persist. Third, there is some
evidence that better venture capitalists get better deal terms (for example lower valu-
ations) when negotiating with start-ups.
Value added services Value added services provided to the investee companies, such as
advisory services (including position on the Board, assistance with recruiting and com-
pensating management, development/revision of business plan/strategies) and the uti-
lization of syndication networks may improve the returns on investments.
Kaplan and Strömberg (2000) point out that the venture capitalists expect to be active
in areas such as developing the business plan, assisting with acquisitions, facilitating
strategic relationships with other companies, or designing employee compensation.
However, while venture capitalists play a monitoring and advisory role, they do not
intend to become too involved in the company. Hege et al. (2003) find evidence support-
ing the view that venture capital firms in Europe are more deal makers and less active
monitors, lagging in their capacity to select projects and add value to innovative firms.
In Chapter 7, De Clercq and Manigart revisit the evidence on the value added of venture
capitalists.
Multistage investment The ability of venture capitalists to come back to fund successive
stages of a venture is presented as another means used to leverage performance.
Gompers and Lerner (2001) show that staged capital infusions may be the most potent
control mechanism a venture capitalist can employ. Staged capital infusion keeps the
owner/manager on a tight leash and reduces potential losses from bad decisions.
Kaplan and Strömberg (2000) show it is common for a venture capitalist to make
a portion of its financing commitment contingent on subsequent portfolio company
actions or performance. This reduces the amount of funds that the venture capitalist has
put at risk for a given investment and gives greater ability to the venture capitalist to liq-
uidate the venture by not providing funds if performance is unsatisfactory. Higher man-
agement risk and market risk leads to greater use of state contingent contracting and
staged investment commitment.
Environmental factors
A number of structural and environmental factors have also been shown to impact the
reported performance of venture capital firms’ performance (Wang and Ang, 2004).
Availability and status of public markets for IPOs The availability and status of public
markets for initial public offerings strongly influences the reported performance of the
industry.
Gilson and Black (1999) show that an active stock market is important for a strong
venture capital industry because of the potential for venture capital exit through IPOs.
Jeng and Wells (2000) examine the factors that influence venture capital fundraising inter-
nationally. The strength of the IPO market is an important factor, however it does not
seem to influence commitments to early stage funds as much as later stage ones. Both
Gilson and Black (1999) and Jeng and Wells (2000) see access to strong IPO markets as
the key source of US competitive advantage in venture capital, as well as Cochrane (2000)
and Gompers and Lerner (1998).
Jeng and Wells (2000) also show that an increased volume of IPOs has a positive effect
on both the demand and supply of venture capital funds. On the demand side, the exist-
ence of an exit mechanism gives entrepreneurs an additional incentive to start a company.
On the supply side, the effect is essentially the same. Large investors are more willing to
supply funds to venture capital firms if they feel that they can later recoup their investment.
Gompers and Lerner (2001) show that venture capitalists take firms public at market
peaks, relying on private financings when valuations are lower. Seasoned venture capitalists
appear more proficient at timing IPOs. The superior timing ability of established venture
capitalists may be in part due to the fact that they have more flexibility as to when to take
companies public. Less established groups may be influenced in this decision by other con-
siderations – for instance young venture capital firms have the incentives to grandstand.
Nahata (2004) points out that successful exits are critical to ensuring attractive returns
for investors and in turn to their raising additional capital. The choice of exit vehicle is
governed by both firm-specific and VC-specific factors. Better performing portfolio com-
panies not only lead to more successful exits (IPOs or acquisitions) but even among those
two exit scenarios, relatively better performers are more likely to be taken public than sold
to an acquirer. This is in line with the finding by Gompers and Lerner (2001) that IPOs
tend to yield higher return.
Overall economic cycle The investment opportunities available in the context of the com-
petitive environment significantly determine venture capital performance.
Gompers and Lerner (2001) suggest that the valuation of individual deals is affected by
overall macroeconomic conditions and the degree of competition in the venture capital
industry. When a surge of money enters the venture capital industry, but there are only a
certain number of worthy projects to finance, the result can be a substantial decline in
the returns on investment in the industry. This results in ‘too much money chasing too
few deals’.
Inflows of venture capital tend to raise valuations. In the past, overinvestment by venture
capitalists led to too many projects at too high valuations resulting in low returns. Increases
in demand can, in the short run, only be met by existing funds which accelerate their invest-
ment flows and earn excess returns. Increases in supply lead to tougher competition for deal
flow, and private equity fund managers respond by cutting their investment spending.
Supply increases possibly indicate overheating accompanied by poorer performance.
Ljungqvist and Richardson (2003) show that the competitive environment facing fund
managers plays an important role in how they manage their investments. During periods
in which investment opportunities are good, existing funds invest their capital and exit
their investments more quickly, taking advantage of the favourable business climate. This
tends to lead to better returns on their investments. In contrast, when facing greater com-
petition from other private equity funds, fund managers draw down their capital more
slowly and hold their investments for longer periods of time. Returns on investment
undertaken when competition was tougher are ultimately significantly lower.
Gottschalg et al. (2004) support the view that there was a substantial amount of money
chasing too few deals in Europe and that part of the observed European underperform-
ance is explained by this aspect. Fund performance is very sensitive to both business cycles
and stock market cycles.
Regulatory environment The regulatory environment faced by the venture capital indus-
try, in particular capital gains tax rates, the evolution of interest rates (long and short
term), labour market rigidities and information reporting requirements, can all impact on
performance.
Gompers and Lerner (1998) investigate aggregate performance and capital flows. The
authors find that macroeconomic factors like past industry performance and overall eco-
nomic performance as well as changes in the capital gains tax or ERISA provisions (see
Chapter 1 for a review of the development of venture capital in the US) are related to
increased capital flows into private equity. Lower capital gains taxes seem to have a par-
ticularly strong effect on the amount of venture capital supplied by these tax-exempt
investors. The impact of the capital gains tax does not arise through its effect on those
supplying venture capital, but rather by spurring corporate employees to become entre-
preneurs, leading to more demand for venture capital.
Jeng and Wells (2000) also highlight the fact that if the market does not have good infor-
mation on small start-up firms, then investors will demand a high risk premium, resulting
in more expensive funding for these companies. This cost of asymmetric information can
be reduced if the country in which the company operates has strict accounting standards.
With good accounting regulation, venture capitalists need to spend less time gathering
information to monitor their investments.
Gompers and Lerner (2001) show that government policy can have a dramatic impact
on the current and long-term viability of the venture capital sector. In many countries of
continental Europe, entrepreneurs face numerous daunting regulatory restrictions, a
paucity of venture funds focusing on investing in high growth firms, and illiquid markets
where investors do not welcome IPOs by young firms without long histories of positive
earnings.
Despite wide recognition of venture funds as key players underlying a country’s entre-
preneurial performances, there are huge differences across industrialized countries in the
relative amounts invested in venture capital. Jeng and Wells (2000) show that labour
market rigidities, the level of IPOs, government programmes for entrepreneurship and
bankruptcy procedures explain a significant share of cross country variations in venture
capital intensity.
Leleux and Surlemont (2003) highlight the role played by direct state interventions in
the venture capital market across Europe. Their evidence is consistent with state inter-
ventions coming in after the emergence of a venture capital industry and to a large extent
validating the industry, leading to higher private capital flows into the venture capital
industry. They could not support the traditional view that state interventions prime the
market, nor could they find evidence that public interventions crowded out private capital.
Romain and Van Pottelsberghe de la Potterie (2004) show that indicators of techno-
logical opportunity, such as the stock of knowledge and the number of triadic patents
affect positively and significantly the relative level of venture capital activity. Labour
market rigidities reduce the impact of the GDP growth rate and of the stock of know-
ledge, whereas a minimum level of entrepreneurship is required in order to have a positive
effect of the available stock of knowledge on venture capital intensity.
Availability of investors Jeng and Wells (2000) find that the level of investment by private
pension funds in venture capital is a significant determinant of venture capital over time
but not across countries. Using mutual funds as a benchmark, studies by Sirri and Tufano
(1998) and Chevalier and Ellison (1999) indicate that funds that outperform the market
experience increased capital inflows. This relationship tends to be convex; mutual funds
with above-average performance increase their share of the overall mutual fund market,
something shown for private equity by Kaplan and Schoar (2005). The latter show that
capital flows into private equity funds are positively and significantly related to past per-
formance. Fund size is positively and significantly related to the performance of the pre-
vious fund.
Decision making processes by venture capitalists

Hatton and Moorehead (1994) showed that the quality of the entrepreneur ultimately
determines the funding decision. Venture capitalists expect the product to be capable of
high profit margins and to provide exit strategies. Three criteria were shown as heavily
weighted by venture capitalists: (1) the degree of market acceptance for the product;
(2) the return potential; and (3) the need for subsequent investments.
Leleux et al. (1996) use binary conjoint analysis to formally investigate for the first time
the decision tree of venture capitalists across Europe. Using a comprehensive list of
investment criteria, they point out four major ‘types’ of investor, the largest one focusing
primarily on human factors.
Venture capitalists have also been shown to be subject to a number of decision-making

biases. Zacharakis and Shepherd (2001) prove experimental evidence of their possible
overconfidence, dependent upon the amount of information, the type of information,
and whether the venture capitalist strongly believes the venture will succeed or fail.
Overconfidence describes the tendency to overestimate the likely occurrence of a set of
events. Overconfident people make more extreme probability judgements than they
should, and overconfident venture capitalists may overestimate the likelihood that a
funded company will succeed. The authors show that venture capitalists are intuitive deci-
sion makers, and when people are familiar with a decision and the structure of the infor-
mation surrounding that decision, they resort to automatic information processing. It
seems that forcing them outside their comfort zone has a negative effect on their confi-
dence and has an even greater effect (negative) on their accuracy. Venture capitalists rely
on how well the current decision matches past successful or failed investments. The sup-
ported high level of overconfidence in success or failure predictions may encourage the
venture capitalist to limit information search and fund a lower potential investment (or
prematurely reject a stronger potential investment). Overconfident venture capitalists may
not fully consider all relevant information, nor search for additional information to
improve their decision. Moreover, the natural tendency for people to recall past successes
rather than failures may mean that venture capitalists will make the same mistakes again.
Venture capitalists evaluate hundreds of data points during venture screening and due
diligence which can lead to information overload (Zacharakis and Meyer, 2000) – as
venture capitalists are drawn to more salient information factors and may ignore other
factors that are more pertinent to the decision.
Shepherd and Zacharakis (2002) also document the fact that venture capitalists rarely
use decision aids, where bootstrapping models have the potential to improve venture cap-
italists’ decision accuracy, improving consistency, reducing the bias caused by a non-
random sample, and by optimally weighting information factors and reducing the
decision maker’s cognitive load. Decision aids also allow venture capitalists to acquire
expertise faster than do current educational and training methods. Decision aids can
provide cognitive feedback, which is the return of some measure of the person’s cognitive
processes used in the decision. Cognitive feedback helps people come to terms with their
decision environment and has been found to be markedly superior to outcome feedback.
Zacharakis and Shepherd revisit in Chapter 6 the latest evidence on venture capital
decision making.
A fund level perspective on venture capital risk – return performance

Research specifically concerning the returns to private equity has focused on describing
the basic risk/return profiles of investments in private equity partnerships and private
equity investments in companies, as documented by Hand (2004).
Stevenson et al. (1987), in a pioneering study, highlight the following conditions which
lead to high rates of return on venture capital funds: (1) a multistage investment or com-
mitment of funds on an incremental basis with evaluation of venture performance before
commitment of additional funds; (2) an objective evaluation of venture performance with
the clear distinguishing of winners from losers; (3) parlaying funds or having the confi-
dence to commit further funds to ventures identified as winners; (4) a persistence of
returns from one round to the next, which implies that valuable information is gained
from previous rounds of investment in the same venture; and (5) long term holding of
investment portfolios for a period sufficient for geometric averaging of compound returns
to cause winners to take over or raise portfolio returns.
Ljungqvist and Richardson (2003) report that the risk adjusted excess value of the
typical private equity fund is in the order of 24 per cent relative to the present value of
invested capital, probably because of the highly illiquid nature of the fund. Cochrane
(2000) characterizes venture capital returns based on the economics of individual invest-
ments in portfolio companies. He finds that venture returns are very volatile, with later
stage deals showing much less volatility than early stage deals.
Gottschalg et al. (2004) support the opposite view on performance: PE funds in their
sample (raised between 1980 and 1995) seem to under-perform public stock markets. PE
performance is higher when investments are exited in periods of high valuation levels on
public stock markets, as proxied by the overall earning to price ratio. The authors also
show that PE funds are exposed to substantial ‘left tail’ risk, that is they deliver signifi-
cantly higher losses during large market downturns but are not as sensitive to economic
conditions in good times.
Lerner et al. (2004) support the view that the returns realized from private equity invest-
ments differ dramatically across investor groups. In particular, endowments’ annual
returns are nearly 14 per cent greater than average. Funds selected by investment advisors
and banks lag sharply. These results were robust to controlling for the type and year of
the investment, as well as the use of different specifications.
Kaplan and Schoar (2005), on a sample of funds active over the period 1980–1997,
show average fund returns net of fees roughly equal to those of the S&P 500. Weighted
by committed capital, venture funds outperform the S&P 500 while buyout funds do not.
The authors suggest that gross of fees, both types of private equity partnerships earn
returns exceeding the S&P 500. While LBO fund returns net of fees are slightly less than
those of the S&P 500, VC fund returns are lower than the S&P 500 on an equal weighted
basis, but higher than the S&P 500 on a capital weighted basis. They also show that per-
formance persists strongly across funds raised by individual partnerships and improves
with partnership experience.
The industry level evidence: is venture capital delivering?

The European venture capital scene was seriously shaken on its foundations by the
publication in early 2005 of the benchmark returns for the industry, presented below in
Table 9.1 and Figure 9.1. For the first time in its relatively short history, the average 10-year
investment horizon returns for early stage investments became negative on a per annum
basis. For all venture capital classes, including development and balanced funds, the per-
formance was an equally unimpressive 5.3 per cent for the period. The pooled cumulative
returns since inception for funds created since 1980 showed practically a zero return.
The latest figures reported by the National Venture Capital Association (NVCA) for
the US showed an average 10-year investment horizon return of 45.8 per cent per annum
and a 20-year investment horizon return of 19.8 per cent, as shown in Table 9.2. The
broader venture capital class, including also vehicles focusing on development capital,
showed respectively figures of 25.4 per cent and 15.6 per cent for the 10- and 20-year
investment horizons. The differentials between the European and US performance figures
in terms of early-stage deals were the largest reported in the last 20 years.
Table 9.1 European investment horizon returns as of 31 December 2005 (in per cent
per annum)
Net Horizon Returns as of 31 December 2005

1-year IRR 3-year IRR 5-year IRR 10-year IRR
Stage % % % %
Early-Stage 4.9 2.3 7.5 0.1
Development 12.2 0.9 1.6 8.8
Balanced 32.7 2.8 2.7 7.6
All Venture 25.4 0.6 4.0 5.3
Buyouts 20.9 7.9 5.0 12.6
Generalist 51.2 1.2 4.8 9.7
All Private Equity 24.1 5.2 1.2 10.2
40 All Venture
10-Year Rolling IRR (%)
30 All Buyouts
20
+12.6%
10
+5.3%
0
2001
2003
1996
1997
1994
2004
1998
1990
1991
1992
1993
1995
2000
2002
2005
1999
–10
–20
–30
–40
Figure 9.1 European 5-year rolling window IRRs as of 31 December 2005 (in per cent
per annum)
These comparative numbers are intriguing. First, they seem to support the view that
the industries in the US and Europe are at very different stages of their development.
European venture capital industry emerged in the early 1990s, and only faced its first
downturn when the Internet bubble burst. In other words, it never really had a chance to
learn. The poor results indicate a painful ‘teething’ problem by an emerging industry.
Second, it appears that the lessons from the natural selection process that led to a strong
performing US industry were either not transferable or not adopted by its European
counterpart.
Generic issues with industry performance measurement

These industry statistics clearly warrant further investigations. Both the absolute perfor-
mance level of European venture capital and relative to the US industry is intriguing.
In this section, we focus on issues related to the measurement of performance in venture
capital.
Table 9.2 US investment horizon returns as of 31 December 2004 (in per cent
per annum)
Venture Economics’ US Private Equity Performance Index (PEPI)

Fund Type 1 Yr 3 Yr 5 Yr 10 Yr 20 Yr
Early/Seed VC 1.4 5.5 8.6 45.8 19.8
Balanced VC 5.8 1.2 4.2 17.0 13
Later Stage VC 0.4 0.6 6.6 15.2 13.7
All Venture 3.6 1.4 6.3 25.4 15.6
Small Buyouts 24.1 5.4 1.6 8.7 26.7
Med Buyouts 17.8 4.3 3.2 10.6 17.7
Large Buyouts 16.8 9.6 0.9 10.9 14.5
Mega Buyouts 20.6 9.0 2.7 7.7 9.7
All Buyouts 19.8 8.5 1.8 8.7 13.0
Mezzanine 8.5 3.7 1.8 6.9 9.2
All Private Equity 14.0 5.3 0.5 12.5 13.8
NASDAQ 0.3 2.7 15.3 9.4 11.4
S&P 500 4.8 1.0 4.7 9.0 10.8
Notes: * The Private Equity Performance Index is based on the latest quarterly statistics from Thomson
Venture Economics’ Private Equity Performance Database analysing the cash flows and returns for over 1750
US venture capital and private equity partnerships with a capitalization of $585 billion. Sources are financial
documents and schedules from Limited Partners investors and General Partners. All returns are calculated by
Thomson Venture Economics from the underlying financial cash flows. Returns are net to investors after
management fees and carried interest. Buyout funds sizes are defined as the following: Small: 0–250 $Mil,
Medium: 250–500 $Mil, Large: 500–1000 $Mil, Mega: 1 Bil
Source: Thomson Venture Economics/National Venture Capital Association
Issue #1: Valuing early stage companies

We define venture capitalists as risk capital, that is equity-like, investors in young, rapidly
growing companies that have the potential to develop into significant economic contrib-
utors. Their willingness to take the risks associated with such investments is driven by their
beliefs that they can generate superior returns, even after adjusting for the risks prevail-
ing in these settings. By providing critical early capital and hands-on supervision and
advice, aggressively managing their portfolio (divesting poorly performing assets and
reinvesting in successful ones over time), and racing to the most profitable exits, they rep-
resent, in the words of Gompers and Lerner (2000), the ‘Money of Invention’. How much
is created thus depends on the value increase from the time of the investment(s).
The first issue to be tackled in measuring financial returns to venture capital activities
is thus the valuation of early-stage, privately held companies. The valuation exercise is
rarely conducted in the context of a ‘market’ in the economics sense, not even a very
imperfect one. First of all, the number of potential participants on either side of the deal
(buyers or sellers) is too small to justify the term of market. In many instances, a single
buyer and a single seller will be involved. Second, efficient markets suppose the existence
of sufficient information for both parties to properly evaluate the entity to be traded.
Unfortunately, the amount and quality of information available to estimate the true
worth of a private entity is often very limited. The typical valuation context is then one
of bargaining under incomplete and asymmetric information, a field of study that has
received a great deal of attention from academics but has so far not been able to come up
with more than general guidance on how to put a price on a firm.
New valuation guidelines have been adopted recently by the industry, focusing on the
concept of Fair Value (EVCA Valuation Standards, 2005), also known as Fair Market
Value or cash value in the US (PEIGG Valuation Guidelines, 2004). EVCA defines Fair
Value as the amount for which an asset could be exchanged between knowledgeable,
willing parties in an arm’s length transaction. The estimation of Fair Value does not
assume either that the underlying business is saleable at the reporting date or that its
current shareholders have an intention to sell their holdings in the near future. The objec-
tive is to estimate the exchange price at which hypothetical market participants would
agree to transact. Fair Value is not the amount that an entity would receive or pay in a
forced transaction, involuntary liquidation or distressed sale. Although transfers of
shares in private businesses are often subject to restrictions, rights of pre-emption and
other barriers, it should still be possible to estimate what amount a willing buyer would
pay to take ownership of the investment.
In estimating Fair Value for an investment, EVCA recommends a ‘methodology that is
appropriate in light of the nature, facts and circumstances of the investment and its mater-
iality in the context of the total investment portfolio and should use reasonable assump-
tions and estimates’. This definition stresses the subjective nature of private equity
investment valuation. It is inherently based on forward-looking estimates and judgements
about the underlying business itself, its market and the environment in which it operates,
the state of the mergers and acquisitions market, stock market conditions and other
factors. Due to the complex interaction of these factors and often the lack of directly com-
parable market transactions, judgement needs to be exercised. Ultimately, it is only at real-
ization that the true performance of an investment is apparent.
Issue #2: Extensive use of contingent valuation techniques

Standard valuation methodologies, from discounted cash flows to earnings multiples
and real option formulae, are only as good as the fundamental assumptions and data
used to feed them, that is in general very poor. The high level of uncertainty that pre-
vails in the world of venture capital is an intrinsic part of that world, and will not dis-
appear. Hence the very slow adoption of the most sophisticated valuation techniques,
which are for the most part seen as ‘technical overkill’. Early stage financings (venture
capital, angels, and so on) have earned a very distinctive (and deserved) reputation as
some of the more obscure, if not outright esoteric, dimensions of the field. Start-up
firms are a study in paradox, known as much for the passion and drive of their wizard-
driven teams, the revolutionary technologies they hatch and their blind pursuit of the
opportunities they generate as for their bad habit of failing in droves, burning cash as if
there were no tomorrow, and ultimately not delivering the promised bounties, or only
after excruciating delays and sufferings. So, how does one go about analysing and
providing financing to such ‘outliers’ in terms of financial risk? To a large extent, the
inevitable valuation inaccuracies and differences of opinion are ‘hedged’ through
sophisticated contracting schemes which, in effect: (1) provide for ‘contingent repricing’
through time as the venture develops, reallocating cash flow and control rights when
need be; and (2) provide effective screening and incentive mechanisms, helping to ‘smoke
out’ entrepreneurs with lesser quality projects or venture capitalists with low add-on
values (Cossin, Leleux and Saliasi, 2003).
While there is comfort in knowing that initial valuation errors will be corrected over
time, how should venture capitalists report actual deal valuations for the purpose of finan-
cial performance measurement? A first conceptual approach would be to value independ-
ently the multiple options that make up standard investment contracts. But for the very
same reasons that valuations are difficult, derivative valuations are even more uncertain.
A second approach, less elegant but more applicable, consists in ignoring the contractual
contingencies and reporting only the point valuations (that is share prices) at the time of
the deal. While this ignores most of the value-related covenants, the valuation error would
only affect the initial reporting of the deal value: upon exit, the true value creation will be
recognized.
Issue #3: IRR-boosting cash flow management techniques

Measuring the financial performance of a venture capital fund requires taking into con-
sideration the industry’s unique set of operating procedures which impact these reported
performances. The latter include: (1) the progressive commitments, draw-downs and
investments of funds from investors into ventures; (2) the selective re-investments and
divestments from ventures; and (3) the exits and distributions to investors. All the para-
meters of the investment cycle are managed by the venture capitalists to optimize not only
reported IRRs on the fund but also the investment multiple, the two key performance
metrics most watched in the industry.
Venture capitalists’ need to manage IRR translates into a progressive commitment and
drawdowns of the investors’ funds. The ‘clock’, in terms of return on capital, only starts
ticking when the venture capitalist has the use of investors’ money in hand, hence a great
reluctance to take the commitments in cash upfront. Funds either draw down the funds
on the basis of a fixed schedule (for example 12 equal quarterly instalments) or more often
on the basis of cash calls on an as-needed basis, with a 30- to 90-day payment basis.
Venture capitalists’ insistence on progressive capital commitment to a venture is not
only a risk management and control tool but also a cash disbursement mechanism.
Associated with direct monitoring of the ventures, the objective is to minimize the period
of capital usage and maximize its value creation efficiency.
At the end of the process, venture capitalists need to exit the investments and distrib-
ute the proceeds back to investors (Leleux, 2002). Exits happen in a number of ways:
a private recapitalization, a merger with or sale to an acquirer, or in a public offering
(IPO). The exit strategy most frequently chosen in the US is a public offering, otherwise
known as an IPO, since an IPO will provide investors with the highest overall returns.
Once the investment is exited, the venture capital firm must then decide when and how to
distribute the returns to its investors. A venture capital firm can either sell the stock and
distribute the cash proceeds to the investors or it can distribute the stock directly to the
investors. Stock distributions are most commonly selected because they provide the great-
est benefits to the fund’s limited partners. Due to Securities and Exchange Commission
(SEC) restrictions, a venture capitalist cannot easily liquidate its entire position. In
instances when it can sell stock, a large block sale by a venture capitalist would negatively
impact the stock price. However, a venture capital firm can distribute the shares of a port-
folio company to its limited partners, who can then sell these shares without restriction.
If an investor still believes in the long-term prospects of the company, he can also hold
the stock for sale at a later date. Another benefit of this strategy is that a tax liability is
not created until the stock is actually sold. Clearly, the above evidence supports the
claim that a venture capitalist chooses a stock distribution for the benefits it provides to
investors.
As with most debates, there is another perspective to the distribution strategies chosen
by venture capitalists and that is one which is self-serving. In taking a portfolio company
public, a young venture capital firm improves its fundraising prospects (Gompers,
1996). By distributing shares instead of cash, a venture capitalist can increase its com-
pensation, satisfy its largest institutional clients, and increase its overall personal return
on investment.
Issue #4: Collecting and aggregating individual fund IRRs

Venture capital funds belong to the generic ‘private equity’ or ‘alternative assets’ portfolio
allocation class. By definition, that industry deals primarily with private equity situations,
that is situations where information disclosures are going to be extremely limited. In prac-
tice, only limited partners in a fund would receive detailed information as to the actual
performance of the fund they are invested in. Only large institutional investors, such as
major university endowments or fund-of-fund managers would ever accumulate a
sufficiently large number of positions in funds to be able to generate meaningful com-
parisons internally. A number of trade groups, such as EVCA and NVCA, often with the
help of specialist advisory boutiques, such as Venture Economics or Almeida Capital, are
generating their own ‘industry’ performance numbers. In doing so, they face the same
difficulties in accessing the basic fund performance information and have to rely on vol-
untary disclosure by member firms. For example, EVCA and PricewaterhouseCoopers
tapped all national private equity and venture capital associations to identify all com-
panies that participated in private equity activities during 2002 (for the 2002 Annual
European Private Equity Survey, published as the 2003 EVCA Yearbook). A total of 1528
eligible companies were contacted and 73 per cent of the firms, or 1112, responded to the
two-part, self-completion survey. While it would be difficult to criticize the organizations
for the non-respondents, it is fair to question whether self-disclosure leads to censoring of
the performance distribution curve, for example if non-respondents were primarily funds
with low performance during the year.
Issue #5: Industry performance and correlation with other asset classes
Performance and risk can only be evaluated in the context of the correlation of the
venture capital asset class with respect to other major sectors. In particular, if venture
capital exhibited a low level of correlation with respect to these assets, a high proportion
of its risk can be diversified away in a well-balanced portfolio. Unfortunately, the evidence
in this respect is not as encouraging as some would pretend. First of all, the performance
of the venture capital industry is highly correlated to that of technology-rich stock
markets, so that venture capital positions do not provide much diversification to a
Nasdaq-rich portfolio. The best diversification is obtained with respect to portfolios of
real estate or long-term fixed income instruments. Correlations to key equity indices are
in general positive and relatively high (0.5 to 0.7), so that the benefits in including venture
capital in the portfolio are actually relatively minimal.
Conclusions
In this chapter, we document the extent of contributions to understanding the issues in
measuring performance in the venture capital industry. In particular, we highlight the
unreliability of the performance measures in general and the difficulty to access fund level
data. Despite these shortcomings, a rich literature has emerged to identify key drivers of
performance at the fund level or at the level of the investee companies.
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10 An overview of research on early stage venture
capital: Current status and future directions
Annaleena Parhankangas1
Introduction
Entrepreneurship can be seen as an engine of innovation and growth, and a provider of
economic and social welfare (Schumpeter, 1934; Birch, 1979; Birley, 1986; Kortum and
Lerner, 2000). Entrepreneurs developing revolutionary new products require a substan-
tial amount of capital during the formative stages of their companies’ life cycles. Even
though most entrepreneurs prefer internal to external funding, few entrepreneurs have
sufficient funds to finance early stage projects themselves. It is also at this stage of devel-
opment, when collateral-based funding from banks, the second most preferred source of
funding by entrepreneurs (Myers, 1984), is often inappropriate or even potentially life-
threatening to the new firm (Gompers, 1994; Murray, 1999). Therefore, the alternative
provision of venture capital has become an attractive source of finance for potentially
important companies operating on the frontier of emerging technologies and markets
(Tyebjee and Bruno, 1984; Bygrave and Timmons, 1992; Murray, 1999).
However, the management of early stage venture capital investments has proved to be
challenging. Early stage investors are obliged to deal with multiple sources of uncertainty
spanning the commercial, technical and managerial aspects of the new enterprise (Storey
and Tether, 1998). Early stage investments typically involve new products targeted to non-
existing markets developed by management teams with little or no prior history, exposing
investors to significant information asymmetries (Chan, 1983; Amit et al., 1990; Chan
et al., 1990; Sahlman, 1990; Amit et al., 1998). In addition, it will usually take several years
to transform an early stage company to a firm capable of being floated or sold to a trade
buyer (Dimov and Murray, 2006). As a result, early stage venture capitalists are faced with
the combination of long term commitment in a young venture and a considerable likeli-
hood of failure. The venture capital industry has partly responded to these challenges by
rejecting early stage financing activity as too uneconomic (Dimov and Murray, 2006).
Some go as far as to state that efficient markets do not exist for allocating risk capital to
early-stage technology ventures and that most funding for technology development in the
phase between invention and innovation comes from angel investors, corporations and
federal governments, not venture capitalists (Branscomb and Auerswald, 2002).
Given the significant challenges and opportunities associated with early stage venture
capital, the volume of research on this topic is increasing, whether measured in terms of
published research articles, publication outlets, or support provided by private donors or
policy. The initial empirical research was mostly conducted during the 1980s, four decades
after the first venture capital firm was established in the United States. The pioneers in
early stage venture capital research focused on fundamental questions, such as ‘what do
venture capitalists do’ and ‘how do they add value in their portfolio companies’. For
instance, the seminal paper of Tyebjee and Bruno (1984) developed a model of venture
253
capital activity involving five sequential steps: deal origination, deal screening, deal
evaluation, deal structuring and post-investment activities. MacMillan et al. (1985; 1987)
analyzed the criteria used by early stage venture capitalists to evaluate new venture pro-
posals. Bygrave and Timmons (1986) and Gorman and Sahlman (1989) focused on the
role of venture capitalists in promoting innovation and growth in early stage companies.
Bygrave (1988) investigated the logic of syndication in the early stage venture capital
industry. It is noteworthy that these questions still continue to attract the attention of new
generations of researchers.
The pioneers in early stage venture capital research focused primarily on the US
market. However, the diffusion of US style venture capital practices to other nations was
followed by a stream of international venture capital research describing the European
and Asian context (Muzyka et al., 1996; Sapienza et al., 1996; Brouwer and Hendrix,
1998; Bruton and Ahlstrom, 2002; Kenney et al., 2002a; 2002b; Wright et al., 2005). These
studies typically address the cross-country differences in early stage venture capital activ-
ities and the role of the early stage venture capital investments in revitalizing the entre-
preneurial systems of Europe and Asia.
Another significant trend in (early stage) venture capital research is the sharpening dis-
tinction between research on early stage and later venture capital activities, perhaps
reflecting the recent tendency of venture capitalists to shift away from early stage invest-
ments to later stage deals (Tyebjee and Bruno, 1984; Bygrave and Timmons, 1992; Camp
and Sexton, 1992; Gompers, 1994; Mason and Harrison, 1995; Sohl, 1999; Gompers
and Lerner, 2001; Balboa and Marti, 2004). As the original definition of venture capital
involves investments in young firms characterized with high risk and pay-off (Crispin-
Little and Brereton, 1989; Bygrave and Timmons, 1992; Gompers et al., 1998; Sahlman,
1990; Wright and Robbie, 1998; Gompers and Lerner, 2001), investments in early stage
firms may be regarded as classic venture capital. Later stage investments, in turn, are
sometimes labeled as private equity (Lockett and Wright, 2001) or merchant capital
(Bygrave and Timmons, 1992). It was not until later that the notion of early stage venture
capital emerged as several authors demonstrated that the stage focus of a venture cap-
italist is one of the most important features along which venture capital firms could be
distinguished (Robinson, 1987; Ruhnka and Young, 1987; Fried and Hisrich, 1991).
As research on early stage venture capital continues to grow and proliferate, it is import-
ant to take a look back and evaluate the progress made and to identify gaps in the exist-
ing knowledge. This chapter is based on a review of 179 peer-reviewed articles and other
relevant publications focusing on early stage venture capital financing.2 Even though a
great effort was taken to provide a reasonable overview of the existing knowledge, the size
and scope of the research field makes it impossible to provide a detailed description of
every article reviewed or an exhaustive listing of all studies published on the topic this far.
Instead, the focus of the literature review is primarily on scholarly research. It is also
important to note that the studies focusing on the co-evolution of venture capital, regions
and industries (see for instance Manigart, 1994; Martin et al., 2002; Klagge and Martin,
2005) and the policy aspects of early stage venture capital are beyond the scope of this
study, as these topics will be covered in other parts of this book.
This chapter organizes the literature on early stage venture capital financing by first ana-
lyzing the special characteristics of the early stage ventures, investors and funds. Thereafter,
I continue with the implications of these differences for managing venture capitalist
An overview of research on early stage venture capital 255
INSTITUTIONAL SETTING
Characteristics of Management of
early stage venture capital early stage investments Synthesis and analysis of
Characteristics of early early stage venture capital
• Fund raising
stage investments research
• Appraisal
• Market and agency risks • Structuring • Major themes and findings
• Information asymmetries • Monitoring and adding value • Theories and methods
• Exiting and performance • Future research
Characteristics of early
stage investors and funds
Figure 10.1 Outline for the chapter
investment activity (Tyebjee and Bruno, 1984) over the venture capital cycle (Gompers and
Lerner, 2001) in different institutional settings. Finally, this chapter is concluded with a syn-
thesis and analysis of prior knowledge and suggestions for future research. The approach
for presenting and analyzing prior studies is illustrated in Figure 10.1.
Early stage venture capital industry: key characteristics and challenges

In order to gain a better understanding of the challenges and opportunities faced by
early stage investors, I will first identify those key characteristics that distinguish
early stage ventures from later stage deals. Thereafter, I will discuss the major risks
faced by early stage investors and recent trends in the global early stage investment activ-
ity. This subsection ends with a description of the key characteristics of early stage
investors and funds.
Classification of venture capital investments based on their development stage: early stage
ventures vs. later stage deals
Prior literature classifies venture capital investments based on the development stage of
the portfolio company (Robinson, 1987; Bygrave and Timmons, 1992). Stanley Pratt, the
publisher of Venture Capital Journal, distinguishes between ‘seed, start-up, first stage,
second stage, third stage and bridge financing’ (Bygrave and Timmons, 1984; Ruhnka and
Young, 1987). These investment stages have been found to differ in terms of their key char-
acteristics, developmental goals and major developmental risks (Ruhnka and Young,
1987; Flynn and Forman, 2001), as presented in Table 10.1.
The seed, start-up capital and first stage financing are usually considered early stage
venture capital (Pratt’s Guide to Venture Capital Sources, 1986; Ruhnka and Young, 1987;
Crispin-Little and Brereton, 1989). Seed financing involves a small amount of capital pro-
vided to an inventor or an entrepreneur to prove a concept (Sohl, 1999; Branscomb and
Auerswald, 2002), before there is a real product or company organized (NVCA, 2005).
Ruhnka and Young (1987) found that characteristic for the seed stage is the existence of
a mere idea or a concept, and the absence of the management team beyond the founder
and one or more technicians. The critical goals for the seed stage include producing a
product prototype and demonstrating technical feasibility, as well as conducting a pre-
liminary market assessment. Contrary to public perception, seed stage companies are not
likely candidates for venture capital investments, but are more likely to be backed by
Table 10.1 Characteristics of the various investment stages (adapted from Sohl, 1999;
Crispin-Little & Brereton, 1989; Ruhnka & Young, 1987)
Seed Stage Start-Up Stage First Stage Later Stages

Source of Founder, Angels Angels, VCs Angels, VCs VCs, Private
funding Equity
Demand 0–$25K $100K–$500K $500K–$2000K >$2000K
Venture • Idea or concept • Business plan and • Market receptive, • Significant sales
characteristics • only • market analysis • some orders/sales • and orders
• No management, • completed • Marketing push • Increasing
• founders/ • Prototype under • needed • sales/broaden
• technicians only • evaluation/beta • Full management • market
• Prototype not • testing • team in place • (Near) break-even
• developed/tested • Management team • Ramp-up in • or profitable
• incomplete • manufacturing • Seasoned
• Product ready to • needed • management
• market, some • Prototype ready • completed/
• initial sales • revamped
• Established
• product
Major goals • Develop and prove • Complete beta • Achieve market • Increase sales,
• the concept • testing/get product • penetration and • growth, market
• Produce working • ready to the market • sales goals • share targets
• prototype • Make initial sales, • Reach break-even • Need to window-
• Market assessment • verify demand • or profitability • dress for IPO,
• Assemble • Establish • Increase production • buyout or merger
• management team • manufacturing • capacity/reduce • Improve cash
• and structure • feasibility • unit cost • flow break-even,
• company • Build management • Build sales • profitability
• Develop detailed • organization • force/distribution • Diversify products
• business plan • systems • Begin major
• • expansion of the
• company
Major risks • Workable prototype • Beta tests • Founders are poor • Inadequate
• cannot be produced • unsatisfactory • managers/ • management/loss
• Potential market • Founders cannot • inadequate • of key
• not large enough • attract/manage • management team • management
• Development • key management • Product not • Inadequate
• delayed, funds run • Potential market • sufficiently • sales/market share
• out • size/share not • competitive in the • Unanticipated
• Product cannot be • feasible • market • competition
• produced at a • Cash used up, • Manufacturing • IPO window
• competitive cost • inability to attract • costs too high/ • shuts/ no exit
• Founder cannot • additional funding • inadequate profit • vehicle
• manage • Inadequate • margin • Cannot achieve
• development • marketing/sales • Market not as big • adequate profit
• volume • as projected/slow • margin
• Product not cost • market growth • Technological
• competitive • Marketing strategy • obsolescence
• Unanticipated • wrong/inadequate
• delays in product • distribution
• development • Excessive burn
• Competition • rate/inadequate
• develops first • financial controls
informal investors (business angels), family and friends (Tyebjee and Bruno, 1984;
Crispin-Little and Brereton, 1989; Sohl, 1999).
Start-up financing provides funds for product development and initial marketing. In
the start-up stage, the investigation of the feasibility of the business concept has gener-
ally progressed to the point of having a formal business plan together with some analysis
of the market for the proposed product or service. Major benchmarks for this stage
include establishing the technological, market and manufacturing feasibility of the busi-
ness concept (Ruhnka and Young, 1987; Crispin-Little and Brereton, 1989).
The first stage financing provides funds to initiate commercial manufacturing and sales.
The first stage is characterized by having a full management team in place, a market recep-
tive to the product, a need for a ramp-up of the production process, and the existence of
a ready prototype for the market (Ruhnka and Young, 1987; Crispin-Little and Brereton,
1989; Sahlman, 1990; Sohl, 1999; Branscomb and Auerswald, 2002).
Even though there exists less consensus on the typical characteristics of the ventures in
later stages of their development (Ruhnka and Young, 1987), it is possible to distinguish
more mature portfolio companies from early stage investments. As later stage investments
targets have already established their market presence, their key developmental goals
include achieving market share targets and reaching profitability in order to make it pos-
sible for venture capitalists to exit the investment successfully. In comparison to early
stage ventures struggling with challenges related to product, market and organization
development, the later stage investments face the threat of technological obsolescence and
unanticipated competition caused by new entrants (Ruhnka and Young, 1987; Crispin-
Little and Brereton, 1989; Branscomb and Auerswald, 2002).
Major risks associated with early stage investments 3

Of all themes related to early stage venture capital research, perhaps most attention has
been paid to the nature and extent of risks related to investments in nascent ventures. It
is widely believed that early stage ventures imply higher overall risks and volatility of
returns than more established portfolio companies (Brophy and Haessler, 1994). These
risks are particularly serious for new technology-based firms (Bygrave, 1988; Mason and
Harrison, 1995; Balboa and Marti, 2004), such as university spin-outs (Wright et al.,
2006), due to the long lead time of product development and severe difficulties associated
with the transfer of technology into the market place.
The high level of risks inherent in early stage venture capital investments can be partly
explained by the existence of information asymmetries between the venture capitalist and
the entrepreneur (Chan, 1983; Amit et al., 1990; Chan et al., 1990; Sahlman, 1990; Amit
et al., 1998). In early stage companies characterized with intangible assets and a heavy
reliance on R&D (Gompers and Lerner, 2001), the venture capitalist has only a limited
understanding of the quality of the project, and the competence and willingness of the
entrepreneur to act in the interest of the other shareholders. Stated differently, early stage
venture capitalists are exposed to high levels of ‘hidden information’ and ‘hidden action’
on the part of the entrepreneur (Akerlof, 1970; Holmström, 1978). As Amit et al. (1990)
put it: an early stage technology investment often involves (Murray and Marriott, 1998)
a technology that has not yet been proven; which is to be incorporated into novel products and/
or services which still remain solely in the mind of the entrepreneur; and will eventually be
offered to markets and customers whose existence remains purely hypothetical. On the top of
these uncertainties, the new enterprise may uncommonly be managed by a technological entre-
preneur or a founding team whose experience of commercial practices and disciplines is negli-
gible, as are their personal assets by which the venture may be financed or the investment
guaranteed.
The risks inherent in venture capital investments in general and in early stage invest-
ments in particular can be further divided to market and agency risks (Gorman and
Sahlman, 1989; Ruhnka and Young, 1987; 1991; Barney et al., 1994; Fiet, 1995; Murray
and Marriott, 1998; Gompers and Lerner, 2001). Market risk refers to risks due to unfore-
seen competitive conditions affecting the size, growth and accessibility of the market, and
upon factors affecting the level of market demand. Because of high levels of market risks
inherent in young ventures, the early stage investors’ overriding concerns include failures
to capture a large enough market share or to ramp up the production process (Ruhnka
and Young, 1987; 1991; Muzyka et al., 1996).
Agency risk, in its turn, is a risk that is caused by separate and possibly divergent inter-
ests of agents and principals (Sahlman, 1990; Fiet, 1995). Agency risks may result in
opportunism, shirking, conflicting objectives or incompetence (Parhankangas and
Landström, 2004). For example, early stage entrepreneurs might invest in research pro-
jects that bring great personal returns but low monetary payoffs to shareholders
(Gompers and Lerner, 2001). Agency risks may also result in delays in product develop-
ment, or the failure of the founders to comply with the development objectives of their
investors (Ruhnka and Young, 1987; 1991; Murray and Marriott, 1998; Gompers and
Lerner, 2001).
Recent trends in the frequency of early stage investments

The market and agency risks inherent in nascent ventures are likely to make investors
doubtful of their ability to appropriate returns from early stage investments (Branscomb
and Auerswald, 2002). These doubts may be reflected in the decreasing interest in early
stage investments all over the world. Figure 10.2 shows that the share of early stage invest-
ments of the total value of all deals has fallen from approximately 50 per cent in the 1960s
to 15 per cent in 2005. The corresponding figure for European early stage investments was
12 per cent in 2004 (EVCA/Thomson Venture Economics, 2004).
However, the situation looks less alarming, if the percentage of early stage deals of all
investments is used as a proxy. As Figure 10.3 shows, 60 per cent of all deals in Europe
are seed or early stage investments (Bottazzi et al., 2004).
Characteristics of early stage venture capitalists and funds

As early stage ventures differ from later stage deals along several dimensions, it should
come as no surprise that prior studies also report venture capital firms investing in early
stage companies being fundamentally different from their counterparts focusing on more
mature portfolio companies. It has been proposed that early stage investments are typi-
cally made by venture capital firms:
● located in the United States, especially on the West Coast (Crispin-Little and
Brereton, 1989; Black and Gilson, 1998; Gompers et al., 1998; Schwienbacher, 2002);
70%
60%
50%
40%
30%
20%
10%
0%
1960 1980 1990 2005
Source: Venture Economics
Figure 10.2 The share of early stage investments of the value of all global deals during
the years 1960–2005
● located in countries with strong laws for contract repudiation and shareholder
rights (Cumming, Fleming and Schwienbacher, 2006);
● hiring investors with a higher degree of education than venture capital firms focus-
ing on later stage investments (Flynn and Forman, 2001; Bottazzi et al., 2004);
● being older and larger than venture capital firms focusing on later stage deals
(Gompers et al., 1998; Dimov and Murray, 2006) and the dominance of older and
larger firms may be explained by their greater expertise and ability to extract
benefits from early stage investments. However, Bottazzi et al. (2004) and
Schwienbacher (2002) report some contradictory evidence from the European and
Expansion
Start-Up 39%
42%
Bridge
Seed 2%
17%
Source: Bottazzi et al., 2004
Figure 10.3 Venture deals by stage in Europe

US context, suggesting that young venture capital firms are more likely to engage
in seed financing;
● being more often independent than captive (Wright and Robbie, 1996; Kenney
et al., 2002a; 2002b); and
● being less often involved in cross-border investments (Schwienbacher, 2002; Hall
and Tu, 2003).
In a similar vein, funds focusing on early stage investments tend to have some distinct
characteristics. Prior research has paid a significant amount of attention to the relationship
between fund size and early stage investments, producing somewhat mixed results. Some
studies suggest that as venture capital funds become larger, their interest and involvement
in early-stage investments fades (Bygrave and Timmons, 1992; Elango et al., 1995). This
aversion is closely related to the fact that early stage investments are typically very small and
highly uncertain in terms of their outcome. For growing funds, such investments are often
uneconomic given the diversion of scarce investment manager talent (Gifford, 1997).
However, Dimov and Murray (2006) found a U-shaped relationship between fund size and
the number of seed investments; even though the number of seed investments decreases as
the amount of invested capital increases, seed investments nevertheless become a viable
investment option after some minimum capital point has been reached. This finding is con-
sistent with the idea that funds with a seed focus need to have a minimum scale of efficiency
given their fixed cost structures (Murray and Marriott, 1998; Murray, 1999).
Studies focusing on the management of the early stage venture capital investments
As information asymmetries, market risks and agency risks are an integral part of young
ventures, much of the prior literature highlights how venture capitalists may deal with
these challenges over the venture capital cycle and in their relationship with the entrepre-
neur. In particular, special attention will be paid to fund raising, appraisal strategies,
structuring the deal, monitoring and adding value, as well as exit strategies deployed by
the early stage venture capitalists (see Figure 10.4). The availability and feasibility of these
risk reduction strategies depend, to a large extent, on the institutional context of early
stage investors. Therefore, this section ends with a review of management practices
applied by early stage venture capitalists embedded in different institutional contexts.
Fund raising
Funds to be invested in early stage ventures may be raised from pension funds, insurance
companies, banks, government agencies, private individuals or corporate investors. Prior
research reports that corporate and individual backed funds, academic institutions and,
in some cases, pension funds, prefer investments in firms at an early development stage,
whereas banks more often invest in later stage deals (Mayer et al., 2005; Schertler, 2005;
Cumming, 2006a).
Venture capital commitments to early stage firms have been highly variable over time
(Gompers and Lerner, 2001) and across countries (for example, Black and Gilson, 1998;
Jeng and Wells, 2000; Megginson, 2004; Mayer et al., 2005). Even though the United
States dominates the early stage scene by the sheer volume of funds directed to nascent
ventures, the share of early stage venture capital of GDP is even higher in many other
industrialized nations (Figure 10.5).
Fund raising
Appraisal
Structuring
Monitoring and
adding value
Exit
Figure 10.4 Managing early stage investments
0.12
0.10
0.08
Percent GDP
0.06
0.04
0.02
0.00
Greece
Italy
Spain
China
Austria
Australia
Japan
Netherlands
Germany
UK
Norway
France
Finland
USA
Switzerland
Ireland
S. Africa
Singapore
Canada
Belgium
N. Zealand
Denmark
Sweden
Mean
Source: Reprinted with kind permission of Babson College and London Business School, Figure 10.5,
‘Early stage venture capital investment by country’, in M. Minniti, W. Bygrave and E. Autio (2005), Global
Entrepreneurship Monitor 2005 Executive Report.
Figure 10.5 Early stage venture capital investment by country (Percent GDP, 2004)
These drastic cross-national and temporal variations may partly explain the fact that
several studies focus on the role played by various macro-economic and institutional
factors (for example Söderblom and Wiklund, 2006) in either alleviating or aggravating
risks associated with investments in young ventures. In a similar vein, investors’ experi-
ence, size and prior performance (for example Gompers et al., 1998; Marti and Balboa,
2000; Kaplan and Schoar, 2005) seem to facilitate commitments to venture capital funds.
A more detailed review on early stage fund raising activities will be provided in the section
dedicated to institutional environment and the management of venture capital activities.
Appraisal of early stage deals

Prior research has identified several stages of venture capitalists’ appraisal process, includ-
ing deal generation, initial screening, second/detailed screening and deal approval
(Bygrave and Timmons, 1992; Fried and Hisrich, 1994; Wright and Robbie, 1996).
Traditionally, little time was spent on searching for deals, as most proposals received by
early stage venture capitalists were referrals from third parties (Tyebjee and Bruno, 1984).
However, increasing competition between the venture capitalists has created a need to
allocate more time to the deal generation process (Sweeting, 1991; Shepherd et al., 2005).
In a similar vein, early stage venture capitalists exposed to information asymmetries and
adverse selection problems (Amit et al., 1990) spend a significant amount of time and
effort in evaluating and screening early stage investment opportunities (Carter and Van
Auken, 1994; Kaplan and Strömberg, 2001).
In deal generation and initial screening phases, early stage venture capitalists typically
focus on rather general (non-financial) investment criteria, which enable them to conclude
whether a proposal is viable for further consideration (Zacharakis and Meyer, 2000). Such
general evaluation criteria include a wide variety of factors, such as:
● completeness and track record of the management team;

● attractiveness of the business opportunity and industry;
● liquidity of the venture;
● possession of proprietary products and product uniqueness;
● innovation output; and
● similarity of the founding team in comparison to the investor (Tyebjee and Bruno,
1984; MacMillan et al., 1985; 1987; Sandberg et al., 1988; Rea, 1989; Fried and
Hisrich, 1991; Elango et al., 1995; Muzyka et al., 1996; Zacharakis and Meyer,
1998; Shepherd et al., 2000; Kaplan and Strömberg, 2001; Engel and Keilbach,
2002; Franke et al., 2002).
Much of the prior research concludes that the entrepreneur and the entrepreneurial
team are the most important decision criteria in distinguishing between successful and
failed ventures (MacMillan et al., 1985; 1987). Therefore, it is widely believed that most
venture capitalists prefer an opportunity that offers a good management team and rea-
sonable financial and product market characteristics even if it does not meet the overall
fund and deal requirements (Muzyka et al., 1996). However, some more recent studies
contradict this logic by suggesting that the most important selection criteria center on the
market and product attributes (Hall and Hofer, 1993; Zacharakis and Meyer, 1995).
Finally, it is important to note that prior research reports various interactions between the
evaluation criteria presented above. For instance, the study by Zacharakis and Shepherd
(2005) suggests that the more munificent the environment, the more importance the
venture capitalist attaches to general experience in leadership. In addition, start-up expe-
rience may in some cases substitute leadership experience.
Prior studies give us a reason to believe that the evaluation criteria applied by early
stage venture capitalists differ fundamentally from those employed by later stage
investors. For instance, Birley et al. (1999) found that the leadership potential and opera-
tional skills of entrepreneurs dominate when making investments in early stage ventures.
However, when evaluating buyouts, the leadership capability of the whole team increases
in importance. In addition, several researchers suggest that early stage investors attach
more importance to the possession of proprietary products, product uniqueness, high
growth markets and the quality of the entrepreneurial team, whereas late stage investors
are more interested in demonstrated market acceptance, profitability and cash flow as well
as relatively short exit horizons (Fried and Hisrich, 1991; Bygrave and Timmons, 1992;
Elango et al., 1995; Wright and Robbie, 1996).
For early stage venture capitalists, the single most important source of information is
the business plan, projecting the future of the company (MacMillan et al., 1985; 1987;
Wright and Robbie, 1996). An adverse selection problem arises, as venture capitalists have
to rely greatly on information provided by the entrepreneur. Therefore, venture capitalists
exercise considerable efforts in due diligence in order to verify the robustness of reported
accounting information, especially profit and cash flow forecasts (Wright and Robbie,
1996; Manigart et al., 1997). The due diligence process often involves auditing the macro
and legal environment, as well as financial, marketing, production, and management
aspects of a firm (Harvey and Lusch, 1995). In company valuations, venture capitalists
use various standard methods for valuing investments, such as variations of price earn-
ings ratio multiples and capitalized maintainable earnings (EBIT) multiples. However, it
has been found that venture capitalists focusing on early stage investments place signifi-
cantly less emphasis on valuation methods based on past performance information
(Wright and Robbie, 1996; Wright et al., 1997). When assessing the quality of human
capital, past oriented interviews and work samples tend to increase the decision accuracy
for early stage investors (Smart, 1999), even though this process is usually less time-
consuming for seed and start-up investments with smaller entrepreneurial teams with
little or no track record (Cumming, Schmidt and Walz, 2006).
The valuation processes of early stage investments are intrinsically difficult (Tyebjee
ansd Bruno, 1984; Branscomb and Auerswald, 2002). Paradoxically, prior literature has
identified situations where these difficulties have led to a herd mentality (Lerner et al.,
2005) creating an overflow of venture capital in particular sectors (Sahlman and
Stevenson, 1987). It is more common, however, that venture capitalists impose higher
minimum internal rates of return (IRR) and market size hurdles on new, technology-
based firms to compensate for higher levels of risk (Elango et al., 1995; Fiet, 1995; Murray
and Lott, 1995; Wright and Robbie, 1996; Manigart et al., 1997; Lockett et al., 2002).
According to a British study, two-thirds of early stage investors look for rates of return
of at least 46 per cent, whereas 75 per cent of later stage investors settle for an IRR of
35 per cent or below (Wright and Robbie, 1996). As a result, information asymmetries
between investors and entrepreneurs are often cited as one of the major reasons for which
positive net cash flow projects fail to get funded (Leland and Pyle, 1977; Amit et al., 1998).
While relatively little attention is paid to the role of the entrepreneur in the early stages
of the venture capital process, Timmons and Bygrave (1986) and Smith (1999) report that
entrepreneurs evaluate venture capitalists in terms of their value-added, reputation,
industry specialization, the amount of capital, experience, and physical location. It has
been argued that the entrepreneurs are more likely to accept offers from venture capital-
ists with a good reputation, often at a substantial discount of the venture’s value (Hsu,
2004). Finally, entrepreneurial teams may also assume an active role in signaling the value
of their venture to prospective investors (for example, Amit et al., 1990; Busenitz et al.,
2005). In some cases, third parties, such as technology transfer offices, may assist new ven-
tures in the signaling process by participating in screening and preparation of proposals
for venture capitalists (Wright et al., 2006).
Venture capitalists seem to be relatively skilled in picking the most successful new ven-
tures in the industry (Timmons and Bygrave, 1986; Timmons, 1994; Amit et al., 1998).
Their superior screening skills may partly explain the growing research interest in the cog-
nitive processes of early stage venture capitalists embedded in highly uncertain and
ambiguous environments conducive to cognitive biases and the use of heuristics in
decision-making (Baron, 1998). As a starting point for this stream of literature is the
notion of a venture capitalist as an intuitive decision-maker (Khan, 1987), who does not
understand his or her decision process (Zacharakis and Meyer, 1998). Reliance on intu-
ition may stem from information richness or ‘information overload’ surrounding new ven-
tures, making it impossible for investors to increase the quality of decision making by
collecting and processing more information (Zacharakis and Meyer, 2000; 1998). Prior
studies have identified several heuristics characteristic to the venture capitalist’s decision
making, such as representative and satisfying heuristics (Gompers et al., 1998; Zacharakis
and Meyer, 2000). Even though these heuristics may speed up the decision making process
and allow more time for value-adding activities, they may also lead to the underestima-
tion of risks and a herding phenomenon (see Chapter 6 by Zacharakis and Shepherd). It
has also been found that venture capitalists may suffer from overconfidence and attribu-
tion bias, causing them to overestimate the likelihood of success and to attribute
failure to external, uncontrollable events, rather than to their own actions or incompe-
tence (Zacharakis et al., 1999; Zacharakis and Shepherd, 2001; Shepherd et al., 2003).
Within this cognitive research stream, there are also studies analyzing the attempts of
seed and early stage investors to reduce ambiguity surrounding their investment decisions.
For instance, Fiet (1995) focuses on the reliance of formal and informal networks in
venture capital decision making. Moesel et al. (2001) and Moesel and Fiet (2001), in their
turn, set out to explore how early stage venture capitalists use various sense-making tech-
niques to perceive and interpret different forms of order amidst the apparent chaos of the
emerging industry segments. Finally, there is a growing stream of literature analyzing how
venture capitalists may use various decision aids to improve their decision making quality
(Khan, 1987; Zacharakis and Meyer, 2000; Shepherd and Zacharakis, 2002; Zacharakis
and Shepherd, 2005).
Structuring early stage investments and investment portfolios

Prior literature has extensively scrutinized how venture capitalists structure individual
venture capital investments and investment portfolios as a safeguard against moral hazard
and information asymmetries inherent in early stage investments (Sahlman, 1990; Kaplan
and Strömberg, 2001; Cumming, 2005b). Prior studies have identified four major mecha-
nisms of risk reduction: 1) contractual covenants included in the venture capital
contracts; 2) the use of preferred convertible stock; 3) staged capital infusion; and 4) com-
pensation schemes aligning the interests of venture capitalists and entrepreneurs.
First, venture capital contracts typically give investors cash-flow rights, voting rights,
board rights, liquidation rights, as well as non-compete and vesting provisions (Sahlman,
1990). Prior studies suggest that these rights are more often granted to early stage
investors, fraught with information asymmetries and hold-up problems (Carter and Van
Auken, 1994; Kaplan and Strömberg, 2001; Cumming, Schmidt and Walz, 2006). Second,
there is some empirical evidence indicating that convertible preferred equity may mini-
mize the expected agency problems associated with start-up and expansion stage invest-
ments (for example, Sahlman, 1990; Gompers, 1997; Bascha and Waltz, 2001; Kaplan and
Strömberg, 2001; Cumming 2002),4 whereas debt and common stock are more appropri-
ate at the later stages of venture financing (Trester, 1998). Third, staged capital infusion
gives investors the option to cut off badly performing ventures from new rounds of financ-
ing (Sahlman, 1990; Gompers, 1995; Gompers and Lerner, 2001), thus minimizing the
losses carried by the early stage venture capitalist. Fourth, while both venture capitalists
and entrepreneurs receive a substantial fraction of their compensation in the form of
equity and options, they also have an additional incentive to maximize the value of the
portfolio company. The venture capitalist may also employ additional controls on com-
pensation, such as vesting of the stock option over a multi-year period, making it impos-
sible for the entrepreneur to leave the firm and take his or her shares (Gompers and Lerner,
2001). It is interesting to note that similar compensation schemes contingent on perform-
ance, contractual covenants and high levels of monitoring are also applied to mitigate
agency problems between venture capitalists and their fund providers (Sahlman, 1990;
Robbie et al., 1997; Wright and Robbie, 1998).
Venture capitalists may also manage risks on the portfolio level by focusing on partic-
ular industries or geographical areas, limiting the size of investments, or by investing in
syndicates. For instance, there are studies indicating that venture capitalists prefer
less industry diversity and a narrower geographical scope, when dealing with high risk
(early stage) investments (Gupta and Sapienza, 1992; Norton and Tenenbaum, 1992).
According to Robinson (1987), venture capitalists generally favor a larger number of
smaller investments in early stage ventures in comparison to larger investments in more
mature portfolio companies. Ruhnka and Young (1987), in their turn, suggest that venture
capitalists may elicit risks by distributing their investments across various investment
stages. Finally, several authors suggest that the risk sharing motivation for syndication is
significantly more important for early stage venture capitalists than for venture capital
firms investing in later stages only (Bygrave, 1988; Lerner 1994; Gompers and Lerner,
2001; Lockett and Wright 2001; Lockett et al., 2002; Kut et al., 2005; Cumming, 2006a;
Cumming, Schmidt and Walz, 2006).
Monitoring and adding value in early stage investments

It is argued that venture capital investors may address the problems of asymmetric infor-
mation not only by intensively scrutinizing firms before their investment decision and
structuring their investment portfolios with great care, but also by monitoring their port-
folio companies afterwards (Lerner, 1999). As evidence of a more hands-on role of early
stage investors, several scholars found that they spend more time with their portfolio com-
panies than later stage investors (Barney et al., 1989; Gorman and Sahlman, 1989;
Sapienza and Gupta, 1994). In a similar vein, early stage investors are reported to be more
eager to require corrective actions, such as changes in management, if the new venture
fails to live up to the expectations (Carter and Van Auken, 1994; Hellman and Puri, 2002).
However, some contradicting evidence exists suggesting that portfolio companies receive
more venture capitalists’ attention as they mature (Gomez-Mejia et al., 1990). In addition,
some studies propose that the differences in the level of venture capital involvement are
not stage-related (MacMillan et al., 1988; Fried and Hisrich, 1991; Sapienza, 1992), but
depend on a host of other factors, such as the size of the venture capital firm, its level of
experience, the size of the investment, the power of the board of directors or the charac-
teristics of the portfolio company (Flynn, 1991; Fiet et al., 1997; Flynn and Forman,
2001). For instance, Sweeting and Wong (1997) demonstrate that venture capitalists
adopting a hands-off approach tend to focus on companies that are well-managed and led
by experienced teams with proven track records.
In addition to intensive monitoring, early stage venture capitalists may attempt to
increase the value of their investment by providing several ‘value-added services’ to their
portfolio companies. Several scholars conclude that venture capitalists investing in earlier
stages take a more active managerial role in a young firm (Rosenstein et al., 1993; Carter
and Van Auken, 1994; Sapienza and Gupta, 1994; Sapienza et al., 1994; Elango et al.,
1995; Sapienza et al., 1996). The value-adding activities provided by venture capitalists
involve evaluating and recruiting managers after the investment decision, negotiating
employment contracts, contacting potential vendors, evaluating product market oppor-
tunities, or contacting potential customers (Timmons and Bygrave, 1986; MacMillan
et al., 1988; Gorman and Sahlman, 1989; Fried and Hisrich, 1991; Elango et al., 1995;
Kaplan and Strömberg, 2001; Hellman and Puri, 2002). Flynn (1991) goes as far as to
state that early stage venture capitalists take a leadership role in administrative and strate-
gic responsibilities of a new firm. It seems that the level of early stage venture capitalists’
involvement in value-adding activities is determined by various human capital and fund
characteristics: prior consulting, industry and entrepreneurial experience of the venture
capitalist contribute to a higher level of value-adding activities. Prior studies also report
that investment managers of diversified portfolios and captive funds spend less time with
their portfolio companies (Sapienza et al., 1996; Lockett et al., 2002; Megginson, 2004;
Knockaert et al., 2006).
The active involvement of the venture capitalist in the operations of a new venture
seems to matter from a financial point of view (Barney et al., 1994; Flynn and Forman,
2001; Cumming et al., 2005). It has been suggested that the involvement of venture cap-
italists may help the professionalization of young firms and speed up the commercializa-
tion of innovations (Timmons and Bygrave, 1986; Cyr et al., 2000; Engel and Keilbach,
2002; Hellman and Puri, 2002). Venture capital financing may enhance the portfolio
company’s credibility in the eyes of third parties, such as suppliers, customers and other
investors, whose contributions will be crucial for the company’s success (Megginson and
Weiss, 1991; Steier and Greenwood, 1995; Black and Gilson, 1998). Flynn (1995) provides
preliminary evidence that the degree of analysis, assistance in the articulation of strategy,
and pressure to view issues from a longer term perspective by the venture capitalist are
positively associated with the overall performance of a new venture.
Prior studies also emphasize the importance of the relationship quality between
the venture capitalist and the entrepreneur (for example, Fried and Hisrich, 1995). Sapienza
and Koorsgaard (1996) highlight the importance of entrepreneurs’ timely feedback of
information in building trustful relationships with the investor and securing future funding.
Higashide and Birley (2002) argue that conflict as disagreement can be beneficial for the
venture performance, whereas conflict as personal friction is negatively associated with
success. In a similar vein, Busenitz et al. (2004) report a positive association between new
venture performance and procedurally just interventions by venture capitalists.
Exit strategies and performance of early stage investments

There exists some evidence suggesting that early stage venture capitalists view either trade
sales or initial public offerings (Carter and Van Auken, 1994; Murray, 1994; Amit et al.,
1998; Black and Gilson, 1998; Das et al., 2003) as their preferred route to exit.
Surprisingly enough, very few early stage venture capitalists regard later stage investors
as an attractive exit option (Murray, 1994). In their study focusing on the duration of
venture capital investments, Cumming and MacIntosh (2001) found that earlier stage
deals are likely to be held for a shorter period of time than later stage investments, sug-
gesting significant culling of early stage deals.
Several scholars report higher returns to later stage investments in comparison to early
stage deals (Murray and Marriott, 1998; Murray, 1999; Cumming, 2002; Manigart et al.,
2002; Hege et al., 2003; Cumming and Waltz, 2004). However, early stage investors in the
United States tend to outperform their colleagues focusing on later stage deals and
investors in other parts of the world. These differences in performance may reflect the
superior ability of the US investors to manage early stage investments (Sapienza et al.,
1996) or, alternatively, structural issues related to the minimum viable scale for a
technology-based venture capital fund (Murray and Marriott, 1998; Murray, 1999). The
performance of the US and European venture capital funds by stage of investment is
depicted in Table 10.2.
A wealth of studies focuses on the determinants of returns to venture capital invest-
ments (for example, Cumming, 2002; Gottschalg et al., 2003; Ljungqvist and Richardson,
2003; Kaplan and Schoar, 2005). However, it is important to note that these studies focus
Table 10.2 European and US private equity funds’ pooled internal rates of return
(IRR%) by stage of investment in 2003
US
Europe Europe Europe Europe US US US 10-
1-Year 3-Year 5-Year 10-Year 1-Year 3-Year 5-Year Year
Stage IRR IRR IRR IRR IRR IRR IRR IRR
Early stage 1.0 8.8 5.5 0.6 38.9 7.7 1.5 44.7
Balanced 0.5 5.7 0.9 10.3 14.7 0 0.4 18.2
Buyout 22.8 2.6 5.7 12.5 12.2 2.8 1.0 8.6
Note: The sample includes funds created in 1980–2003.
Source: EVCA/Thomson Venture Economics

on venture capital funds in general, not on early stage funds in particular. These studies
report that:
● specialization exerts a positive impact on returns, possibly due to learning curve

effects enjoyed by venture capitalists accumulating superior knowledge in a specific
industry sector (Gupta and Sapienza, 1992; De Clerq and Dimov, 2003);
● successful venture capitalist firms outperform their peers over time, suggesting ‘per-
sistence phenomena’ or the development of core competences that cannot be easily
imitated (Gottschalg et al., 2003; Ljungqvist and Richardson, 2003; Cumming
et al., 2005; Diller and Kaserer, 2005; Kaplan and Schoar, 2005);
● the relationship between experience and performance is ambiguous. For instance,
Manigart et al. (2002) and Diller and Kaserer (2005) report a positive relationship,
Fleming (2004) reports no relationship and De Clerq and Dimov (2003) an adverse
relationship between experience and performance;
● larger funds outperform smaller funds, but only up to a point, suggesting an
inverted U-shaped relationship between fund size and performance (Gottschalg
et al., 2003; Hochberg et al., 2004; Laine and Torstila, 2004; Kaplan and Schoar,
2005);
● fast fund growth is negatively associated with performance (Kaplan and Schoar,
2005);
● the number of portfolio companies per investment manager and performance
exhibit an inverted U-shaped curve (Jääskeläinen et al., 2002; Schmidt, 2004);
● performance is positively associated with the number of endowments and nega-
tively associated with the number of banks investing in the fund (Lerner et al.,
2005); and
● narrow geographical focus is associated with lower performance (Manigart et al.,
2002).
It is hardly surprising that various management practices applied over the venture
capital cycle have the potential to contribute to the performance of venture capital
funds. For instance, the ability to generate a continuous stream of high quality invest-
ment opportunities (Ljungqvist and Richardson, 2003; Megginson, 2004) and sharp
screening and selection skills (Hege et al., 2003; Schmidt, 2004; Diller and Kaserer,
2005) are reported to lead to superior performance. In a similar vein, a number of
factors related to deal structuring, such as the type of contracts (Kaplan et al., 2003),
staged financing (Gompers and Lerner, 1999; Hege et al., 2003), convertible securities
(Hege et al., 2003; Cumming and Walz, 2004), venture capitalists’ ownership stake
(Amit et al., 1998; Cumming, 2002), syndication (Jääskeläinen et al., 2002; De Clerq and
Dimov, 2003; Cumming and Waltz, 2004) and acting as a lead investor (Sahlman, 1990;
Manigart et al., 2002; Gottschalg et al., 2003), have performance implications. Prior
research also emphasizes venture capitalists’ ability to add value in their portfolio com-
panies (Barney et al., 1994; Flynn, 1995; Flynn and Forman, 2001; Diller and Kaserer,
2005) from a financial point of view. In terms of exit strategies, it has been stated
that going public is the most profitable exit route for venture capitalists (Black and
Gilson, 1998).
Institutional context and the management of early stage investments

Cross-national differences in the management of early stage investments have received a
fair amount of attention in venture capital literature. Prior studies report that such
differences may exist in the way in which the venture capital firms are organized, as well as
in fund raising, deal generation, deal screening, investment structure and post-investment
activities. On the whole, these institutional differences may play a major role in deter-
mining the ability of early stage investors to shield themselves from risks and profit from
their investments.
For instance, Megginson (2004) shows that venture capital firms in the United States
usually take the form of independent limited partnerships and obtain their funding from
institutions, such as pension funds. This structure and larger average fund size offer sub-
stantial contracting benefits for investors operating under information asymmetries and
uncertainty (Murray and Marriott, 1998; McCahery and Vermeulen, 2004; Söderblom
and Wiklund, 2006). Europeans, in their turn, organize their venture capital firms as
investment companies or subsidiaries of larger financial groups (Wright et al., 2005).
Factors promoting fund raising activities include GDP growth and the growth rate of
R&D (Gompers et al., 1998; Jeng and Wells, 2000; Romain and Pottelsberghe, 2004),
favorable tax, regulatory and legal environments (La Porta et al., 1997; Gompers et al.,
1998; Marti and Balboa, 2000; Da Rin et al., 2005, forthcoming), and government pro-
grams facilitating investments in young ventures (Lerner, 2002; Leleux and Surlemont,
2003; Cumming, 2006b, forthcoming). Commitments to early stage ventures are nega-
tively affected by labor market rigidities (Black and Gilson, 1998; Jeng and Wells, 2000;
Romain and van Pottelsberghe, 2004), high capital tax gains (Gompers et al., 1998), and,
in some cases, the presence of government programs crowding out private venture
capital investors (Armour and Cumming, 2004). There is some disagreement among the
researchers regarding the role of deep and liquid stock markets. While some researchers
argue that venture capital fund raising is boosted by well-functioning public markets that
allow new firms to issue shares (Black and Gilson, 1998; Armour and Cumming, 2004;
Da Rin et al., 2005, forthcoming), others argue that this positive effect exists only for later
stage investments and not for early stage deals (Jeng and Wells, 2000). As the aforemen-
tioned determinants of fund raising have mostly been studied in the context of venture
capital in general,5 future research should confirm these results for early stage venture
capital in particular.
It is worth mentioning that the studies focusing on the determinants of funds raised by
early stage venture capitalists largely ignore cultural and social factors (Wright et al.,
2005). A notable exception is the study by Nye and Wassermann (1999) showing that
differing levels of cultural learning contribute to different rates of growth of venture
capital industries in India and Israel. In a similar vein, cultural factors may play a signifi-
cant role in either promoting or hindering entrepreneurship, thus affecting the supply of
high quality investment opportunities available for early stage venture capitalists (Acs,
1992; Baygan and Freuedenberg, 2000; Hayton et al., 2002; Kenney et al., 2002b).
Relative to deal generation, deal screening and valuation, several researchers conclude
that venture capitalists in the United States apply a more comprehensive set of criteria for
evaluating risks associated with new ventures than their colleagues in other parts of the
world (Ray, 1991; Ray and Turpin, 1993; Knight, 1994; Hege et al., 2003). Also the rela-
tive importance of evaluation criteria may vary across nations. Americans tend to value
potential for significant market growth, whereas venture capitalists in transition

economies rely on foreign business education or exposure to Western business practices
as an important signal of managerial ability. Asian venture capitalists, in their turn, seek
personality compatibility when assessing management teams (Ray, 1991; Knight, 1994;
Bliss, 1999). In addition, prior studies suggest that venture capitalists in developed
markets use external specialists for investment appraisal and apply sophisticated valua-
tion procedures based on standard corporate finance theory. Investors in emerging
venture capital industries, in their turn, rely on their own expertise and cash flow methods
for valuation and put greater emphasis on information related to product, market and
proposed exit (Ray, 1991; Ray and Turpin, 1993; Wright and Robbie, 1996; Karsai et al.,
1997; Manigart et al., 2000; Lockett et al., 2002; Wright et al., 2004).
Variations in corporate and tax law environments may have implications for the financ-
ing structure of venture capital investments (Wright et al., 2005). For example, convert-
ible instruments are more widely used in common law countries than in civil law countries
(Cumming, 2002; Cumming and Fleming, 2002; Hege et al., 2003; Kaplan et al., 2003;
Cumming, 2005a; Lerner and Schoar, 2005). Kaplan et al. (2003) report that venture
capital contracts vary across legal regimes in terms of the allocation of cash flow, board,
liquidation and other control rights. However, more experienced venture capitalists all
over the world seem to implement US-style contracts regardless of the legal regime.
Finally, the motivations for and the use of syndication strategies tend to differ depending
on the institutional context (Manigart et al., 2006).
Although investors’ monitoring behavior shares many similarities across nations (Ray,
1991; Pruthi et al., 2003; Bruton et al., 2005), there exist some differences relative to the
nature of post-investment relationship between the entrepreneur and the venture capital-
ist. The active managerial role adopted by the venture capitalist tends to be particularly
visible in the US high-tech industries, where many senior partners have become legendary
for their skills in finding, nurturing and bringing to market high-tech companies
(Megginson, 2004). In line with this reasoning, Sapienza et al. (1996) found that venture
capitalists in more developed venture capital markets (the United States and the United
Kingdom), are more involved in their portfolio companies and add more value than their
colleagues in less developed venture capital markets (France). Hege et al. (2003) and
Schwienbacher (2002), in their turn, report that US venture capital firms, in comparison
with European firms, are more likely to take corrective actions in their portfolio compa-
nies. Unlike Westerners, Asians view capitalist firms and their portfolio as a single collec-
tive entity, which reduces the need to manage and control the agency risks (Bruton et al.,
2003). This greater relationship orientation stemming from a more collectivistic culture is
also reflected in the value-added services provided by venture capitalists while American
venture capitalists are more involved in serving as a sounding board to the venture and in
financially oriented services, Asian venture capitalists emphasize the efforts to build rela-
tionships both inside and outside of the firm. Prior research also reports cross-national
variations in preferred exit strategies and the timing of exit (Cumming and MacIntosh,
2003; Cumming, Schmidt and Walz, 2006). For instance, IPOs are reported to be a more
common exit vehicle in countries where legal investor protections are strong, whereas buy-
backs gain importance in countries with a weaker legal framework protecting the interests
of investors.
The effect of various environmental and institutional factors on fund performance is
mostly indirect in nature (Söderblom and Wiklund, 2006). However, there is some
evidence that overall business cycles, industry cycles and stock market cycles (Gottschalg
et al., 2003; Avnimelech et al., 2004; Diller and Kaserer, 2005; Kaplan and Schoar, 2005)
directly influence the returns to early stage funds. A factor that also seems to have a major
impact on fund performance is the allocation and level of funds. Several researchers show
that an increase in the allocation of money exerts a significant negative impact on fund
performance (Gompers and Lerner, 2000; Ljungqvist and Richardson, 2003; Hochberg
et al., 2004; Da Rin et al., 2005, forthcoming; Diller and Kaserer, 2005). Finally, legal pro-
tections available for investors have been reported to contribute to the superior perform-
ance of venture capital funds (Armour and Cumming, 2004; Kaplan et al., 2003;
Cumming and Walz, 2004; Lerner and Schoar, 2005).
To sum up the discussion above, investors in successful early stage venture capital
markets (in terms of the volume of and return on investments) tend to be more active in
alleviating risks associated with early stage venture capital investments. This more exten-
sive reliance on risk reduction strategies may be explained by the superior skills of
investors operating in mature markets and institutional environments with favorable legis-
lations, government policies and tax regimes. It is noteworthy, however, that the very
nature of risk, or at least the perception of it, may differ depending on the institutional
environment. Therefore, the solutions originating mostly from the Anglo-Saxon context
may not be readily applicable in nations with drastically different normative, cognitive and
regulatory institutions.
Conclusions and discussion

The purpose of this chapter was to review decades of research on early stage venture
capital, basically focusing on two major research themes. The first one describes the
differences between investments in early stage ventures and later stage deals. The second
dominant theme identifies several management practices available for early stage venture
capitalists exposed to high levels of information asymmetries and related risks. I will first
summarize the key findings emerging from these two research streams. Thereafter, I will
continue with some theoretical and methodological considerations, as well as suggestions
for future research.
Summary of key findings

Based on the studies discussed above, it is possible to argue that early stage investment
targets, investors and funds differ from those involved in later stage venture capital activ-
ities. Perhaps most importantly, early stage ventures struggle with challenges associated
with new product and market development, building up a competent management team
and managing growth, making them more susceptible to market and agency risks than
more mature investment targets. The venture capital firms focusing on early stage invest-
ments tend to be shielding themselves from these risks by relying on their experience and
size. In a similar vein, there seems to be a minimum scale of efficiency, after which early
stage investments become a viable option for venture capital funds. Early stage venture
capital has also been found to flourish in institutional environments enjoying favorable
tax, regulatory and legal environments, providing investors with incentives and protection
from various market and agency risks.
Prior literature suggests that early stage venture capitalists actively seek to reduce the
risks and uncertainties at every stage of the venture capital cycle. First, prior studies list
several criteria along which early stage venture capitalists and entrepreneurs may assess
each other’s potential. The most recent literature pays increasing attention to the cog-
nitive processes of venture capitalists in highly uncertain decision contexts. Second,
early stage investors may alleviate information asymmetries and risks through contrac-
tual covenants included in the venture capital contracts, the use of preferred convertible
stock and staged capital infusion, as well as compensation schemes aligning the inter-
ests of venture capitalists and entrepreneurs. Venture capitalists may also attempt to
control the risks by focusing on particular industries or geographical areas, limiting the
size of the investments, or investing in syndicates. Third, early stage venture capitalists
typically devote a substantial amount of time to monitoring and value-adding activities
in the post-investment phase. Finally, relative to the exits and fund performance, early
stage investors are reported to severely under-perform in later stage deals. In a similar
vein, American early stage funds enjoy significantly higher returns than their counter-
parts in Europe. The factors determining the performance of early stage venture capital
investments include the characteristics of venture capital firms and funds, the manage-
ment of the investment process, as well as various macro-economic and institutional
factors.
Theoretical and methodological considerations

Research on early stage venture capital has been conducted by scholars representing many
different disciplines, most notably finance and economics, entrepreneurship and cognitive
psychology. First, finance scholars (for example, Chan, 1983; Amit et al., 1990; 1998;
Lerner, 1994; Gifford, 1997; Gompers, 1995; 1997; Elitzur and Gavious, 2003; Hsu, 2004)
have primarily relied on asymmetric information, signaling and agency theories when
trying to explain the nature of the relationship between venture capitalists and early stage
ventures. Given this theoretical orientation, the focus tends to be on the dark side of the
venture capitalist–entrepreneurship interaction and how venture capitalists may alleviate
problems associated with moral hazard and asymmetric information all over the world
(for example, Cumming and Fleming, 2002; Hege et al., 2003; Kaplan et al., 2003; Lerner
and Schoar, 2005).
Second, entrepreneurship scholars have traditionally taken a rather atheoretical
approach (for example, Camp and Sexton, 1992; Carter and Van Auken, 1994; Elango
et al., 1995; Brouwer and Hendrix, 1998; Balboa and Marti, 2004) or borrowed from
‘Stages of Development Theories’ of new ventures (Ruhnka and Young, 1987; Flynn and
Forman, 2001), when describing the global trends in early stage venture capital invest-
ments or identifying characteristics distinguishing early stage ventures from later
stage deals. However, more recently, entrepreneurship scholars have turned to strategy
and sociology literature – drawing mostly on the resource-based theory, procedural justice
theory and institutional theory, when analyzing the intricacies of the social relationships
in early stage venture capital investments (Fiet et al., 1997; Karsai et al., 1997; Bruton and
Ahlstrom, 2002; Bruton et al., 2002; Busenitz et al., 2004; Manigart et al., 2002; Bruton
et al., 2005). Unlike the studies conducted by finance scholars, this research stream tends
to emphasize more the sunny side of early stage venture capital investments as engines of
growth and innovation and the crucial role of venture capitalists as providers of value-
added services to nascent ventures.
It is important to note that both finance and entrepreneurship scholars emphasize

issues embedded in the venture capitalist–entrepreneur relationship and the external
environment surrounding nascent ventures. An emerging stream in early stage venture
capital research has taken a more introspective view by focusing on the role of cognitive
and sensemaking processes of venture capitalists (for example Zacharakis and Meyer,
1998; Moesel and Fiet, 2001; Moesel et al., 2001; Zacharakis and Shepherd, 2001). This
shift in focus is hardly unexpected, as cognitive processes are likely to play a crucial role
in the reduction of uncertainty and chaos surrounding new ventures.
In terms of research methods used, there is relatively little variation in early stage
venture capital research. A vast majority of studies reviewed adopt a quantitative
approach relying on information derived from surveys or data base data. Only a fraction
of papers represents either a purely theoretical or qualitative approach. However, it seems
likely that as our need for a more in-depth understanding of early stage venture capital
grows, other research methods, such as experiments and ethnographies, will increase in
importance in the future.
Moving forward: Suggestions for future research

After decades of research, our knowledge on early stage venture capital remains limited.
For instance, although several scholars have acknowledged the recent declining trend in
investments in early stage ventures, we still know very little about the reasons underlying
this development. Therefore, future studies should set out to identify changes in the incen-
tive systems and governance structures within the venture capital industry, potentially
explaining the relative decline in investments in young ventures. Approaching this ques-
tion would also necessitate a shift toward more longitudinal research methods than hith-
erto applied in early stage venture capital research.
Second, several studies suggest that the financial needs of early stage ventures might be
best addressed by a combination of public funding schemes and informal venture capital
(Branscomb and Auerswald, 2002). An interesting area for future research would thus be
addressing the complementarities between public funding and early stage venture cap-
italists (Lerner, 2002) or the synergies between business angel funding and early stage
venture capital (Harrison and Mason, 2000).
Third, there seem to be significant regional differences in the operations and perform-
ance of early stage venture capitalists. On the one hand, prior literature gives us a reason
to believe that the Anglo-Saxon nations in general and the United States in particular have
managed to create an institutional environment conducive to early stage venture capital,
and therefore, could act as role models for other nations. On the other hand, it is also pos-
sible to argue that nations with institutional environments drastically different from that
of the United States should develop their own versions of early stage venture capital. An
interesting avenue for future research would thus involve exploring how this modified
version of venture capital should look, operate and help investors deal with risks inher-
ent in early stage investments.
Fourth, the greatest challenges associated with early stage venture capital investments
are cognitive in nature. These challenges relate to the perceptions of risks and sense-
making processes of venture capitalists facing chaotic environments surrounding new
ventures. As Fried and Hisrich (1994) put it, successful venture capitalists are, above all,
efficient information processors and producers. This gives us a reason to believe that
research on early stage venture capital will continue to benefit from borrowing from
research on human cognition and information processing mechanisms.
Notes
1. The author would like to thank Hans Landström, Mike Wright, and the participants of the Workshop on
Venture Capital Policy in Lund for their invaluable comments on the earlier version of this chapter.
2. I used ABI Inform/Proquest, JSTOR, Google Scholar and SSRN electronic databases to identify suitable
references. In addition, I reviewed the reference sections of all articles to find more relevant references. The
main focus of the literature search was on papers focusing explicitly on early stage venture capital and on
articles comparing early stage venture capital to investments in later stage deals.
3. Strictly speaking, there is a distinction between uncertainty and risk: risk is an uncertainty for which prob-
ability can be calculated (with past statistics, for example) or at least estimated (doing projection scenarios).
However, for uncertainty, it is impossible to assign such a (well grounded) probability (www.wikipedia.org).
In this chapter, these two terms are often used as synonyms, reflecting their usage in prior studies.
4. However, Norton and Tenenbaum (1993) and Cumming (2005a; 2006a) found that the use of preferred
stock is not more frequent in early stage ventures.
5. The studies reviewed herein focus on the performance of venture capital funds, excluding buyouts. However,
these studies do not focus solely on seed, start-up and first stage investments.
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11 Private equity and management buy-outs
Mike Wright
Introduction
Management buy-outs and related transactions involve simultaneous changes in the own-
ership, financial structure and incentive systems of firms. Although buy-outs can be
traced back to the eighteenth and nineteenth centuries, the modern phenomenon began
to appear in the late 1970s in the US and diffused to the UK in the early 1980s (Wright
et al., 1991). Buy-outs represent an important part of private equity markets internation-
ally, yet present major challenges that may differ from investing in early stage entrepre-
neurial ventures (see Chapter 10).
In terms of their importance to private equity markets, buy-outs have accounted for
major shares of both the volume and value of transactions since the 1980s (Wright et al.,
2000a). In many European private equity markets they account for the majority of funds
committed annually (EVCA, 2004). Buy-outs have played an important role in the tran-
sition from Communism in Central and Eastern Europe from the beginning of the 1990s
(Wright et al., 2002a). Buy-outs offered a mechanism to effect transition that would
enhance the ownership and control of enterprises where there were strong insider inter-
ests and often an absence of external buyers. For similar reasons, further privatization and
restructuring activity has seen the spread of buy-outs to Africa (Wright et al., 2000c).
Buy-outs are now spreading in significant numbers to Asia in both developed markets that
need to restructure, such as Japan and Korea, as well as emerging and transition
economies such as China (Wright et al., 2003a).
By enabling corporations to restructure, buy-outs have become an important part of
the overall mergers and acquisitions market, for example, accounting for the majority of
transactions in the UK (CMBOR, 2005). The incentive and monitoring mechanisms they
introduce may help to enhance firm performance. These mechanisms, coupled with the
lower risk from investing in established firms, have contributed to private equity firms’
buy-out portfolios outperforming other venture capital investment stages (EVCA, 2004;
BVCA, 2004).
In terms of challenges, buy-outs raise a number of important issues across the private
equity investment life-cycle that may differ from those relating to early stage investments.
Buy-outs involve more established businesses that reduce some of the problems associ-
ated with early stage ventures such as the identification of a new market and the valua-
tion of businesses with little or no cash-flow. However, buy-outs raise challenges that
relate, for example, to the identification of ways to generate capital gains in mature busi-
nesses, to whether managers of existing businesses can make the transition to owner-
managers and become entrepreneurial, to achieving the appropriate balance of debt and
equity financing in structuring transactions, and to the identification of suitable means to
obtain capital gains from businesses that may be difficult to exit through an IPO.
This chapter examines the issues relating to private equity and management buy-outs.
The buy-out literature can be characterized as having two main streams, a finance stream
281
and an entrepreneurship stream. In the US, buy-outs have traditionally been viewed as a
corporate finance phenomenon (Jensen, 1989; 1993). The major focus of much research
is on financial aspects relating to buy-outs at the bought out firm level. This research has
examined in detail the antecedents of buy-outs and their performance effects. In Europe,
buy-outs have tended to be viewed as an entrepreneurial phenomenon with the private
equity market having a long-standing involvement (Wright and Coyne, 1985). This
chapter seeks to integrate these streams and generate themes for further research. There
is relatively little work, however, that considers the whole of the private equity investment
life-cycle. Similarly, little work has examined the role of private equity financiers and the
managers and entrepreneurs in the bought out companies.
The structure of the chapter is as follows. The first section provides an overview of the
development of buy-outs, starting with a consideration of definitions of buy-outs. This is
followed by a brief elaboration of a framework for analysing the factors leading to the
development of a private equity-based buy-out market and a review of the development
of the main private equity-backed buy-out markets. The second principal section analy-
ses private equity and buy-outs using a life-cycle perspective. Specifically, this section con-
siders buy-out deal generation and antecedents; screening and negotiation; valuation;
structuring; monitoring and adding value; and exit and longevity. Both theoretical per-
spectives and empirical evidence are considered. Finally, some conclusions are presented
and areas for further research outlined.
The development of private equity and buy-outs

This section begins by defining different forms of buy-out. It goes on to outline the factors
influencing the development of a private equity-based buy-out market and then summa-
rizes the trends in the international growth of buy-out markets.
Definitions of buy-outs
In general, buy-outs involve the creation of a new independent entity in which ownership
is concentrated in the hands of management and private equity firms, if present, with sub-
stantial funding also provided by banks. Private equity firms become active investors
through taking board seats and specifying contractual restrictions on the behaviour of
management which include detailed reporting requirements. Lenders also typically
specify and closely monitor detailed loan covenants (Citron et al., 1997).
As shown in Table 11.1, buy-outs may take a number of forms. In a leveraged buy-out
(LBO), typically a publicly-quoted corporation or a large division of a group is acquired
by a specialist LBO association. In the US, the resulting private company is typically con-
trolled by a small board of directors representing the LBO association, with the CEO
usually the only insider on the board (Jensen, 1989; 1993). As the name suggests, these
deals are generally highly leveraged, with the LBO association acquiring a significant
equity stake. The same institutions may be involved as debt and equity subscribers – under
a so-called ‘strip financing’ arrangement – or, alternatively, specialist institutions may be
involved with debt instruments ranging from secured loans to junk bonds (Jensen, 1989).
By contrast, a management buy-out (MBO) usually involves the acquisition of a
divested division or subsidiary or of a private family-owned firm by a new company in
which the existing management takes a substantial proportion of the equity. In place of
the LBO association, MBOs usually require the support of a private equity firm. The
Private equity and management buy-outs 283
Table 11.1 Definitions of buy-outs
Management Buy-out (MBO) Existing Management Main Non-Venture Capital Owners

Management Buy-in (MBI) Outside Individuals Main Non-Venture Capital Owners
Management Employee Buy-out Existing Management and Employees Significant Owners
(MEBO)
Leveraged Buy-out (LBO) Outside LBO Association Main Owners; high debt
Investor-led Buy-out (IBO) Venture Capital Firm Initiates Transaction; Management
Some Equity
Leveraged Build-up (LBU) Initial Buy-out Used as a Platform to Develop Larger
Group By Acquisitions
Buy-in Management Buy-out Hybrid Buy-in/Buy-out
(BIMBO)
former parent may retain an equity stake, perhaps to support a continuing trading rela-
tionship. In smaller transactions management are likely to obtain a majority of the voting
equity (CMBOR, 2005). MBOs typically involve a small group of senior managers as
equity-holders but depending on circumstances equity-holding may be extended to other
management and employees, creating a management–employee buy-out (MEBO).
MEBOs may occur, for example, where it is important to tie in the specific human capital
of the employees or where a firm is widely spread geographically, making direct manage-
ment difficult, or on privatization where there is a need to encourage trade unions to
support the transfer of ownership (for example, in bus services and transportation).
A management buy-in (MBI) (Robbie et al., 1992) is simply an MBO in which the
leading members of the management team are outsiders. Although superficially similar
to MBOs, MBIs carry greater risks as incoming management do not have the benefits of
the insiders’ knowledge of the operation of the business. Venture capitalists have sought
to address this problem by putting together hybrid buy-in/management buy-outs (so-
called BIMBOs) to obtain the benefits of the entrepreneurial expertise of the outside
managers and the intimate internal knowledge of the incumbent management.
Investor-led buy-outs (IBOs) involve the acquisition of a whole company or a division
of a larger group in a transaction led by a private equity firm and are also referred to as
bought deals or financial purchases. The private equity firm will typically either retain
existing management to run the company or bring in new management to do so, or
employ some combination of internal and external management. Incumbent manage-
ment may or may not receive a direct equity stake or may receive stock options. IBOs
developed in the late 1990s when private equity firms were searching for attractive deals
in an increasingly competitive market and where corporate vendors or large divisions
were seeking to sell them through auctions rather than giving preference to incumbent
managers.
Leveraged build-ups (LBUs) involve the development of a corporate group based on
an initial buy-out or buy-in which serves as a platform investment to which are added a
series of acquisitions. LBUs developed as private equity firms sought new means of gen-
erating returns from buy-out type investments. The initial platform deal may need to be
of a sufficiently large size for it to attract the management with the skills and experience
to grow a large business through acquisition. LBUs may be attractive in fragmented
industries with strong demand prospects. The potential problems with LBUs relate to the
identification, purchase and subsequent integration of suitable acquisition candidates.
Factors influencing the development of a private equity-based buy-out market

Wright et al. (1992) develop a framework to examine the factors influencing the
differential development of management buy-out markets. They identify three main
factors that need to be present for a buy-out market to develop:
● The generation of deal opportunities is likely to be heavily influenced by both the

supply of deal flow from different vendor sources and the demand for private equity
in terms of the willingness of managers to take risks and their willingness to buy
enterprises.
● The infrastructure to complete transactions includes sources of funding both in
respect of private equity and the availability of senior and mezzanine debt. It also
covers the nature of legal and taxation regimes, including corporate reporting
regimes, and the existence of advisors who can both identify and negotiate buy-outs.
● The existence of suitable exit routes comprises the availability of stock markets,
mergers and acquisitions markets and the scope for recapitalizations through sec-
ondary buy-outs.
Using this model, Table 11.2 provides an illustrative comparative synthesis of the
factors influencing the development of private equity-based buy-out markets in UK,
Germany, Central and Eastern Europe (CEE) and Japan which represent different insti-
tutional contexts. A detailed comparison of the factors influencing the development of all
markets is beyond the scope of this chapter (for further discussion see Wright et al., 1992;
2003a; 2004; 2005).
Panels A and B in Table 11.2 relate to the generation of deal opportunities. Panel A
illustrates the important differences between these countries in terms of the supply of buy-
out opportunities. For example, in the UK the strongest supply of opportunities was the
restructuring of diversified groups, with going private transactions becoming more
important latterly. In contrast, in Germany the need to deal with succession problems in
family-owned firms was relatively more important. In CEE, the transition from commu-
nism initially created opportunities to privatize state-owned assets. In Japan, the need to
restructure the keiretsus provides major scope for divestment buy-outs.
Panel B examines the demand side and in particular emphasizes differences in attitudes
to entrepreneurial risk and the willingness of management to undertake a buy-out. The
most notable distinction is that in the UK these factors were considerably more positive
than in the other countries, but some change in attitudes there is noted.
Panel C relates to the infrastructure to complete deals. Again, the UK has more devel-
oped private equity and debt markets, better intermediary networks and more favourable
legal and taxation frameworks than in continental Europe. It is notable that in the other
countries, changes are underway to make this infrastructure more favourable. These
changes reflect the pressures from the potential supply of deals to enable industrial
restructuring to take place noted in Panel A.
Finally, Panel D relates to the existence of suitable exit routes and their importance for
private equity firms to realize their gains in buy-out investments. There are notable
Table 11.2 Comparison of factors affecting MBO market development in Western

Europe, CEE and Japan
Panel A: Supply of opportunities

Supply of
opportunities UK Germany CEE Japan
• Need to deal Moderate need High need Low need Moderate
• with family
• succession
• problems
• Need to Established Becoming Increasingly Substantial and
• restructure patterns established from established in increasing from
• diversified groups
throughout mid-1990s early 2000s 2000
period
• Need to privatize Well established Former GDR Bulk of Low, slowly
• state-owned programme apart, relatively privatizations gaining
• companies from 1980s; little completed momentum
now complete under the
Koizumi
Administration
• Scope for ‘going- Large stock Relatively small Many candidates; Moderate but
• private’ market; few number of specific growing since
• transactions initial deals now quoted opportunities 2003
significant companies must grow
• Development Highly developed Becoming active Relatively active Active in light
• stage of M&A of need for
• markets restructuring
Panel B: Demand for private equity

Demand for private
equity UK Germany CEE Japan
• Attitude to Was very Traditionally Positive and Traditionally
• entrepreneurial positive from low, changing growing very low; very
• risk early 1980s slowly slow change
• Willingness of High Starting to High, but Increasing in
• managers to buy develop lacking light of
financial frustrations in
means larger groups &
perceived
greater rewards
available
Panel C: Infrastructure to complete deals

Infrastructure to
complete deals UK Germany CEE Japan
• Private Equity Grew rapidly Traditionally Small but Significant
• and Venture from early small & not developing recent entry of
Panel C: Infrastructure to complete deals (continued)

Infrastructure to
complete deals UK Germany CEE Japan
Capital market 1980s MBO funds for MBOs
orientated
• Supply of debt High Tradition of Low but Banks
high leverage growing undergoing
major
restructuring
but buy-outs
seen as
attractive
option
• Intermediaries Highly Fragmented Highly Quite developed
• network developed developed
• Favourability of Favourable Moderately Favourable Recent positive
• legal framework favourable changes in buy-
out specific
aspects; efforts
to increase
flexibility
• Favourability of Favourable Reforms in Moving to Reforms in
• taxation regime progress favourable progress
with EU
reforms
Panel D: Realization of gains

Realization of gains UK Germany CEE Japan
• Stock markets Receptive to New issues Growing Recent
private equity sparse; domestic development
cos. From secondary tier capital pool aiding buy-out
mid-1980s; market closed and appetite exit
now more
difficult
• Trade sales Highly active M&A market Highly active Active
developing
• Secondary Increasing Possible route Possible Beginning to
• buy-outs/ interest exit route appear
• restructuring
Source: CMBOR
differences in the role of stock markets in facilitating IPOs. However, even developed
stock markets provide limited opportunities to exit buy-out investments, unless they are
larger, fast growing businesses. Accordingly, acquisitions markets assume an important
role to enable businesses to be sold to other corporations. As many corporations begin to
complete their restructuring and as markets become more concentrated and global, there
is less scope for the trade sale exit route, especially for smaller deals. This shift has seen
the emergence of the secondary buy-out or buy-in where an initial deal is sold to another
private equity firm enabling the first to achieve an exit. This option is important in the
more developed UK market but as the other markets become more mature and need to
seek exits, the ability to achieve a secondary buy-out may be useful in an environment of
relatively weak stock and corporate acquisition markets.
Trends in the development of private equity-based buy-out markets

In this section, the development of private equity-based buy-out markets in different
countries is discussed.
Buy-outs in the US Although buy-outs were present in the US during the 1960s and
1970s, the major period of growth was in the 1980s with the taking private of listed cor-
porations a prominent feature (Figures 11.1 and 11.2). The US economy of the 1980s
was characterized by extensive (hostile) corporate takeovers and restructuring. Jensen
(1991) argues that during this period, LBOs and MBOs functioned as the necessary cat-
alyst for change in inefficient conglomerate firms. The US market developed with the
greater use of senior and mezzanine debt than in Europe and a concentration on mature
sectors with low investment needs. The existence of a quoted market for high yield
debt enabled very large transactions to be completed and allowed LBO specialists and
200
Value $bn
180
160
140
120
100
80
60
40
20
0
1988 1990 1992 1994 1996 1998 2000 2002 2004
Figure 11.1 Value of LBOs in the US

900
800 number
700
600
500
400
300
200
100
0
1988 1990 1992 1994 1996 1998 2000 2002 2004
Figure 11.2 Number of LBOs in the US
management teams to compete with corporate acquirers (Kaufman and Englender,

1993; Baker and Smith, 1998). The culmination of the 1980s LBO wave was associated
with many bankruptcies and fierce public and political resistance (anti-takeover legisla-
tion) such that activity slowed abruptly (Kaplan and Stein, 1993). From 1997 onwards,
there was a modest rise in both public to private (PTPs) and divestment buy-outs in
the US, with a sharp increase taking place in 2003 to 2005 in both value and volume.
The concept became more associated with seeking growth opportunities than with
cost reduction and asset stripping as previously (Kester and Luehrman, 1995).
Correspondingly, private equity firms have also emerged as more important financiers
in the US buy-out market. Since 2000, PTPs were initially motivated by the decline of
the stock markets which seems to make the sale of public equity too costly as a source
of funds. The implementation of the Sarbanes-Oxley Act which tightened disclosure
requirements for listed corporation following corporate governance concerns in the
wake of the Enron scandal is said to increase the costs of a listing substantially. The
level of buy-outs of private companies is very low in the US compared to most other
countries.
Buy-outs in the UK Wright et al. (2000a) identify four phases in the development of
the UK buy-out market. The first phase involved initial market development in the early
1980s. In the context of deep recession, many deals involved failed firms or firms
restructuring to avoid failure. Relaxation of the prohibition on firms providing finan-
cial assistance to purchase their own shares in 1981 reduced the barriers for lenders to
obtain security for the funds they advanced. The second phase involved rapid market
growth from the mid-1980s to the end of the decade. Buy-outs were increasingly the
result of considered refocusing strategies and a first peak was reached in 1989. Deal
numbers rose throughout the 1980s up to 1990. The advent of specialist private equity
and mezzanine funds together with entry by US banks from the mid-1980s helped fund
this development. The shift to buy-out funds reflected a need for specialized managers
who can provide professional monitoring and advice. In addition, funds enabled larger
deal sizes to be completed than were typically feasible with straight captive funding by
parent banks or insurance companies. Further, the raising of funds by former captives
(to create semi-captives) provides a mechanism to tie executive remuneration more
closely to returns from investment, which may not be possible within an overall
bank/insurance company corporate remuneration structure. The third phase involved
the collapse of large deals and resurgence of deals involving distressed firms in the reces-
sion of the early 1990s. The ending of the recession in 1994 saw the emergence of a
fourth phase involving rapid growth in market value, which reached a new peak in 2000.
Greater focus on larger transactions by market players saw deal numbers fall. Beyond
the period covered by Wright et al. (2000a), the years after 2000 marked a major
reassessment of the market in the wake of the collapse of the dot.com boom and its
wider repercussions.
In contrast to the US, divestments from larger groups have been more important
sources of buy-out in the UK. Toms and Wright (2005) attribute this difference to a
number of factors relating to financing availability and taxation differences. In the UK,
both buy-outs involving divestment and those involving family-owned firms have become
less important in recent years. Correspondingly, secondary buy-outs and public to private
buy-outs in particular became more important from the mid-1990s. The lack of liquidity
and the need for expansion capital as a consequence of the cut-off of institutional equity
finance, is argued to have pressured small listed companies to respond to advances by
private equity firms. However, this is only part of the explanation as increasingly larger
corporations are being targeted (CMBOR, 2005).
Continental Europe The continental European buy-out market was generally slower to
develop but some countries saw more active buy-out markets much earlier than others,
such as the Netherlands and Sweden (Tables 11.3a and 11.3b) (Wright et al., 1991). The
French market began to develop from the mid-1980s as concerns about succession in
family businesses led to the introduction of fiscal incentives to undertake buy-outs.
Market growth was also fuelled by a change to a more positive entrepreneurial culture
towards buy-outs. The French private equity industry grew rapidly from the mid-1980s,
with lawyers particularly playing an important role in the diffusion of the buy-out
concept. Development of the Second Marché and the Nouveau Marché enhanced the
scope for the realization of buy-out investments although partial sales have provided a
frequent realization route for investors. Buy-out activity could be identified in Germany
in the early 1980s, but it was only from the early 1990s that the market began to show sig-
nificant growth leading to a peak in 2000 before market value halved the following year.
In contrast to the UK and France, the willingness of German managers to undertake buy-
outs has traditionally been low but is changing as the growth of corporate restructuring
has significantly reduced managerial security of tenure. The infrastructure to complete
German deals was for a long time less than favourable – few intermediaries, an under-
developed private equity market and high rates of taxation. Many of these restrictions did
not begin to ease until the mid-1990s, such as relaxation of the capital gains tax regime
relating to share disposals. Stock markets in Germany have traditionally been less devel-
oped than in the other two countries.
Table 11.3a Number of buy-outs/buy-ins
Country Name 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Austria 4 6 7 5 4 13 7 17 12 14
Belgium 2 11 10 19 16 18 25 24 20 36
Denmark 7 14 16 13 18 18 11 18 12 16
Finland 21 25 33 16 19 15 23 29 28 27
France 95 115 137 155 147 128 126 123 142 150
Germany 79 73 97 79 51 66 90 102 104 110
Ireland 7 9 9 15 9 12 16 19 14 9
Italy 12 23 25 33 42 29 17 38 43 43
Netherlands 59 56 61 74 65 78 59 60 74 68
Norway 6 7 6 4 8 7 9 12 16 11
Portugal 8 5 3 6 6 5 1 6 5 3
Spain 14 13 23 39 30 28 37 42 51 33
Sweden 14 16 21 23 33 24 48 25 23 39
Switzerland 45 53 65 51 56 54 50 35 30 28
Total (CE) 373 426 513 532 504 495 519 550 574 587
UK 598 646 707 688 653 614 638 628 699 686
Total (inc UK) 971 1072 1220 1220 1157 1109 1157 1178 1273 1273
Source: CMBOR/Barclays Private Equity/Deloitte
Table 11.3b Value of buy-outs/buy-ins (€m)
Country Name 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Austria 56 68 128 95 680 734 47 150 303 88
Belgium 14 147 414 823 2595 337 1744 517 1448 2266
Denmark 54 388 263 269 2165 1313 498 1391 848 335
Finland 189 723 455 559 1085 675 1047 460 1039 977
France 1424 2189 5250 6198 8375 6448 6405 15550 8768 11878
Germany 1208 1704 3523 5313 4660 15076 7500 8121 11578 17912
Ireland 172 116 97 258 1475 259 5021 4918 779 935
Italy 271 1115 3115 695 2714 2550 737 3428 7770 2472
Netherlands 857 988 1059 3435 2901 1739 4428 1793 4958 6936
Norway 18 316 181 23 226 1004 1371 142 301 427
Portugal 344 154 64 84 206 83 2 26 54 8
Spain 241 227 374 861 1713 944 1530 2069 970 2791
Sweden 685 700 1551 928 2926 3164 3000 1116 2223 1813
Switzerland 712 1276 2426 1347 1013 1772 715 2764 864 1327
Total (CE) 6245 10111 18900 20888 32734 36098 34045 42445 41903 50165
UK 9012 12602 17109 23265 26750 38339 31334 24823 23518 30074
Total (inc UK) 15257 22713 36009 44153 59484 74437 65379 67268 65421 80239

Table 11.4a Continental European buy-outs/buy-ins by source: number of deals
Type 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Family & Private 87 96 125 167 126 117 92 88 114 136
Foreign parent 56 63 73 74 69 69 96 102 99 85
Local parent 149 153 203 162 168 176 210 198 188 218
Privatization 16 8 8 9 4 4 3 3 4 1
Public buy-in 0 2 3 3 1 8 2 2 2 2
Public to Private 2 8 8 5 31 20 14 13 18 10
Receivership 16 22 14 10 11 8 11 43 21 14
Secondary Buy-out 5 7 10 22 29 30 30 29 61 68
Unknown 42 67 69 80 65 63 61 72 67 53
Total 373 426 513 532 504 495 519 550 574 587
Table 11.4b Continental European buy-outs/buy-ins by source: value (€m)
Type 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Family & Private 1473 2870 5503 6867 5686 2508 3496 4314 4025 6695
Foreign parent 1144 940 2865 3616 5059 5584 4676 3925 4253 3965
Local parent 2784 4430 5898 6741 13456 14945 16176 18575 18236 16340
Privatization 226 238 2289 1259 387 1092 97 2441 989 4
Public buy-in 0 10 121 204 32 904 173 237 571 1070
Public to Private 47 259 286 477 5248 6204 7502 6676 3788 7928
Receivership 159 203 93 85 85 79 58 1688 945 105
Secondary Buy-out 71 360 1264 654 1934 3709 1376 4066 8413 13054
Unknown 340 800 581 984 849 1073 491 523 683 1004
Total 6244 10110 18900 20887 32736 36098 34045 42445 41903 50165
The overall European trend in buy-out vendor sources is shown in Tables 11.4a
and 11.4b. In France, deal opportunities initially arose from a need to sell businesses by
the owners of family firms facing succession problems. Succession and portfolio reorgan-
ization issues in the large number of family-controlled listed companies in France also
contributed to a marked growth in buy-outs from this source. Divestments from corpor-
ations have now become a major part of the French private equity market associated with
growing competitive pressures on French industry and increasing focus on corporate gov-
ernance and shareholder value.
Reluctance by founders of small and medium sized firms in countries like Germany,
Spain and Italy both to let go and to sell to private equity firms has restricted market
growth. Buy-outs from family firms have become relatively less important as divestments
have become more important alongside secondary buy-outs. The European market for
PTP transactions is still small, in part because Continental European countries have fewer
listed companies. Culture may also be important, with managers in some countries
wishing to avoid the burden of a listing in the first place while in others managers may be
too proud of their listing to even rationally consider going private (CMBOR, 2002).
Buy-outs worldwide The buy-out concept has also spread to Japan as the country faced
major problems of corporate reorganization in the light of macro-economic problems.
The country saw occasional buy-outs during the early 1990s but 1998 marked the real
birth of the market. The market continued to grow from 2000, and by 2003 67 deals were
completed with the total value increasing almost five-fold over the previous year to 520
billion yen (€4200 million). Divestments by Japanese corporations have consistently pro-
vided the largest source of buy-outs to date. An important development from late 2000
was the appearance of buy-outs of whole listed companies. Buy-outs of failed firms also
contribute an important element of the market being facilitated by the establishment of
the Civil Rehabilitation Law in 2000, which provided a more flexible in-court corporate
rescue scheme to help deal with the problem of distressed firms resulting from the
country’s macro-economic difficulties. Buy-outs of privately-owned (family) firms have
also increased in relative importance.
Despite these growth trends, the maturity of different buy-out markets varies quite
markedly. An indicator of relative market maturity is the ratio of the value of buy-out
transactions to a country’s GDP across Europe (Figure 11.3). The UK is by far the largest
single buy-out market as a proportion of GDP, while the French and German markets
fare less well compared to their overall buy-out market size. Most notably, Spain and Italy
as relatively large economies are seen to have very undeveloped buy-out markets.
Summary
This section has shown the heterogeneity of the buy-out concept and demonstrated its
applicability to different firm and country contexts. The heterogeneity of market devel-
opment shown in Figure 11.1 strongly reflects the impact of the differences in the factors
influencing the development of buy-out markets outlined earlier in the section. The
pattern of individual market development over time suggests that changes in these factors
do help to stimulate market growth. Those countries with low buy-out market value to
GDP ratios may need to consider how some of these factors can be relaxed to facilitate
the development of buy-out markets to address needs for restructuring corporations and
effecting ownership transition in family firms.
The buy-out life-cycle

To examine the issues relating to private equity and management buy-outs, we adopt a
life-cycle perspective of the buy-out process (Wright and Robbie, 1998). Essentially, the
life-cycle perspective involves the deal generation; screening and negotiation; valuation;
structuring; monitoring and adding value; and exiting and longevity. We discuss each of
these stages in the life-cycle in turn. The discussion encompasses examination of buy-outs
of listed firms that are taken private and buy-outs of privately-owned firms.
Buy-out deal generation and antecedents

Buy-out deal opportunities which developed in the 1980s were linked to agency cost prob-
lems and a failure of firms’ internal control mechanisms (Jensen, 1993). In particular, the
UK
Netherlands
Germany
Belgium
France
Finland
Sweden
Ireland
Switzerland
Spain
Norway
Italy
Denmark
Austria
Portugal
0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50% 4.00% 4.50%
2004 2003 2002
Source: CMBOR/Barclays Private Equity/Deloitte and OECD Statistics
Figure 11.3 Buy-outs as a percentage of GDP
multi-divisional firm was argued to be failing to deliver shareholder benefits (Thompson

and Wright, 1988). Although the multi-divisional firm was hypothesized to reduce man-
agerial discretion, many firms nominally structured in this way in practice lacked the control
and incentive mechanisms that were conceptually necessary to generate performance
improvements (Hill, 1985). Moreover, the comparative advantage of the internal capital
market, a central feature of resource allocation in multi-divisional firms, was argued to have
declined with improvements in the efficiency of external markets (Bhide, 1992).
Jensen (1989) argued that these problems were particularly acute in mature businesses
which generated free cash flows since these firms would tend to engage in unprofitable
diversification rather than disgorge the cash in abnormally large dividends. This diversi-
fication may be beneficial to managers remunerated on the basis of firm size but not for
shareholders. Similarly, a multi-product firm with satisfactory overall cash flow and weak
governance may experience considerable inertia in taking decisions to reorganize its activ-
ities in line with changing market conditions (Jensen, 1993).
These situations generated the conditions for buy-outs to improve efficiencies. First,
reconcentration of equity in the hands of insiders and/or with private equity firms with a
close association with the new firm provides the incentive to seek profitable opportunities.
Second, private equity firms become active monitors, unlike passive shareholders in a
listed corporation, and have the specific skills to undertake this monitoring. Third, the
large-scale substitution of debt, quasi-debt and quasi-equity, for ordinary equity in the
financing of the buy-out carries a commitment to meet servicing costs which reduces man-
agerial discretion and places pressure on management to perform. Fourth, management’s
equity stake may also be based on performance outcomes, according to a performance-
contingent contract or ratchet mechanism (Thompson et al., 1992). Finally, where there
is a trading relationship with a former parent, a divestment buy-out may have an increased
incentive to perform where it is heavily dependent on its former parent and where the
former parent retains an equity interest (cross-holding) (Wright, 1986).
The failure of internal control systems may also be seen in more innovative firms. In large,
integrated diverse organizations, bureaucratic measures may be adopted to try to ensure
performance but these measures may restrict experimentation and constrain innovative
activity (Francis and Smith, 1995). Managers in the pre-buy-out situation thus face invest-
ment restrictions from headquarters, particularly where their firms are peripheral to the
main product line of the parent company (Wright et al., 2001). These problems may be
eased after the buy-out. Instead of obeying orders from headquarters that block innova-
tion and investment in order to optimize the goals of the diversified parent company, the
buy-out creates discretionary power for the new management team to decide what is best
for the business, how to organize and lead the company, and how to set up a business plan
that is most profitable for themselves and the firm (Wright et al., 2000b; 2001).
Several further arguments have been advanced to explain buy-outs, particularly those
involving the taking private of listed corporations. First is the tax hypothesis. As the vast
majority of PTP transactions take place with a substantial increase in leverage, the
increase in interest deductions constitutes an important source of expected wealth gains.
Interest tax deductibility on the new loans constitutes a major tax shield increasing the
pre-recapitalization value.
Second is the transaction cost hypothesis associated with the direct costs of maintain-
ing a stock exchange listing (DeAngelo et al., 1984). The transaction costs hypothesis sug-
gests that the wealth gains from going private are largely the result of the elimination of
the direct and indirect costs associated with maintaining a stock exchange listing.
Third is the defence against hostile takeover hypothesis which suggests that the premi-
ums in PTPs reflect the fact that the management team may intend to buy out the other
shareholders in order to insulate itself against an unsolicited takeover. Lowenstein (1985)
reports that some corporations have gone private via an MBO as a defensive measure
against a hostile takeover threat.
Fourth is the undervaluation hypothesis which states that when the pre-transaction firm’s
stock is underperforming, the management or an LBO specialist are able to pay higher pre-
miums in a PTP transaction as they are expected to create additional shareholder value once
the firm is private. There may be asymmetric information between management and out-
siders about the maximum value that can be realized with the assets in place. Management
with superior private information may perceive that the share price is undervalued in rela-
tion to the true potential of the firm. This problem may be exacerbated where listed corpor-
ations find it problematical to use the equity market to fund expansion, as it may be difficult
to attract the interest of institutional shareholders and fund managers. The lack of interest
in such shares creates illiquidity and implies that they are likely to remain lowly valued
which provides an impetus to go private. Lowenstein (1985) argues that management may
employ specific accounting techniques to depress the pre-announcement share price, such
as manipulating dividends and deliberately depressing earnings.
Fifth is the wealth transfer from other stakeholders hypothesis. A firm going private
can transfer wealth from bondholders to stockholders by issuing debt of higher or equal
seniority. In PTPs, the third mechanism in particular can lead to substantial bondholder
wealth expropriation.
Sixth, potential financial distress costs may deter firms from going private and hence
the expected benefits associated with this form of organizational structure may not be
realized (Opler and Titman, 1993).
Much of the evidence relating to deal generation concerns the antecedents to the taking
private of listed firms in the US. US studies of the role of free cash flow in the decision to
go private have produced mixed results. Lehn and Poulsen (1989) and Singh (1990) report
that firms going private have greater free cash flow than firms remaining public, but lower
sales growth. However, Kieschnick (1998) reworked Lehn and Poulsen’s sample using a
weighted logistic regression and found free cash flow and sales growth to be insignificant.
In addition, Opler and Titman (1993) find that leveraged buy-outs are more likely to
exhibit only the combined characteristics of low Tobin’s Q and high cash flow than firms
remaining public. Further, Halpern et al. (1999) also find no evidence to support the free
cash flow hypothesis. This US evidence, therefore, suggests that going private is not being
driven by the need to return free cash to the shareholders.
Kaplan (1989b) estimates the tax benefits of US PTPs to be between 21 per cent and
72 per cent of the premium paid to shareholders to take the company private for the first
half of the 1980s. Singh (1990) reports that US MBOs were significantly more under
takeover pressure prior to the MBO than a sample of matched firms. DeAngelo (1986) finds
no evidence of systematic manipulation of pre-buy-out accounting data by incumbent
management. Wu (1997) does show evidence consistent with the view that managers manip-
ulate earnings downwards prior to the MBO proposal. Asquith and Wizman (1990), Cook
et al. (1992) and Warga and Welch (1993) show that bondholders with covenants offering
low protection against corporate restructuring lose some percentage of their investment.
UK evidence indicates that firms that go private through a buy-out are more likely than
those that remain listed to have higher CEO ownership, higher institutional ownership
and more duality of CEO and chairman (Weir et al., 2005a). These firms did not have
excess free cash flows or face a greater threat of hostile acquisition but they did have lower
growth opportunities. In a related study, Weir et al. (2005b) find that managers’ percep-
tion that the market undervalued the company was significantly associated with going
private. Renneboog et al. (2007) find for a sample of UK PTPs completed between 1997
and 2003 that the main sources of the shareholder wealth gains are undervaluation of the
pre-transaction target firm, increased interest tax shields and incentive realignment. In
contrast, they find that an expected reduction of free cash flows does not determine the
premiums nor are PTPs a defensive reaction against a takeover.
The buy-out concept may also apply to private family-owned firms. There is increasing
recognition that there may not be suitable family members willing or able to take on the
ownership and management of the business (Wright et al., 1992; Bachkaniwala et al.,
2001). In mature private family firms, growth opportunities may have been exhausted and
founders somewhat detached from the running of the business as they begin to pursue
other interests. Second tier management may possess greater information about the
running of the business and possess the managerial skills to introduce needed professional
management but not be in a position to take appropriate decisions (Howorth et al., 2004).
A management buy-out may be a means of effecting succession and be acceptable to
the founder as the best way to preserve their psychic income through maintaining the
company’s independent identity and culture, as well as continuing to be involved in the
business. However, dominant founders may not have developed strong second tier man-
agement who could become owner-managers. If this is the case, a management buy-in
may be needed (Robbie and Wright, 1996).
Screening and negotiating buy-outs

In appraising potential investments, private equity firms are faced with an adverse selec-
tion problem (Amit et al., 1993). In contrast to early stage owner-managed ventures,
private equity firms considering funding management buy-out proposals need to take
their decisions on the basis of observed managerial performance in post, expectations
about whether improving managerial incentives will improve performance and manage-
ment’s willingness to take on the risk of a buy-out in order to secure the fruits of their
human capital. Management buy-ins typically focus on enterprises which require turn-
around and restructuring, but as the buy-in entrepreneur comes from outside there are
problems of asymmetric information, both in relation to their true skills and because it
has not been possible to observe the manager in post. These problems create uncertainty
for the private equity financier about whether the deal in which they are investing is what
they thought it was, which may be difficult to address before they commit their funds.
In a management buy-out, private equity firms may be guided by incumbent manage-
ment’s deep knowledge of the business (Birley et al., 1999). Management may not necessar-
ily have clear incentives to reveal truthful information since they may either wish to underplay
problems in their anxiety to make the deal appear viable or overplay problems in order to
reduce the transaction price. However, detailed probing may enable the private equity firm
to uncover major difficulties and approach an accurate assessment of the true state of affairs.
By investing in insiders, private equity firms may be able to reduce uncertainties more than
is the case for management buy-ins. Management buy-in entrepreneurs may be able to reduce
some of the problems of asymmetric information where they have detailed knowledge about
the industry sector but even here, information availability for private firms may be limited
(Robbie and Wright, 1995). In such cases they may be able to use personal networks to carry
out informal verification about the state of the target enterprise. These problems may arise
in both buy-outs of listed corporations and those involving private firms.
One way to improve the chances of success in negotiating a buy-out of a listed corpor-
ation is to seek irrevocable commitments from significant shareholders to accept the
bidder’s bid before the offer is made public. Gaining these commitments means that the
bidder is sending a signal to other non-committed shareholders that the deal is a good
one. The announcement of substantial irrevocable commitments may also make other
potential bidders less likely to enter the contest with an alternative bid. The initial com-
mitment ensures that, without any higher alternative bid, the agreement to sell the share
becomes binding. Private equity bidders for listed companies may use irrevocable com-
mitments in an attempt to ensure the success of a PTP proposal and reduce the costs asso-
ciated with failure, as well as avoiding a bidding contest that would potentially reduce
their returns from the investment. Weir et al. (2007) find that those proposing a manage-
ment buy-out (MBO) are more likely to gain the backing of other shareholders the greater
the bid premium and the more reputable the private equity backer.
Informational asymmetries between vendors and purchasers may impact buy-outs
involving private family firm succession. Flows of information may impact both succes-
sion planning and buy-out negotiation process. A number of negotiation issues are raised,
which centre around information asymmetries between founders and managers, as well as
the extent to which negotiations are dominated by one or other party or whether they are
collaborative (Howorth et al., 2004). Scholes et al. (2005) find lower information asym-
metry problems if family firm vendors and the existing management team are equally
involved in succession planning. However, they found that negotiations were less likely to
involve a mutually agreed price where the succession process was driven by the vendor.
Valuation
Private equity investors need to value potential deals in order to consider whether they
are likely to achieve their target rates of return. Private equity firms typically use a com-
bination of price/earnings multiples and discounted (free) cash flow multiples (Manigart
et al., 1997). Other things being equal, the higher the premium that purchasers pay, the
more that needs to be done post-deal to achieve target rates of return. At the same time,
vendors, seeing that the private equity and management purchasers are undertaking a
buy-out as they believe they can enhance performance, may seek to capture some of these
future gains by seeking a higher price before being persuaded to sell their shares.
For listed corporations, the value vendors place on a business is reflected in the share
price response to the announcement of an attempt to take a firm private. A series of US
studies (DeAngelo et al., 1984; Kaplan, 1989a; Lehn and Poulsen, 1989; Marais et al.,
1989) finds a large abnormal gain for the target’s shareholders when a going private LBO
deal is announced. Kaplan (1989a) reports a median abnormal gain of 42 per cent for
76 US buy-outs in the period 1980–86. Similar stock market studies of voluntary divest-
ments as LBOs by diversified companies (for example Hite and Vetsuypens, 1989;
Markides, 1992) reveal small but significant positive announcement effects. This US
evidence is also reflected in the UK. Renneboog et al. (2007) examine the valuation of
buy-outs of listed corporations in the UK during 1997–2003 and find that the share price
reaction to the PTP announcement is about 30 per cent.
There is the possibility of systematically lower premiums where insiders involved in the
buy-out take action to reduce the apparent valuation in order to buy out at a price that is
advantageous to themselves. This could be passive, where managers simply exploit asset
prices which appear (to them) to be too low or it could be the result of some deliberate
misrepresentation or concealment by them. Evidence on the former has been obtained
from abnormal stock market returns for announced and then withdrawn LBOs
(DeAngelo et al., 1984; Marais et al., 1989). Smith (1990) argues that abandoned, hidden-
information buy-outs should show the same subsequent performance gains as completed
ones and hence the same market response, assuming the buy-out is solely motivated by
insider information. She finds no such evidence and hence concludes against the hidden
information view. However, the stock market response appears to depend substantially on
whether or not a subsequent bid occurs (Lee, 1992), whilst existing owners’ returns are
greater when competitive bids are received (Easterwood et al., 1994).
Insiders may manage earnings prior to a management bid in order to reduce the profits
base for valuing the business. The evidence is somewhat contradictory: DeAngelo (1986)
reports none whilst Perry and Williams (1994) find evidence of consistent falls in the last
complete financial year prior to an announcement. Kaplan and Stein (1993) analyse the
structure of MBO pricing across the whole of the 1980s. They suggest that deal prices rose
with the level of leverage leading to over-heating and a sharp rise in the failure rate at the
end of the decade. Thus if there were initial transfers from the pre-MBO owners, this
trend was reversed across the period.
Structuring
The structuring of buy-out deals involves both the combination of financial instruments
required to effect the purchase and the contractual mechanisms introduced by private
equity firms which give them various cash flow and control rights. The latter may be either
attached directly to particular financial instruments or be included in the corporate
charter, shareholders’ agreement, or articles of association.
In the US, Cotter and Peck (2001) show that active monitoring by a buy-out specialist
substitutes for tighter debt terms in monitoring and motivating managers of LBOs. Buy-
out specialists that control a majority of the post-LBO equity tend to use less debt in
transactions. Buy-out specialists that closely monitor managers through stronger repre-
sentation on the board also tend to use less debt.
In the UK, where evidence is most comprehensive, the majority of buy-outs are backed
by private equity firms and hence are likely to use equity and quasi-equity instruments.
The probability of receiving equity backing increases with size (CMBOR, 2005). While in
the late 1990s, about a half of buy-outs with a transaction value of less than £10m
received private equity backing, this proportion had fallen to about one fifth a decade
later. At the largest end of the market, it is relatively rare for deals with a transaction value
above £100m to be wholly debt funded (Tables 11.5a and 11.5b).
In contrast to early stage venture capital deals, buy-outs tend to make use of a wider
range of financial instruments comprising equity, quasi-equity (for example redeemable and
convertible shares), quasi-debt (various layers of privately and publicly placed mezzanine
or subordinated debt), senior debt (various layers of secured debt with different maturities
and return characteristics) and asset-based financing such as leasing (Wright et al., 1991).
The relative importance of these financial instruments is shown in Tables 11.6a and 11.6b
which provide mean deal structuring data for all UK buy-outs completed in each year.
Although continental Europe has a bank-based system (Black and Gilson, 1998), US
buy-outs typically involve greater levels of debt. In the US, banks appear to be more
Table 11.5a Share of UK buy-outs that are private equity backed
1997 2000 2002

Deal Size VC Total % VC VC Total % VC VC Total % VC
Range Backed Deals Backed Backed Deals Backed Backed Deals Backed
Less than £10m 277 548 50.5 134 424 31.6 113 493 22.9
£10m – £25m 65 74 87.8 69 89 77.5 44 67 65.7
£25m – £50m 32 38 84.2 22 27 81.5 22 28 78.6
£50m – £75m 22 22 100.0 20 26 76.9 14 16 87.5
£75m – £100m 10 11 90.9 7 7 100.0 5 6 83.3
Over £100m 15 16 93.8 40 45 88.9 24 27 88.9
Table 11.5b Share of UK buy-outs that are private equity backed
2003 2004 2005

Deal Size VC Total % VC VC Total % VC VC Total % VC
Range Backed Deals Backed Backed Deals Backed Backed Deals Backed
Less than £10m 108 569 19.0 105 506 20.8 115 497 23.1
£10m – £25m 43 54 79.6 51 72 70.8 46 63 73.0
£25m – £50m 31 39 79.5 37 45 82.2 38 47 80.9
£50m – £75m 18 23 78.3 20 24 83.3 14 16 87.5
£75m – £100m 5 5 100.0 7 7 100.0 11 11 100.0
Over £100m 20 21 95.2 43 47 91.5 48 51 94.1
Table 11.6a UK buy-out/buy-in deal structures, less than £10m financing
Type of Finance (Average %) 1993 2000 2001 2002 2003 2004

Equity 41.0 54.4 41.1 30.4 43.1 41.1
Mezzanine 3.4 4.6 1.8 1.7 0.6 1.0
Debt 36.2 35.0 46.6 48.9 47.8 44.8
Loan Note 7.4 3.6 2.8 10.5 3.0 7.1
Other Finance 14.1 3.0 7.5 8.5 5.6 6.0
Total financing (£m) 265 331 402 290 223 228
Vendor contribution 10.8 2.7 4.1 6.6 2.8 7.2
Management contribution 16.0 6.3 5.0 7.6 3.5 8.6
Proportion of equity held 68.7 63.7 61.8 78.4 66.8 61.8
by management

Table 11.6b UK buy-out/buy-in deal structures, £10m or more financing
Type of Finance (Average %) 1993 2000 2001 2002 2003 2004

Equity 33.2 43.3 37.2 37.6 41.6 39.9
Mezzanine 4.5 4.7 5.0 4.6 3.6 5.2
Debt 47.5 46.4 46.6 50.2 49.3 50.7
Loan Note 8.6 1.7 4.0 3.2 2.8 1.9
Other Finance 8.2 3.8 7.3 4.4 2.7 2.3
Total financing (£m) 1905 13339 13614 9934 10922 11463
Vendor contribution 5.1 2.3 4.3 3.4 1.2 2.9
Management contribution 2.4 5.3 2.1 2.0 3.1 2.7
Proportion of equity held 27.6 32.1 36.8 35.7 27.7 33.0
by management
willing to lend on the basis of stable cash flow and the ability to sell assets in liquid cor-
porate asset markets at going concern value. In the bank-based systems of continental
Europe, asset markets are much less liquid, and collateral value may be more likely to be
based on estimated distress value. In continental Europe, the mezzanine finance providers,
which can help increase the debt available in buyouts, are relatively less well-developed
and unbundling deals involving the sell-off of surplus assets post-buy-out are quite
unusual compared to the US (CMBOR, 2005).
As Kaplan and Strömberg (2001) find for venture capitalists, Sahlman (1990) and
Robbie and Wright (1990) indicate that private equity investors in buy-outs also use
various contractual mechanisms to encourage entrepreneurs both to perform and to
reveal accurate information. These mechanisms include staging of the commitment of
investment funds, convertible financial instruments (‘equity ratchets’) which may give
financiers control under certain conditions, basing compensation on value created, pre-
serving mechanisms to force agents to distribute capital and profits, and powers written
into Articles of Association which require approval for certain actions (for example acqui-
sitions, certain types of investment and divestment, and so on) to be sought from
the investor(s) (Robbie and Wright, 1990). In addition to such structural mechanisms, the
process of the relationship with the investee company is also an important aspect of the
corporate governance framework.
Monitoring and adding value

In this section we consider the mechanisms and processes of monitoring and adding
value, the effects of monitoring and investor involvement, and aspects relating to restruc-
turing failure.
Mechanisms and process Active private equity investor monitoring in buy-outs and buy-
ins has some similarities with that undertaken by venture capital firms in early stage ven-
tures. Sahlman (1990) in comparing LBO Associations with venture capitalists notes that
executives in the former may typically assume control of the board of directors but are gen-
erally less likely than venture capitalists to assume operational control. UK evidence in
buy-outs and buy-ins shows that board representation is the most popular method of mon-
itoring investee companies, with there also being a requirement for the regular provision of
accounts to the private equity investor (Robbie et al., 1992). However, reflecting the greater
asymmetric information issues in buy-ins, private equity firms exercise a greater degree of
control than for buy-outs (Robbie et al., 1992). Equity ratchets are also found to be more
frequently used in buy-ins, reflecting the greater uncertainty about their future performance.
With respect to the process of monitoring, evidence from buy-outs and buy-ins empha-
sizes the extent of keeping the private equity firm informed of developments through
regular contact. Hatherly et al. (1994) show that on balance the relationship between
financial institutions and management buy-outs involves partnership and mutual interest
with devices to control agency problems generally being used in a flexible manner.
However, in smaller buy-ins in particular, private equity firms do not appear to be particu-
larly active in responding to signals about adverse performance or in developing rela-
tionships with entrepreneurs (Robbie and Wright, 1995). In larger buy-ins there is
evidence of extensive and repeated active monitoring (Wright et al., 1994). This difference
illustrates the comparative cost–effort–reward trade-offs involved in the active monitor-
ing of large and small investments.
Bruining and Wright (2002) provide exploratory case study evidence suggesting how
private equity firms can enhance the entrepreneurial orientation through integrating the
contributions of specialist top management decision-making, influencing the leadership
style of CEOs, keeping value added strategy on track and assisting in new ventures, and
in broadening market focus. Bruining et al. (2004) also provide detailed case analysis of
how private equity firms can contribute to the development of management control
systems that facilitate strategic change in different types of buy-outs.
Effects of monitoring and involvement Research on US LBOs during the 1980s indicates
substantial mean improvements in profitability and cash flow measures over the interval
between one year prior to the transaction and two or three years subsequent to it (Kaplan,
1989a; Muscarella and Vetsuypens, 1990; Smith, 1990; Opler, 1992; Kaplan and Stein,
1993; Smart and Waldfogel, 1994). Similarly, UK evidence indicates the vast majority of
buy-outs show clear improvements in profitability and working capital management
(Wright et al., 1992). Wright et al. (1996a) concluded that firms experiencing an MBO
generated significantly higher increases in return on assets than comparable firms that did
not experience an MBO over a period from two to five years after buy-out. In the French
market, Desbrieres and Schatt (2002) find that firms that were acquired outperform com-
parable firms in the same industry both before and after the buy-out. However, in con-
trast to findings relating to US and UK LBOs, the performance of French MBO firms
declines after the transaction is consummated, but this downturn seems to be less detri-
mental to former subsidiaries of groups than to former family businesses, the latter
forming a more important part of the French market.
Buy-outs are a means for refocusing the strategic activities of the firm (Seth and
Easterwood, 1993; Phan and Hill, 1995). Both Wright et al. (1992) and Zahra (1995) find
that buy-outs are followed by significant increases in new product development and other
aspects of corporate entrepreneurship.
Buy-outs also improve productivity. Lichtenberg and Siegel (1990) found that total
factor productivity for plants involved in LBOs rose from 2 per cent above its industry
control pre-LBO, to 8.3 per cent above over the first three years of post-LBO operation.
For the UK, Wright et al. (1996a), Amess (2003) and Harris et al. (2005) show that man-
agement buy-outs are associated with improvements in total factor productivity. Harris
et al. (2005) show, in contrast to US evidence, that MBO establishments were approxi-
mately 2 per cent less productive than comparable plants pre-LBO but experienced a
substantial increase in productivity of approximately 90 per cent post-LBO. US evi-
dence strongly supports the view that capital investment falls immediately following the
LBO as a result of the increased leverage (Kaplan, 1989a; Smith, 1990). The evidence
on UK MBOs is rather different. Wright et al. (1992) report that asset sales are offset by
new capital investment, particularly in plant and equipment. The effect of buy-outs on
R&D is less clear, although on balance there seems to be a reduction (Smith, 1990;
Lichtenberg and Siegel, 1990; Long and Ravenscraft, 1993). However, as many LBOs
are in low R&D industries, the overall effect may be unsubstantial. There is some evi-
dence that in buy-outs that do have R&D needs, this expenditure is used more effectively
(Zahra, 1995).
There is mixed evidence on the effects of buy-out on employment. Kaplan (1989a),
Smith (1990), and Opler (1992) – but not Muscarella and Vetsuypens (1990) – report small
increases in total firm employment following LBOs. Kaplan (1989a) and Smith (1990),
however, report that buy-outs do not expand their employment in line with industry aver-
ages. Lichtenberg and Siegel (1990) report an 8.5 per cent fall in non-production workers,
over a three-year period, with production employment unchanged.
Early UK evidence suggested that job losses occur most substantially at the time of the
change in ownership (Wright et al., 1992). Amess and Wright (2007) show in a panel of
1350 UK buy-outs covering the period 1999–2004 that employment growth is 0.51 of a
percentage point higher for MBOs after the change in ownership and 0.81 of a percent-
age point lower for MBIs. These findings are consistent with the notion that MBOs lead
to the exploitation of growth opportunities, resulting in higher employment growth. The
same patterns do not emerge from MBIs, typically because the latter transactions involve
enterprises that require considerable restructuring.
The wealth of existing bondholders will be adversely affected if new debt, issued at
the time of the restructuring, impacts adversely on the perceived riskiness of the origi-
nal debt. Marais et al. (1989) fail to detect any such wealth transfer but Asquith and
Wizman (1990) report a small average loss of market value but those original bonds with
protective covenants showed a positive effect. As buy-outs typically substitute debt for
equity they tend to reduce corporate tax liabilities but this tax saving generally accounts
for only a small fraction of the value gain in buy-outs (Schipper and Smith, 1988;
Kaplan, 1989b).
Some indications of the effects of monitoring mechanisms introduced in buy-outs are
given by comparing alternative organizational forms. For example, leveraged recapital-
izations, which simply substitute debt for equity in quoted companies, have been shown
to raise shareholder value (Denis and Denis, 1993) but they do not appear to have the
same performance impact as LBOs, which also involve managerial ownership and insti-
tutional involvement (Denis, 1994). Similarly, defensive Employee Share Ownership Plans
(ESOPs), in which leveraged employee share purchases are used to forestall takeovers, do
not appear to perform as well as LBOs (Chen and Kensinger, 1988). Thompson et al.
(1992) found that the management team shareholding size had by far the larger impact
on relative performance in UK MBOs. Similarly, Phan and Hill (1995) found that
managerial equity stakes had a much stronger effect on performance than debt levels for
periods of three and five years following the buy-out.
Nikoskelainen and Wright (2007) examine the role of corporate governance in enhanc-
ing the real returns to exited buy-outs and find an average (median) return of 22.2 per cent
(5.3 per cent) net of market index returns based on a sample of 321 exited buy-outs in
the UK between 1995 and 2004. Their analysis shows that a balance of interrelated firm-
level corporate governance mechanisms (including gearing, syndication and management
ownership) is critical for value-increase in buy-outs, and the importance of these mech-
anisms for enhancing returns is context-dependent in relation to the size of the transac-
tion, among other things.
Cumming and Walz (2004) assess the returns to buy-outs from the investor’s perspec-
tive based on a sample of 39 countries around the world. For the subset of the buy-out
data from the US and the UK which spans the 1984–2001 period, they find an average
(median) return to LBOs to be 26.1 per cent (31.4 per cent) and an average return to
MBOs/MBIs to be 21.5 per cent (18.5 per cent) net of market index returns. This study
also shows that the average returns to earlier stage venture capital investments are signifi-
cantly greater than the average returns to buy-outs, whereas the median returns to buy-
outs are greater than the median returns to earlier stage venture capital investments.
Cumming and Walz (2004) find that returns are high for syndicated investments but lower
for co-investments, which suggests the capital from a follow-on fund is used to bail out
the bad investments from earlier funds. Knigge et al. (2006) show that, in contrast to
venture capital funds, the performance of buy-out funds is largely driven by the experi-
ence of the fund managers regardless of market timing.
Restructuring and failure High leverage in the structuring of buy-outs may mean that
financial distress is signalled sooner than if an enterprise were funded substantially by
equity (Jensen, 1991). A firm which defaults on interest and loan payments may still retain
greater value and stand a better chance of being reorganized, than one which is finally
forced to waive a dividend. Kaplan and Stein (1993) in a study of larger US buy-outs and
Wright et al. (1994) for the UK provide strong evidence that higher amounts of debt were
associated with an increased probability of failure or needing to be restructured. Many of
these firms may be restructured and sold as going concerns (Citron et al., 2003). However,
a problem of enforcing restructuring is that it may be difficult to agree with other parties
what form it should take, especially in smaller investments where management are usually
important majority shareholders. If institutions are a controlling shareholder, as is
usually the case in larger buy-outs and buy-ins, making changes is theoretically straight-
forward. However, in cases with large syndicates of financiers, restructuring may be
delayed or may take a particular direction because of differences in the attitudes of syn-
dicate members (Wright and Lockett, 2003).
An important issue in dealing with investees that are in distress concerns whether or not
to replace the CEO. Larger management buy-ins may be able to bear extensive restructur-
ing, and it may be economical for institutions to invest the effort to undertake it, whereas
the possibilities may be very limited for smaller cases. In small buy-outs and buy-ins, man-
agement may own the vast majority of the equity and a very small group of managers may
carry out the major functions, thus making it difficult to remove underperforming
management or to enforce a trade sale until a pressure point arises which cannot be
relieved by other funding sources. In larger buy-outs and buy-ins, no single manager may
be indispensable and it may thus be easier for institutions to exert pressure to remove
under-performing senior managers.
Exit and longevity

There is some debate about whether buy-outs are a long or short term form of organiza-
tion (Jensen, 1989; Rappaport, 1990). Evidence suggests that the longevity of buy-outs is
heterogeneous, with some remaining with the buy-out structure for long periods, while
others change quite quickly (Kaplan, 1991; Wright et al., 1995). Important issues relate
to the need to understand the influences on this longevity and the effects on performance
once the firm has exited from the buy-out structure.
With respect to the first point, Wright et al. (1993) suggest that a range of institutional
factors including the state of development of asset and stock markets, legal infrastruc-
tures affecting the nature of private equity firms’ structures and the differing roles and
objectives of management and private equity firms influence the timing and nature of
exits from buy-outs. Importantly, private equity firms’ desire for realization in order to
achieve their target returns may influence the nature of their involvement to achieve a
timely exit (Wright et al., 1994). Buy-outs funded through closed-end funds may especially
seek exit within a given time period compared to those funded through other sources of
finance (Chiplin et al., 1995). In order to achieve timely exit, private equity firms are more
likely to engage in closer (hands-on) monitoring and to use exit-related equity-ratchets on
management’s equity stakes (Wright et al., 1995).
With respect to what happens following exit from the private buy-out structure,
Holthausen and Larcker (1996) find that while leverage and management equity falls
when buy-outs return to market (reverse buy-outs), they remain high relative to compa-
rable listed corporations that have not undergone a buy-out. Pre-IPO, buy-outs’ account-
ing performance is significantly higher than the median for the buy-outs’ sector. Following
the IPO, accounting performance remains significantly above the firms’ sector for four
years but declines during this period. Consistent with other studies, they find that the
change is positively related to changes in insider ownership but not to leverage. Bruton
et al. (2002) also find that agency cost problems did not reappear immediately following
a reverse buy-out but rather took several years to re-emerge.
Venture-backed MBOs in the UK tend to IPO earlier than their non-venture-backed
counterparts (Jelic et al., 2005). There is some evidence that they are more underpriced
than MBOs without venture capital backing but not that they perform better than their
non-venture capital-backed counterparts in the long run. In contrast to the grandstand-
ing hypothesis (Gompers, 1996), private to public MBOs backed by more reputable
venture capitalists in the UK tend to exit earlier, and these MBOs performed better than
those backed by less prestigious venture capitalists.
Summary
This review has shown that there has been differential research attention to the different
elements of the buy-out life-cycle. There has been extensive attention to the deal gener-
ation and antecedent aspects, the premiums paid and the performance effects of buy-outs
in particular. There has been relatively little work relating to the valuation mechanisms
used by private equity firms, structuring of deals and the processes by which value is
added by both entrepreneurial management and private equity firms. This different degree
of attention reflects the emphasis, especially in the US literature, on buy-outs as a finan-
cial rather than an entrepreneurial phenomenon. More recent evidence suggests a ques-
tioning of the dominance of the traditional financial, agency cost-based arguments for
buy-outs. This has been notable, for example, in respect of the role of managers’ private
information and perceived undervaluation of shares in the decision to take a company
private as well as with respect to the creation of value post-buy-out. Most research has
also focused on buy-outs involving public corporations but there is growing recognition
of the distinctive nature of buy-outs involving family firms. This increasing attention has
been associated with attention to the buy-out negotiation process but little work has been
conducted on such aspects as the role of auctions involving private equity firms and their
impacts on valuations and financial structuring.
Conclusions and topics for future research

The theoretical and empirical discussion in this chapter indicates that private-equity
backed buy-outs can yield large gains in shareholder value and operating performance. In
this section we draw on the findings presented above to consider topics for further
research. Broadly following the structure of the chapter, this section considers the main
research gaps under the principal headings of the development of private equity and buy-
outs, and the life-cycle of buy-outs to be in terms of: changes in deal characteristics over
time; international developments, sources of buy-outs; organizational forms of buy-out
financiers and their involvement; generating value; and exiting buy-outs.
The development of private equity and buy-outs
Changes in deal characteristics over time The discussion of the trends in private equity
backed buy-outs showed that the characteristics of deals have changed over time with
private equity firms adapting the types of deal in which they invest. As private equity firms
become more involved in buy-outs, there may be scope for deals in more innovative sectors
(Robbie et al., 1999). There is a need for further research to address questions such as: how
do private equity-driven MBOs differ in the 1990s/2000s from those of the 1980s? What
factors are influential in determining private equity deals now compared to the 1980s?
Comparative analysis of the 1980s with the current period might usefully examine
differences in vendor and sector deal source and consider to what extent these are associ-
ated with changes in the generation of deal opportunities, changes in regulatory conditions,
developments in financing techniques and entry of new types of financiers, and so on.
International aspects As has been shown, buy-out markets are developing internation-
ally as countries come under increasing pressure to restructure their economies. Public to
private LBOs have been occurring in significant volumes over the past five years in coun-
tries where they were previously absent. These developments add to the growing interest
in the influence of contextual factors in finance and governance. How do the determinants
of private equity deals in different countries differ from those relating to the US?
The international spread of the buy-out phenomenon raises the role of international-
ization by private equity firms which at present is little understood (Wright et al., 2006).
Internationalization may take different forms and may involve different scope and
different modus operandi. What determines the decisions by private equity firms to inter-
nationalize? What resources distinguish those private equity firms that internationalize
from those that do not? How do private equity firms investing in buy-outs decide on which
markets to enter and what mode of entry to adopt?
Sources of MBOs The focus in this chapter has been on two main sources of buy-outs,
public to private transactions (PTPs) and buy-outs of family firms. The regulatory costs
associated with a stock market listing have important implications regarding the attrac-
tiveness of the stock market for firms. Modest sized firms with growth and restructuring
opportunities may find it difficult to raise funds. Emphasis on accountability may stifle
the ability of firms to realize entrepreneurial opportunities. In these circumstances,
private equity investors can provide both finance to realize growth opportunities as well
as active governance. What is the impact of regulatory changes on developments in public
to private transactions?
Further examination is required relating to the attractiveness to private equity firms of
secondary buy-outs which, as we have noted, have become a major feature of buy-out
markets. Relatedly, a further neglected area concerns the low levels of purchases by buy-
out funds from early stage venture capital funds. Murray (1994) suggests that greater
value can be obtained through IPO or sale to a trade buyer. But we know from statistics
provided by country venture capital associations that by no means all exits from early
stage funds are via these exit routes. It may be that buy-out funds do not possess the
appropriate skills to continue to develop relatively early stage growing firms (Lockett et
al., 2002). Detailed examination of the links between early stage venture capital funds and
buy-out funds might provide useful insights into this part of the private equity market.
Internationally, transactions involving family firms facing succession problems account
for significant shares of buy-out markets, yet relatively little work has been focused on this
aspect. Increasing recognition of agency issues in family firms (Schulze et al., 2003) draws
attention to the information asymmetry problems that may occur in negotiating buy-outs
on succession. What are the implications of pre-buy-out governance and ownership struc-
ture in family firms for the scope for a management buy-out in addressing succession
issues? How do venture-backed and non-venture-backed buy-outs of family firms
compare in terms of negotiating a deal that is satisfactory to both the family owners and
the non-family owners buying out?
The buy-out life-cycle
Life-cycle behaviour and organizational forms of financiers Perhaps because of the US

emphasis of much of the work on buy-outs there has been little attention to the nature
and effects of the organizational form of the private equity firms involved. Private equity
firms can take several organizational forms including: independent limited partnerships
established and managed by professional private equity firms or leveraged buy-out asso-
ciations that act as general partners in managing the fund on behalf of the limited part-
ners; captive firms that obtain their funding from a parent financial institution;
semi-captive firms that obtain their finance partly from their parent and partly by raising
closed-end funds; and public sector firms. How do different organizational forms impact
private equity firms’ investment behaviour including the types of deals sought, screening
of investments and the sources of deal value that are sought, the degree of their involve-
ment in monitoring and value adding activities, and their investment time horizon?
Relatedly, to what extent are these different dimensions associated with the use of different
forms of financial instruments and incentives for management? Further work is also
needed to examine systematically how the structure of buy-outs funds and limited partner
agreements differ from the structure of early stage venture capital funds. Similarly, there
is an absence of work that compares the contractual structures used by buy-out firms
compared with those used by early stage venture capital firms.
The attractive risk–return trade-offs available from private equity transactions have
also encouraged new types of entrants seeking to emulate these returns. Hedge funds in
particular have become attracted to making private equity investments, yet raise a
number of issues regarding their transaction oriented nature and their ability to add
value to investees. Further research might usefully compare the role of private equity
firms and hedge funds in the buy-outs market. What is the impact of large funding avail-
ability and the entry of new types of competing bidders, such as hedge funds, on private
equity deal pricing, and expected and realized returns? Relatedly, what are the implica-
tions of new forms of financial instruments and the holders of these instruments, such
as hedge funds? For example, how are distressed private equity deals restructured? How
do private equity firms and hedge funds compare in terms of providing governance for
investee firms?
Adding value in MBOs Our analysis has suggested there may need to be greater empha-
sis on entrepreneurial activity to improve the upside potential of these firms. Evidence on
the total factor productivity improvements in buy-outs has so far not teased out the con-
tribution of innovative activities. Research in this area may require the construction of
novel datasets involving the integration of multi-level, multi-source data. Quantitative
research is also required to consider the generalizability of qualitative findings regarding
the role of private equity firms in enhancing entrepreneurial behaviour by buy-outs.
Private equity firms may have a role in preserving value, especially where buy-outs
encounter problems. What role do private equity firms play relative to that of secured
creditors in reorganizing distressed buy-outs? To what extent is there evidence of conflicts
between the interest of the secured lender and the private equity firm? To what extent do
these cases represent examples where the private equity firm did not engage in sufficient
monitoring? To what extent were the problems the result of the private equity firm failing
to identify issues at the initial due diligence stage? In addition, how successful have private
equity firms been in successfully turning around failing businesses or exiting distressed
businesses through sale to another corporation?
Research at the private equity firm level is probably where the greatest gap exists. A start
in this area has been made by Berg (2005) who presents a framework based on Porter’s
value chain approach to look at private equity firms’ strategies using evidence from their
websites. Further research might adopt alternative frameworks such as a resource-based
approach (Barney et al., 2001) and undertake more systematic survey research to provide
richer insights. For example, in the light of Lei and Hitt’s (1995) argument that LBOs may
lead to a reduced resource base for organizational learning and technology development,
to what extent do private equity firms help fill this gap?
Wright et al. (2000b; 2001) theorized the need for different types of mindsets for
different types of buy-outs. Further systematic analysis is required to test these arguments
and to identify the effects of these different types of entrepreneurs. As markets mature
and extensive exits from earlier deals become prevalent, an emergent phenomenon of
serial buy-out or buy-in entrepreneurs is occurring (Wright et al., 1997a; 1997b; Wright
et al., 2000d; Ucbasaran et al., 2003a; 2003b). How do entrepreneurs involved in private
equity-backed secondary buy-outs differ from those in first time buy-outs in terms of their
motivations and strategies to create value? How and to what extent do serial buy-out/buy-
in entrepreneurs learn from their previous experience and how is this reflected in the buy-
out/buy-in opportunities in which they invest, the strategies they adopt and subsequent
performance? How do private equity firms identify and screen experienced entrepreneurs
for buy-out and buy-in investments and how does this differ from their approach to serial
start-up entrepreneurs?
Exiting MBOs Finally, changes in stock and takeover markets also introduce issues con-
cerning the ability of private equity firms to realize the gains from their investments, espe-
cially for modest sized deals in mature sectors, while at the same time meeting investors’
expectations of significant returns within a particular time period. As such, private equity
firms have had to develop new forms of exit, such as the widespread growth in secondary
buy-outs, but these raise questions concerning the returns that can be generated and the
willingness of limited partners to invest in the same deal a second time through a follow-
on fund. At present, there is limited research on these phenomena. What is the role of sec-
ondary LBOs and releveraging in enhancing the longevity of private equity deals? What
are the implications of secondary LBOs for returns to private equity funds and Limited
Partners?
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Finance, 12, 373–89.
Zahra, S.A. (1995), ‘Corporate entrepreneurship and financial performance: the case of management leveraged
buy-outs’, Journal of Business Venturing, 10, 225–47.
PART III
INFORMAL VENTURE
CAPITAL
12 Business angel research: The road traveled and
the journey ahead
Peter Kelly
An enduring phenomenon
It’s [informal venture capital] not a new phenomenon, of course. Henry Ford’s auto empire
was launched thanks to five [business] angels who plunked down $40,000 in 1903. (Conlin,
1989, p. 32)
Can you imagine what it must have been like for Henry Ford to find backers for his entre-
preneurial dream more than a century ago? Finding an individual with cash to invest,
expertise to share and who is not related to you, a business angel in accepted parlance of
today, must have been a severe challenge for him. What is particularly striking is that if
Henry asked a business angel researcher where to find backers, our suggestions would be
little different than today. Tap into your own network of contacts for leads. Look around
your neighborhood for people that live in large houses or, in his day, those who owned a
telephone. His search would have probably been confined geographically as he was
proposing to create a mass-market transportation revolution. Once located, the deal
would be consummated in a wood paneled room in private.
Fast forward 100 years. In today’s world of modern communications, Henry could
conduct a google search on the terms ‘business angel’ and ‘business angel network’ which
would produce 45 million and 20 million hits respectively. For perspective, he could pick
up a copy of a growing number of popular books about business angels (Benjamin and
Margulis, 1996; 2005; Coveney and Moore, 1998; van Osnabrugge and Robinson, 2000;
Amis and Stevenson, 2001; May and Simmons, 2001; Hill and Power, 2002). If he wanted
to locate angel capital in the US or Europe, he could log onto www.eban.org and
www.angelcapitalassociation.org for leads and advice. For a snapshot of market activity,
he could also navigate through numerous analytical reports from the Centre for Venture
Research (www.unh.edu/cvr). In venture finance circles, business angels are and continue
to be front page news. In no small measure, this growing awareness of the critical role busi-
ness angels play in supporting the growth ambitions of entrepreneurs has been fueled by
a substantial and sustained body of research undertaken by scholars around the world
over the past 15 years.
Business angel research traces its roots back to the early 1980s and a pioneering study
conducted by William Wetzel (1983) in New England. This first ABC-study (attitudes,
behaviors, characteristics) provided insights into what had been, up to that time, a largely
neglected phenomenon. Wetzel discovered that business angels were difficult to identify
as they preferred to operate anonymously, shared common traits as they were typically
wealthy, self-made males, were highly active, invested locally and early on, and relied
heavily on their network to undercover investment opportunities. In putting some bound-
aries on our ignorance, Wetzel’s (1983) work spurred replication efforts in California
315
(Tymes and Krasner, 1983), the Sunbelt region (Gaston and Bell, 1986), the Great Lakes
region (Aram, 1987), and the East Coast (Haar et al., 1988).
Significantly, much of this research was funded by the US Small Business
Administration who took an early and active interest to support research efforts aimed at
understanding the size and underlying dynamics of the business angel phenomenon
(Gaston and Bell, 1988). Collectively described as the informal venture capital market,
business angels were recognized from the outset to be a specialized species of equity
financier, quite distinct in character from venture capital financiers. Of perhaps greater
significance, this pioneering work in the US market spurred research efforts internation-
ally in the UK (Mason et al., 1991), Canada (Riding and Short, 1987), Sweden
(Landström, 1993), Finland (Mason and Lumme, 1995), Norway (Reitan and Sørheim,
2000), Germany (Brettel, 2003), Australia (Hindle and Wenban, 1999), Japan (Tashiro,
1999), Singapore (Hindle and Lee, 2002), among others.
On the back of this first generation of demographic studies that described what busi-
ness angels look like (Mason and Harrison, 2000), researchers increasingly turned their
attention towards understanding how the informal venture capital market operates. A
number of these second generation studies focused on the investment decision-making
process (Riding et al., 1994; Landström, 1995; 1998; Mason and Rogers, 1996; van
Osnabrugge, 2000). Others were directed at policy-makers aimed at reducing the search
costs incurred by entrepreneurs and investors alike through the development of business
angel networks and stimulating market activity (Harrison and Mason, 1996a). Yet
another significant stream of research that was undertaken at this time explored the extent
to which theoretical perspectives such as decision-making (Landström, 1995; Feeney
et al., 1999), agency theory (Landström, 1992; Fiet, 1995; van Osnabrugge, 2000), social
capital (Sætre, 2003; Sørheim, 2003), and signaling (Prasad et al., 2000) could be usefully
applied into the domain of business angels.
2006 will mark the 25th anniversary of Wetzel’s pioneering study that stimulated the
creation of a specialized field of study, informal venture capital. In his pioneering study,
Wetzel (1983) spoke of ‘putting boundaries on our ignorance’. The first objective of this
chapter is to put some boundaries on our knowledge. What have we learned about the
informal venture capital phenomenon over the past quarter century? Having said this, we
as researchers are trying to describe a largely invisible market that is only partially visible
to the eye. The second objective of this chapter is to highlight some of the burning issues
that we need to tackle to further the development of this field of study. Finally, I want to
draw out some of the implications of why research in this domain is vital for practition-
ers and policy-makers alike.
Boundaries on our knowledge

Business angel research has followed a distinct pattern over time. The formative studies
were conducted in the early 1980s in the US and sought, in the first instance, to estimate
the size of the informal venture capital market and to describe the ABCs (attitudes, behav-
iors, and characteristics) of business angels themselves. Public policy-makers, in particu-
lar the Small Business Administration (SBA), took an active interest in funding research
projects throughout the US. What early researchers discovered was that across all regions
studied in the US, the informal venture capital market was large, very active, discrete in
nature, and that business angels shared similar traits.
Business angel research 317
Market scale
Relying on a market-based approach, Wetzel (1986) estimated that the angel market in the
US involved 100 000 individuals investing a total of $5 billion. In arriving at this estimate,
he made assumptions about the proportion of start-ups that need external finance (5 per
cent), the average amount they raised ($200k), and estimates about the proportion and
investment activity levels of the population based on the Forbes 400 list of richest people.
Relying on SBA Dun’s Market Identifier data (Gaston, 1989b) employed a firm-based
approach extrapolating the observed propensity of firms in his sample to raise business
angel finance to the nation as a whole. On this basis, he estimated that 720 000 private
investors made 490 000 investments totaling $32.7 billion in equity and $23 billion in debt
finance to some 87 000 ventures. Another estimate (Ou, 1987) based on data obtained
from the 1983 Survey of Consumer Finance, concluded that two million families in the
US held investments totaling some $300 billion in privately-held businesses in which the
investor had no management involvement. In terms of size, the informal venture capital
market in the US was some eight to fifteen times larger, measured in terms of number
of investments made, than the formal venture capital industry. Interestingly, more con-
temporary research in the US reaffirms both the scale and highly active nature of the
informal venture capital market, estimating that 300 000 to 350 000 angels invest about
$30 billion a year in 50 000 ventures (Sohl, 2003).
Mason and Harrison (2000) took a slightly different tack to estimate the size of the
informal venture capital market in the UK by extrapolating from the activity levels
observed in the visible part of the market, namely among business angels registered in
business angel networks. Based on assumptions regarding the proportion of business
angels that participate in BANs, their estimates ranged from 20 000 to 50 000 investors
investing £500 million to £2 billion. Van Osnabrugge and Robinson (2000) estimated that
business angels do thirty to forty times as many deals as venture capital funds. Recent
research completed in Sweden (Avdeitchikova and Landström, 2005) based on a large rep-
resentative sample of the Swedish population, estimated that approximately 2.5 per cent
of the population aged 18 to 79 (150 000) have made informal investments totaling in
excess of $11 billion. Getting a handle on market scale is important as it has provided a
stimulus among policy-makers, entrepreneurs, business angels and by implication,
research funding bodies, that the informal venture capital phenomenon needs to be
defined and understood before it can be properly stimulated.
Attitudes, behaviors and characteristics: business angels in profile

For the most part, formative angel research followed a familiar pattern. Business angels
were uncovered through a combination of direct (contacts made through referrals, mainly
business angel introduction services) and indirect (wealth indicators) approaches. Early
researchers quickly discovered that business angels typically know other business angels;
hence the adoption of the term ‘snowball sampling’. The challenge of finding business
angels persists today both for researchers seeking insights and for entrepreneurs seeking
capital. By its very nature, the business angel market is discrete in nature; it is an elusive
phenomenon to study, but perhaps that is inevitable.
Based on convenience samples, a number of studies have been completed around the
world, relying, for the most part, on survey instruments with little theoretical guidance
soliciting the views of business angels about their background, interest and means of
investing in private companies. With remarkable consistency, business angels in the US

(Gaston, 1989a; Freear et al., 1994), UK (Mason et al., 1991), Sweden (Landström, 1993),
Finland (Lumme et al., 1998), Norway (Reitan and Sørheim, 2000), Canada (Riding,
1993), Germany (Brettel, 2003; Stedler and Peters, 2003), Australia (Hindle and Wenban,
1999), Singapore (Hindle and Lee, 2002), or Japan (Tashiro, 1999), exhibited common
traits:
● A typical business angel is a middle-aged male (40) with entrepreneurial street

smarts (new venture experience).
● The investment decision is motivated by the prospect of financial return and sig-
nificant non-financial motivations (psychic hot buttons to use William Wetzel’s
terminology).
● Business angels rely on a close circle of business associates and friends to refer
potential investment opportunities to them.
● A typical deal involves a syndicate of business angels and is usually made in ven-
tures close to the home base of the investor(s).
● Angels are attracted to proposals where they can apply their knowledge, skills and
experience thus bringing value added benefits to the venture.
● A substantial minority of business angels (up to 40 per cent or more) have yet to make
their first investment, variously described as latent angels or virgin angels (Freear
et al., 1994; Coveney and Moore, 1998; van Osnabrugge and Robinson, 2000).
While it is appealing to conclude that business angels as a group across a number of coun-
tries share similar traits, the evidence collected to date supports the notion that the business
angel market is rather heterogeneous in character (Wetzel, 1994). One of the early pieces of
research that explored this issue (Postma and Sullivan, 1990) identified three distinct groups
of business angels based on their motivation for investment – financial, altruistic or self-
oriented. Gaston (1989a) developed a ten-category classification scheme based on metrics
related to investment activity, post-investment involvement, and personal characteristics.1
In much the same spirit, Benjamin and Margulis (1996) developed a nine-category classifi-
cation scheme of their own.2 Coveney and Moore (1998) highlighted an important, yet
largely neglected, category of business angel, namely those that want to make investments
but have not yet done so.3 Early research from Freear et al. (1994) coined the term ‘virgin
angels’ to describe these latent investors. Other authors (Kelly and Hay, 1996a; 1996b) have
focused on the active market element, so-called serial investors, who have completed a
number of deals. Finally, Sørheim and Landström (2001), have developed a four-category
classification scheme based on investment activity and investor involvement. To them, a
business angel is defined as being both highly active and highly involved.
This early base of research, or first generation studies, provided a necessary foundation
for future work, as researchers:
● Demonstrated that the informal venture capital market was large and very active,
particularly in the crucial early stages of venture development.
● Confirmed that indeed informal venture capital is a global phenomenon.
● Developed a common basis for defining the terms ‘business angel’ and ‘informal
venture capital’.
● Highlighted the heterogeneous nature of the market and some of the practical
difficulties undertaking research on a largely invisible population.
● Articulated questions for future research based on insights and observations from
mapping the terrain.
Beyond ABCs: second generation studies

Moving beyond describing the informal venture capital phenomenon, researchers began
to turn their attention to issues related to: (1) how the informal venture capital market
operates in practice (Riding et al., 1994; Mason and Harrison, 1996; van Osnabrugge,
2000); (2) the role of public policy-makers in stimulating and supporting market devel-
opment (Harrison and Mason, 1996b; Wetzel and Freear, 1996); and (3) the introduction
of an element of theoretical rigor into the field (Landström, 1992; 1995; Fiet, 1995; van
Osnabrugge, 2000; Kelly and Hay, 2003). In many respects, first generation studies were
the pilot from which researchers developed increasing levels of sophistication in terms
of the choices made with respect to: i) framing research questions; ii) data collection; and
iii) analysis. In addition a great impetus for these second generation studies, was the
growing number of academic outlets in which to publish this work. Informal venture
capital research was coming of age as a field of academic study. What have we learned
from this large and growing body of second generation studies?
How do they do it?

Early work in Canada (Riding et al., 1994), provided some insights into the business angel
decision-making process. The authors concluded that business angels are highly selective
investors who form initial assessments based on concept feasibility, management cap-
ability, and prospective financial return. The perceived attractiveness of a given opportun-
ity also appears to be influenced greatly by deal referrers. While adopting a rather
informal approach to due diligence, a key factor in the decision to invest is the personal
chemistry that develops between the entrepreneur and the angel.
Mason and Harrison (1996) reached broadly similar conclusions as Riding et al. (1994)
in their study of angel decision-making behavior in the UK. Relying on verbal protocol
techniques, they concluded that angels form opinions about the potential trustworthiness
of the entrepreneur rather quickly, so-called swift trust (Harrison et al., 1996). Early on,
angels look for deal killers and over time make an assessment of both the attractiveness
of the opportunity and the perceived level of competence of the management team to
exploit it.
Van Osnabrugge and Robinson (2000) conducted a large scale comparative study con-
trasting the decision-making approaches of business angels and venture capitalists. While
both were attracted to opportunities with strong growth potential and driven by capable
management teams, business angels spent less time investigating and relied less on outside
parties to assess the attractiveness of a given investment opportunity.
Landström (1995) identified two distinct strategies used by business angels to aid them
in making investment decisions. Specialist investors choose to limit their activity in areas
related to their particular market and/or technical expertise. Compared to investors that
sought portfolio diversification, specialists examined fewer proposals and exhibited a
higher propensity to invest than explicitly diversified investors. Having said this, the two
groups relied on broadly similar criteria to evaluate opportunities.
Public policy
A second body of work focused on some of the challenges that impede the development
and growth of the informal venture capital market and discussed some of the mechanisms
by which public policy can alleviate this situation. Broadly speaking, the challenges to be
addressed include: i) conditions of excess demand for equity capital in the early stages, the
capital problem; ii) the difficulties encountered in trying to bring suppliers and users of
capital together, the search problem; and iii) finding ways to stimulate market activity, the
incentives problem.
The capital problem was diagnosed as early as the 1930s by the Macmillan Committee
on Finance and Industry of the UK government and is most acutely felt in early stage
technology-based ventures requiring less than $500 000 in equity and that have exhausted
other financing sources including own funds and those provided by friends and family.
Mason and Harrison (1994) also confirm the existence of this gap in the UK. Sohl (1999)
has also identified the appearance of a second equity gap for ventures seeking between $2
and $5 million, an amount that is too large for consideration by business angels and too
small to attract the attention of venture capital funds in the US. That the capital problem
persists may be symptomatic of the complex and dynamic nature of the interplay between
love money (founders, family and friends), soft money (government), play money (angels)
and custodial money (venture capitalists). In fact, I believe there is a strong basis to con-
clude that researchers and public policy-makers will always be grappling with this issue
given the dynamism of the problem we are trying to solve.
The search problem arises from the fact that given the largely invisible character of the
informal venture capital market, it is difficult for business angels and entrepreneurs to find
each other. Developing forums through which capital seekers and providers can meet has
been a longstanding concern of scholars both in the US (Wetzel and Freear, 1996) and
the UK (Harrison and Mason, 1996a; 1996b). Governments around the world have keenly
embraced the development of business introduction services and business angel networks
to alleviate the search problem for entrepreneurs and business angels alike. Generally
speaking, these mechanisms provide a forum for entrepreneurs and angels to develop their
networks. While differing greatly in terms of size, scope and method of operation, most
of these forums provide guidance to entrepreneurs seeking cash and opportunities to be
introduced to prospective investors.
Increasingly, business angel networks have begun to address the incentives problem,
acting as an important conduit through which lobbying efforts have been made to influ-
ence policy. The introduction of various forms of tax relief for business angel investing in
the UK owe much to the work of Harrison and Mason and to the growing number of
highly active business angel networks operating in the UK. More research needs to be
undertaken to determine the impact these incentives have both in terms of expanding the
number of investments made and importantly the quality and sophistication of deal
making in the informal venture capital market.
Building bridges to theory

As researchers moved beyond fact gathering to more theoretically grounded studies,
a growing body of research looked to other fields of study for guidance including agency
theory (Landström, 1992; Fiet, 1995; van Osnabrugge, 2000; Kelly and Hay, 2003), social
capital (Kelly and Hay, 2000; Carter et al., 2003; Sætre, 2003; Sørheim, 2003), and
signaling theory (Prasad et al., 2000). Each of these theoretical anchors will be discussed
in turn, beginning with agency theory.
Agency theory On the face of it, the domain of the business angel is potentially rife with
agency risks. Investors and entrepreneurs alike find it very difficult to identify all of the
options available to them (Harrison and Mason, 1996b). Once identified, it also appears
difficult for business angels to fully assess the intentions and competence of the entrepre-
neur and vice versa (van Osnabrugge, 2000). Moreover, business angels are very active
participants in the venture development process; involvement that can be seen as both
making a value added contribution to the venture and as a means for investors to keep
tabs on or monitor the activities of the entrepreneur. Finally, the most significant negoti-
ating issue between the parties is the distribution of equity stakes, in other words, the
incentive structure (Benjamin and Margulis, 1996), a central pillar of agency theory.
In a comparative study of venture capitalists and business angels, Fiet (1995) examined
the extent to which investors relied on themselves as opposed to others for obtaining
market (unforeseen competitive conditions) and agency (the possible divergence of inter-
ests between investor and entrepreneur) risk reducing information. He found that agency
risk was the primary preoccupation for business angels whereas venture capitalists were
much more concerned about market risk.
Landström (1992) surveyed firms that received business angel finance. Relying on
agency theory, he hypothesized that business angels would be more involved in ventures
that were: a) highly innovative; b) early stage; c) operating in turbulent environments;
d) managed by inexperienced entrepreneurs with lower equity stakes in the venture;
e) located close to the investor’s home base of operation; and f) competing in an indus-
try familiar to the investor. He found support only for the geographic proximity and
industry familiarity predictors. In interpreting the findings, Landström concluded that:
‘it is not the required level of control which is most influential in determining the fre-
quency of contacts and (level of) operational work. It is rather the feasibility for active
involvement that seems to be most influential’ (1992, p. 216). Moreover, he stated that
the relationship between the parties is highly personal and infused with trust, calling into
question the inherently negative assumptions about people upon which agency theory is
based.
Van Osnabrugge (2000) found support for the notion that compared to venture capi-
talists, business angels work from a notion that contracts between themselves and the
entrepreneur are necessarily incomplete (the incomplete contracts approach). For busi-
ness angels, control over the entrepreneur’s behavior and the venture’s development is best
achieved through being actively involved in the venture post-investment as opposed to
devoting undo time, attention and detail to crafting a comprehensive contract ex ante (the
principal–agent approach).
In their study, Kelly and Hay (2003) found support for a central notion of agency
theory, namely that the relative equity stakes of the parties matter. The higher the equity
stake of the investor(s), the more attention to contractual detail particularly with regard
to specific provisions that could, in some way, impact the relative equity stakes
going forward. However, he concluded that the economic relationship between investor
and entrepreneur appears to be infused with high levels of interpersonal trust from
the outset; a finding consistent with that of Landström (1992). Moreover, the level
and form of investor involvement with the venture post-investment appeared to be

motivated more from venture need as opposed to being a means of checking up on the
entrepreneur.
Social capital The intuitive appeal of social capital perspectives into the field of infor-
mal venture capital is quite clear. Entrepreneurs and business angels alike need to develop
and manage their network of connections to support the development of their ventures
and portfolios respectively (Birley, 1985). The notion of social capital is also captured in
the work of Politis and Landström (2002), who regard informal venture capital investing
as part of one’s entrepreneurial career. The accumulated experience and connections an
individual makes building a business as an entrepreneur, prove to be an invaluable and
transferable resource that can be leveraged as a business angel.
In his examination of the pre-investment behaviour of business angels, Sørheim (2003)
unpacked the notion of social capital into structural (network ties), relational (trustwor-
thiness of the parties to the deal) and cognitive (shared vision or common ground) dimen-
sions. A key finding of his work, based on interviews with experienced business angels in
Norway, is that the development of common ground is a necessary antecedent for build-
ing a long-term trusting relationship between the business angel and entrepreneur.
Based on interview data obtained from companies that received angel investment in
Norway, Sætre (2003) introduced the notions of competent and relevant capital. By com-
petent capital, he means the base of new venture, general management, educational and
experience gained as a business angel investor that an individual brings to the venture.
What is an even more valuable commodity for entrepreneurs is business angels that bring
a base of experience in the industry in which the venture competes, so-called relevant
capital.
Social capital has also been used as a lens to examine the challenges that female entre-
preneurs face in their quest to secure equity financing (Carter et al., 2003). Raising equity
finance necessitates developing and utilizing one’s social network, an area where female
entrepreneurs appear to be disadvantaged (Brush et al., 2002). Establishing network con-
nections appears to be an important conduit for entrepreneurs to uncover the informal
venture market (Amatucci and Sohl, 2004). From the capital supply perspective, Harrison
and Mason (2005) concluded that male and female business angels differ very little but
that there are gender differences evident in networking behaviors, with females being less
connected with or knowing other business angels.
Signaling theory There is an obvious intuitive appeal to exploring the potential utility of
signaling theory in the informal venture capital domain. Entrepreneurs and investors
alike need to be able to provide informative signals as to the quality of the opportunity
and their capability to successfully exploit it. Prasad et al. (2000) argued that prior
research demonstrates that the proportion of equity retained by the entrepreneur is a
signal of project quality when personal funds available to invest in the project are unlimi-
ted. They develop a model that relaxes this assumption and concluded that a more
appropriate signal in the domain of the business angel is the proportion of the entrepre-
neur’s wealth invested in the venture. The higher the proportion, the stronger the signal
of both the venture’s perceived value and the entrepreneur’s commitment to the venture.
It is important to note that this model is developed from the entrepreneur’s perspective
only and focuses on the utility of a one-dimensional signal, proportion of personal wealth
invested.
That researchers have looked to theoretical perspectives developed in other fields of
study is in itself a signal of the growing maturity of informal venture capital as a field of
study. Building on this base of emerging knowledge, where do we go from here? It is to
this question that we now turn our attention.
Research agenda
Bridging the gap between FFFs and business angels

A recent research report (Bygrave et al., 2003) based on data collected as part of the
Global Entrepreneurship Monitor (www.gemconsortium.org) research initiative high-
lighted the importance of informal investment across a sample of 18 countries where data
had been provided by 40 or more informal investors. Annual informal investment for the
period 1997–2001 was estimated to be almost $200 billion, two-thirds of which occurred
in the US. The vast majority of informal investment made (88 per cent) was from family
members, relations, friends and neighbors. Raising money from the three Fs (family,
friends and fools), is the predominant source of start-up finance, an observation consis-
tent with analysis of sources of funding for the Inc 500 listing of America’s fastest
growing private companies (Inc, 2000).
Sohl (2003) highlighted the gap between what might be termed founding capital (FFFs)
and business angel finance. The GEM study demonstrates that founding capital appears
to be a necessary pre-condition to start-up, yet there appears to be a significant discon-
nect when time comes for an entrepreneur to raise money from business angels. What are
the causes of this disconnect? On what terms and conditions is founding capital raised?
To what extent is founding capital and business angel capital compatible? It is, in some
respects, very remarkable that we know virtually nothing about the founding capital
phenomenon despite the fact that this source invests more than $150 billion annually and
is, in essence, a feeder to the business angel market.
Demographic research: mapping the terrain

Two other significant strands of research also follow from the GEM research initiative.
First, we should undertake business angel demographic studies beyond developed
economies to include developing nations such as Korea ($17 billion annual informal
investment), Mexico ($3 billion), Argentina ($1 billion) and Brazil ($1 billion). Such
research will help us to better understand the influence that contextual and environmen-
tal variables have on business angel investment activity. What framework conditions
encourage or discourage business angel investment activity?
A second strand of research springs forth from the finding that across the entire sample
of 29 nations (including the 11 nations where the number of informal investors surveyed
was less than 40), almost one-third of informal investors are female. Most of the received
demographic studies conducted to date have concluded that the population of business
angels is predominantly middle-aged males. Female business angels appear to be a sig-
nificant source of capital for entrepreneurs. To date, very few studies have been con-
ducted to contrast the approach of female versus male business angels (Harrison and
Mason, 2005).
Public financiers: help or hindrance

Yet another under-researched area is the role and impact of public sector funding instru-
ments targeted at bridging the equity gap between founders’ capital and obtaining busi-
ness angel finance. European governments have been particularly active in this regard,
establishing a wide variety of financing programs to stimulate regional entrepreneurship,
the development of technology-based ventures, and university spin-outs, among count-
less other objectives. For example, in Finland an entrepreneur can raise money from
public agencies to build a prototype and hire consultants to develop a business plan. In
Sweden, the number of programs and support services have become so numerous that
consultants have established thriving practices helping entrepreneurs successfully to navi-
gate this highly crowded field.
Having said this, a number of important questions need to be addressed. When is gov-
ernment support most needed, wanted and in what form(s)? To what extent are the goals
of government funding bodies compatible with those of the entrepreneur and professional
outside investors? What implications does the decision to raise funds from public sector
source have in terms of subsequent fund raising? Signaling theory may be a potentially
useful lens through which to address these issues. In what circumstances does the presence
and involvement of a public sector catalyst send a positive or negative signal to follow-on
financiers? This line of research enquiry could also be usefully extended to consider to
what extent the presence and involvement of a particular business angel(s) sends positive
or negative signals to other external investors. It is to a discussion of the relationship
between business angels and venture capitalists to which we now turn our attention.
Bridging the gap between business angels and venture capital funds
We know that business angels tend to invest earlier, in smaller amounts and in more busi-
nesses than venture capital funds (van Osnabrugge and Robinson, 2000). A typical angel
deal occurs at the seed or early stage of development in the range of $100 000 to $2 million
from a syndicate of six to eight investors (Sohl, 2003). The observed differences in invest-
ment preferences have led some authors to conclude that business angels are the farm
system for venture capitalists and thus complementary in nature (Freear and Wetzel,
1990; Harrison and Mason, 2000). Given the entrepreneurial background and experience
of angels and their desire to be actively involved in the venture post-investment, there is
good reason to believe that raising angel capital should enhance the fundability of a pro-
posal by raising valuations to a level that warrants much larger venture capitalist follow-
on investment.
However, the extent to which the business angel and venture capital markets are indeed
complementary in nature is still an open area for further research (Harrison and Mason,
2000). A consequence of the rapid growth in the venture capital industry, particularly in
the US, is that there has been a continual movement towards larger deals at later stages of
venture development. The venture capitalist comfort zone appears to be later stage deals
that require $10 to $15 million in investment. Sohl (2003) has concluded that a secondary
(and growing) funding gap exists for ventures requiring between $2 and $5 million, an
amount too large for angels but too small for venture capital funds to provide economi-
cally. Rather than being complementary, the two markets may in fact be moving towards
being distinctly different in character, a theme that Jeffrey Sohl will explore in Chapter 14.
We know that both business angels and venture capitalists are attracted to proposals
driven by a talented team exploiting high growth opportunities. We also know that both
business angels and venture capitalists expend effort evaluating opportunities, albeit the
former in a much less formal and comprehensive manner (van Osnabrugge, 2000) and that
an important motivation for investing is capital gains appreciation. However, the infor-
mal and formal venture capital market differs in two key respects: i) angels do not face the
same pressures to invest as it is their own capital at risk; and ii) angels participate for the
fun element and the prospect of capital gain whereas venture capitalists are motivated, in
large part, by the latter. On the face of it, the formal and informal venture capital markets
appear to be complementary (Harrison and Mason, 2000) but are they in fact compatible?
Further research needs to explore in what ways the informal and formal venture capital
markets work together or at cross purposes. Allow me to highlight some interesting ques-
tions that, to date, have not been addressed. Complementarity presumes that business
angels invest early and bring venture capitalists in as equity financiers later. We desper-
ately need more longitudinal research to satisfy ourselves that this is, in fact, the case.
Second, assuming that bridges exist between the informal and formal venture capital
markets, it raises the question as to how this hand-off between business angel and venture
capitalist can best be achieved and by whom. Third, it appears that the emerging venture
capital financier start-up model implies a fund placing many large bets in a given oppor-
tunity space to achieve a hit. This approach is fundamentally at odds with that of busi-
ness angels who prefer to invest smaller amounts of capital early on. Which raises the
question, is one approach better than the other? Do these distinct styles of start-up
finance actually place business angels and venture capitalists in a competitive as opposed
to cooperative relationship? Fourth, what role, if any, is there for public policy-makers to
stimulate more deal flow from angels to venture capital funds and vice versa (Harrison
and Mason, 2000)? In short, we need to understand better how to create an environment
that nurtures and supports the development of rapid growth ventures, particularly in
rapidly changing knowledge-based economies.
Tapping into experience

Another consistent theme that has been highlighted in emerging research is that a sub-
stantial minority of individuals who deem themselves business angels have yet to con-
summate their first investment, so-called latent or virgin angels (Freear et al., 1994;
Coveney and Moore, 1998; van Osnabrugge and Robinson, 2000). Moreover, based on
estimates in the US (Sohl, 2003), some 2 million individuals fit the business angel profile
but in any given year only some 250 000 are active market participants. There is immense
untapped potential in the informal venture capital market, which gives rise to a number
of important research questions.
First, it appears that business angel investing is a learning-by-doing experience (Kelly
and Hay, 1996a; 1996b). Starting out an individual needs to learn how to tap into sources
of deal flow, once uncovered evaluate opportunities, structure sensible deals, help entre-
preneurs build value and hopefully realize successfully on the value created as a result. If
indeed angels learn through practice, researchers ought to be focusing more attention on
the minority of business angels that are highly active, so called serial investors (Kelly and
Hay, 1996a; 1996b; van Osnabrugge, 2000) or deal-makers (Kelly and Hay, 2000). My own
research tends to support the view that successfully cashed out entrepreneurs whose ven-
tures relied on external equity to support growth become very active business angels soon
after cashing out. Do these wealthy and highly experienced entrepreneurs turned investors
share common traits? Do they go about the task of finding, evaluating and closing deals
in a different way from less wealthy and less experienced counterparts? Are these types of
individuals more compatible in approach with venture capital funds, having probably
raised money from this source before as an entrepreneur? My sense is that we have only
begun to tap into this most discrete and most active segment of the business angel market.
Second, we know that business angels are increasingly using syndication as means of
diversifying risk, participating in larger deals than they might otherwise be able to,
sharing information, and as a means for building their network of relationships with
other business angels and capital providers. While the advantages of syndication are
clear-cut, our understanding of how they come about and operate is rather limited. How
do business angels choose syndicate partners? How are the goals of individual syndicate
members reconciled? How should the interface between the syndicate and the entrepre-
neur be optimally managed? Does the presence of a syndicate encourage or deter follow-
on financiers?
Third, we need more detailed research profiling the similarities and differences of
the distinct subsets of business angels identified as a result of previous research efforts
(Coveney and Moore, 1998; van Osnabrugge and Robinson, 2000; Sørheim and
Landström, 2001). In what ways are latent or virgin angels different from highly active
business angels? One of the key advantages of raising money from business angels is the
ability to tap into a base of personal experience building new ventures. As a prospective
business angel with new venture experience, how can I best use it? As a prospective busi-
ness angel lacking this experience, how can I compensate for it?
Sharing entrepreneurial knowledge

Researchers often use the term smart money to describe business angel finance. Angels
are attracted to proposals where their experience can be applied so as to enhance the
prospects of creating economic value both for themselves and the entrepreneur. When all
is said and done, the decision to invest is a highly personal one influenced to a great degree
by gut feeling, particularly as it is the business angel’s own capital that is put at risk. Too
often, in my opinion, we consider business angel investments as business transactions,
ignoring the mating and relationship rituals that cause them to happen. Perhaps we ought
to look to fields like psychology and sociology for guidance in exploring why certain busi-
ness angels and entrepreneurs connect while others fail to do so. As most business angels
are highly experienced in building new ventures from scratch, in choosing to back a par-
ticular entrepreneur, an angel is choosing to share their entrepreneurial experience and
knowledge with them. What triggers this highly personal decision? What sort of know-
ledge and experience matters most in favorably skewing the odds of success? How best
should this knowledge and experience be shared? Acting as a sounding board and being
a mentor to the entrepreneur are often cited as key contributions made by business angels
(Coveney and Moore, 1998; van Osnabrugge and Robinson, 2000; Hill and Power, 2002).
What specifically does this mean in practice? On what issues are business angels sounded
out? How is the relationship between angel and entrepreneur managed in practice? Only
by getting a clearer picture of what goes on both inside an angel’s head and between them
and the entrepreneurs they back can we understand the dynamics of how the informal
venture capital market operates in practice.
Revisiting methodological approaches

Very early on, the pioneer of business angel research, William Wetzel, observed that the
informal venture capital market is largely invisible in nature. As a result, the size and char-
acteristics of the angel marketplace is ‘unknown and probably unknowable’ (Wetzel,
1983). In the absence of knowing what the population looks like, any sample that
researchers have drawn upon for insight is, by definition, unrepresentative and will,
despite our best efforts, remain so in the future.
As our body of accumulated research grows, so too does our understanding of how the
informal venture capital market operates. Early efforts to define market demographics
relied on replicating studies made in the US in the early 1980s. For the most part,
researchers have relied on surveys administered to convenience samples drawn mainly
from formalized networks of angels, business introduction services. As the received base
of business angel research has grown, so too has our sophistication in identifying and
dealing with some of the significant methodological challenges we face. In an effort to
guide future research efforts with the aim of expanding and deepening our knowledge of
a complex social phenomenon, I wish to highlight a number of issues here.
First, by relying on insights from business angels who have chosen to register in a formal
network, we may be excluding a substantial proportion of deal-makers (van Osnabrugge,
1998; Kelly and Hay, 2000; Sørheim and Landström, 2001) who appear to have little need
for the services of network providers such as business angel networks to generate invest-
ment leads. A convenience sample drawn from a network is, pardon the pun, convenient.
Future research efforts should consider ways to engage business angels that have, so far,
eluded our attention. One potentially useful resource to identify new leads is to engage
and identify active business angels from within a university’s alumni base.
Second, in markets where numerous studies of business angels have been conducted,
particularly in the US, UK, Canada and Scandinavia, there has, at times, been heavy
reliance on respondents drawn from similar network organizations over time. To the
extent that these networks attract new blood, fresh insights are obtained. We must be
mindful, however, of the potential biases introduced by continuing to seek out informa-
tion from individuals positively inclined to participate in any and all research studies.
Third, much of the received research undertaken to date has been cross-sectional in
nature. That is to say, we rely too much on surveys designed to collect data at a particu-
lar moment in time. In doing so, we tend to have focused on informal venture capital as
an economic transaction as opposed to a highly fragile, personal commitment of two
parties to work together. What is desperately needed is longitudinal transaction-based
research relying on the deal as the unit of analysis. With this longitudinal perspective, we
are better able to understand the complex dynamics of what brings entrepreneurs and
business angels together, what keeps them together, what drives them apart and why some
deals succeed while others fail. To capture the richness and complexity of these relation-
ships, researchers should undertake more studies that employ structured interviewing and
participant observation, among others.
Fourth, the primary focus of research undertaken to date has sought out the views of
investors only. While this is eminently sensible in situations where an individual alone
decides whether to invest or not and on what terms, we need to balance the views of capital
providers with that of entrepreneurs in need of capital. We know that both angels and
entrepreneurs find it very difficult to find each other in a timely manner. A great deal of
literature has examined the role of network intermediaries to facilitate this introduction.
Having said this, a number of pressing research questions remain. Why do deal-makers
appear to shun network intermediaries? How do deal-makers build their network? How
do entrepreneurs seeking funding build their network? We know a great deal about what
attracts angels to particular investment proposals. On the flip side, what attracts a particu-
lar entrepreneur to an angel? We also know that angels, at least the successful ones, want
to be actively involved in the venture post-investment. How do entrepreneurs feel about
this interaction? How do they manage it? There also appears to be a growing consensus
that business angels tend to want to invest in a project with other business angels. How
do entrepreneurs manage a syndicate?
Business angel research: the journey ahead

Looking back, considerable progress has been made mapping the business angel terrain,
but much work remains to be done. We have reached what Malcolm Gladwell has termed
a ‘tipping point’ where both the volume and sophistication of business angel research is
set to explode. We know that business angels are the second most important source of
capital next to founders, family and friends. We know that business angels fill the ever-
increasing vacuum being left by venture capital fund managers funding seed stage ven-
tures. We know that business angels are a difficult domain to study and a difficult force to
mobilize given the discrete and invisible nature of informal venture capital. Researchers,
practitioners and policy-makers alike have a shared interest to cultivate a deeper under-
standing of how the informal venture capital operates. Developing this understanding
entails significant challenges for all of these three interlinked stakeholder groups.
If informal venture capital is to develop into a mainstream field of academic study,
researchers will need to pay more attention to the following issues. The term ‘business
angel’ has, at times, been expanded to include related investors such as family and friends.
My preference is to see the term ‘business angel’ retained for arm’s length investors and
that related investors be explored as a distinct class of investor. Second, researchers will
need to move beyond convenience surveys to employ more sophisticated sampling and
research designs. Third, we need to anchor more studies in theoretical perspectives drawn
from other fields and importantly, developed within the informal venture capital field
itself. For practitioners, including business angels and various intermediaries who seek to
bring investors and entrepreneurs together, three significant challenges need to be
addressed. First, I believe we are working under the presumption that market trans-
parency is a desirable end objective; with clarity more deals would be consummated. The
venture capital market is highly transparent but for most entrepreneurs inaccessible. My
own belief is that the invisible character of the informal venture capital market is both its
defining trait and an important stimulus for investment itself. In short, business angels are
attracted to invest in private companies precisely because the market is demonstrably
inefficient. Second, mechanisms need to be explored to facilitate the sharing of experience
and risk-taking among active business angels and importantly between active and virgin
business angels. Third, business angels and particularly intermediaries, have a crucial role
in bridging the two gaps between FFFs and venture capital funds.
Public policy-makers will need the courage to move beyond promoting business angel
capital as an important source of finance to creating conditions where business angel
capital can be optimally mobilized. My sense is that we treat business angel finance at
times as a public good finding ways to make the market more visible (like that for venture
capital) and more active. My own view is that the market is attractive for business angels
because it is difficult to access. Public policy-makers also need to look at the impact that
tax incentives and other stimuli have on business angel investing activity. I also believe
public policy-makers have a vital role to play to provide transactional lubrication between
love money (FFFs) and custodial money (venture capital). Finally, I appeal to the public
sector to continue to fund business angel research as we are only now beginning to attack
this challenging field of study in the sophisticated manner in which research has been
undertaken in the venture capital field over the past 30 years. Our journey has just begun.
Notes
1. ‘Devils’ – angels who gain control of the company; ‘Godfathers’ – successful, semi-retired consultants or
mentors; ‘Peers’ – active business owners helping new entrepreneurs, with vested interest in the market,
industry, or individual entrepreneur; ‘Cousin Randy’ – a family-only investor; ‘Dr Kildare’ – professionals
such as MDs, CPAs, lawyers and others; ‘Corporate Achievers’ – business professionals with some success
in large corporate organizations but who want to be more entrepreneurial and in top-management roles;
‘Daddy Warbucks’ – the minority of business angels who are as rich as all angels are commonly, and
incorrectly, believed to be; ‘High-Tech Angels’ – investors who invest only in firms manufacturing high-
technology products; ‘The Stockholder’ – an angel who does not participate in the firm’s operations; and
‘Very Hungry Angels’ – angels who want to invest over 100 per cent more than deal flow permits.
2. ‘Value-Added Investors’ – very experienced individuals who invest in syndicates and want to be actively
involved in the venture development process; ‘Deep-Pocketed Investors’ – individuals who have built and
sold a business of their own, have corporate experience, seek control and some level of involvement with
the venture; ‘Consortium of Individual Investors’ – individuals who have built new ventures, prefer passive
involvement with the business and who invest as a group in a wide variety of different proposals including
early stage ventures; ‘Partner Investors’ – a buyer in disguise who has high needs for control, wants an exec-
utive position but lacks the funds to buy out a business outright; ‘Family of Investors’ – represents a pool
of funds supplied by family members, astutely managed and desirous of being intensely involved over short
periods of time; ‘Barter Investors’ – focus on early-stage growth businesses providing needed resources to
support growth in exchange for equity; ‘Socially Responsible Investors’ – seek intense interaction with ven-
tures that share a common cause with them; ‘Unaccredited Investors’ – less experienced, less affluent indi-
viduals who invest small amounts of capital in a diversified manner; and ‘Manager Investors’ – individuals
who have a low tolerance for risk and want to buy into a challenging job by making one personally signifi-
cant investment in a venture in which they are actively involved.
3. ‘Virgin Angels’ – individuals with funds available who are looking to make their first investment; ‘Latent
Angels’ – rich individuals who have made angel investments, but not in the past three years; ‘Wealth
Maximizing Angels’ – rich individuals and experienced businessmen who invest in several businesses for
capital gain; ‘Entrepreneur Angels’ – very rich, very active entrepreneurial individuals who back a number
of businesses both for the fun of it and as a better option than investing in the stock market; ‘Income Seeking
Angels’ – less affluent individuals who invest some funds in a business to generate an income or even a job
for themselves.
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13 Investment decision making by business angels
Allan L. Riding, Judith J. Madill and George H. Haines, Jr
Introduction
It is widely acknowledged that business angel investors (BAs) are important sources of
financing for early-stage growth-oriented new businesses (see Chapter 12 by Kelly). The
focus of this chapter is to review the research literature with respect to the investment deci-
sion-making process employed by business angels. This is important for several reasons.
First, understanding business angels’ decision-making is important to public policy
makers. Governments have recognized the importance of business angels and are seeking
ways of encouraging higher levels of business angel investment activity. This goal prompts
two debates. One issue is whether governments ought to encourage participation of more
business angels; the other issue is how to encourage additional investment by business
angels. As to the first issue, Gompers and Lerner (2003) argue that encouraging amateur
informal investors may be counterproductive from a societal perspective in part because
their investment decisions may not be well-founded. As to the second issue, Bygrave and
Hunt (2005) advocate a ‘tax break and other [unspecified] incentives’ for business angels
and other informal investors (examples of which are described by Lipper and Sommer,
2002); however, the design of any such incentives should be grounded in a thorough
understanding of business angels’ motivations, decision-making processes and criteria.
Accordingly, understanding business angels’ decision-making process may be a key to the
appropriate design of public policy initiatives that seek to expand the supply of business
angel investment without encouraging less-than-competent informal investors.
Second, the study of the decision process employed by business angels is of potential
importance to researchers. As van Osnabrugge (2000) observes, decision-making at this
level provides a unique laboratory in which to examine the impacts of agency theory and
how investors deal with agency risk. At the heart of the process, a single business angel
investor must decide whether or not to invest personal funds in a risky venture. This venue
strips away the effects of a corporate environment in which investment decisions are often
made by a group of managers in the context of a stewardship function. Likewise, the busi-
ness angel situation differs from the setting faced by institutional venture capital investors
who typically make investment decisions as agents of the funds providers. Accordingly,
the decision processes and criteria employed by business angels potentially provide a base-
line setting against which investment decisions of other types of investor may be com-
pared and thereby gain an improved understanding of investment decision-making in
general and of principal–agent relationships in particular.
Third, gaining a still better understanding of business angels’ decision-making is of
potential value to entrepreneurs and to business angels themselves. To the extent that
entrepreneurs understand the kinds of information that business angels seek and how
various components of information are weighted in business angels’ decisions, they may
be better able to present the relevant information and to negotiate from a better informed
perspective.
332
Investment decision making by business angels 333
Therefore, this chapter examines the recent literature with regards to how business
angels make investment decisions. To provide a framework for the review of research liter-
ature that comprises the task of this chapter, the five-stage structure shown in Table 13.1
will be employed. In drawing on this five-stage categorization, it is not intended that this
should be construed as ‘the’ model of angels’ decision-making process; rather, it is simply
a means of structuring this particular review of the literature. To report on the state of
research about the decision process, this paper is organized such that the research liter-
ature relating to each of these stages is described in turn. First, to provide a setting for this
discussion, a brief consideration of business angels’ investment process is in order.
On business angels’ investment process

Within the research literature, there are few models of the process by which business
angels make investment decisions. In most instances the models are essentially based on
prior models of how institutional venture capitalists make decisions (Tyebjee and Bruno,
1984 and their successors). For example, among the first to model business angels’ invest-
ment decision process were DalCin et al. (1993) and Duxbury et al. (1997). Based on in-
depth interviews from a national (Canadian) survey of almost 300 business angels this
research team outlined one plausible model of business angels’ decision process. They
concluded that the decision process could reasonably be characterized as a five-activity,
or five-step, linear process.
The stages were: (a) deal origination and first impressions; (b) review of business plan;
(c) screening and due diligence; (d) negotiation; and (e) consummation and deal struc-
turing. DalCin and her colleagues argued that business angels in fact make investment
decisions at several stages as the process unwinds and that criteria would logically differ
from stage to stage. At each stage, the business angel investor could decide immediately
to invest, immediately to reject, or to continue on to the next stage. This research appears
to be the only published study that documents business angels’ rejection rates at each stage
of the investment process.
This process is echoed in van Osnabrugge’s (2000) comparison of the decision-making
processes employed by business angels and venture capitalists. Agency theory predicts
that business angels and institutional venture capitalists differ in fundamental ways (van
Osnabrugge, 2000). Business angels invest personal funds and are principals in the
process, coping with incomplete contracts through active involvement in the firms in
which they invest. Venture capital fund managers, as paid employees, act as agents on
behalf of their funders and create more ‘professional’, often bureaucratic, decision struc-
tures. Accordingly, the decision-making process and criteria are also likely to differ.
However, implicit in van Osnabrugge’s reasoning is a five-stage investment process much
like that developed by DalCin et al. (1993) and Duxbury et al. (1997). Table 13.1 summa-
rizes this investment process and suggests ways in which business angels and institutional
venture capitalists might differ at each point.
In addition to the investment process models postulated by DalCin and her colleagues
and van Osnabrugge, other researchers have advanced models, explicitly or implicitly, of
the business angel decision process; however, these models are quite similar to that
described in Table 13.1. For example, Stedler and Peters (2003) implicitly model the
process as a linear progression that proceeds from deal flow to due diligence to monitor-
ing. Likewise, Amatucci and Sohl (2004) invoke a process that is comparable to that
Table 13.1 Stages of business angel investment decisions
Potential VC-Angel Differences

Stage Events Business Angel Decision (Van Osnabrugge, 2000)
Sourcing of This stage involves encountering and This stage concludes with the VCs generate and maintain a higher
potential deals and engaging businesses in which investments investors’ decision to reject the deal flow than business angels (BAs).
first impressions might follow and a ‘first sight’ informal opportunity out of hand or to VCs are more selective at the initial
evaluation. invest additional time to screening.
investigate the proposal.
Evaluation of the This stage involves examination of the This stage concludes with the VCs conduct more due diligence.
proposal business plan and conducting due investor’s decision to enter into VCs place more emphasis on
diligence. Investors meet with the negotiations, or not. observable criteria; BAs place more
founders, consult with potential emphasis on investment criteria
syndicate partners as appropriate, and related to ex post involvement.
conduct external and internal evaluation
of the opportunity and the
334
entrepreneurial team.
Negotiation and In this stage, the investor(s) and the Investor can either reach an VCs create contracts that provide
consummation entrepreneur(s) negotiate the terms of agreement with founder(s) or more control over investments than
the deal. terminate the relationship. BAs.
Post-investment In this stage, the investor(s) work BAs monitor post-investment more
involvement with the firm in various capacities actively than VCs in large part
and in various levels of involvement because of the nature of their post-
to develop the business further. investment hands-on value added
(see Manigart and DeClercq,
Chapter 7 of this volume).
Exit At this point, the business angel sells VCs are more concerned about
the investment in the firm (or writes exiting than BAs.
it off!).
depicted in Table 13.1. A common element of all approaches is that they depict the deci-
sion process as proceeding in a linear stepwise manner from deal sourcing through exit.
As van Osnabrugge (2000, p. 98) points out, however, a linear model would not capture
the fact that there may be feedback and looping within each activity and presumably
investors may cycle across stages and activities. Alternatively, it is conceivable that stages
could be skipped entirely. It also seems reasonable to expect that criteria may vary across
stages. Further, one could conceive of the decision process as being populated by multi-
ple participants on both the supply side (business angels, syndicate members, advisors,
angels’ family members) and the demand side (business owners, partners, advisors).
Even though these models of the decision process argue that investors make decisions
at various stages, most research studies focus on particular stages in the investment
process without necessarily situating the work in the context of a decision-making
process. For example, several studies have undertaken to document angels’ decision crite-
ria, often without consideration of the stage of the decision process; others have sought
to document non-financial contributions, and others have tried to measure realized rates
of return and exit mechanisms. Landström (1998, pp. 322–3) observes that ‘there are few
studies which have attempted to bring out the nuances in informal investors’ decision-
making criteria by considering investment as a process in which decision-making criteria
may vary in the course of time.’
Consequently, it would appear that there remains considerable room for research on the
nature of the investment process itself. Research might profitably investigate the invest-
ment process from both the investor and entrepreneur perspectives. Moreover, both mar-
keting and social psychology have posited models of how individuals arrive at decisions,
models that do not as yet appear to have been considered with respect to business angels.
Further study is indicated on how the various decision criteria are weighted at different
points in the process. It would also be of considerable interest to understand better how
those individuals who work with angels (such as lawyers, accountants, family) and those
who might work with the entrepreneurial team (consultants, family, partners, and so on)
might interact as the decision process progresses. In this context, decision models such as
the theory of planned behaviour first developed by Ajzen (1988) and Fishbein and Ajzen
(1981) might provide a means of assessing how the relative weightings of the investors’
values, salient others, and perceived feasibility are weighted throughout the decision
process.
Deal sourcing and initial screening

The first opportunity at which business angels can make a decision is when they initially
learn of the investment opportunity – at first sight and even before they have read a pro-
posal document or a business plan. While business angels rarely make the decision to
invest at this point, they frequently make decisions to reject the opportunity. DalCin and
her colleagues (1993) found that, on average, 70 per cent of rejections occurred out of
hand – on first sight of the proposal, confirming that investment decisions were being ren-
dered even as deals are being sourced. Riding et al. (1997) report that at the initial screen-
ing stage, ‘the most important criterion . . . is the fit between proposal and investor.’
There is evidence that rejection rates depend on the mechanism by which business
angels learn of an opportunity (Riding et al., 1997). Van Osnabrugge and Robinson
(2000, pp. 77–84) list and describe ten ways, including professional networks, through
which business owners seeking informal investors find potential investors (though they
present no data on relative frequencies). Since Wetzel’s (1983) seminal study, it is gener-
ally accepted that the primary means by which investors learn about potential investment
opportunities is through referrals from business associates (DalCin et al., 1994; Mason
and Harrison, 1994; 1996a; Sohl, 1999). DalCin et al. (1993, p. 195) conclude that busi-
ness angels prefer to rely on close associates ‘with whom they have had extensive invest-
ment experience’. However, she also notes that introductions from acquaintances were
more typical of business angel informants but that referrals from close associates were rel-
atively rare. She nonetheless suggests that entrepreneurs would be well advised to seek
introductions to angels through angels’ close associates. This is consistent with the finding
that rejection rates were lower for opportunities that were referred to investors from busi-
ness associates (Riding et al., 1997).
It is worth noting that most of the research on business angels’ investment process is
based on data gathered from business angels: there is little information that outlines the
deal origination process from the viewpoint of the entrepreneur. With that caveat, there
is a high level of consistency to the effect that individual business angels do not generally
seek out potential investments; on the contrary, business angels are often profiled as desir-
ing anonymity. More generally, entrepreneurs seek out business angel investors, with
potential investors frequently being approached to consider a wide range of investment
opportunities.
There is evidence that this process of deal origination is changing. Two forces are
driving these changes. First, governments at all levels and trade associations have sup-
ported business angel matchmaking initiatives. The last fifteen years have witnessed a
proliferation of market-making facilities that range from the equivalent of computer
dating services, to business angel networks (BANs) that are national in scope, to localized
introduction mechanisms that also include early stage entrepreneur training and pre-
screening. Mason and Harrision (1996b) review several of these market-making initiatives
and Sohl provides an updated and comprehensive review in Chapter 14 of this volume.
Second, business angels – once loosely and informally networked – are increasingly
entering into more formal business angel groupings. Sohl (1999) and de Noble (2001,
p. 362) have both commented that formal angel ‘clubs’ and ‘groups’, as well as angel side
funds, are becoming increasingly important sources of potential deals, most notably in
the US. Other countries appear to be lagging in this regard. There is little published
research that examines the decision-making process and criteria of these more formal syn-
dicates – another potential area for future research.
Evaluation and due diligence

Those potential deals that have survived the initial screening stage then become subject
to more detailed evaluation and due diligence. DalCin et al. (1993) report that another
20 per cent of investment opportunities are rejected at this stage of the process.
Due diligence
This stage often involves extensive information gathering by investors. Little theoretical
work has been reported about business angels’ evaluation and due diligence processes.
Prasad et al. (2000, p. 167) are among the few to use a theoretical approach to explore
business angel decision-making. They use a signaling theory approach to suggest that the
proportion of the entrepreneur’s initial wealth invested in the project ought to be an

important criterion for angels because ‘it indicates both the project’s value and the entre-
preneur’s commitment to the project’. It will be seen that there is little work that exam-
ines this factor directly and that other factors appear to be more important.
Van Osnabrugge (2000) used an agency-theoretic approach to derive a series of
hypotheses that compared the approaches of business angels with those of institutional
venture capitalists. He argues (p. 99) that managers of institutional venture capital funds
who act as agents working on behalf of the fund providers (principals) ‘must demonstrate
competent behaviour’. This entails (p. 99) ‘an additional level of the agency relationship
for VCs [venture capital managers] to deal with that BAs do not’. As a result of this rea-
soning, van Osnabrugge contends that business angels would conduct relatively less, and
less formal, pre-investment due diligence than would managers of institutional venture
capital funds. Van Osnabrugge hypothesizes that business angels would place more
emphasis on ex post involvement in the firms. Empirically, he found support for this
hypothesis but that differences may be sensitive to the regional business and legal context:
‘it is apparent that BAs [business angels] in the UK tend to be less sophisticated and
more ad hoc in their due diligence activities than VCs and possible BAs in other countries’
(p. 103).
In the Canadian setting, Haines et al. (2003) find support for van Osnabrugge’s pre-
diction and report that business angel investors use a wide range of due diligence
approaches. At one extreme, business angels indicate that their due diligence process is
ad hoc and informal: the business angels ‘go over’ the financial statements and projections
that are available about the potential opportunity, they ‘meet with the principals and get
to know them’ over a period of time, and they conduct informal reference checks on the
track records of the principals. Using these informal approaches, some business angel
investors indicate that they depend on ‘gut feel’ and have to trust the people involved in
potential deals and have to want to work with them. This same wording was also
expressed by van Osnabrugge (2000, p. 104) that ‘they (business angels) invest on a gut
feeling rather than based on comprehensive research’. At the other extreme, a small
number of business angels who participated in the study by Haines and his colleagues
indicated that their due diligence process is very sophisticated and involved extensive
checklists, thorough documentation checks and an active search for independent evidence
about the principals of the firm seeking investment. These tended to be larger scale
investors.
Decision criteria
This discussion of how business angels conduct due diligence and arrive at investment
decisions prompts an examination of their investment criteria. Most of the studies of the
business angel decision process have indeed focused on the decision criteria that business
angels employ.
In an early study, Mason and Harrison (1994) adopted a case study approach and
analysed the transcripts of interviews with one experienced private investor in the UK.
They found that the majority of the investment proposals (22 out of 35) were rejected fol-
lowing a detailed examination of the business plan. Of the remaining 11 proposals which
passed the initial review, nine were rejected after the syndicate had conducted its own
research on the marketplace and the principals.
In subsequent work, Mason and Harrison (1996a; 1996c) returned to the issue of busi-
ness angels’ decision criteria. In their 1996a study, Mason and Harrison drew on inter-
view data with 31 business angels who made investments in unquoted companies as well
as with 28 owner-managers who had raised capital from private investors. They found that
‘the key considerations in the investors’ decisions to invest were associated with the attrib-
utes of the entrepreneurs and the market-product characteristics of the business’ (p. 109).
The most important attributes of the entrepreneurs were their expertise, their enthusiasm,
and other personal qualities of honesty and trustworthiness. The growth potential of the
business idea was the most important of the business attributes. Mason and Harrison
(1996c, p. 45) also noted that ‘the most common deal rejection factors are associated with
the entrepreneur/management team, marketing and finance’. Among the most frequently
mentioned deal killers were: ‘one man shows’ and where there were significant gaps in the
management team; flawed or incomplete marketing strategies; and incomplete or unreal-
istic financial projections.
In their 1997 article, Harrison, Dibben and Mason explore the question of trust as a
factor in business angels’ investment decision. Harrison et al. (1997, p. 67) define trust as
‘the expectation that arises, within a community, of regular honest and cooperative behav-
ior, based on commonly shared norms, on the part of other members of that community.’
Although the research reported by Harrison et al. (1997) and Dibben et al. (1998) focused
on the initial screening stage – at which time the above authors show swift trust to be the
most frequently invoked trust concept – it seems clear that trust is also relevant in sub-
sequent stages. Drawing on both a theoretical framework and the use of a real-time verbal
protocol analysis of a business angel’s decision process, this work found that ‘the building
of trust relationships between the entrepreneur and the informal investor appears to be
essential for successful capital investments on the part of the investor to take place’ (p. 77).
Several other teams of researchers have also sought to examine the decision
criteria employed by business angels (Haar et al., 1988; Harrison and Mason, 1992; van
Osnabrugge, 1998; Erikson et al., 2003). There is a high level of agreement among these
studies: business angels attach great importance to the competence, integrity and capabil-
ity of the management team and to the market potential of the firm’s product or service.
Stedler and Peters (2003) present data from Germany that show that German angels
are influenced by a greater number of factors than have been identified in earlier studies
based on UK, Canadian and US data. In Germany, key decision factors include: the
entrepreneur/management team, product/service uniqueness and competitiveness, growth
potential, profit margins and being able to move into a profitable position quickly. Stedler
and Peters also note that the opportunities’ exit options, rates of return, and degree of
self-financing are also important. It is therefore possible that decision processes and cri-
teria vary across cultures.
Also, angels are not a homogeneous population. Hence, it is reasonable to expect that
decision criteria would vary across different types of business angels. For example, van
Osnabrugge (1998) compared decision criteria employed by ‘serial angels’ with those used
by ‘non-serial angels’. He found that serial angels are ‘less concerned with agency risks
and more concerned with market risks’ than their less-experienced counterparts (p. 23).
He also found that, relative to non-serial angels, serial angels appear to conduct more
research, are more likely to co-invest, and are less concerned with the location of the
venture.
Two further issues arose. The first is the extent to which criteria change as the process
unwinds. The second is whether factors leading to rejection differ from factors leading to
acceptance.
In terms of the first issue, Harrison and Mason (2002) and Fiet (1995) both contend
that business angels emphasize the qualities of the entrepreneurial team more than the
product or service itself. This conclusion is also consistent in spirit with van Osnabrugge
(2000). In particular, the role of trust in the decision process appears to be a non-
compensatory decision criterion in that trust is a prerequisite for investment (Manigart
et al., 2001; Kelly and Hay, 2003). While the development of trust is initiated during the
due diligence/evaluation process, it is furthered in the negotiation and consummation
phase.
However, the debate over which matters most – the importance of the business or the
quality of the entrepreneur(s) – is perhaps addressed by Mason and Harrison (1996a) who
noted that decision criteria vary by the stage of the decision process, that what matters
most changes over the unwinding of the process: ‘deals rejected at the initial review stage
tended to be on the basis of the cumulation of a number of deficiencies rather than for a
single reason; conversely, opportunities rejected after further research were more likely to
be characterised by a single deal killer.’
This result is consistent with the findings of Duxbury et al. (1997) who also found that
criteria weights used by informal investors shifted across stages and that as the process
unwinds the importance of the principals and of financial rewards both increase.
These findings suggest that researchers’ conclusions about the importance of particu-
lar factors depend on the stage of the investment process being considered. This is a result
that might usefully guide future research in that it would appear that identification and
importance of decision criteria are both dependent on the stage of the investment process
and the context.
Feeney et al. (1999) sought to address the second issue: whether factors leading to rejec-
tion differ from factors leading to acceptance. To identify factors that discouraged private
investors from making investments, they asked a sample of 115 ‘active’ business angel
investors and 38 ‘occasional’ business angel investors: ‘In your experience, what are the
most common shortcomings of the business opportunities you have reviewed recently?’
To identify attributes that prompted investors to decide to invest, they asked: ‘What are
the essential factors that prompted you to invest in the firms you chose?’ The researchers
concluded that informal investors consider both the attributes of the business and the
attributes of the entrepreneur as important when they consider whether to invest in or
reject a proposal. Mason and Stark (2004) reinforce these findings in their analysis of what
attributes of entrepreneurs’ business plans business angel investors sought. They report
(2004, p. 240), ‘BAs [business angels] . . . emphasize financial and market issues . . . [and]
give . . . emphasis to investor fit considerations.’
Negotiation, consummation, and deal structure

The next stage, negotiation and potential consummation, occurs when the investor(s) have
completed enough of the due diligence process to undertake formal pricing negotiations.
This can be a contentious stage in the investment process. This is often because founders
and business angels disagree about the relative values of their respective contributions to the
firms. Typically, founders provide the original innovation and energy about a potential
product or services. Angel investors then provide the capital necessary (as well as
substantive non-financial contributions) to take the innovation to commercialization.
Mason and Harrison (1996c, p. 42) reported that the overriding issue at this stage of the
decision process was disagreement on valuation and that this led to a high proportion of
proposals not being consummated. DalCin et al. (1993) confirm this observation and report
that of the 10 per cent of investments that reach the negotiation stage, half of those do not
survive negotiations.
Elitzur and Gavious (2003) address this through a game-theoretic analysis of the
process of negotiation and consummation between an entrepreneur and a potential angel
investor. They argue that the process will result in a moral hazard problem, where moral
hazard is defined (2003, p. 718) as ‘the form of post-contractual opportunism that arises
when actions required or desired under the contracts are not freely observable’. Certain
kinds of behaviour are specified which alleviate the moral hazard problem: payment in
the form of stock options, the angel sitting on the board of directors of the business in
which the angel has invested, specialization by the angel, staged financing rather than
all-in-one financing, and use of convertible preferred stock. Conceivably, this explains the
widespread use of shareholder agreements. Hatch and MacLean (1995) provide a
summary of the typical attributes found in shareholder agreements and the high fre-
quency with which business angels remain actively involved in the firms in which they
invest (van Osnabrugge, 2000; Madill et al., 2005).
Elitzur and Gavious also analyse a situation where the initial investment by an angel is
followed by a later investment by a venture capitalist. They conclude (2003, p. 721): ‘that
the opportunistic behavior of both the entrepreneur and VC leads to a moral hazard
problem, with these two players becoming “free riders”, coasting on the investment made
by the angel.’
The argument that moral hazard issues may arise during the negotiation and consum-
mation phase of the decision process is particularly interesting in the light of the relevance
of the concept of trust. In addition to the work of Harrison et al. (1997), Manigart et al.
(2001) investigated the impact of trust on private equity contracts. They concluded:
Trust between investor and entrepreneur is essential to help overcome control problems, espe-
cially in an environment with severe agency risks and incomplete contracts. In this study . . . we
find that trust has an impact on the desired contracts of entrepreneurs, but not on that of
investors. [The] findings suggest that for parties, faced with potentially large agency problems
(investors), trust and control seem to play complementary roles. On the other hand, for parties
with smaller agency problems (entrepreneurs), trust seems to be a substitute for control.
The issue of trust also arises in Kelly and Hay’s (2003) examination of the content of
contracts between business angels and entrepreneurs. On the basis of their interpretation
of agency theory, Kelly and Hay hypothesize that contracts are likely to be ‘tighter’ when
either the angel or entrepreneurs has more experience, investors are syndicated, the
investor is highly involved in the firm, and ‘looser’ when the entrepreneur is referred to the
business angel by a trusted associate or when trust between angel and entrepreneurs has
already been established. Kelly and Hay identify five non-negotiable aspects of the con-
tract terms: veto rights over acquisitions/divestitures; prior approval of strategic plans
and budgets; restrictions on management’s ability to issue share options; non-compete
contracts; restrictions on addition financing. Negotiable aspects included: forced exit
provisions; approval for senior hires/fires; need for investors to countersign bank cheques;
equity ratchet provisions; specification of dispute resolution provisions.
It is interesting that Kelly and Hay (2003) conclude that contracts are a complement to
high degrees of involvement. Van Osnabrugge (2000) regards active involvement of busi-
ness angels as a key means of reducing ex ante uncertainty. Empirical findings of the
importance of active involvement by business angels are reported by Haines et al. (2003,
pp. 24–5). Their work, based on analysis of qualitative interview data with business
owners and business angels suggests that the opportunity for the business angel to be able
to add significant non-financial value may be so important as to qualify as a decision
criterion, one that is especially significant at the negotiation stage. This latter result is in
keeping with van Osnabrugge’s (1998) hypothesis that business angels would stress post-
investment involvement as a factor in their decision criteria.
Post-investment involvement
It is important to include a discussion of post-investment involvement in this discussion
of business angels’ investment decision process. This is so for three reasons. First, busi-
ness angels’ investment decision must take account of the moral hazard problem inherent
in such investments. Perhaps the single most effective means of dealing with the moral
hazard problem is to reduce the information asymmetry between the founders and the
investor, and the best way to do so is to become a principal within the firm. Second, and
to some extent related to the moral hazard issue, recall that Madill and her colleagues
(2005) have found that the opportunity to add mentoring and other forms of non-
financial value-added appears to be a parameter of the decision process itself. Third,
(DalCin et al., 1993) found that business angels have high internal loci of control as well
as high needs for achievement. The fact that angels have their own funds at stake such that
they are principals, rather than agents, provides them with incentive to help the firms
prosper. Again, this suggests that post-investment involvement plays an important role in
the decision process. With expectations of a 30–40 per cent annualized rate of return, high
needs for achievement, internal loci of control, and in the face of moral hazard it appears
reasonable to expect angels to take on proactive roles in the firms in which they invest.
Landström (1998, p. 328) reports that ‘informal investors tend to see their investments as
“subjects”, where the prime motive to invest is the chance to create business opportuni-
ties and a desire to participate in the process.’
In this regard, it is widely accepted and understood that angels do make non-financial
contributions to the firms in which they invest. Wetzel (1994), Mason and Harrison
(1996a), and Lumme and her co-workers (1998) are among those who argue that the non-
financial role of angels can be important to themselves and to the business enterprise.
Mason and Harrison (1996a) explored this in their study of both the supply side (angel
investors) and the demand side (businesses that had received angel investment). From a
sample of 20 dyads and eight additional owner-managers, Mason and Harrison identified
contributions that included: strategic advice, networking, marketing, management func-
tions, finance and accounting functions, financial advice, and general administration.
A minority of investors made no contributions aside from their financial stake. Half of
the entrepreneurs reported that the investors’ contributions were either helpful or
extremely helpful. Likewise, Madill et al. (2005) document contributions that include:
ongoing advice particularly with respect to financing and business strategy; contacts that
include additional sources of financing as well as potential customers; participation on

boards of directors; involvement in hands-on day-to-day operations of the firm; business
and market intelligence; and, credibility.
Given the frequency of high levels of post-investment involvement, the question arises
as to whether firms financed by business angels exhibit superior performance. There is
some evidence to this effect.
First, Farrell (1998) found that the incidence of business failure among 264 firms that
had not received ‘private investment’ (in Farrell’s study, it is not clear if this is exclusively
from business angels) was 20.5 per cent while the failure rate among 46 enterprises that
had received private investment was lower, 17.4 per cent. However, this small difference
may equally be attributable to the counterfactual problem: that firms that had received
business angel financing may have been, in the first place, better quality investments.
Second, Madill and her colleagues (2005) report that firms financed by business angels
were more likely to obtain institutional venture capital than other firms. Again, it is pos-
sible that the counterfactual is attributable for this but it is also possible that non-financial
contributions of angels may better qualify such firms for being able to grow and access
institutional venture capital.
Third, firms financed by business angels may experience better exit events. Landström
(1993) reports on expected rates of return and holding periods for business angels.
According to various studies, modal expected rates of return appear to be in the range of
30 to 40 per cent on an annualized after-tax basis. However, a small but significant frac-
tion of angels expect a rate of return of less than 20 per cent, while others expect a rate
of return of over 60 per cent.
Aside from the exploratory study by Lumme et al. (1996), Mason and Harrison’s (2002)
study appears to be the only published examination of realized rates of return and exits.
Their work was based on 127 exits reported by 126 Scottish angels. They found that trade
sales of the businesses was the most frequent form of profitable exit. They also demon-
strated that business angels experienced superior returns to those obtained from a sample
of UK venture capital firms, finding that 34 per cent of angels’ reported exits were total
losses, but that 23 per cent were exits in which the annualized rate of return exceeded
50 per cent.
It is difficult to find other studies reporting realized rates of return on the part of infor-
mal investors. This is an important topic for future research. This importance stems from
the growing realization by policy makers of the importance of business angels and their
attempts to stimulate business angel investment. Likewise, there is a need to address
Gompers and Lerner’s (2003) questioning of public policy initiatives that seek to
‘encourage amateur informal investors’. The informal market comprises a variety of
investor types that include business angels as well as the category sometimes referred to
as ‘family, friends, and fools’. Examination of realized returns is one way of informing
this discussion.
Post-investment involvement appears to be an important aspect of business angels’
investment decision process. Through this involvement, business angels are better able to
assess and control the moral hazard inherent in such investments. Because business angels
have high internal loci of control as well as high needs for achievement, they have power-
ful incentives to help actively with the development of the firms. There is some prelimin-
ary evidence to the effect that angel-financed firms perform relatively well. Accordingly, it
seems reasonable that Madill and her colleagues (2005) have found that the opportunity
to add mentoring and other forms of post-investment non-financial value-added may be
a parameter of the decision process itself.
Conclusions and directions for future research

This chapter has provided a review of the state of the literature regarding investment deci-
sion-making by business angels. Table 13.2 provides an overview of this process and a
Table 13.2 Business angel investment decisions: key references
Stage Events Key References

Sourcing of This stage involves encountering DalCin et al. (1993)
potential deals and engaging businesses in which Mason and Harrison (1994; 1996b)
and first investments might follow and a Fiet (1995)
impressions ‘first sight’ informal evaluation. Riding, Duxbury and Haines (1997)
Sohl (1999)
Van Osnabrugge and Robinson
(2000)
Evaluation of This stage involves examination of Haar, Starr and MacMillan (1988)
the proposal the business plan and conducting Harrison and Mason (1992)
due diligence. Investors meet with DalCin et al. (1993)
the founders, consult with potential Mason and Harrison (1994;
syndicate partners as appropriate, 1996a; 1996c)
and conduct external and internal Harrison, Dibben and Mason (1997)
evaluation of the opportunity and Van Osnabrugge (1998; 2000)
the entrepreneurial team. Feeney, Haines and Riding (1999)
Prasad, Bruton and Vozikis (2000)
Manigart, Korsgaard, Folger,
Sapienza and Baeyens (2001)
Erikson, Sørheim and Reitan (2003)
Haines, Madill and Riding (2003)
Kelly and Hay (2003)
Stedler and Peters (2003)
Mason and Stark (2004)
Negotiation In this stage, the investor(s) and the Mason and Harrison (1996c)
and entrepreneur(s) negotiate the terms Harrison, Dibben and Mason (1997)
consummation of the deal. Manigart, Korsgaard, Folger,
Sapienza, and Baeyens (2001)
Elitzur and Gavious (2003)
Kelly and Hay (2003)
Post-investment In this stage, the investor(s) work with Landström (1993)
involvement the firm in various capacities and in Mason and Harrison (1996a)
various levels of involvement to Farrell (1998)
develop the business further. Madill, Haines and Riding (2005)
Exit At this point, the business Lumme, Mason and Suomi (1996)
angel sells the investment of Mason and Harrison (2002)
the firm (or writes it off!).
tabular summary of some of the key references. An overview of this literature reveals
several recurring issues that researchers have not yet fully surmounted. Each of these
therefore provides fertile ground for future work.
This review suggests that one important direction for future research lies in the devel-
opment of a comprehensive model of investment decision-making. Several models of
decision-making have been developed in other fields, some of which have been applied to
entrepreneurship research (but not to research on business angels). For example, Orser
et al. (1998) successfully applied the theory of planned behaviour (Fishbein and Ajzen,
1981; Miniard and Cohen, 1981) to entrepreneurs’ decision of whether or not to pursue
growth as an objective for their firms. This approach allows for both the primary players
(investors and firm founders) to have a role but also allows for the participation of others
(syndicate partners, spousal partners, and so on) to have input into decisions. This may
prove to be a fruitful direction for future work.
A second direction relates to the identification of the ways in which decision criteria
(or the weightings accorded these criteria) might systematically change as the decision
process unwinds. Previous research has suggested that such changes occur; however,
this line of enquiry does not appear to have been pursued to the extent that might be
possible.
A third area of enquiry relates to the ways in which post-investment involvement miti-
gates the moral hazard problem. While it appears that business angels are actively
involved in the firms in which they invest, it is not clear to what extent this is a response
to the moral hazard aspect of the investment process. The moral hazard issue can be
addressed through contracting or through monitoring mechanisms. An alternative expla-
nation for active involvement could relate business angels’ high internal loci of control
and their high needs for achievement.
Fourth, there is virtually no work on the ways in which business angels, founders and
later stage investors interact. Findings that firms financed by business angels are more
likely to obtain institutional venture capital prompt the need to examine how the founders
and the angels comprise a team that together seeks to ensure success of the enterprise. To
the extent that this is true, the role of business angels in economic development may con-
tinue to be underestimated. A related aspect of this issue is the ways in which business
angels’ roles might change with the arrival of venture capital. While not strictly related to
the issue of decision-making, this topic is nonetheless a potentially useful direction for
future research.
Methodological issues
Notwithstanding the many potential directions for future research, ongoing investigation
of business angel decision-making must contend with several important methodological
challenges, problems that pervade much of the literature on business angel decision-making.
First, much of the work is empirical and lacks a theoretical framework. While there are
obvious exceptions to this rule, studies that are rooted in a theoretical perspective are rare.
This is particularly surprising when it comes to modelling the investment decision process.
The literature of social psychology and marketing is rich with theory-based models of
decision-making; yet none appear to have been applied to the business angel context.
Examples of potential models include the theory of planned behaviour (Fishbein and
Ajzen, 1981) among other possible frameworks, some from the theories of consumer
decision-making. This appears to be one area in which future research might help us
better understand the decision-making process.
Second, almost all of the empirical studies (again with a few notable exceptions) use
data drawn exclusively from the supply side of the informal market. While this may be
appropriate for many of the research objectives, it is not sufficient to address other
research goals. In particular, one-sided data cannot fully characterize the decision process,
nor can it fully describe business angels’ non-financial value added. Useful directions here
might be examination of the factors that prompt business owners to seek business angels
as financing sources and the examination of how attributes of firms financed by business
angels might differ from other firms.
Third, definitional problems and inconsistencies persist. The terms ‘informal investor’
and ‘business angel’ are often used interchangeably; but just as often are distinguished one
from the other. Studies of business angels refer to them as informal investors, and vice
versa. Business angels and other types of informal investor do differ in significant ways
(Erikson et al., 2003) including how they make decisions (van Osnabrugge, 1998). This
debate prompts the need to decompose the informal market into relevant segments and
to examine more precisely the behaviour and experiences of investors in each of the con-
stituencies of the informal market.
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14 The organization of the informal venture capital
market
Jeffrey E. Sohl
Introduction
In spite of the volume of business angel investing, the early stage equity market is fraught
with inefficiencies. For firms with established financial records and tangible assets, finan-
cial markets supply an extensive assortment of financing instruments. These markets are
relatively accessible and the owner is left to decide the optimum mix of a financial struc-
ture based on the cost of capital (Brophy, 1997). However, the high growth entrepre-
neurial firm seeking early stage equity capital is faced with significant problems in finding
this risk capital due to the inefficiency of the early stage equity market. Thus, the type of
early stage financing required by high growth entrepreneurial firms, namely high risk
equity capital, is not readily available. While variations in the availability of early stage
capital exist across countries, and regionally within countries, overall there is a persistent
lack of high risk capital for entrepreneurial ventures (Riding and Short, 1987; Gaston,
1989; Mason and Harrison, 1992; Harrison and Mason, 1993; Landström, 1993; Freear
et al., 1994a). Business angels, who collectively comprise the informal venture capital
market, are the major supply of early stage equity capital, and improvements in the
efficiency of this market will increase both the size and the accessibility of early stage
equity capital.
There are three main reasons for the inefficiencies, and thus the lack of early stage
capital, in the informal venture capital market. First is the invisibility of business angels,
second, the high search costs for both business angels seeking investment opportunities
and entrepreneurs seeking investors and third, an inadequate supply of capital (Freear
et al., 1994b; Mason and Harrison, 1995). As a consequence of the suppliers of capital
(business angels) seeking a degree of anonymity consistent with the need to maintain rea-
sonable deal flow, information flows very inefficiently (Freear et al., 1994b; Mason and
Harrison, 1996a). This difficulty in finding business angels and the lack of ‘investor ready’
quality deals, combined with an inadequate supply of capital, results in a primary seed
gap. Further compounding the inefficiencies in the informal venture capital market is a
second funding gap, the secondary post-seed gap. These larger capital requirements have
traditionally been considered too large for business angels and, as the venture capital
industry migrates to later stage and larger deal size, are deemed too small for venture cap-
italists. Recent research indicates that business angels are increasing their investments in
this secondary post-seed gap (Table 14.1) as market conditions require business angels to
provide some follow-on financing for their investments (Center for Venture Research,
2004; 2005). However, this movement by business angels to second stage financing is a
redistribution of risk capital and as such, exacerbates the primary seed gap (Sohl, 2003).
These systemic market inefficiencies and persistent funding gaps (primary seed gap
and secondary post-seed gap) have led the angel market to adopt various organizational
347
Table 14.1 Funding gaps
% of angel investments
2002 2003 2004 2005
Primary seed gap 50% 52% 43% 55%
Secondary post-seed gap 33% 35% 44% 43%
structures and market mechanisms to increase the efficiency of quality deal flow and
increase the availability of capital. Adapting to changing market conditions, multifaceted
angel organizations, or angel portals, have evolved. Collectively, the business angel portals
comprise today’s business angel market. These portals represent how entrepreneurs find
potential investors, how business angels find and screen deals, how they syndicate into
small groups to make an investment and how business angels interact within the larger
angel market. Angel portals shed considerable light on the angel market and provide a
potential lens to the future of the market.
The scope of this chapter is a discussion of the current structure of the business angel
market with respect to the various types of angel portals in existence today. A business
angel portal is an organization that provides a structure and approach for bringing
together entrepreneurs seeking capital and business angels searching for investment
opportunities. The primary goal of angel portals is to increase the efficiency in the early
stage market, increase deal flow for business angels and provide entrepreneurs with access
to angel capital. The portals range from informal collections of business angels to dues-
paying members with investment requirements for each member. Most require their busi-
ness angel members to meet a minimum net worth/income requirement, which serves as
a proxy for ascertaining if the business angel has sufficient knowledge of the risks and
illiquidity inherent in angel investing. The remainder of the chapter is organized as
follows: an examination of the previous research on business angel portals, a discussion
of the types of business angel portals that exist today including a description, an example
and a discussion of the effectiveness of each type, and some concluding remarks.
Early research on business angel portals

The early research on angel portals focused on measuring the effectiveness of business
introduction services in various countries (Blatt and Riding, 1996; Landström and
Olofsson, 1996; Mason and Harrison, 1996a; Wetzel and Freear, 1996). In general, these
studies define effectiveness as meeting the needs of the angel market. Although these
needs vary across countries, the literature has considered effectiveness to include changes
with respect to higher quality deal flow, improving the efficiency of the angel market,
raising the awareness of business angels as a source of equity financing, and increasing
the availability of angel capital and the level of angel investments.
Initiatives in the United States

The first angel portal in the world, Venture Capital Network, was organized in 1984 as a
not-for-profit matching network affiliated with the Center for Venture Research at the
University of New Hampshire in the United States. An evaluation of the operations of
Venture Capital Network (VCN) noted some of the problems with both assessing the
The organization of the informal venture capital market 349
effectiveness of networks and in developing and growing a matching network (Wetzel and
Freear, 1996). In the case of VCN, investment security regulations prohibited VCN from
any role in the process beyond the initial introduction. As such, data on the success or
failure of the introduction, the quality of the deal flow as perceived by the investors and
the amount of funding generated were difficult to obtain. However, research indicates that
it was difficult and time consuming to find investors to join the network, that funding for
operations was a persistent issue and the likelihood of profitability was slight, and that
there was an acute need to demonstrate to investors an adequate level of high quality deal
flow (Wetzel and Freear, 1996). In a study of VCN investors it was determined that
approximately 10–15 per cent of entrepreneurs received funding through the matching
service and approximately 40 per cent of the entrepreneurs received funding through the
venture forum format (Sohl, 1999). However, it is important to note that the venture
forum format included fewer entrepreneurs, higher levels of screening, and received
coaching from VCN before their presentation to investors.
Initiatives in Canada
One of the early studies on the effectiveness of an angel portal was the examination of the
Canada Opportunities Investment Network (COIN), a national angel network (Blatt and
Riding, 1996). The goal of COIN was the development of a matching service to meet the
unsatisfied demand by Canadian entrepreneurs and to access the large pool of private
savings held by Canadians. Unfortunately, these goals were not realized. Research indi-
cates that investors did not consider COIN to be a valuable service. Over 60 per cent of
investors surveyed reported that it was difficult to find high quality investment opportun-
ities within the COIN network and most did not find COIN to be an essential, or even
important, component of their investment sourcing (Blatt and Riding, 1996). In addition,
business angels registered with COIN noted that they often used their own leads and refer-
rals to find deals. It appears COIN was ineffective in that it was designed to solve a
problem that did not exist. COIN sought to increase the opportunity for business angels
and entrepreneurs to make contact, but the underlying problem was not the inability of
business angels to contact entrepreneurs, but rather the scarcity of high-quality invest-
ments. In essence, the low barrier of entry with respect to entrepreneurs submitting busi-
ness plans and little screening of these ventures resulted in investors concluding that
COIN was of little value (Blatt and Riding, 1996).
Initiatives in the United Kingdom

In contrast to the COIN approach (building a national network that seeks to address
needs at a local level), the Local Investment Networking Company (LINC) in the UK
adopted the strategy of aggregating local enterprises into a national business introduc-
tion service. Founded in 1987, LINC offers several approaches to assist entrepreneurs,
including a matching service, an investment bulletin (a short description of firms seeking
capital) and the venture forum format. Early research on the effectiveness of LINC indi-
cated that the impact on marshaling the pool of angel capital had been modest (Mason
and Harrison, 1996b). Reasons for this modest impact included the relatively small
database of firms and investors that existed, a limited marketing budget that resulted in
a low awareness among investors and entrepreneurs, a need to be more selective in
accepting firms for listing and a fragmented organizational structure. On the positive
side, it is noted that LINC was a relatively efficient source for investors and that entre-
preneurs received several ancillary benefits from LINC membership, especially the
advice from the LINC business advisors and feedback from investors (Mason and
Harrison, 1996b).
Similar to the bottom-up approach of LINC, an early initiative in facilitating the
growth of the angel market in the UK was the Department of Trade and Industry
Informal Investment Demonstration Projects. This program provides direct government
financial assistance to create a number of local business angel networks. An evaluation of
these demonstration projects found the initiative to be quite successful. Specifically, it
appears that the Informal Investment Demonstration Projects have resulted in a signifi-
cant pool of capital, have stimulated demand for equity capital and succeeded in facili-
tating an increase in the level of angel investment activity (Harrison and Mason, 1996).
However, it should be noted that these conclusions are based on a small number of pro-
jects (5) and it is possible that a substantial expansion of this program could result in some
diminishing returns or possibly an overcapacity of government subsidied angel networks
competing with each other for the same market.
Initiatives in Sweden
In contrast to the proliferation of angel networks in the UK, Sweden has shown less of a
penchant for these introduction services. In an early study of individual investors in
Sweden, very few business angels noted the need for an introduction service since the
search for new investments was not considered troublesome in the informal market
(Landström and Olofsson, 1996). Previous research on the first angel network in Sweden,
the Chalmers Venture Capital Network (CVCN), appeared to corroborate this lack of
need. The CVCN had the primary goal of facilitating the commercialization of technol-
ogy that originated in the Chalmers University of Technology. A classic matching
network modeled after the Venture Capital Network in the US, the CVCN was a two-stage
computerized subscription network that matched entrepreneurs with angel investors.
Research indicates that CVCN is relatively unknown within the angel community, par-
tially as a result of a small regional focus. More importantly, given that proposals are not
evaluated before inclusion in the listing, there exists a high potential for low quality in the
deals offered to investors (Landström and Olofsson, 1996).
Initiatives in Denmark
Danish business angels invest in a robust cross-section of business sectors, with a major
emphasis on the seed and start-up stage. The holding period of 3–6 years compares favor-
ably with business angels in other countries, as does the sale of the company as the major
exit vehicle (Vækstfonden, 2002). For business angels in Denmark, networking among
business associates is the dominant form of finding investment opportunities. However, it
appears that this informal networking does not have the optimal impact since over 40 per
cent of Danish business angels claim they have difficulty in identifying potential entre-
preneurs and investment opportunities (Vækstfonden, 2002). In addition, two thirds of
business angels in Denmark co-invest with other business angels, which is a higher syndi-
cation rate than business angels in the UK but less than those in the US (Vækstfonden,
2002). Research also indicates that capital from Danish business angels is available
provided that quality investments can be found (Koppel, 1996). Thus, the desire for
syndication and the need for a more efficient method to find investments indicate that
angel portals should have a place in the Danish informal venture capital market. In add-
ition, research indicated that Danish business angels noted the need for a government
entity to act as an intermediary or facilitator between business angels and entrepreneurs
(Koppel, 1996). In 1991, with the support of the National Agency of Industry and Trade,
the Business Innovation Center initiated the Business Introduction Service (BIS). The BIS
was created for the purpose of assisting entrepreneurs in developing their financial plan,
introducing the entrepreneur to a potential business angel, and mediating the negotiation
between the entrepreneur and business angel. Despite the apparent need and desire for a
business angel portal the BIS initiative was not successful for a number of reasons
(Koppel, 1996). First, the description of the investor’s criteria for investments was too
narrow, resulting in a decreased chance of finding a suitable proposal. Second, the work
involved in matching entrepreneurs and business angels is labor intensive and relies
heavily on the personal characteristics of the entrepreneur and business angel. This
resulted in a considerable expense to the BIS and the business angels were not interested
in paying for the full cost of this service. Third, the pool of business angels in the BIS was
not large enough to provide a reasonable chance for the entrepreneur to receive financing
(Koppel, 1996).
Initiatives in Finland
Research on business angels in Finland identified several key factors for the successful
implementation of an angel portal. Among Finnish business angels the favored model for
an angel portal is a computer based matching service (Lumme et al., 1998). In this type
of angel portal (discussed in detail in the following section) the entrepreneur submits an
executive summary of the business plan, along with a short form detailing some key char-
acteristics of the business. The computer system matches the investment preferences of
business angels with those of the submitted business plans. If the business angel is inter-
ested, then the matching service provides the introduction. It is interesting to note that
venture forums, essentially forums for pre-screened entrepreneurs to present their busi-
ness concept to an audience of business angels, did not appear to be of particular inter-
est to Finnish business angel service (too much effort to attend), nor did on-line data bases
(too complex to use) (Lumme et al., 1998). In 1996 a consortium of public and private
sector entities launched Matching-Palvelu, a Helsinki based computer matching service
for business angels and entrepreneurs. Venture forums were also part of Matching-
Palvelu. Based on an evaluation of Matching-Palvelu, it appears to be quite successful for
several reasons (Lumme et al., 1998). First, the service was designed based on research on
the needs of the business angel. Second, heavy investor recruitment to Matching-Palvelu
was conducted through an investment fair. Third, extensive media coverage and presen-
tations on the concept to business organizations helped to develop interest and awareness
of Matching-Palvelu. A similar model has also enjoyed success in Finland. Sitra PreSeed
Finance introduced INTRO Venture Forums. Every 12 months five INTRO Venture
Forums are organized to bring pre-screened entrepreneurs to present their business
concept to business angels. Sitra PreSeed Finance also coordinates the investment nego-
tiations between the entrepreneur and business angel. To date, the INTRO Venture
Forums have been quite successful, with one out of every three companies securing financ-
ing (Sitra PreSeed Finance, 2006).
Initiatives in Singapore
Business angels in Singapore represent a significant source of funding for entrepreneurs,
with a mean investment amount of S$350 000 and a total investment amount close to S$30
million, which indicates that a substantial business angel market exists in Singapore
(Hindle and Lee, 2002). In 2001 the Business Angel Network Southeast Asia (BANSEA)
was established to promote development of the angel investment community in Asia
through education and facilitating the matching of start-ups with angel investors (Kam
and Ping, 2003). BANSEA also initiated the BANSEA Mentoring Program to assist
entrepreneurs in the development of start-ups to provide quality deal flow to business
angels. To date there has not been any independent evaluation of the effectiveness of
BANSEA. It is important to note that while business angels in Singapore are similar
to their western counterparts, a distinguishing characteristic is the prior relationships
with the entrepreneur. The majority of business angels in Singapore have an established
relationship with the entrepreneur prior to the investment, with more than 80 per cent
knowing the entrepreneur at least one year prior to the investment, and over half having
known the entrepreneur for more than five years (Hindle and Lee, 2002). In addition,
54 per cent of the business angels invested in ventures started by friends or neighbors and
40 per cent in ventures begun by family members (Kam and Ping, 2003). These findings
on the prior relationship appear to indicate that any evaluation of the effectiveness of
angel portals in Singapore must adopt a long term approach. That is, while the business
angel network is in the business of introducing business angels to entrepreneurs with the
goal of securing an investment for the entrepreneur, the measurable effects of these ini-
tiatives would likely not occur for over a year, and may take close to five years to come to
fruition. Thus, researchers should be cautioned when conducting an evaluation of angel
networks in Singapore, and possibly in Asia in general, since such analysis would need to
be longitudinal and conducted over a considerable period of time.
Initiatives in Australia
Business angels in Australia, while similar to business angels in other countries,
have several distinguishing characteristics (Hindle and Wenban, 1999). Most notably,
Australian business angels are younger than the average business angel. In terms of edu-
cation, Australian business angels fall into two distinct categories: older business angels
with little more than a high school education but with much entrepreneurial work experi-
ence and highly educated young professionals. With respect to the size of investments two
categories emerge: business angels that tend to make only large investments in the range
of $200 000 to $500 000 and those that restrict their investments to much smaller amounts,
typically below $50 000 (Hindle and Wenban, 1999). Of note is that the size of the busi-
ness angel market in Australia appears to be 35 to 50 per cent of the venture capital
market, which is significantly lower than that of Canada, the US and UK (Caslon
Analytics, 2006). To provide these business angels with investment opportunities there has
been a proliferation of business angel portals in Australia with 16 angel portals in oper-
ation today. The largest of these portals is the Founders Forum, which operates in three
regions of Australia: Brisbane, the Gold Coast and Perth. Started in 2000, the Founders
Forum has invested over $20 million in entrepreneurial ventures (Founders Forum, 2006).
Another large business angel portal is Enterprise Angels, which provides a range of ser-
vices, including an online matching service for companies seeking less than $2 million in
angel investment (Murphy, 2003). While there is a wide range of angel portals in oper-
ation in Australia, to date there does not exist any comprehensive research on the
effectiveness of these portals.
Initiatives in Germany
The predominant angel portal in Germany is BAND (Business Angel Network
Deutschland) which is affiliated with, and provides services for, over 40 business angel
networks in Germany and is involved with providing introduction services between busi-
ness angels and entrepreneurs. BAND was established in 1998 and operates under the
patronage of the Federal Ministry for Economy and Labor and is financed by sponsor-
ship and member fees. The multi-faceted goals of BAND include the establishment of
contacts between business angels and young innovative ventures, services to the business
angel networks throughout Germany, engagement in political lobbying and public rela-
tions, and the development of workshops for both business angels and entrepreneurs
(Günther, 2005). Research indicates that BAND and its affiliated networks play an
important role in the German business angel community. While business contacts provide
German business angels with over 90 per cent of the investment opportunities and close
to 80 per cent of the investments, investment clubs and matching services account for
35 per cent of the investment opportunities and close to 20 per cent of the investments
(Brettel, 2003). In a similar study, 41 per cent of German business angels use networks to
gain access to potential investments (Stedler and Peters, 2003). In addition, over half of
German business angels work in syndicates, predominately for the purpose of raising
sufficient funds to make an investment (Brettel, 2003). The type of activities, finding
investment opportunities and syndication, valued by German business angels, are activ-
ities that BAND has been an active participant in. Since the inception of BAND in 1998
the concept of business angels has gained traction and BAND has raised the interest
of the individuals in the angel market, and the economy has responded successfully
(Kosztopulosz, 2004).
Lessons from early business angel networks

Some valuable lessons can be learned from the early attempts to develop business angel
networks, many of which are pertinent in today’s informal venture capital market. One of
the greatest, and lasting, contributions of the early angel portals was to increase the
awareness of business angel investing and the important role played by business angels in
the early stage equity financing of entrepreneurial ventures. Thus, while the majority of
the early attempts at angel portals were not necessarily successful in their stated goals,
many did have some modest ancillary effects with respect to awareness elevation among
entrepreneurs and potential business angels. In addition, these early angel portals pro-
vided the foundation for both the design and success of many of the later attempts.
The lessons that can be gleaned from the early angel portals are centered on four issues:
investor membership, quality deal flow, funding and awareness. Much of the early
research on angel networks points to the difficult, and time consuming, task of finding
investors to join the network. As a result, many of these networks had a small data base
of business angels. Networks that were successful, such as Matching-Palvelu, conducted
intensive investor recruitment through venture fairs and the media. Quality deal flow was
a persistent problem for the early networks. It was often cited that the low barrier of entry
for entrepreneurs to submit business plans and the difficulty for the networks in finding
quality deals resulted in an overall lack of quality deals in the data base. The general con-
clusion is that the networks either did not evaluate the business plans before they were pre-
sented to investors or that the network operators needed to be more selective in deciding
what investments to offer to their members. Thus, the underlying problem was not neces-
sarily the inability of business angels to contact entrepreneurs, but rather the paucity of
high-quality investments. Funding was also a continuing issue for these early networks.
Funding issues centered on the general lack of funding for operations, a limited market-
ing budget and the labor-intensive, and thus costly, nature of matching entrepreneurs with
investors, finding quality deals and screening potential investment opportunities. The
awareness of the existence and value of the networks among the business angel commu-
nity was perceived to be low for many of the early networks. Thus, investors did not per-
ceive the networks as providing value to them and often used their own leads and referrals
to find deals rather than the network. It should be noted that this inability to create
sufficient awareness of the existence and value of the networks is likely to be related to the
inability of the networks to attract a substantial membership of angel investors. Those
networks that were successful, such as LINC and Matching-Palvelu, undertook extensive
efforts to develop interest and awareness.
The early work on evaluating the effectiveness of angel portals raises five serious con-
cerns that should be addressed during any evaluative study. First, most of the angel
portals do not have a cost effective mechanism to track the investments of their business
angel members and thus any data needed to conduct an evaluation is difficult to obtain.
Second, since business angel investments often take over five years to reach an exit, any
comprehensive evaluation of the portal must be conducted over the long term.
Unfortunately, the inherent long term nature of the evaluation process does not often
match the short term needs of the angel portal in judging effectiveness. Third, any rea-
sonable and accurate evaluation of the effectiveness of an angel portal requires a signifi-
cant commitment of funds and is labor intensive, two resources that angel networks have
in short supply. Fourth, developing measures of success pose a significant challenge, and
this is compounded by the fact that it is often difficult to even determine the goals of the
angel portal, let alone the measures of success. Lastly, in any evaluative study the import-
ance of an independent third party assessment is critical, which would require funding
from an equally independent source and not from any organization with an inherent inter-
est in the success of angel portals.
Types of angel portals

The angel market can be characterized along six different forms of angel portals, each rep-
resenting a distinguishable type of angel portal through which business angels interact
with entrepreneurs. The primary goal of each of these types of portals is to increase
the efficiency in the early stage market, increase deal flow for business angels and
provide entrepreneurs access to angel capital. With high transaction costs for the entre-
preneur, raising private equity capital involves a costly and time-consuming personal
networking process. For the investor considerable time and dollars are spent searching
and evaluating investment opportunities. Angel portals seek to mitigate some of these
time-consuming activities. Preservation of the anonymity of angel investors is also an
important consideration in the structure of these portals. The six types of portals or angel
Table 14.2 Angel portals
Proportion of
total market Membership Organizational Percentage of
investments criteria Visibility structure latent angels
Matching LOW MED HIGH HIGH MED
networks
Facilitators MED LOW MED LOW MED-HIGH
Informal angel HIGH LOW MED LOW LOW
groups
Formal angel MED HIGH HIGH HIGH HIGH
alliances
Electronic VERY LOW MED HIGH MED HIGH
networks
Collection of HIGH LOW LOW LOW LOW
individual
angels
organizations may be categorized as: matching networks, facilitators, informal angel

groups, formal angel alliances, electronic networks and individual angels. Table 14.2 pro-
vides a summary of the characteristics of the types of angel portals. In Table 14.2 five
characteristics are used to describe angel portals: the proportion of total market invest-
ments, membership criteria, visibility, organizational structure and the percentage of
latent angels. The proportion of total market investments is a measure of the market
share, in terms of the total number of investments made by members of the angel portal
as a percentage of the total investments by all types of angel portals. Membership crite-
ria is defined as the criteria that members of the angel portal must have. Thus, a rating of
‘high’ for membership criteria indicates that the portal requires the members to meet
several requirements, such as minimum yearly investment activity, annual dues and/or
contributions to an investment fund. Visibility is the degree of awareness that entrepre-
neurs and business angels have of the existence of the portal. Organizational structure is
the level of structure in the angel portal. An angel portal with a high organizational struc-
ture would include such organizational components as a paid executive director, the elec-
tion of officers, a formal investment committee and organization bylaws that govern the
activities of the portal. The percentage of latent angels is the percentage of the individ-
ual members of the angel portal that have the necessary net worth, but have never made
an investment.
Matching networks
Matching networks, or business introduction services, are the oldest form of an angel
portal and for a decade after their inception they were the only type of organized angel
portal in existence. The matching networks represent the first attempt to increase the
efficiency of the early stage market by providing a mechanism for investors to evaluate
opportunities, and for entrepreneurs to gain access to business angels. These networks are
typically not-for-profit organizations with an established connection to the investor and
entrepreneur community in their respective region. The first matching network, founded
at the University of New Hampshire by William Wetzel in 1984, at that time called the
Venture Capital Network (VCN), provided the model for matching networks that is still
followed today. VCN was based on four fundamental principles: the need to protect
investor anonymity, to provide access to capital for entrepreneurs, to have an efficient
mechanism for business angels to screen investment opportunities and the importance of
face-to-face interaction between business angels and entrepreneurs. These principles set
the stage for the foundation for the majority of matching networks in operation
today, such as Business Angels Party Limited in Australia, Halo in Northern Ireland
and Euregional Business Angel Network in Germany. Over time, this last principle,
face-to-face interaction, has been demonstrated to be a key element of angel investing.
Amit et al.’s (1990) examination of the implications of the relationship between entre-
preneurs and venture capitalists found that the significant information asymmetries inher-
ent in the private equity market highlight the importance of the principal–agent
relationship and allow for significant agency risks, particularly adverse selection prob-
lems. Business angels attempt to overcome these inherent difficulties with an increased
reliance on personal communications with the entrepreneur and the ability to judge the
character through face-to-face communications and interactions in a variety of settings.
Bearing out this point, the angel market has been one that conducts business on a face-
to-face level for both deal sourcing (Freear et al., 1994a; Coveney and Moore, 1998;
Reitan and Sørheim, 2000; Sørheim and Landström, 2001) and investment decisions
(Landström, 1992; Fiet, 1995a; Harrison and Mason, 2002). Likewise, business angels
tend to depend on the entrepreneur to protect them from losses due to market risk and
are thus more concerned with agency risk than market risk. To accomplish this, business
angels develop a close working relationship with entrepreneurs in the post-investment
stage as a way to mitigate risk and bring value to the investment (Fiet, 1995b).
To address the need to protect investor anonymity, provide access to capital for entre-
preneurs, have an efficient screening mechanism and the face-to-face interaction, VCN
implemented a three-tiered approach: (i) a matching database; (ii) the venture forum
format; and (iii) educational seminars.
The matching database requires the submission of an executive summary of the busi-
ness plan by the entrepreneur. Investors list investment preferences, including size, stage
and location. The network screens for those business plans that match investor criteria
and forward an anonymous copy of those business plans satisfying the criteria to the
individual investor. The investor, if interested, contacts the network for information on
the entrepreneur and the network facilitates the introduction and then exits from the
process. All subsequent contact is between the investor and the entrepreneur directly
(Sohl, 1999).
These matching networks initiated the venture forum format, where pre-screened entre-
preneurs are given the opportunity to present their business plan to groups of early stage
investors. In this context, investors were afforded the opportunity to have a face-to-face
interaction with several entrepreneurs, to view several presentations within a reasonable
period of time, and initiate contact if the venture appeared promising. The venture forum
also provided the opportunity for investors to interact with each other and to syndicate
around a deal.
The importance of education was underscored, and the matching networks were
the first to produce educational seminars, for both the entrepreneur and investor, on
investing in the early stage market, market trends, and similar timely investment infor-
mation. These educational seminars became an integral component of the matching
network concept.
At the high point of their tenure matching networks were the dominant form of angel
portal for nearly a decade. During that time, in terms of facilitating early stage invest-
ments, statistics indicate that the success rate for the network member entrepreneur in
receiving equity financing was in the 10 to 15 per cent range for the matching service and
approximately 40 per cent for the venture forum format (Freear et al., 1994a).
Today, very few classic matching networks are in existence in the US, although their
numbers are greater in Europe. Some have evolved into providing only venture forums or
educational seminars, while others have ceased to exist. However, the importance of this
initial effort to increase the efficiency of the angel market cannot be understated. This first
model spawned an entire industry. The unique combination of matching service, venture
forum format and educational initiatives set the stage for the development of these
important initiatives that have educated a generation of entrepreneurs and investors on
the central mysteries of angel investing. Also, the initial success of the venture forum has
been adopted as one of the predominant mechanisms in today’s market for bringing entre-
preneurs and investors together.
Facilitators
The second model of angel portal, facilitators, is one of the least organized of the angel
portals. These facilitators generally do not have any formal angel membership but rather
maintain a list of interested parties, including private investors, entrepreneurs and service
providers. They are often considered ‘event planners’ in the sense that they plan events
that seek to bring business angels and entrepreneurs together. These events are organized
around a specific issue, with a speaker, or panel of speakers, addressing a topic germane
to the angel market. These topics include valuations, setting terms and conditions, prepar-
ing a presentation and organizing a business plan. Thus, to some extent, facilitators
provide educational opportunities for the angel and entrepreneur community. These
events will also include the venture forum format. With ample time for networking, the
real focus of these facilitators is to assist, in a passive manner, the introduction of entre-
preneurs to business angels. Examples (cases) of facilitators are the Technology Capital
Network and the 128 Innovation Capital Group in the US, the ‘netzwerknordbayern’ in
Germany and Gate2Growth in Belgium.
These facilitators take on two organizational forms: private sector for profit organiza-
tions and public/private sector hybrids. The hybrids, often some form of economic devel-
opment agency, have as their primary focus the fostering of economic development in
their geographic area. Examples of this type of facilitator are International Angel
Investors in Tokyo, Japan and TechInvest in Wales, UK. The geographic footprint can be
as small as a mid-sized town of 150 000 residents to as large as a state or province. While
angel investing is not their core business, they often view angel capital as a key compon-
ent in increasing the economic vitality of their region. The facilitators embark on initia-
tives to begin to encourage angel investing in the community or, within an established
entrepreneurial sector, to sustain and grow angel investing. At the present time, there are
close to 100 active angel portals in the US that would be considered facilitators and prob-
ably as many in Europe (Sohl, 2003).
It is difficult to assess the effectiveness of the facilitators since they often do not keep
records of their success in these entrepreneur and angel interactions. One of the
difficulties is that the business angel–entrepreneur interactions are serendipitous in nature
and the facilitators do not have a formal list of either their entrepreneur or business angel
members. It does appear that these facilitators have been successful in three facets of the
business angel market. First, the facilitators have raised the visibility of the business angel
community in the region within which they operate. Second, they provide an informal
meeting structure for business angels to meet other business angels and possibly syndicate
with each other around a particular deal. Third, the facilitators provide a venue for entre-
preneurs to present their business concept, and through interactions with the business
angels and entrepreneurs at the meetings they often gain an assessment of the quality of
their presentation and the business plan.
Informal angel groups

The third type of angel portal is the myriad collection of informal angel groups. These
groups have members, although the membership criteria are quite broad, typically involv-
ing attendance at meetings and an interest, ability, and net worth, to engage in angel invest-
ing (Table 14.2). These groups can be as small as a handful of members to as large as
50 private investors (Center for Venture Research, 2005). Collectively, informal angel groups
represent the second largest of the six types of angel portals, in terms of total number of
members and investment activity. In the US there are several hundred of these informal
angel groups. Examples of informal angel groups are Envestors in London, UK, CatCap in
Germany, Founders Forum in Australia, and eCoast Angels and Walnut Ventures in the US.
The key distinguishing feature of the informal angel group, in addition to their size, is
the reliance on members to perform many of the ‘back office’ functions of the portal. The
informal angel groups rely on the members to bring the majority of the investment oppor-
tunities to the group for investment consideration. Thus, initial screening is the member
referral, and in some cases, the commitment of one member to invest funds is required
before the entrepreneur can present to the group. As such, the trust relationship among
members appears to be a mechanism to mitigate some of the risk inherent in angel invest-
ing. Members perform due diligence and are free to invest when they wish, usually without
any stated minimum investment activity required to remain a member of the group.
Members often syndicate with other members of the group based on a specific deal, with
one of the business angels assuming the role of lead investor. However, not all members
of the group invest in all deals, thus preserving the ability to manage their own angel
investment portfolio. The informal angel group affords the opportunity for members to
archive a level of sector diversification through this co-investing. That is, research indi-
cates that business angels typically invest in technologies in which they have experience
that has been garnered either as former successful entrepreneurs in the particular indus-
try or through prior sector investing experience. Thus, through a reliance on other
members with expertise in the particular industry, and the trust relationship they have
developed, business angels can achieve some industry-level portfolio diversification. The
venture forum format, although quite informal in nature, is the predominant mechanism
for assessing the investment opportunity. These informal angel groups have a small
number of latent angels, indicating that investment activity, while not a formal require-
ment for membership, appears to be at least an implicit one.
The informal angel groups have been quite effective in several facets of the angel
market. Since the screening of the investment opportunities is through a member referral
or a commitment of one member to invest funds, the investment opportunities presented
to their members are consistently of high quality. Informal angel groups also offer busi-
ness angels the opportunity to achieve some market diversification through co-investing
with other members. In addition, since most informal angel groups have a low percentage
of latent angels, the entrepreneur has a higher chance of securing investment capital.
Formal angel alliance

The fourth model of angel portal is the formal angel alliance. These alliances are distin-
guishable from the informal angel groups in that they tend to have a larger membership
per group and have a higher degree of visibility. However, the collective membership (and
investment activity) of informal angel groups and the individual angel market (discussed
below) exceeds that of the formal angel alliances.
The angel alliance phenomenon began in 1994 with the formation of the Band of
Angels in Silicon Valley by Hans Severiens. The original concept was to form a group of
private investors with a ‘storefront’ that gives visibility to the group but not to the indi-
vidual members, and to have a more rigid organizational structure than the informal angel
group. This formalized organizational structure is a distinguishing feature of the formal
angel alliance. Most alliances have specified articles of incorporation and are organized
as limited partnerships, general partnerships, limited liability corporations or corporate
entities (Table 14.2). The alliances often have criteria for membership in addition to
accredited investor status. These additional requirements include education, referral by a
member in good standing and past investment experience. Members may also include
venture capitalists and most alliances have some form of annual membership fee.
Decisions on investments include individual member decision making, voting by
members, or decisions by an investment committee. The high visibility of the formal angel
alliance was conceived as a mechanism to attract deal flow but had the unintended con-
sequence of attracting a multitude of deals with variegating quality, resulting in the need
for screening committees, staff support and the increased burden of screening these deals.
This deal flow volume and entrepreneur inquiries led to the need for paid back office staff,
board of directors and an executive director that assumes the ‘face’ of the portal for the
entrepreneurial community. Examples of the formal angel alliance include the Angels
Forum and BlueTree Allied Angels in the US, Advantage Business Angels and London
Business Angels in the UK, Nippon Angels Forum in Japan, and Mentor Investor
Network Events for Business Angels in New Zealand.
The original concept of the formal angel alliance has spawned a myriad of hybrid
alliance organizations that can be categorized by membership investment requirements,
investment decisions and the source of capital. The classic angel is an individual that
manages their own money and decides when, and how much, risk capital to invest in entre-
preneurial ventures. Some of the hybrid formal angel alliances have increased the burden
on members by specifying a minimum number, and size, of annual investment activity. An
example of this type of hybrid is the Tech Coast Angels in the US. This requirement may
lead to less than optimal investment decision making since angel investments are related
to the portfolio of private equity holdings of the individual angel and the investment
opportunity, rather than an artificially imposed investment frequency.
In another hybrid of the angel alliance, the decision making ability of the individual is
often restricted by certain forms of group decision making. Robin Hood Ventures in the
US operates as this type of hybrid. These group decisions take the form of voting, either
by members or by an investment committee, with a positive vote requiring all members to
invest in the venture. As such, the individual angel’s decision making authority is usurped
by the alliance.
The last form of hybrid angel alliance results from the pooling of funds. In this
instance, all members are required to invest in the angel alliance fund and this fund is the
sole source of capital for alliance investments. An example of this type of angel portal is
the Mid Atlantic Angel Group in the US. In some cases business angels may make an
additional investment, but only after the fund has decided to make the investment. In this
case, angel investing has morphed into classic venture capital funds, with limited/general
partners (the general partners are wealthy individuals), and the name ‘angel fund’ is the
only similarity to angel investing. These ‘angel funds’ result in a reallocation of angel
capital away from individual investing (and possibly seed stage investing) to venture
capital fund investing. While the investment objective of the fund may be seed stage, fund
size may dictate later stage investing and a diminishment in the value-add of the angel
investor.
The formal angel alliance has achieved much success, but this success is not without a
cost. The formal angel alliance has increased the visibility of angel investing and has
achieved a large number of member business angels per angel portal. However, while this
increased visibility has increased the number of deals for the alliance, this has not corres-
ponded with an equal increase in the quality of the deals. This variability in deal quality
has necessitated the initiation of screening committees and additional staff to review the
quality of the investment opportunities, which has resulted in increased operating costs.
In addition, the rigid organizational structure of the formal angel alliance is not in align-
ment with the general individualistic behavior of business angels and as such, these formal
angel alliances may be more attractive to inexperienced wealthy individuals seeking a
passive investment vehicle, rather than a value-added and active angel investor.
Electronic networks
The fifth, and smallest in terms of investment activity, type of angel portal is the electronic
network. These electronic networks were a product of the Internet bubble of 2000 and are
close to extinction in today’s angel market. Electronic networks were largely a misguided
effort and in some cases an attempt to profit from the irrational behavior of unseasoned
investors that entered the angel market during the dot.com bubble of 1999/2000. During
their peak in 2000 about thirty of these electronic networks sprouted on the World Wide
Web (Sohl, 1999). The electronic networks attempted to mirror the matching networks
through the medium of the Internet. Examples of electronic networks include Local Fund
and Funding Match in the US, and the Private Equity and Entrepreneur Exchange and
Aussie Opportunities in Australia. Unlike the matching networks, these electronic net-
works typically do not engage in any educational function nor do they use the venture
forum paradigm. Requirements for the entrepreneur cover the spectrum from the sub-
mittal of a two-page executive summary to detailed business plans. Pending investor
accreditation and an annual fee, individual investors peruse the network for investment
opportunities.
Electronic networks have been largely unsuccessful, with less than 1 per cent of equity
capital raised harvested on-line (Private Equity Week, 1998). Several factors attributed to
the demise of the electronic network. Strategies of many electronic networks were to
develop a national angel market operating with one platform and structure, which failed
to address the regional nature of the market and the necessity of being grounded in the
regional entrepreneurial market. One especially misguided government-sponsored effort
envisioned a central database for the US and over 50 local networks, the majority of which
had absolutely no understanding of the angel market. Also, angel investing is a face-to-
face phenomenon and no amount of electronic interfacing, in the present form, will
replace a seasoned investor’s ability and desire to review the deal, and the entrepreneur,
up close. In addition, in light of the overwhelming success of the venture forum format,
electronic networks provide no such venue. The future for electronic networks most prob-
ably lies in providing an efficient method for deal screening. Unfortunately, in many, if not
all, of the initiatives, the failure to grasp key concepts of the angel market resulted in poor
strategic selection and hampered the penetration of electronic networks into the early
stage equity market.
Collection of individual investors

The last type of angel portal, the collection of individual investors, is the largest and
oldest segment of the angel community. This is also the least understood of the angel
portals, since the individual angel market is largely invisible, and reliable data is difficult
to acquire. The individual investor portal accounts for the majority of deals and invest-
ment dollars in the angel market. Although the largest segment of the angel market, this
collection of individual angels is the least organized of the angel portals. These individual
angels are not directly affiliated with any angel portal, although loose connections with
informal angel groups and, to some extent, formal angel alliances, do exist and the indi-
vidual angels may co-invest with members of these other portals.
Despite the lack of organization, deal flow does not appear to be an issue, and the deals
may be of higher quality, on average, than those of the other portals (Table 14.2). Drawing
on their social and human capital, individual angels rely on referrals to generate deal flow.
These gatekeepers, such as other entrepreneurs, lawyers and service providers, often
provide that crucial initial introduction for the entrepreneur. Since the referral sources are
often trusted friends and business associates, who know what type of deals they invest in
with respect to sector, stage and size, there appears to be less need for screening. Tapping
into the individual angel portal is often a random occurrence and a time-consuming
process punctuated by many misguided approaches. As such, transaction costs for the
entrepreneur may be substantial.
Conclusion
Systemic market inefficiencies and two persistent funding gaps – the primary seed gap and
the secondary post-seed gap – have led the angel market to assume several organizational
strategies to increase the efficiency of quality deal flow and increase the capital available.
Adapting to changing market conditions, multifaceted angel portals have evolved.
Collectively, individuals and angel portals comprise today’s angel market. Angel portals
have increased the visibility, and importance, of business angels, and have provided entre-
preneurs with a venue in their search for seed funding. An examination of these types of
angel portals sheds considerable light on the angel market and provides a potential lens to
the future of the market. Six types of angel portals – matching networks, facilitators, infor-
mal angel groups, formal angel alliances, electronic networks and individual angels – were
examined. Hybrid forms were noted where appropriate. The existence and market pene-
tration of these types of portals vary across nations. In the future, it is important to under-
stand why some angel portals may be more apposite for certain regions and countries and
not for others.
Implications for portals

Based on this examination of angel portals it appears that for angel portals to be effective
in solving the primary seed gap and the secondary post-seed gap they should adopt some
basic features that reflect the fundamental tenets of the angel market. Perhaps most
importantly, angel portals should maintain an informal structure that has few rules or
restrictions for membership, such as minimum investment requirements, member voting
for deal investment approval and conditions that all portal members invest in all the deals
that are approved by the membership. Business angels invest in markets where opportu-
nities exist, such as in the primary seed gap and secondary post-seed gap, and thus restric-
tions on investment activities would prevent capital from being used where it is most
needed.
The three portal types, informal angel groups, the collection of individual angels and
matching networks, are most suited for investing in the primary seed gap. It is in this
primary seed gap that the angel and entrepreneur relationship is most critical and the pos-
ition where business angels can be most effective in their value-add. That is, since business
angels bring much start-up experience to their investments, this experience and expertise
is most effective in the early stages of development of the entrepreneurial venture. In add-
ition, this start-up experience affords business angels the opportunity to use their exper-
tise in evaluating the potential investment opportunity. In contrast, the formal angel
alliance, and in some instances the matching network, are best positioned in investing in
the secondary post-seed gap. The formal angel alliance, with extensive membership cri-
teria including minimum investment requirements and the presence, in many cases, of an
investment fund, allows the angel alliance to participate in these larger post-seed invest-
ment rounds. However, it is important to note that this extensive organizational structure
of the formal angel alliance may have some unintended consequences. Specifically, these
‘angel’ funds can be viewed as venture capital funds with wealthy individuals as limited
partners and such a structure represents a redistribution of business angel capital away
from the individual angel investor to a fund structure. Such redistribution would only
result in an exacerbation of the persistent, and troublesome, seed financing gap facing
entrepreneurs seeking early stage capital. This potential institutionalization of the busi-
ness angel market could present a significant impediment to the viability of the business
angel investor as the major provider of seed capital to entrepreneurial ventures (Amatucci
and Sohl, forthcoming).
There are four key considerations for angel portals to be successful. First, portals
should be based on a regional model, rather than one that is national or state/province in
scope. Since business angels predominately invest in deals within a half-day travel time
from their principal residence, this regional approach is most appropriate and would assist
in solving local capital gap issues. Second, angel portals need to provide for a face-to-face
interaction between business angels and entrepreneurs since the investment decision often
relies on the quality of the management team. Certainly, angel groups should be con-
nected to the regional entrepreneur and angel community and strive to develop an under-
standing of these regional communities within which they operate. Related to this
connection to the angel and entrepreneur community, angel portals should undertake a
marketing effort that includes building awareness among angels and those entrepreneurs
offering quality deal flow. Such a marketing effort requires an allocation of resources to
marketing initiatives. Third, portals should strive to provide quality deal flow for their
members. As such, angel portals should conduct some level of screening and develop
some hurdles for entrepreneurs to increase the proportion of proposals that are investor-
ready. This screening should focus on deals that occupy the primary seed gap and sec-
ondary post-seed gap, since this spectrum is where business angels have the opportunity
to be effective and realize returns commensurate with the risk they face. Fourth and most
important, portals must remember that they are collections of angel investors who make
individual investment decisions and that they are not venture capitalists that manage a
pool of capital. Such movement to the institutionalization of the angel market would have
serious consequences for the supply of critical seed and start-up capital. In the worst case,
an institutionalization of the angel market could result in a movement to later stage
investments, which would only exacerbate the primary seed and secondary post-seed gaps.
Once angel portals adopt the basic tenets outlined above for an organizational structure,
they will be in a better position to solve some of the inherent inefficiencies and capital
shortages that exist in the two capital gaps.
While angel portals have emerged, and evolved, over the years, and the angel market
has gained visibility, the angel market is still very informal, and relies on a collection of
individuals who are willing to invest a portion of their portfolios in high risk entrepre-
neurial ventures. Business angels are independent by nature and they invest their own
money where and when they want to. The market is a highly personalized one character-
ized by individuals (business angels) investing in individuals (entrepreneurs). When busi-
ness angels syndicate around a deal, they syndicate with other trusted business angels of
their choosing. The value-added component of angel investing, and the psychic income
the business angel acquires from investing is derived from the individual angels working
with the entrepreneurs they invest in. These individuals are the real adventure investors in
today’s market for risk capital.
Policy implications
Public policy can play a role in facilitating the development of a vibrant and active angel
market at a regional level and enhancing the flow of early stage equity capital to entre-
preneurial ventures. Specifically, four levels of policy recommendations are offered:
(i) linkages; (ii) research; (iii) education; and (iv) monetary incentives. With respect to
linkages, an active angel market requires the presence of innovators who develop the idea,
entrepreneurs who form a business around the innovation, and business angels who
provide the capital to move the idea from the laboratory to the marketplace. While some,
or all of these, are present in communities, it is important that the linkages between these
groups be established and public policy can play a role in fostering and nurturing these
linkages. Specifically, an active public policy to support the development of the business
side of the innovation (the innovator to entrepreneur linkage) would support both an
information clearing house for innovators and entrepreneurs to find each other, and a
sponsored venue for these meetings to take place. In addition, a physical location, such as
an accelerator, would further the development of the innovator–entrepreneur interaction.
To foster the growth of the business angel linkage with both the innovator and entrepre-
neur requires a pro-active public policy to facilitate, and act as a catalyst for, these
interactions to take place. Also, since angel investing requires substantial screening of
opportunities, public support of this screening function would assist business angels in
their search for quality deals.
Public policy can also play a role in supporting research to increase the understanding
of the changing nature of the angel market. The angel market is a myriad collection of
angel portals and a difficult market to gain access to for research purposes. Research
efforts in this context are labor intensive, costly and must be longitudinal in nature. Such
an extensive and comprehensive research undertaking is beyond the purview and the
resources of local governments and private sector firms. Research efforts of this magni-
tude are best supported through public policy agencies or a public/private sector part-
nership to provide the patient capital to design and undertake business angel research on
a national scale. This research can assist governments in making informed policy deci-
sions regarding the growth and sustainability of the business angel market.
Educational programs should be developed that target both the supply and demand.
Namely, education should be directed to latent angels to assist in understanding the
central mysteries of angel investing and for entrepreneurs to appreciate the requirements
necessary to become investor ready. Successful educational programs would result in
an increase in both available capital and quality deal flow. There exist some limited
private sector initiatives in this area, such as the Power of Angel Investing in the US and
Angel Academies in Europe. While private sector initiatives can play a limited role in edu-
cation, the public sector is uniquely positioned to marshal the appropriate individuals and
garner the resources necessary to develop and implement a comprehensive education
program that is available to all entrepreneurs and business angels at a subsidized price. The
public sector, in combination with existing research and funded research projects, can
ensure the consistency of the educational content. In addition, public sector involvement
and funding of educational programs will ensure that the content is based on research
studies, avoiding the incidence of anecdote-based training that occurs in a number of
existing private sector programs.
Public policy monetary incentives should focus on enhancing the flow of early stage
equity capital to entrepreneurial ventures. First, to increase a supply of start-up capital
and to leverage existing angel resources, a pool of capital, the Archimedes Fund, needs to
be created at a regional or national level. This Archimedes Fund would be the source of
leverage for angel investors. The creation of a fund with a 3 to 1 leverage would both
increase the available start-up capital and provide a form of downside risk protection for
angel investors. As an example, in an investment of US$1 000 000 the angel would provide
US$750 000 and draw US$250 000 (3 to 1 match) from the Archimedes Fund. At the exit
event, any capital gains would be redistributed to the Archimedes Fund, in the 3 to 1 ratio,
for future investments. It is important to note that the Archimedes Fund is not a venture
capital fund, but rather a matching fund for business angels. As such, management of the
fund would be substantially less burdensome than a classic venture capital fund. It is
important that the source of capital for the Archimedes Fund be corporate partners or
governments and not individual investors, to enhance the creation, rather than the redis-
tribution, of equity capital. An example of such a monetary initiative is the Scottish
Enterprise Business Growth Fund and the Scottish Co-investment Fund. These two funds
accounted for 7 per cent of the total monies invested in Scottish early stage companies in
2004 and were represented in 55 per cent of all the deals recorded (Don and Harrison,
2006). In addition, the leverage effect of the Scottish Co-investment Fund is substantial,
with the average business angel deal size in 2004 increasing from £179 to £475 when busi-
ness angels co-invested with the fund (Don and Harrison, 2006).
Second, to enhance the quality of deal flow, it is suggested that a web-based system be
created for entrepreneurs to submit business plans for potential angel funding. Utilizing
the resources of university business schools, students would provide initial screening and
due diligence for the proposals and complete a short assessment of the investment oppor-
tunity. This assessment would be available to business angels to help manage deal flow and
also available to entrepreneurs as a timely feedback mechanism in their search for equity
capital. Funds for this web-based screening system can be garnered from a small man-
agement fee that is part of the Archimedes Fund and government support.
Future research
While the angel portal has received considerable attention from researchers, there exist
many potential research topics that would add greatly to the understanding of this
important equity market. Much of the angel portal research to date has been based on a
cross-sectional analysis of the market taken at various points in time. A longitudinal
approach would provide for the opportunity to track changes in various portals over time.
One potential approach for longitudinal investigation is using the deal level as the unit of
analysis. In this scenario, the angel deal from each angel portal is tracked from the time
of investment to the exit. Such an approach would provide valuable insights into chang-
ing valuations and understanding the conditions for deals that exit when funding is
restricted to angel portals without any institutional venture capital. This longitudinal deal
tracking would also illuminate some of the conditions why an angel deal was not suc-
cessful across portals. Through longitudinal tracking at periodic intervals of time, infor-
mation as to how and why angel deals fail with respect to the type of angel portal would
be available for study.
With respect to the myriad of angel portals that exist, it is important to understand why
some angel portals may be more appropriate for certain regions and not for others. In this
context, regional level angel portal investment data, combined with regional R&D invest-
ments, measures of the entrepreneurial climate, industry infrastructure, workforce charac-
teristics and other economic variables could help in explaining the differences between
angel portals. In addition, such an analysis would provide economic planners with a poten-
tial map of how best to organize business angels within their region.
Another potential area of future research is the evolving relationship between angel
portals and venture capitalists. While these two entities are understood to be comple-
mentary and to occupy different places in the private equity market, these lines are becom-
ing less distinct, especially with the emergence of the formal angel alliance and the angel
fund. The potential for conflict exists and an understanding of the nature of these venture
capital–angel portal relationships and how best they can be nurtured for the benefit of
both parties would be an important contribution to the literature.
Another potentially interesting line of inquiry is the role of angel portals in regional
economic development. While angel portals typically restrict their investment activity to
the regions within which they operate, there has been little study on how angel portals
interact within the larger sphere of regional economies and with other portals within the
region. Screening and due diligence conducted by angel portals has often been studied
through interviews and cases. Research into the actual due diligence, through the direct
analysis of actions (reject, continue due diligence or invest) by the screening and due dili-
gence committees of angel portals, could assist entrepreneurs in developing business plans
more compatible with the criteria of the type of angel portal that is their target. While it
has been noted that the angel market is experiencing an increase in organization, the
potential for the institutionalization of the angel market and the subsequent abandon-
ment of the seed and start-up stage market has serious considerations. Research into this
potential institutionalization, the conditions for development and the consequences
within angel portals, are of vital concern to the future of the angel market.
There exists a notable lack of a theoretical framework for business angel research in
general and for angel portals in particular. Since angel portals are essentially collections
of individuals that operate within a group, one potential theoretical development for
angel portals is the effectiveness of group structure on the investment decision process.
The concept of the interplay of group dynamics and the interaction within and among
portals could also provide a valuable theoretical perspective. While it may be possible to
examine which portal structure operates best with respect to the quality and quantity of
investments, theories of group dynamics and efficacy could provide the why behind these
empirical findings. It appears that social capital also has an important role in business
angel investing. Many of the sources of deals are from referrals from trusted associates
and the practice of angels syndicating around a deal is a relationship based on trust.
Theories of social capital and social networks, as a way of building trust within these busi-
ness angel relationships, has the potential for providing a valuable lens into this behavior.
In a similar context, social networks and homogeneity theory may provide a foundation
for the differences between male and female angel portals with respect to the seek rates
for women entrepreneurs. To clarify, would women entrepreneurs be more likely to seek,
and receive, funding from angel portals that have a high proportion of women business
angels? Following this gender construct, feminist theory would be helpful in exploring
whether structural and social barriers impede women’s access to angel portals or their
ability to pass the screening process in these portals, and thus they may seek funding from
angel portals at a lower rate than men.
Business angels invest in the entrepreneur, in the context of agency theory, as a means to
mitigate the risk inherent in investing in early stage ventures with little or no historical finan-
cial or operating data. Extending the principal–agent theory to angel portals is a potentially
fruitful area of research. In this context, angel portals appear to be conducting a heightened
level of screening of entrepreneurs before presenting these investment opportunities to their
members, partially as a means to reduce the risk for business angels. Could this additional
screening change the dynamics of the principal–agent relationship away from the business
angel–entrepreneur framework? That is, would the principal–agent relationship shift to one
between the angel and the deal and mitigate the influence of the entrepreneur?
While there is considerable knowledge about the angel market, there remain many
facets that are misunderstood and much research to be undertaken. Through high quality,
well designed and timely academic research, business angels, entrepreneurs and policy-
makers will be in a better position to make informed decisions regarding their role in the
development of a vibrant, and sustainable, angel market.
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PART IV
CORPORATE VENTURE
CAPITAL
15 Corporate venture capital as a strategic tool for
corporations
Markku V.J. Maula
Introduction
Corporate venture capital, that is, equity or equity-linked investments in young, pri-
vately held companies, where the investor is a financial intermediary of a non-financial
corporation, has become an increasingly important phenomenon in venture capital.
Although many active companies scaled down their corporate venture capital after the
peak of the IT bubble in 2000, when the annual global corporate venture investments
reached over 20 billion dollars or over 15 per cent of the whole venture capital market,
corporate venture capital has still remained as an important tool in the corporate
venturing toolbox of many major corporations (Chesbrough, 2002; Maula and Murray,
2002; Dushnitsky and Lenox, 2005a). Recently, after a few slower years following
the burst of the IT bubble, many corporations have again started to set up new corpor-
ate venture capital funds, such as Intel Capital, which has established four new corpo-
rate venture capital funds targeted in China, India, the Middle East and Brazil in
2005–2006.
Before the latest wave of corporate venture capital investment, research on corporate
venture capital was quite limited (for some early contributions, see Fast, 1978; Rind, 1981;
Hardymon et al., 1983; Siegel et al., 1988; Winters and Murfin, 1988; Sykes, 1990).
However, during the past few years the research on corporate venture capital has become
significantly more active (for example, Maula, 2001; Hellmann, 2002; Maula and Murray,
2002; Maula et al., 2003a; 2003b; 2005; Dushnitsky, 2004; Dushnitsky and Lenox, 2005a;
2005b; Hill et al., 2005; Rosenberger et al., 2005; Schildt et al., 2005; Bassen et al., 2006;
Dushnitsky and Lenox, 2006; Mathews, 2006; Maula et al., 2006b; Schildt et al., 2006;
Riyanto and Schwienbacher, forthcoming). However, the body of literature on corporate
venture capital is still quite fragmented and has not been systematically reviewed. It is the
purpose of this chapter to summarize and synthesize the literature on corporate venture
capital with a particular emphasis on research examining corporate venture capital from
the corporate perspective.1
The rest of the chapter is structured as follows. After the introduction, a brief discus-
sion of the definitions of corporate venture capital is provided. Thereafter, the research
on the motives of corporations to invest in corporate venture capital is reviewed. Then,
the factors influencing the decisions of corporations to invest in corporate venture are
summarized. Thereafter, research examining how corporations invest in corporate
venture capital is reviewed. This is followed by a review of the research on the perform-
ance of corporate venture capital. Then, the theories and methods applied in the research
on corporate venture capital are reviewed. Finally, some concluding remarks are made
and potential avenues for future research are discussed.
371
Defining corporate venture capital

Before analyzing the role of corporate venture capital as a specific tool in the corporate ven-
turing toolbox of corporations, it is important to clarify our understanding of the domain
and the terminology of corporate venturing. To sharpen the picture, an important distinc-
tion made in the earlier literature on corporate venturing is the distinction between internal
corporate venturing and external corporate venturing (Ginsberg and Hay, 1994; Sharma
and Chrisman, 1999; Keil, 2000; Miles and Covin, 2002). Internal corporate venturing refers
to new innovations developed at various levels of the firm but within the boundaries of the
firm (Burgelman and Sayles, 1986; Keil, 2000). Sharma and Chrisman (1999) defined inter-
nal corporate venturing as ‘corporate venturing activities that result in the creation of
organizational entities that reside within an organizational domain’. However, corporate
venture capital is clearly a boundary spanning operation and belongs to the other class of
venturing tools labeled as external corporate venturing. Sharma and Chrisman (1999)
defined external corporate venturing as ‘corporate venturing activities that result in the cre-
ation of semi-autonomous or autonomous organizational entities that reside outside the
existing organizational domain’. Based on extensive case research of seven leading corpo-
rations in the information and communications technology sector in the United States and
Europe, Keil (2000) developed a classification of external corporate venturing modes. The
classification is shown in Figure 15.1 (direct corporate venture capital is in bold).
In this framework, Keil (2000) first distinguished external venturing from internal ven-
turing and thereafter grouped external venturing modes into three: corporate venture
capital, venturing alliances and transformational arrangements. Corporate venture capital
resembles the operations of traditional venture capital firms in referring to programs resid-
ing at various levels of corporations where investments are made in independent external
companies. In the case of corporations, investments were made directly into ventures or
indirectly through dedicated funds or pooled funds managed by external venture capital
firms. These modes are fairly well in line with the extant literature on corporate venture
capital (Bleicher and Paul, 1987; Sykes, 1990; McNally, 1997; Kann, 2000). Some additional
distinctions have been made concerning the organization of direct investments. McNally
(1997) proposed distinction between ‘ad hoc’ investments and a more formal fund.
Corporate venturing
Internal venturing External venturing
Corporate venture Venturing alliances Transformational

capital arrangements
Third party Dedicated Self- Non-equity Direct Joint Acquisitions Spin-offs

funds funds managed alliances minority ventures
funds investments
Source: Adopted from Keil (2000)
Figure 15.1 External corporate venturing modes

Corporate venture capital as a strategic tool 373
Similarly, Winters and Murfin (1988), Sykes (1990), and Mast (1991) recognized varying
levels of formality in the organization of corporate venturing activities. An important point
to remember from these distinctions is that the present chapter focuses on the direct invest-
ments made by corporations. This focus is highlighted in bold in Figure 15.1.
To summarize, in this chapter, corporate venture capital is considered as a specific tool
in the external corporate venturing tool portfolio as outlined by Keil (2000). However, it
also recognizes that corporations have varying motives for making corporate venture
capital investments (Siegel et al., 1988; Winters and Murfin, 1988; Sykes, 1990; Alter and
Buchsbaum, 2000; Kann, 2000; Keil, 2000; Maula and Murray, 2002; Dushnitsky and
Lenox, 2006), and varying strategies regarding the level of hands-on involvement with the
ventures in addition to financial investment (McNally, 1997; Kann, 2000; Kelley and
Spinelli, 2001; Henderson and Leleux, 2002). Relationships stemming from corporate
venture capital investments made for financial purposes may develop over time into rela-
tionships that may appear more like a direct minority investment (McNally, 1997; Kann,
2000; Kelley and Spinelli, 2001; Henderson and Leleux, 2002).
Furthermore, there are several ways to define and map the concept of corporate venture
capital. The two main alternative perspectives are viewing corporate venture capital: (1) as
a mode of external corporate venturing from the perspective of the corporation (for
example, Kann, 2000; Henderson and Leleux, 2002; Keil, 2002; Keil et al., 2004;
Dushnitsky and Lenox, 2005a; 2005b; Schildt et al., 2005; Dushnitsky and Lenox, 2006);
or (2) as an alternative source of funding from the perspective of an entrepreneurial
company (for example, Gompers and Lerner, 1998; Maula, 2001; Maula and Murray,
2002; Maula et al., 2003a; 2005; 2006a; Rosenberger et al., 2005). This chapter primarily
employs the former perspective, while the next chapter in this Handbook (Chapter 16)
examines the entrepreneur’s perspective.
Why do companies invest in corporate venture capital?

In the research on corporate venture capital, one of the most active areas of research has
been the stream on the goals and objectives of corporations that invest in corporate
venture capital. Several studies have compared the relative importance of the various
goals corporations have for their corporate venture capital operations (Siegel et al., 1988;
Sykes, 1990; Silver, 1993; McNally, 1997; Bannock Consulting, 1999; Alter and
Buchsbaum, 2000; Kann, 2000; Keil, 2000; Chesbrough, 2002; Dushnitsky and Lenox,
2006). However, no single goal appears to be consistently most important. Instead, cor-
porations tend to have multiple goals and different strategies in their corporate venture
capital activities. For instance, Siegel et al. (1988) found that return on investment was
the most important goal of corporations, followed by exposure to new technologies and
markets. Sykes (1990) found that identifying new opportunities and developing business
relationships were the most important goals for corporations investing directly. Silver
(1993) found in his survey that finding acquisition targets, getting exposure to new
markets, adding new products to existing distribution channels, externalizing R&D,
exposing middle management to entrepreneurship, training managers, and utilizing
excess plant space, time and people were the most important objectives. McNally (1997)
surveyed UK corporations regarding their goals and found that identifying new markets,
exposure to new technologies, financial return, identifying new products, and developing
business relationships were the five most important corporate objectives for direct
corporate venture capital. Bannock Consulting (1999) found in their survey of 150
European corporations that on average 62 per cent had strategic goals, and 27 per cent
had financial goals, as their primary motivations for corporate venture capital invest-
ments, while many had several goals. In her analysis of 152 observed corporate venture
capital programs, Kann (2000) classified 45 per cent of the programs as being primarily
focused on external R&D, 30 per cent as investing with the goal of accelerated market
entry, and 24 per cent investing in order to enhance demand for their products.
Comparing the role of financial goals and various strategic goals, recent research has
shown that strategic and financial objectives are not substitutes; instead both are
very important motivations for corporations (Bannock Consulting, 1999; Alter and
Buchsbaum, 2000; Keil, 2000). Keil (2000) concluded that, while strategic objectives are
often the driver for setting up a corporate venture capital program, investments are often
made using financial criteria. Financial investment goals and investments in the financially
most promising companies give a window to the best companies (where there is more to
learn from) and minimize conflicts of interests (Keil, 2000).
Most of the research on corporate objectives has been based on rankings of long lists
of potential objectives by the respondents (Siegel et al., 1988; Sykes, 1990; Silver, 1993;
McNally, 1997). Besides these long lists and the distinction between strategic and finan-
cial objectives, some more fine-grained classifications of goals have also been made in the
recent literature (Kann, 2000; Keil, 2000).
Based on an extensive archival research of 152 corporate venture capital programs,
Kann (2000) distinguished three classes of strategic objectives for corporations; external
R&D, accelerated market entry, and demand enhancement. External R&D is the most
‘aggressive’ goal referring to the intent of corporations to enhance their internal R&D by
acquiring resources and intellectual property from ventures. Accelerated market entry
refers to corporations trying to access and develop resources and competences needed to
enter a new product market. Enhancing demand refers to corporations leveraging their
strong resource base and stimulating new demand for their technologies and products by
sponsoring companies that use and apply those technologies and products.
Finally, Keil (2000; 2002) identified four primary strategic objectives; monitoring of
markets, learning of markets and new technologies, option building, and market enactment.
Monitoring of markets refers to a warning system or antenna for gathering weak signals on
the future developments of the markets. Learning new markets and technologies refers to
learning from the relationships with ventures and requires more collaboration with them.
Options to expand refers to placing bets to be ready if certain markets prove important and
valuable. Market enactment refers to a more proactive approach where corporate venture
capital investments are used to shape markets, set standards and stimulate demand.
In the following, the literature on corporate venture capital goals is summarized and a
summary classification is illustrated in Table 15.1.
In this classification, the first distinction is between strategic and financial goals. Financial
goals of corporate venture capitalists have been reported in several studies; the term refers
to gaining financial gains from investments (Siegel et al., 1988; Silver, 1993; McNally, 1997;
McKinsey & Co., 1998; Bannock Consulting, 1999; Alter and Buchsbaum, 2000; Keil, 2000).
However, there are a wide variety of strategic goals reported in the extant literature. In this
classification, strategic goals are divided into three main categories; learning, option build-
ing and leveraging. All these main categories have subcategories, which are discussed below.
Table 15.1 Potential benefits for corporations from corporate venture capital
Objectives Examples
Financial objectives
Financial gains • (Siegel et al., 1988; Silver, 1993; McNally, 1997; McKinsey & Co.,
• 1998; Bannock Consulting, 1999; Alter and Buchsbaum, 2000;
• Keil, 2000)
Strategic objectives
Learning
Market-level • Radar-like identification of, monitoring of, and exposure to new
learning • technologies, markets, and business models (Winters and Murfin,
• 1988; Sykes, 1990; Silver, 1993; McNally, 1997; Keil, 2000; Maula
• et al., 2003b)
Venture-specific • External R&D (Sykes, 1990; Silver, 1993; McNally, 1997; McKinsey &
learning • Co., 1998; Kann, 2000), Improving manufacturing processes (Siegel
• et al., 1988; McNally, 1997)
Indirect learning • Change corporate culture (Sykes, 1990; McNally, 1997)
• Train junior management (Silver, 1993)
• Learn about venture capital (Sykes, 1990; McNally, 1997)
• Improve internal venturing (Winters and Murfin, 1988; Keil, 2000)
• Complementary contacts (Winters and Murfin, 1988)
Option building
Options to acquire • Identify and assess potential acquisition targets (Siegel et al., 1988;
companies • Winters and Murfin, 1988; Sykes, 1990; Silver, 1993; McNally, 1997;
• Alter and Buchsbaum, 2000; Maula and Murray, 2000; Benson and
• Ziedonis, 2004)
Options to enter • Accelerated market entry (Kann, 2000)
new markets • Option to expand (Sykes, 1986; Chesbrough, 2000; Keil, 2000)
Leveraging
Leveraging own • Increase demand for technology and products (Kann, 2000; Keil, 2000;
technologies and • Chesbrough, 2002; Gawer and Cusumano, 2002; Riyanto and
platforms • Schwienbacher, forthcoming)
• Shape markets (Kann, 2000; Keil, 2000; Maula et al., 2006b)
• Steer standard development (Kann, 2000; Keil, 2000)
• Support development of new applications for products (McKinsey &
• Co., 1998)
Leveraging own • Add new products to existing distribution channels (Siegel et al., 1988;
complementary • Winters and Murfin, 1988; Sykes, 1990; Silver, 1993; Alter and
resources • Buchsbaum, 2000)
• Utilize excess plant space, time, and people (Silver, 1993)
Learning motives
Learning can take place in corporate venture capital investments in many ways (Keil et al.,
2004). Three categories of learning benefits in this classification are market-level learning,
venture-specific learning and indirect learning.
Market-level learning refers to learning from constantly monitoring the new ventures
and therefore being exposed to developments of markets, technologies and business
models (Winters and Murfin, 1988; Sykes, 1990; Silver, 1993; McNally, 1997; Keil, 2000;
Keil et al., 2003; Maula et al., 2003b; Keil et al., 2004; Schildt et al., 2005; Schildt et al.,
2006). Some corporations use their corporate venture function to support their strategy
process (Keil, 2000). Weak signals can be derived from deal flow, without having to invest
in every opportunity in order to learn (Keil, 2000; Maula et al., 2003b). This allows invest-
ments in the financially most attractive companies while still delivering strategic benefits
(Keil, 2000).
Venture-specific learning refers to learning from the relationships with portfolio com-
panies. Some corporations use corporate venture capital as a form of external R&D to
develop their knowledge base, competencies, technologies, products and processes (Siegel
et al., 1988; Sykes, 1990; Silver, 1993; McNally, 1997; McKinsey & Co., 1998; Kann, 2000;
Dushnitsky and Lenox, 2005a; 2005b). Realizing this type of benefit often requires closer
collaboration and frequent communication with portfolio companies (Sykes, 1990; Kann,
2000; Keil, 2000). Most investments with the goal of venture-specific learning and exter-
nal R&D are made in ventures operating in the same or related industries (Kann, 2000).
Indirect learning refers to learning from the corporate venture capital process.
Corporate venture capital has been used to change corporate culture (Sykes, 1990;
McNally, 1997), train junior management (Silver, 1993), learn about venture capital
(Sykes, 1990; McNally, 1997), support the development of internal venturing processes
(Winters and Murfin, 1988; Keil, 2000), and to provide contacts with related actors like
investment banks, scientists and venture capitalists (Winters and Murfin, 1988).
Option building motives

There are two categories of option building; options to acquire companies and options to
diversify to new markets. These are explained in the following.
Options to acquire companies refers to corporate venture capital investments made as
options to acquire the portfolio company later if it proves strategically valuable.
Identification and assessment of potential acquisition targets has been reported as a goal
of corporations in several studies (Siegel et al., 1988; Winters and Murfin, 1988; Sykes,
1990; Silver, 1993; McNally, 1997; Alter and Buchsbaum, 2000). However, many studies
have also argued that this goal does not work well because of the inherent conflicts of inter-
est with entrepreneurs and other, financially oriented, investors (Winters and Murfin, 1988;
Sykes, 1990; Keil, 2000; Maula and Murray, 2000). Maula and Murray (2000) found that
only a very small share of acquired corporate venture capital-backed companies had been
acquired by one of the corporate venture capital investors. Most of the acquisitions had
been made by outsider companies. Similarly, Intel Capital had acquired only two compa-
nies from the 450 companies in their portfolio by 2000 (Christopher, 2000). It has been sug-
gested that a more successful way to view corporate venture capital as a supportive tool for
acquisitions is to refer potential acquisition targets identified in the deal flow to the M&A
department or business units of the parent corporation (Maula and Murray, 2000).
Options to enter new markets refers to another form of options to enter new businesses.
Besides building options to acquire portfolio companies, corporations can also prepare for
entering new markets and use corporate venture capital investments as probes (Brown and
Eisenhardt, 1997; Eisenhardt and Brown, 1998) to learn the necessary skills and ensure
right timing (Kann, 2000; Keil, 2000). Investments made with the goal of facilitating
potential entry to new markets are made in ventures operating in industry sectors different
from those in which the corporation currently operates (Kann, 2000). Extant literature
demonstrates that corporations use pre-entry alliances with new firms to prepare for enter-
ing new markets (Mitchell and Singh, 1992). Similarly, corporations use corporate venture
capital to hedge their bets and to ensure that they have some stakes in emerging techno-
logical platforms, in order to be prepared when the dominant design emerges (Keil, 2000).
Resource leveraging motives

There are two categories of leveraging; leveraging own technologies and platforms and
leveraging own complementary resources. These categories are explained in the following.
Leveraging own technologies and platforms refers to corporations using corporate
venture capital to stimulate demand for their technologies and products by sponsoring
companies using and applying them (McKinsey & Co., 1998; Kann, 2000; Keil, 2000;
Maula et al., 2006b). Corporations can also use corporate venture capital to shape
markets proactively, and steer and promote the development of de facto standards around
their technologies, by supporting favorable companies through corporate venture capital
(Kann, 2000; Keil, 2000). As an example of proactive shaping of the industry, Intel, who
has been highly dependent on the development of Microsoft operating systems in their
own development, recognized the emergence of Linux as an alternative and made very
early phase corporate venture capital investments in the most promising Linux operating
system supplier, Red Hat Linux in 1998 (Young and Rohm, 1999). Thereafter, Intel
invested in many other Linux companies together with other companies, such as IBM,
Compaq, Dell, Oracle and Novell, who also wanted to reduce their dependence on
Microsoft operating systems. These investments have been critically important in making
the Linux a more credible alternative in the corporate world (Young and Rohm, 1999).
Leveraging own complementary resources refers to corporations leveraging their com-
plementary assets such as distribution channels and production facilities. Companies have
been reported to use corporate venture capital to add new products to existing distribu-
tion channels (Siegel et al., 1988; Winters and Murfin, 1988; Sykes, 1990; Silver, 1993;
Alter and Buchsbaum, 2000) and find use for excess plant space, time and people (Silver,
1993). Technology-based ventures are acknowledged to be better at adopting and com-
mercializing new technology than large corporations, meaning that they are superior in
pursuing the highly focused rapid paced development of new product opportunities after
the research phase is complete. This process often leads to opportunities for the corporate
investor to acquire licenses for state-of-the-art technologies (Winters and Murfin, 1988).
Furthermore, technology-based new ventures have often limited distribution networks, at
least when compared to any multinational corporation acting as a corporate venture
capital investor. Even if the start-up would not like to license the technology, there is an
opportunity for marketing agreements, especially in areas that the start-up could not
otherwise access. This is especially important when the start-up operates in a small home
market and has a foreign or global corporation as an investor.
Taken together, these studies show that the goals of corporations engaging in corpor-
ate venture capital has been one of the most actively researched areas of corporate venture
capital. The research clearly highlights that companies typically have multiple goals when
engaging in corporate venture capital. While financial goals often play some part in moti-
vating corporate venture capital programs, in order to be sustainable, corporate venture
capital activity should have a strategic role for the parent corporation. While many goals
have been recognized, there is still quite limited understanding on the circumstances under
which different goals can create value for corporation as well as the proper design of
effective corporate venture capital programs depending on the goals and other circum-
stances.
When do companies invest in corporate venture capital?
Cyclical history of corporate venture capital

When examining the history of corporate venture capital, three different ‘waves’ of cor-
porate venture capital activity have been identified (Gompers and Lerner, 1998; Maula
and Murray, 2002; Dushnitsky and Lenox, 2006). First, in the late 1960s, corporations
engaged in corporate venture capital in order to gain a ‘window on technology’. More
than 25 per cent of the Fortune 500 corporations were engaged in corporate venture
capital activities in the late 1960s and early 1970s (Gompers and Lerner, 1998). Following
the collapse in the market for initial public offerings in 1973, the returns on venture capital
rapidly declined and most of the corporate venture capital programs were soon dissolved.
The second wave in corporate venture capital took place in the 1980s, when it was used as
a diversification tool. This wave peaked in 1986 when 12 per cent of the total venture
capital investments were managed by corporate venture capital programs (Gompers and
Lerner, 1998). However, not a great number of the corporate venture capital programs
were successful and most of them were again quickly dissolved after the stock market
crash at the end of the 1980s. Finally, during the latter half of the 1990s, corporate venture
capital emerged again, this time in a much larger scale than ever before, both in absolute
terms, and in relative terms compared to traditional venture capital. Direct venture capital
investments made by the subsidiaries and affiliates of industrial corporations more than
doubled during each of the last six years of the decade. However, after the peak in 2000,
the economic slowdown resulted in a rapid decrease in the volume of corporate invest-
ments in the beginning of 2001. Since then, the number of active firms and the amount
of annual investments have stabilized on a level that still exceeds the levels before 1999.
For many major corporations corporate venture capital has been a strategic instrument
and the activity has been sustained independent of the financial cycles. The development
of corporate venture capital is depicted in Figure 15.2.
Industry and firm level drivers of corporate venture capital investment

Although aggregate statistics highlight the overall cyclicality and the impact of economic
climate on corporate venture capital investment, from a corporate perspective it is import-
ant to understand the firm and industry level circumstances that influence the usefulness
and effectiveness of corporate venture capital. Although there are not many studies exam-
ining the determinants of corporate venture capital investments, there are a few recent
studies that have examined this issue (for example, Chesbrough and Tucci, 2004;
Dushnitsky and Lenox, 2005a; Basu et al., 2006; Gaba and Meyer, 2006; Li and Mahoney,
2006). Some of the findings of this stream of research are summarized in Table 15.2.
In their recent study, Dushnitsky and Lenox (2005a) examined the firm and industry level
drivers of corporate venture capital investments. At the industry level, it has been found
that weak intellectual property protection, high technological ferment and high importance
of complementary distribution capability are positively related to the level of corporate
25 600
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Annual volume of investments by CVC investors in U.S. portfolio companies
Annual number of active CVC investors
Source: Based on Venture Economics data, May 2006
Figure 15.2 Annual volume of corporate venture capital investments and number of
corporate venture capital investors in 1980–2005
Table 15.2 The determinants of corporate venture capital investments
Level Factor Examples

Industry Industry IPR regime Weak intellectual property protection (Dushnitsky and
Lenox, 2005a)
Industry capability needs Importance of complementary distribution capability
and types of innovations (Dushnitsky and Lenox, 2005a)
Systemic nature of innovations (Maula et al., 2006b)
Industry dynamics High technological ferment (Dushnitsky and Lenox,
2005a)
Firm Firm free cash flow Firm’s free cash flow (Dushnitsky and Lenox, 2005a)
Firm absorptive capacity Firm’s absorptive capacity measured as Internal R&D
(Chesbrough and Tucci, 2004; Dushnitsky and
Lenox, 2005a) or patent stock (Dushnitsky and
Lenox, 2005a)
Firm size Firm size (Dushnitsky and Lenox, 2005a)
venture capital investments (Dushnitsky and Lenox, 2005a). Similarly, Maula et al. (2006b)
argue that the systemic nature of innovations in an industry increases the usefulness of cor-
porate venture capital. At the firm level, it has been found that firms’ cashflow and absorp-
tive capacity are positively related to the level of corporate venture capital investments
(Dushnitsky and Lenox, 2005a). At the firm level, several studies suggest that corporate
venture capital investments will be actively used by companies who are in a position to drive
a market ecosystem (Chesbrough, 2002; Gawer and Cusumano, 2002; Maula et al., 2006b).
Taken together, research on explaining the development of corporate venture capital
investments has evolved from focusing on the cyclicality of corporate venture capital
investments over time to developing increasingly sophisticated theory-based explanations
of under what circumstances corporations invest in corporate venture capital. The indus-
try and firm level determinants of corporate venture capital investments have started to
receive increasing attention in the evolving literature. Quite recently this area has become
an active area of research with several theory-based analyses on the drivers of corporate
venture capital investments employing robust longitudinal research designs. However,
despite the recent new theory-based studies on the determinants of corporate venture
capital investments and adoption of corporate venture capital programs (for example,
Basu et al., 2006; Gaba and Meyer, 2006; Li and Mahoney, 2006), the research on when
and why corporations invest in corporate venture capital is far from saturated.
Limitations in current empirical data and methods as well as various competing explana-
tions suggest that more research is still needed to develop a full understanding of the
drivers a corporate venture capital programs and investments.
How do companies invest in corporate venture capital?

From the corporate perspective, corporate venture capital is one important tool in the cor-
porate venturing toolbox used to develop new business (Roberts, 1980; Rind, 1981;
Roberts and Berry, 1985; Venkataraman and MacMillan, 1997; Keil, 2002; Maula et al.,
2006b). Other tools in this ‘toolbox’ include activities like internal corporate ventures,
acquisitions, joint ventures, alliances, research collaboration, and spin-offs as outlined
earlier in Figure 15.1.
As shown in the same figure, there are several ways in which corporations can engage
in corporate venture capital. Many companies start by making arm’s-length investments
in independent funds to learn the venture capital game; move on to co-investments with
their venture capital partners; and once they have sufficient experience, establish their own
corporate venture capital fund. At each stage, the strategic and financial upside potential
increases. Finally, some corporate investors like Intel Capital and Nokia Venture Partners
have established new funds co-financed with external partners. These independent
investors give the fund financial autonomy, which helps insulate the corporate venture
capital program from abrupt changes in the parent company’s fortunes. They also make
the corporate venture capital operation more sustainable by providing strategic benefits
at lower cost. Importantly, this structure allows the corporate venture capital operation
to offer competitive compensation schemes to help retain a successful investment team.
In corporate venture capital programs, there are also a number of design parameters
that corporations can adjust depending on the objectives of the program (Birkinshaw
et al., 2002; Keil et al., 2004). In a recent conceptual paper, Keil et al. (2004) presented a
model of organizational learning in corporate venture capital. Adopting a program-level
perspective and applying the organizational learning theory, their paper suggests that cor-
porate venture capital investments can result in both explorative and exploitative learn-
ing. The relationship between corporate venture capital and organizational learning is
moderated by the investment portfolio and the organization of the corporate venture
capital program. Concerning the corporate venture capital program portfolio, the paper
highlights the moderating roles of relatedness, dispersion, and the development stage of
the ventures. Concerning the program, the paper highlights the roles of structural auton-
omy, knowledge integration and absorptive capacity.
In terms of empirical research, the organizational design of corporate venture capital
programs has received relatively little attention, which is probably due to the difficulty of
getting information concerning the organization of the programs. Most of our knowledge
of corporate venture capital has been based on anecdotes and industry reports such as the
report by Corporate Executive Board (2000) which provides very interesting examples on
how companies such as Intel, Novell, Motorola, HP and United Parcel Service have
organized some aspects of their corporate venture capital programs. For example, Intel
included investment professionals in strategy development of business units to help them
identify strategic investment targets; Novell aligned investments and strategy by requir-
ing the venture group to collaborate with senior managers; UPS required board observa-
tion rights for senior business unit managers; Motorola improved knowledge transfer by
employing a knowledge transfer team with the responsibility of transferring knowledge
between portfolio companies and parent firm; and HP tracked investments against strat-
egic objectives to make informed portfolio-management decisions. However, there is rel-
atively little empirical research that explains why corporations organize their corporate
venture capital activities in a certain manner and what the performance implications of
the organization are. In particular, there is very little quantitative research on the way cor-
porations organize their corporate venture capital activities.
The survey of 95 corporate venturing programs (both corporate venture capital and
other types of venturing programs) by Birkinshaw et al. (2002) is one of the rare excep-
tions. The report provides a wealth of descriptive statistics of the organization of different
types of program showing for instance that most of the employees and the funding of the
programs tend to come from the parent corporation, deal flow comes quite evenly from
inside and from collaborating venture capital, and that most common compensation is
still straight salary although many programs also have other types of incentives including
carried interest. Similarly, EVCA (European Private Equity and Venture Capital
Association) (EVCA, 2001) has surveyed European corporate venture capital investors
and has reported various descriptive statistics showing that more than one third of their
deals were syndicated, three quarters of the corporate venture capital programs were
organized as a subsidiary, the average corporate venture capital unit consists of 7 employ-
ees responsible for about a €50 million portfolio, and that interest in using carried inter-
est as a compensation method was increasing, with more than a third of the corporate
venture capital programs already using it. Another recent empirical study examining the
structure of corporate venture capital programs is the case study by Henderson and
Leleux (2002) in which they carry out an in-depth analysis of six corporate venture capital
programs highlighting the arrangements concerning research transfers between ventures
and parent organizations of the corporate venture capital program.
In addition to design characteristics, some scholars have recently started to examine the
required capabilities and their development. Based on two longitudinal case studies of
large corporations operating in the information and communication technology sector in
Europe, Keil (2004) developed a model emphasizing the learning processes that enable
firms to build up an external corporate venturing capability, by utilizing learning strat-
egies both within and outside venturing relationships. To build this new capability, firms
engage in acquisitive learning, and the capability is deepened by adapting all knowledge
to the firm-specific context through experiential learning mechanisms. Keil also highlights
the importance of initial conditions and knowledge management practices influencing
the direction and effectiveness of learning processes that lead to an external corporate
venturing capability.
Demonstrating some of the tensions related to the design of corporate venture

capital programs, Dushnitsky (2004) showed that some design choices such as tight inte-
gration to the parent firm that would aid the corporation in assessing and benefiting from
corporate venture capital activity inhibit an investment relationship with many such ven-
tures that would be most relevant from the learning point as a result of self selection by
entrepreneurs.
Taken together, despite the acknowledged difficulties of organizing a performing and
sustainable corporate venture capital program, there are perhaps surprisingly few pub-
lished articles on how corporations actually implement corporate venture capital pro-
grams. There is still quite a limited literature on the actual choices companies make and
the design and management of corporate venture capital programs. Most of the existing
knowledge is based on anecdotes and examples. However, theory-based and/or represen-
tative quantitative research is largely missing, perhaps given the obvious large difficulties
in accessing such rich internal company data that would be needed for studies analyzing
the organization of corporate venture capital programs, the determinants of the ways
these programs are organized, and the performance of the organizational choices.
Therefore, the organization and management of corporate venture capital is clearly an
area of research that has still a lot of room to expand.
How has corporate venture capital performed?

One of the most discussed areas of corporate venture capital is the performance of cor-
porate venture capital activities. Following increased interest and mixed perceptions,
different dimensions of performance have received increased attention in research during
the past few years. In the following two subsections the studies examining performance
and the determinants of performance are reviewed.
Performance of corporate venture capital

The performance of corporate venture capital and its determinants have become import-
ant research topics in corporate venture capital during recent years (Gompers and Lerner,
1998; Maula and Murray, 2002; Dushnitsky and Lenox, 2005b; Dushnitsky and Lenox,
2006; Wadhwa and Kotha, 2006). In contrast to earlier dominant perception of corpo-
rate venture capital being ‘dumb money’ and leading to poor results, most of the newer
academic studies have analyzed the outcomes of corporate venture capital and venture
capital-backed companies and found that corporate venture capital investments had a
higher likelihood of initial public offerings and higher IPO market valuations when con-
trolling for various other factors (Gompers and Lerner, 1998; Maula and Murray, 2002).
These studies are summarized in Table 15.3.
Dushnitsky and Lenox (2005b) analyzed a large panel of public firms over a 20-year
period and found that increases in corporate venture capital investments are associated
with subsequent increases in firm patenting. They also found that these programs are
especially effective in weak intellectual property regimes and when the firm has
sufficient absorptive capacity. In another paper Dushnitsky and Lenox (2006) examined
the value creation by corporations from corporate venture capital programs by exam-
ining the impact of corporate venture capital on Tobin’s q (market value of a firm
divided by total assets). Using a panel of corporate venture capital investments they
found evidence that corporate venture capital investment will create greater firm value
Table 15.3 Performance of corporate venture capital programs
Study Sample Finding

Gompers and Lerner 32364 venture capital and Higher share of IPOs in corporate
(1998) corporate venture capital venture capital investments than
investments in the in traditional VC
United States
Maula et al. (2003b) A panel of 110 largest US ICT Positive impact on recognizing
companies 1990–2000 technological discontinuities
Keil et al. (2003) A panel of 110 largest US ICT Positive impact on patenting
companies 1990–2000
Wadhwa and Kotha A panel of 36 corporations An inverted U-shaped relationship
(2006) between 1989–1999 in the between CVC investments and
telecommunications equipment patenting
industry
Dushnitsky and Lenox A panel of US public firms Positive impact on Tobin’s q from
(2006) during the period 1969–1999 the founding of a CVC program
Dushnitsky and Lenox A panel of US public firms Positive impact on patenting
(2005b) during the period 1969–1999
Schildt et al. (2005) A panel of 110 largest US ICT Positive impact on explorative
companies 1990–2000 learning from target companies
when firms explicitly pursue corporate venture capital to harness novel technology com-
pared to other goals.
Maula et al. (2003b) examined the impact of corporate venture capital on recognizing
technological discontinuities early. Based on a longitudinal study of information and
communications technology firms, established companies’ position in venture capital net-
works is related to the early recognition of technological discontinuities. Incumbents’
absorptive capacity moderates this relationship. In another study, Keil et al. (2003) inves-
tigated the impact of different governance modes for external corporate ventures and
venture relatedness on innovative performance of the firm. Building on studies that have
suggested that external corporate ventures enhance the innovative performance of the
firm, the paper argued that governance modes and venture relatedness interact in their
effect on innovative performance. In their empirical analysis of a panel of the largest firms
in the information and communication technology sector during 1990–2000, they found
that corporate venture capital investments had a positive impact on patenting and that
the impact was moderated by the relatedness of the ventures. Finally, Schildt et al. (2005)
examined the antecedents of explorative and exploitative learning of technological
knowledge from external corporate ventures. They compared different forms of external
corporate venturing, namely corporate venture capital investments, alliances, joint ven-
tures, and acquisitions, as alternative avenues for interorganizational learning, and tested
the effects of multiple relational characteristics on the type of learning outcomes using
citations in patents filed by a sample of 110 largest US public information and commu-
nications technology companies during the years 1992–2000. They found that corporate
venturing mode and technological relatedness have significant effects on the likelihood of
explorative learning.
Taken together, the studies on the performance of corporate venture capital have shown
primarily positive effects although it has been shown that there may be diminishing
returns to corporate venture capital (Wadhwa and Kotha, 2006). However, further
research on the longer time horizons is warranted. Furthermore, the research contrasting
the costs and benefits of corporate venture capital under different circumstances is still
quite limited. Overall, the measurement of performance measurement of corporate
venture capital is quite challenging. The majority of the performance studies have inferred
the effects from quantitative analyses of different dimensions of corporate performance
controlling for other performance determinants. However, future research could also
attempt to develop more direct measures of performance for corporate venture capital
(see Allen and Hevert, 2006, and Bassen et al., 2006, as two recent examples).
Performance determinants in corporate venture capital

The research on corporate venture capital has increasingly examined the determinants of
the performance of corporate venture capital programs. A brief summary of the research
is provided in Table 15.4.
In one of the earliest widely cited studies on corporate venture capital, Siegel et al. (1988)
received survey responses from 52 corporate venture capitalists and, based on their analy-
ses, concluded that performance is influenced by the autonomy of the program, skills (that
is venture capital expertise/background of employees), compensation and incentives,
primary focus on financial returns so that potential strategic goals do not interfere with the
investment activity. In another survey, Sykes (1990) received responses from 31 corporate
venture capital programs and found that the choice of primary strategic objective, type and
Table 15.4 Determinants of performance in corporate venture capital investments
Determinant Examples
Long term focus (Ernst et al., 2005)
Sufficient autonomy (Siegel et al., 1988; Birkinshaw and Hill, 2005;
Hill et al., 2005)
Sufficient absorptive capacity (Maula et al., 2003b; Dushnitsky and Lenox, 2005b)
Strong ties to venture capital community (Maula et al., 2003b; Birkinshaw and Hill, 2005; Hill
et al., 2005)
Appropriate compensation systems (Block and Ornati, 1987; Siegel et al., 1988;
Birkinshaw and Hill, 2005)
Strategic objectives that enable aligned (Sykes, 1990; Dushnitsky and Lenox, 2006)
objectives with portfolio companies
Active involvement and frequent (Sykes, 1990; Henderson and Leleux, 2002; Wadhwa
communications with portfolio and Kotha, 2006)
companies
Team members with venture capitalist (Siegel et al., 1988; Birkinshaw and Hill, 2005)
background
Relatedness of portfolio companies Positive relationship: (Gompers and Lerner, 1998)
Inverted-U-shaped relationship: (Keil et al., 2003;
Keil et al., 2004; Hill et al., 2005)
Industry sectors with weak IP regime (Dushnitsky and Lenox, 2005b)
frequency of communications with the ventures or limited partners, return on portfolio

investment, and the mode of investment (direct investments or indirect investments via
independent venture capital fund) influenced the performance of the programs.
In a stream of newer studies employing longitudinal analyses employing corporate
venture capital investment data and patent data, Keil et al. (2003) analyzed the impact of
different types of external corporate venturing activities on the patenting rates of firms.
In their longitudinal analysis of the 110 largest companies in four information and com-
munications sectors, they found that corporate venture capital has a positive effect and
that the relatedness of the corporate investor and the portfolio company had an inverted
U-shaped relationship. Dushnitsky and Lenox (2005b) tested the impact of corporate
venture capital on patenting and found that weak IP regime in the industry as well as high
absorptive capacity increased returns to corporate venture capital investment. Finally,
Wadhwa and Kotha (2006) analyzed the impact of corporate venture capital on patent-
ing. In their analysis of 36 telecommunications equipment companies over time, they
found that the number of corporate venture capital investments had an inverted U-shaped
relationship with patenting. They also found that this relationship was moderated posi-
tively by corporate involvement with portfolio companies (board seats and alliances with
corporate venture capital portfolio companies).
Based on a recent global survey of corporate venture capital investors, Birkinshaw and
Hill (2005) analyzed 95 corporate venturing programs including a large number of corpor-
ate venture capital programs and found that three key success factors hold across multiple
sub-types of corporate venture units: giving venture units substantial autonomy, creating
strong ties to the venture capital community, and structuring appropriate compensation
systems. In another paper Hill et al. (2005) analyzed separately the drivers of strategic and
financial performance of the corporate venture capital programs in the sample and found
that financial performance had an inverted U-shaped relationship with the relatedness of
the ventures and positive relationship with vertical autonomy (that is autonomous struc-
tural position). Strategic performance similarly had an inverted U-shaped relationship
with relatedness. In addition, strategic performance was positively related to communica-
tions with venture capital community, negatively related to vertical autonomy and posi-
tively with horizontal autonomy (that is how extensively other business units within the
parent company were involved in corporate venture capital unit decision-making). The
authors concluded that the financial and strategic outcomes of corporate venture capital
programs need to be understood in terms of distinctive sets of investment and organiza-
tional antecedents. Finally, in a recent German study, Ernst et al. (2005) analyzed 21 cor-
porate venture capital programs in Germany and came to the conclusion that a short-term
focus on financial objectives of these corporate venture capital programs prohibits the
achievement of long-term strategic benefits from external innovation.
Taken together, studies on the performance determinants of corporate venture capital
have relatively strong convergence concerning the importance of certain design character-
istics on the performance of corporate venture capital programs. For instance, most of the
studies have raised strategic relatedness or complementarity of the portfolio companies,
close interaction with the ventures and/or venture capital community as well as a sufficient
autonomy of the corporate venture capital operation as success factors. However, there are
many other factors that only some studies have included and found significant. Overall,
there is still lack of convergence in the understanding of the circumstances under which
corporate venture capital can provide financial or strategic benefits. In addition to further
testing of suggested determinants, there are further challenges that should be taken into
account when trying to improve the understanding of performance determinants. First, it
is important to take into account the potential contingencies that influence the optimal
organizational configurations. Depending on the goals and organizational and environ-
mental circumstances, the optimal organizational structure and management of corporate
venture capital programs is likely to differ between companies and even within companies
over time. Furthermore, when examining the performance implications of strategic
choices, the endogeneity of the choices should be accounted for (Hamilton and Nickerson,
2003). Finally, while some studies find determinants that improve performance, the studies
should also take into account the costs and risks associated with the strategic or oper-
ational choices to give a balanced picture of the effects of the choices. Given all these chal-
lenges, the analysis of performance determinants of corporate venture capital programs
continues to be an important and developing research stream.
Theoretical perspectives applied in research on corporate venture capital

Until recent years, the limited research on corporate venture capital was primarily descrip-
tive. However, following the most recent wave of corporate venture capital activity, the
research on corporate venture capital has both increased in volume and has become more
deeply rooted in various theoretical perspectives. The theoretical perspectives that have
so far been applied in research on corporate venture capital have been summarized in
Table 15.5.
Analysis of the literature suggests that so far different strands of learning theories have
been the most commonly applied perspectives in the analysis of corporate venture capital
from a corporate perspective. This is well in line with learning being the most common
strategic goal for corporations in corporate venture capital. In terms of learning litera-
ture, interorganizational learning and particularly absorptive capacity (Cohen and
Levinthal, 1990) are commonly invoked concepts. Recently the dynamic capabilities view
has also received attention in the analysis of corporate venture capital.
Another theoretical base that has been used, but significantly less often, is the theories
of economics of information including adverse selection, moral hazard and signaling. In
Table 15.5 Theoretical perspectives applied in research on corporate venture capital
Theoretical base Examples

Learning theories (Keil et al., 2003; Keil et al., 2004; Schildt et al., 2005;
Gaba and Meyer, 2006; Wadhwa and Kotha, 2006)
Absorptive capacity (Maula et al., 2003b; Keil et al., 2004; Dushnitsky and
Lenox, 2005b; Lim and Lee, 2006; Schildt et al., 2006)
Dynamic capabilities (Keil, 2004)
Economics of information (Dushnitsky, 2004)
(adverse selection, moral hazard,
signaling)
Network theories (Maula et al., 2003b)
Real options (Basu et al., 2006; Li and Mahoney, 2006)
Institutional theory (Gaba and Meyer, 2006)
addition, network theories have so far received very little attention. The same is also the
case with real options as well as with institutional theory.
Taken together, it appears that the literature on corporate venture capital is still very
young and underdeveloped when it comes to its theoretical underpinnings. Following
the development path common in many other areas of management research, the early
literature was primarily descriptive. Only recently has the research on corporate venture
capital become more connected to theoretical literature. Although it appears that most
of the major theoretical lenses of management theory have been recently applied at least
once in research of corporate venture capital, there is clearly more work to do in rooting
the understanding of corporate venture capital better in management theory.
Research designs and methods applied in research on corporate venture capital

As with research on many other phenomena, early research on corporate venture capital was
largely descriptive, attempting to chart what kind of companies engage in corporate venture
capital and how they do it. The research methods were typically surveys or case studies. The
research settings were frequently cross-sectional. As the field has started to mature during
recent years, the research settings have more frequently become longitudinal, allowing for a
better control for unobserved heterogeneity and measurement of change over time (for
example, Dushnitsky and Lenox, 2005a; 2005b; Keil et al., 2005; Schildt et al., 2005;
Dushnitsky and Lenox, 2006; Schildt et al., 2006; Wadhwa and Kotha, 2006). Improved data
availability has allowed large scale panel datasets combined with other databases.
In the future, it can be expected that research designs will become increasingly longitu-
dinal. Controls for the endogeneity of investment decisions are likely to become increas-
ingly standard features of quantitative research designs. The realization of the fact that
one size does not fit all means that future research will increasingly focus on contextual
determinants that influence the design of programs and their effects on the performance
(see for example, Keil et al., 2004; Wadhwa and Kotha, 2006). Although most of corpor-
ate venture capital research focused on US companies, some recent studies have also
examined it in other regions, for example, Germany (Weber and Weber, 2005; Reichardt
and Weber, 2006), Korea (Lim and Lee, 2006) or taking a more global perspective
(Birkinshaw et al., 2002).
Although longitudinal quantitative research designs are going to have an important
role in theory testing, it is also expected that in-depth qualitative research can deepen our
understanding of the choices and solutions in the design and management of corporate
venture capital programs (see for example, Keil, 2002; 2004). As noted above in sections
reviewing literature on different facets of the corporate venture capital phenomenon,
there are many areas where we still have very limited knowledge of the practices of cor-
porations and the determinants of those practices. Furthermore, the limitations in the
available large scale datasets will continue to provide many research opportunities for
those researchers who gather in-depth primary data from corporations active in corpor-
ate venture capital.
Conclusions and avenues for future research

Although corporate venture capital has a cyclical history with mixed success in compa-
nies, corporate venture capital remains an important tool in the corporate venturing
toolbox of corporations. While some corporations have engaged in corporate venture
capital opportunistically following good returns from the venture capital markets during
boom periods, many other corporations have taken a much more strategic approach and
use corporate venture capital as an important tool to support their strategy independent
of fluctuations in financial markets. However, as research has shown, there is often a long
and sometimes costly learning curve to climb before becoming a successful private equity
investor. While there are strategies that may be more effective for certain corporations
than others, even they may not necessarily be feasible from day one. However, the research
and practices of corporate venture capital have become increasingly sophisticated, and
many corporations have learned how to use corporate venture capital properly as a tool
to support the corporate strategy and innovation while also gaining financial returns.
When assessing the existing body of literature on corporate venture capital, it appears
that there is a relatively convergent stream of literature answering why corporations invest
in corporate venture capital. Corporations often have multiple goals for corporate venture
capital, but most often it is more for strategic than financial reasons that corporations
engage in corporate venture capital. The research on when corporations engage in cor-
porate venture capital is newer, but it has started to develop and test multiple determin-
ants on industry and firm levels based on several theoretical lenses including learning
theories, institutional theory and real options. The research on how corporate venture
capital should and has been organized is still relatively underdeveloped, and provides cur-
rently primarily descriptive insights and examples. Research on how corporate venture
capital has performed has developed rapidly and has become increasingly sophisticated.
This stream of literature has found corporate venture capital to have positive effects on
several tested performance measures including patenting and firm value creation. Also the
research on the performance determinants of corporate venture capital has produced
several commonly agreed performance determinants, but there are also many areas where
future research is needed.
Theoretical understanding of corporate venture capital has developed significantly and
the studies have developed from descriptive analyses to testing the applicability of broader
theoretical frameworks from economics, sociology and management theory as well as to
develop specific theory on corporate venture capital, or even to contribute to the devel-
opment of broader management theories based on insights made in the analysis of cor-
porate venture capital.
Similarly, methodologically the literature on corporate venture capital has evolved like
many streams of research that focus on a certain phenomenon. From the early pioneer-
ing that qualitatively describes the phenomenon, the research has subsequently advanced
through wider cross-sectional surveys and in-depth case studies to increasingly longitu-
dinal research settings frequently testing alternative theoretical explanations employing
large panel datasets.
While recently activated research on corporate venture capital has answered many pre-
viously puzzling questions, there remain many avenues for future research that can help
companies use corporate venture capital more successfully to create value in collaboration
with entrepreneurs and the venture capital community.
Some of the areas for future research on corporate venture capital include the analysis
of benefits over costs under different circumstances including various firm and industry
level determinants and different corporate venture capital strategies. Overall, prior
research suggests that there are many alternative models of corporate venture capital that
can be feasible, but the research on the circumstances under which each model is optimal
is still underdeveloped. Furthermore, the performance measurement is in general an area
that requires additional research. There is still relatively little research examining the
impact of corporate venture capital on the performance of corporations. Even more so,
the cost side, including the indirect costs from leveraging corporate resources, has been
largely neglected. Furthermore, the long run effects of corporate venture capital for the
performance of corporations are still an under-researched area.
Another area of development is how corporations manage and should manage their
corporate venture capital operations including investment processes, the use of corporate
resources to facilitate corporate venture capital activity, knowledge integration from cor-
porate venture capital investments, as well as internal performance measurement. There
are many tensions concerning various choices inherent in corporate venture capital. For
instance, if a corporation wants to learn from corporate venture capital, how should it
arrange the activity to get to see the most interesting deals (Dushnitsky, 2004)? While there
is already some theoretical research examining the organizational choices related to
different learning goals (Keil et al., 2004), there is a need to understand more broadly how
corporate venture capital should be organized depending on different goals and circum-
stances. Furthermore, empirical research in this area is still nearly non-existent. Also the
role of corporate venture capital in the broader toolbox of corporations and the pros and
cons of different external venturing modes and their interactions are still relatively unex-
plored areas of research (Dushnitsky and Lavie, 2006; Keil, 2002; Keil et al., 2003; Schildt
et al., 2005).
Overall, although the research on corporate venture capital, both from corporate and
entrepreneurs’ perspectives, has developed rapidly during the past few years, there are still
many important areas warranting further research. I believe that corporate venture
capital continues to be an interesting research area given the economic importance for
many major corporations as well as the complexities and practical challenges in manag-
ing it successfully.
Note
1. For another parallel review of literature on corporate venture capital, see Dushnitsky (2006).
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16 Entrepreneurs’ perspective on corporate venture
capital (CVC): A relational capital perspective
Shaker A. Zahra and Stephen A. Allen
Introduction
The relationship between industry incumbents and new ventures has been a subject
of much interest in the literature (Zahra et al., 1995; Gompers and Lerner, 1999;
2001; Zahra, 2006a; 2006b). Traditional analyses have emphasized the potential role of
new ventures in displacing industry incumbents as a natural part of the process of
Schumpeterian creative destruction (Christensen, 1997). More recent analyses highlight a
‘co-specialization’ dynamic, where new ventures excel in discovery and invention and
incumbents are better equipped to successfully exploit and commercialize these discover-
ies. Research applying the co-specialization dynamic recognizes the rivalrous nature of the
relationship that might exist between incumbents and new ventures but also highlights
opportunities for fruitful collaboration (Chesbrough, 2002).
Corporate venture capital (CVC) is one approach some incumbents have used to
connect with new ventures in and outside their industries (Keil, 2002; Dushnitsky, 2004;
Keil et al., 2005; Maula et al., 2005; Rosenberger et al., 2005). Maula (see Chapter 15)
has comprehensively reviewed and summarized the relationship between CVC and other
activities that companies undertake to venture into new fields, internally or externally.
Maula’s review suggests that companies use CVC for multiple reasons, giving these
transations distinctiveness. As Maula indicates, CVC refers to equity-linked investments
that incumbents make in young, privately held companies – where the investor is a finan-
cial intermediary of a non-financial corporation. While CVC programs can generate sub-
stantial direct financial gains or losses (Allen and Hevert, 2007), incumbents may also use
these programs to gain access to the knowledge and innovative technologies that new ven-
tures create. Researchers examining CVC often frame their analyses within the ‘co-spe-
cialization perspective’, positing that these transactions could evolve into ‘win–win’
outcomes for both incumbents and new ventures (McNally, 1997; Maula, 2001; Keil,
2002). Still, incumbents can use their CVC investments to delay or even thwart new
ventures’ efforts to develop and introduce new technologies that are viewed as threats
to their market positions or as changing the rules of competition (Gompers and Lerner,
1998; 1999).
Objectives, focus and contribution

Dushnitsky (2006) and Maula in Chapter 15 provide comprehensive and informative
reviews of the literature on CVC. Most prior research stresses the role and effective man-
agement of CVC in established corporations (Rind, 1981; Winters, 1988; Sykes, 1990;
McNally, 1995; 1997; Dushnitsky and Lenox, 2005; 2006). Even though some CVC deals
are purely financial investments, researchers have given special attention to the conditions
under which established companies learn from CVC investments. Prior analyses, however,
393
have given far less systematic attention to clarifying the consequences of CVC for the
success of new ventures (McNally, 1995; Ivanov and Xie, 2005; Maula et al., 2006). As a
result, theoretical and empirical research on these issues has been sparse and fragmented,
making it difficult to guide future intellectual inquiry and effective managerial practice.
This is problematic because new ventures need to assemble resources quickly and use
these resources to develop capabilities which can create and protect a competitive advan-
tage (Zahra, 2006a; 2006b). Most new ventures usually have one or a few capabilities
that should be kept current while assembling other skills and capabilities through the infu-
sion of new knowledge and other resources from external sources or internal develop-
ment. CVC enables new ventures to obtain the financial resources and business contacts
needed to assemble and use these skills, deploy them in a timely fashion, and build a
strong market presence. McNally (1997), Rosenberger et al. (2005), Dushnitsky (2006),
Dushnitsky and Lenox (2006) and Maula et al. (2006) offer detailed discussions of the
various financial, operational and strategic benefits that new ventures can gain from their
CVC relationships. Concern persists that CVC investments also open the door for oppor-
tunism by established companies that could appropriate much of the value of these ven-
tures’ intellectual property or stifle their growth.
In this chapter, we hope to fill a gap in the young but growing literature on CVC.
Specifically, we adopt the perspective of entrepreneurs to: (1) examine potential financial
and non-financial benefits new ventures can gain from CVC investments; (2) discuss
factors that can mitigate or limit these potential gains; and (3) consider effective strategies
that entrepreneurs can use to maximize gains from CVC while curbing possibilities for
incumbent partner opportunism.
To accomplish these three objectives, we ground our arguments in the knowledge-based
(Grant, 1996) and relational capital (Dyer and Singh, 1998) perspectives. Invoking the
knowledge-based view, we propose that a key source of potential value creation for new
ventures that engage in CVC relationships is the creation of unique and inimitable know-
ledge that becomes embedded in their operations. Exploiting this knowledge creatively
can give new ventures competitive advantages over their rivals (Zahra, 2006a). Knowledge
creation per se may not enhance the firm’s value or owners’ wealth. Instead, this know-
ledge has to be used in developing and introducing new products, goods or services. New
ventures can also ‘sell’ their knowledge through licensing or other means. We invoke the
relational perspective to suggest that contracts have limits in curbing opportunism. When
a relationship develops between two or more social actors, it becomes possible for them
to share what they know, collaborate, and reveal the ‘hidden code’ in the information
being transferred. This makes the information accessible to the recipient, promoting
mutual understanding and co-operation. It also makes it easier to use this knowledge,
which is important for those new ventures that gain access to their partners’ knowledge
through relationships. Still, CVC relationships are susceptible to opportunism because
incumbents and new ventures have different goals and control different resources and
knowledge. Therefore, we propose that entrepreneurs can reduce this risk using a variety
of contractual, structural and behavioral mechanisms. Relationships develop over time,
giving participants an opportunity to learn about and from each other, decipher their
mental models, and appreciate their intentions and goals. Information gleaned from these
relationships, however, is imperfect because actors have strong incentives not to reveal
fully what they know or do, limiting others’ ability to comprehend what they are doing.
Entrepreneurs’ perspective on corporate venture capital 395
The fact that information could be gained from these relationships makes it imperative
for new ventures to develop their absorptive capacity to spot, capture, assimilate and
exploit relevant and useful knowledge from incumbents (Zahra and George, 2002).
We make three contributions to the literature in this chapter. The first is examining CVC
within a relational (rather than a merely transactional) framework, making it possible to
articulate the benefits that entrepreneurs can gain from collaboration with incumbents.
Other researchers have recognized the merits of this approach and have used it in their
analyses (Maula et al., 2006; see also Chapter 15). In contrast, transaction-based analyses
often consider formal means of reducing opportunism, taking into account the costs and
benefits involved. These analyses often overlook the dynamics of the relationships that
develop among companies or parties to exchange over time. Transaction-based analyses
also highlight the financial costs of opportunism, ignoring the social implications of such
behavior. We argue that a transactional perspective by either party can be short-sighted,
undermining the potentially more valuable, longer term collaborations. When there is
sufficient goal congruence, a relational perspective provides a better means for analyzing
new ventures and incumbents’ interactions. These relationships are complex and require
considerable investments in time, energy and resources for the development and payoff for
the parties involved. Our analyses suggest a number of ways in which new ventures could
balance transaction and trust-based governance, protecting their intellectual property.
Our second contribution lies in recognizing that differences in the goals between and
within new ventures and incumbents create unique dynamics that influence the outcomes
of CVC relationships. Neither incumbents nor new ventures are homogeneous groups,
though prior analyses have often erred in treating them as such. By recognizing the diver-
sity of motives of various types of CVC-supported ventures, we set the stage for thought-
ful theorizing about the potential vs. realized gains from CVC. This issue has been widely
ignored in the CVC literature, creating a serious gap in our understanding of effective
ways that companies can organize and cultivate their relationships and create value.
Our third contribution in this chapter is to explore the limits of the relational capital
perspective in the context of the CVC relationship. Increasingly, some researchers (for
example Maula et al., 2006) have used this perspective in lieu of the transactional costs
perspective (Williamson, 1985) in theorizing about the dynamics of the relationship
between established and new firms. While relational capital can enhance trust and reduce
partner opportunism, some recent analyses ignore unique and idiosyncratic qualities of
the relationship between new ventures and incumbents that make opportunism likely (and
perhaps inevitable) in some situations. By considering the limits of the relational per-
spective, we provide a more realistic picture of its usefulness especially among new ven-
tures. Excessive trust could be as damaging as lack of trust to business and value creation
(Zahra et al., 2006b).
The remainder of the chapter progresses as follows. First, we briefly review the growing
importance of CVC, especially in emerging high technology industries. Once we have
discussed the importance of CVC, we analyze entrepreneurs’ objectives related to these
activities. Specifically, we distinguish between exploratory and exploitative objectives
(March, 1991). We use the knowledge based (Grant, 1996) and relational capital per-
spectives (Dyer and Singh, 1998) to argue that one of the key benefits of CVC for entre-
preneurs is gaining and developing new knowledge that can accelerate their firms’
development. While we highlight the relational aspect of CVC investments, we underscore
the conflicting goals of incumbents and new ventures. Our discussion will show how these
conflicting motives may come to bear on new ventures’ potential benefits from CVC-based
relationships. Our discussion recognizes that entrepreneurs can fail to gain the full range
of potential benefits in their CVC relationships.
Next, we identify several factors that can contribute to the gap between potential and
realized CVC benefits. We examine differential power, reputations and status as possible
sources of this gap. We also examine how partner opportunism and organizational
process (and cultural) dissimilarities can contribute to this gap. To achieve our objective,
we turn to transaction cost theories (Williamson, 1985). We also highlight how differences
across industries in the strength of intellectual property protection regimes can contribute
to the gap between potential and realized benefits of CVC.
Finally, we discuss key strategies that entrepreneurs can use to reduce the potentially
dysfunctional side of CVC relationships. We cover the importance of due diligence in
partner selection, syndicated investment with independent venture capitalists, governance
mechanisms (such as board composition and voting rights), use of proactive relationships
with a CVC program’s parent organization, and terms of licensing agreements. We con-
clude the chapter by summarizing the implications of our arguments for entrepreneurs
and future research.
Importance and growth of CVC

CVC investments grew dramatically during the past decade (see for example Dushnitsky,
2006; see also Chapter 15), receiving increased attention from researchers in the fields of
strategy, innovation and entrepreneurship (Keil, 2002; Chesbrough, 2003; Christensen
and Raynor, 2003; Dess et al., 2003; Keil et al., 2005). This interest relates to wider
research agendas on organizational learning and renewal (Cohen and Levinthal, 1990;
March, 1991) and on the different roles incumbent and young firms play in industry
ecosystems (Hagedoorn, 1993; Zahra and Chaples, 1993; Iansiti and Levien, 2004).
Evidence on the broad patterns of CVC investments during the past decade has several
implications for new ventures considering funding and for the strategic relationships they
might form with established companies.1 CVC investments were a significant source
of funding for young companies, primarily in emerging high technology industries. An
estimated worldwide population of 447 programs made some $44 billion of investments
during 1994–2003, rising from $120 million in 1994 to a peak of $17 billion in 2000,
and falling to a still substantial $2 billion in 2003 (Birkinshaw et al., 2002; National
Venture Capital Association, 2004).2 US companies accounted for nearly 84 per cent of
investments, representing 12 per cent of formal US venture capital activity during
the 1994–2003 period. While these figures suggest a broad but temporally variable CVC
investor opportunity space for new ventures, the effective space was narrower because
more than 70 per cent of the programs were initiated by companies within two economic
sectors – information technology-telecom and biotech-pharmaceuticals-chemicals.
These programs focused their investments within their respective sectors (Kann, 2000;
Birkinshaw et al., 2002). Programs in these two sectors accounted for as much as 90 per
cent of US CVC investments (Dushnitsky and Lenox, 2006).
New ventures seeking attractive CVC investors should be aware of the diversity among
programs with respect to scale, experience, longevity and parent funding. Half of the exist-
ing CVC programs were small by US venture capital industry standards (for example
cumulative investment was less than $95 million). However, as many as 25 programs invested
more than $500 million (Allen and Hevert, 2007). Most programs were initiated after 1992,
roughly half had five or less years of investing experience through 2003, and many were
discontinued after a few years of activity. For example, of the 447 programs identified by
Birkinshaw et al. (2002), 31 per cent were inactive or closed by early 2002. While some pro-
grams, like independent venture capital funds, received long-term commitments from their
investors, many did not (Gompers, 2002). These programs were likely to be more vulnerable
to funding volatility or eventual closure (Birkinshaw et al., 2002; Gompers, 2002).
CVC programs that fail to achieve material and sustained funding are less likely to assist
new ventures in establishing alliance activities with parent organizations or to participate
in multiple financing rounds. Even though the relative youth of many CVC programs
makes the identification of most attractive partners a challenge, some due diligence can
reduce prospects for adverse selection. Other things being equal, the most attractive CVC
investors are likely to have longer experience, substantial scale (for example $100–500
million in cumulative investment over several years), and committed parent funding.
Another factor for new ventures to consider is the track record of the CVC program in
co-investing with well-regarded venture capital funds (Maula and Murray, 2000). In this
case, venture capitalists may be signaling their implied endorsement of a CVC program’s
staying power, potential reputational benefits, or record of productively working with
younger companies and their other investors (Breyer, 2000).
Strategic motives for CVC-based relationships

Established companies generally cite both strategic and financial goals in initiating CVC
programs (Siegel et al., 1988; Birkinshaw et al., 2002). Similarly, new ventures have both
financial and strategic motives for seeking CVC investments (see Chapter 15). In this
section we set aside the issue of direct financial objectives of corporate investors,3 focus-
ing instead on the strategic benefits each party might seek from a CVC investment; situ-
ations in which there may be congruence or conflict between the goals of these parties;
and how goal congruence–conflict may differ across developmental stages of young com-
panies, investment rounds and economic sectors. Consequently, we first consider the
objectives of corporate investors and then the goals of new ventures seeking funding
through CVC programs.
Corporate investor perspectives

The literature highlights different reasons that lead established companies to use CVC
(for a detailed discussion see Keil, 2002; Maula et al., 2003; Keil et al., 2005; Maula et al.,
2005; see also Chapter 15). It suggests that rapid technological change has encouraged
incumbents to search beyond their existing capabilities for innovation. Rapid technological
obsolescence has made it essential to obtain new and diverse knowledge from external
sources to augment the firm’s internal operations and discoveries. New ventures are a key
source of new knowledge that can be brought into the organization and combined with
existing skills to create new products and services. As noted, the knowledge-based theory
of the firm highlights the importance of exploiting knowledge for creating value (Grant,
1996). Combinative knowledge, in particular, can be an important source of value creation
(Kogut and Zander, 1992). Some established companies have turned to CVC investments
because their internal R&D activities have failed to recognize serious technological
discontinuities. Even when they did recognize pending technological change, their devel-
opment process was sometimes too slow to pre-empt smaller or more flexible rivals (Foster,
1986; Gompers and Lerner, 1999; 2001). Several surveys provide rankings of the strategic
objectives cited by companies in initiating CVC programs (Siegel et al., 1988; Corporate
Strategy Board, 2000; Kann, 2000; Birkinshaw et al., 2002). Findings from these surveys
converge around three clusters of highly rated objectives. The first and most highly ranked
goal is exposure and access to emerging technologies, including both complementary and
disruptive technologies. Incumbents frequently use their CVC investments to canvass a
wide range of technological fields and learn more quickly about forthcoming technological
discontinuities (Maula et al., 2003).
The second goal cited by CVC programs is to expose incumbents to new markets and
gain access to resources and relationships which can accelerate these firms’ ability to enter
new markets. CVC relationships give incumbents opportunities to learn about different
new ventures, their strengths and weaknesses and their potential to change the dynamics
of industry structure. This information can help incumbents reshape their technological
portfolios, enter new markets, and identify attractive acquisition targets. The third goal
centers on enhancing the demand for current products or services of the investor. One
version of this is ecosystem investing in the information technology sector, in which
the primary goal is to support a network of suppliers, complementors, customers and
investors that can help create or defend de facto technology standards for the investing
firm (Chesbrough, 2003).
Some research shows that incumbents attach different priorities to different CVC goals.
Kann (2000) found that the importance of these strategic objectives differed significantly
across industries. For example, gaining timely exposure and access to emerging technol-
ogies was the main objective for pharmaceutical and chemical companies, while enhanc-
ing demand was the dominant theme among software firms. These differences reflect
industry dynamics and the powerful forces that govern competition.
A key limitation of past research findings is its failure to address the potential for goal
congruence or conflict between incumbents and new ventures. Conflict in goals can under-
mine this relationship and lower the potential gains of the corporate investor and new
venture. Goals underlying these investments also change over time. Unfortunately, it is not
clear from the literature how this congruence (or conflict) may change over development
cycles and funding rounds. To explore these issues more fully, in Table 16.1 we depict
the perspective of a CVC investor as a function of: (1) strategic investment objectives;
(2) potential impact of the investees (new ventures) on strategy of the CVC program’s
parent; and (3) preferred timing of investment. Even though Table 16.1 focuses on estab-
lished corporate investors, we believe that understanding what these investors seek and
how they make their strategic decisions can help new ventures and their managers refine
their strategies for collaboration with established companies. Inexperienced new ventures
often fail to consider the consequences of the strategic imperatives CVC investors have on
the decisions these investors make to ensure the flow of funds, resources and knowledge
to the companies in their portfolios.
Focusing on strategic investment objectives (Table 16.1), we distinguish between explor-
ation and exploitation (March, 1991). Exploratory investments can be viewed as equity
funded intelligence gathering with the possibilities for follow-up actions and investments
within the investor’s parent company and through alliance activity with the new ventures
Table 16.1 Perspectives of corporate venture capital investors
Potential impact of (1) Strategic investment objectives

entrepreneurial firm on
strategy of CVC Explores Exploits
program’s parents Early Later Early Later
stage stage stage stage
Threatens
Unclear or mixed
Supports
in their portfolio. This type of investment gives incumbents a window on emerging busi-
ness models as well as technological, marketing and business process innovations that could
alter industry dynamics and boundaries. Incumbents may also learn about their rivals’
emerging technologies and how they might evolve over time. Exploratory investments can
lead to (or occur simultaneously with) exploitative actions. For example, Henderson and
Leleux (2003) found that 56 per cent of telecom CVC investors announced collaboration
agreements with new ventures in their portfolios. Alternatively, exploratory investments
need not result in alliances between incumbents and new ventures because incumbents may
decide to limit the application of any learning they obtain to internal projects.
Exploitative CVC investments do not have to precede exploratory investments
(Rothaermel, 2001). In fact, incumbents may elect to wait to invest until later funding
rounds or to seek only licensing agreements. If the objective is other than gaining early
exposure or obtaining rights to new technologies, later direct exploitation moves may be
preferred. In this vein, Henderson and Leleux (2003) found that decisions to initiate
investment in later rounds were a significant predictor of the likelihood of collaboration
agreements in the telecom sector.4
The second factor we highlight in Table 16.1 is the perceived impact of the entrepre-
neurial firm on the strategy of the CVC program’s parent. Hellmann (2002) observes that
non-contractible activities between CVC investors and new ventures may be comple-
mentary or competing. We assume that incumbents’ key decision makers develop percep-
tions of the degree to which the new venture is supportive or threatening to their firms’
strategy. This perception may result from search and screening processes for initial invest-
ments or may emerge over time. Thus, perceived strategic fit can change over time.5 It is
also possible that a CVC program or different business units may have conflicting views
on goal congruence. For instance, the new venture might be seen as an ally of internal
units pursuing a disruptive technology but as a threat to others supporting alternative
technologies or defending current technology bases within incumbent organizations.
Therefore, in Table 16.1, we provide a third category of potential impact reflecting unclear
or conflicting perceptions and the possibility of a mixed threat–support situation.
The final factor we highlight in Table 16.1 is the preferred timing of the initial invest-
ments. If the initial strategic objective is to gain exposure to new technologies, then the
incumbent is likely to invest in early, pre-revenue rounds. Evidence suggests that up to 40 per
cent of transactions (not value) by CVC investors are in seed money through development
rounds, reinforcing an inference of importance for exploratory activities (Gompers and

Lerner, 1998; Kann, 2000).
Overall, Table 16.1 highlights six different scenarios of CVC investors with different
implications for preferred timing of initial investments. New venture managers should
be aware that the exploration–exploitation dimension may or may not involve path
dependency, depending on the preferences of incumbents’ senior managers. Each of the
six scenarios suggested in Table 16.1 implies a different foundation of common interests
and information upon which to build productive collaborations between incumbents and
new ventures.
The entrepreneurial firm’s perspective

As noted, limited research exists on the objectives and priorities that new ventures
pursue when they seek CVC investors. New ventures are heterogeneous in their ownership,
strategic focuses, resources, skills and experiences. Owners and managers may also differ
significantly in their goals; some may want to develop the venture just enough to make it
a candidate for acquisition. For others, the goal may be to become a leading player in their
industries (Zahra, 2006b). These variations can lead to major differences in new ventures’
motivations to pursue CVC relationships. The paucity of empirical research on these vari-
ations leads us to rely on anecdotal evidence plus studies that address the broader topic of
strategic alliances between incumbents and young companies. Specifically, we explore the
factors highlighted in Table 16.1 from the new ventures’ perspective and add financing and
endorsement needs, which we believe to be unique to this side of the CVC relationship.
It is important to recognize that some subset of CVC relationships may be viewed by
both parties as serving short-term financial and strategic objectives. Long-term learning
and collaboration would be viewed as secondary considerations. These investments would
be likely to mirror the logic of transaction-cost analysis (Williamson, 1985). Effort and
resources would be committed to making the transaction efficient and profitable over a
short time horizon but little attention would be given to developing mechanisms for build-
ing a basis for multiple future collaborations. We would expect this type of CVC rela-
tionship to make extensive use of traditional contracting safeguards. It may also be more
prone to opportunistic behavior. Whether either of these predictions is true remains an
empirical question which has yet to be fully explained by the literature.6
New ventures are needy creatures on several counts. An immediate need is often to avoid
running out of cash before sufficiently resolving uncertainties surrounding planned
offerings (Kaplan, 1994). This can limit new ventures’ discretion and bargaining power in
their selection of and negotiations with potential investors (Smith, 2001). Lerner and
Merges (1998) show this to be a common issue for young biotech firms seeking development
funding from larger companies. Kann (2000, p. iv) also observes that CVC investing involves
‘collaborative agreements with unequal partners centered on a one-directional equity
investment’. Under these circumstances, CVC investors may have the upper hand in shaping
the course of negotiations with new ventures, determining the amount of intellectual
property disclosure, and setting terms for sharing the benefits from collaboration.
Reflecting on Table 16.1, we first consider the various exploitation objectives of new
ventures in higher goal congruence situations. One key motive is to obtain access to CVC
investors’ resources and networks. In this case, the preferred timing for seeking investors
is usually at the later development or go-to-market stages. A related goal is often to secure
incumbents’ endorsement of the ventures’ emerging technologies or products (Stuart,

2000) and reduce liabilities of newness (Schoonhoven, 2005). These endorsements can sig-
nificantly improve the new firm’s name recognition, encourage buyers and suppliers to
collaborate, and increase overall market standing. In this vein, Leibelein and Reuer (2004)
provide evidence of small US semiconductor firms initiating equity alliances with larger
partners with a primary goal of increasing foreign sales.
Early-stage, exploratory CVC investments can also offer new ventures prospects for
credible endorsements and access to diverse strategic resources. Still, they may carry higher
risks of opportunistic and harmful behavior by well established partners. Consider, for
example, the information technology sector which is characterized by system-level design
rules and horizontal networks of developers of sub-systems and components (Baldwin and
Clark, 2000). In this sector, CVC relationships can provide an avenue for gaining access to
technology roadmaps of leading firms, access to their promotional activities at trade
shows, and improved prospects for design-in of young companies’ products. In contrast,
for young biotech firms, the goal of early stage CVC deals may be gaining access to larger
companies’ capabilities in conducting clinical trials and pilot production for trials. In both
these early-stage situations, the words explore and exploit will be likely to raise few eye-
brows in larger companies. Yet, they often raise the pulses of entrepreneurs who are
concerned that larger company exploration can translate into the appropriation of intel-
lectual property. Another concern for entrepreneurs is that larger partners, by intent or
because of internal conflicts, may fail to deliver access to capabilities. These are classic
agency issues of adverse selection, moral hazard, and hold-up (Jensen and Meckling, 1976;
Kaplan and Stromberg, 2002) but treating new ventures as the principals.
Concerns about harmful behavior by larger, powerful and established partners should
be greater when they see new ventures as a threat to their market leadership or growth
goals. When new ventures control innovative and proprietary technologies that can dis-
place incumbents, they are likely to be viewed as credible threats. Under these conditions,
one would expect new ventures to avoid those prospective investors; but this is not always
the case. There is evidence that low or mixed goal congruence situations are common in
the biotech industry (Pisano, 1991; Lerner and Merges, 1998; Rothaermel, 2001). This
seems to reflect new ventures’ need to gain access to larger pharmaceutical companies’
capabilities as well as long development cycles which often cannot be fully funded from
venture capital and public market sources. In both the information technology and biotech
sectors, gaining access to established companies’ marketing, distribution and manufac-
turing capabilities, as well as the need for cash, may often trump concerns about large
partner behavior (Kaplan, 1994; Smith, 2001).7 If the new venture has sufficient financing
and can choose among different investors, it can employ multiple criteria in searching and
screening for attractive CVC partners or in deciding to avoid potentially opportunistic
partners. Yet, Alvarez and Barney (2001) found that it was not unusual for new ventures
to devote as little as half a day to conducting due diligence on a potential alliance partner.
While this may reflect limited management time and cash, it can set the stage for a failed
relationship between the venture and its CVC investors.
Effective due diligence by new ventures should go beyond the most tangible issues (for
example financial resources and investment windows) when evaluating potential CVC
investors. It should probe CVC providers’ track records in working with portfolio firms,
transferring knowledge and skills, connecting these companies to potential suppliers and
customers, and contributing to the quality of their management. The quality as well as
the durability of the potential relationship should also be investigated to establish CVC
providers’ claims and credibility.
Do entrepreneurial firms capture CVCs’ strategic benefits?

Evidence on the strategic benefits that new ventures gain from CVC-based relationships
reveals considerable diversity with respect to the particular benefits gained and to the
positive and negative outcomes.8 This supports our portrayal of the diversity of interests
of the parties to CVC relationships and reflects differences in how new technologies
and products are developed and commercialized across industries (Davidson, 1990;
Hagedoorn, 1993). Three studies suggest positive effects of CVC investors in information
technology and telecom industries. Maula and Murray (2000) found higher post-IPO
valuations for companies financed by multiple CVC investors and by CVC investors and
venture capital funds than for those funded only by venture capital funds. Henderson and
Leleux (2003) found higher IPO rates for new ventures that also announced collaboration
agreements with their CVC investors. Stuart (2000) also found that young semiconductor
companies that developed technology alliances with large, technically well-endowed
partners benefited in terms of augmented sales growth and patent activity.
Recently, Maula et al. (2005) sought to identify the sources of new venture satisfaction
with CVC investors in relationships that remained active. Two major benefits were found:
(1) technological knowledge and social capital in (2) seeking access to additional funding
and (3) to foreign customers. However, market knowledge and social capital in gaining
access to partners or to domestic markets were not significant in explaining satisfaction.
Even though these results attest to key strategic benefits from ongoing alliances, they
do not address survival rates. In contrast, a study by Alvarez and Barney (2001) of 128
alliances in the biotech, information technology and oil and gas industries reported that
80 per cent of new ventures felt unfairly exploited by their large partners. In some cases,
this involved actions detrimental to the long-term success of alliances and, in others, the
disproportionate appropriation of value created in these alliances.
Two linked studies of 200 R&D alliances of young biotech firms provide evidence of
how the bargaining power of larger partners can negatively impact performance (Lerner
and Merges, 1998; Lerner et al., 2003). Large, corporate partners often extracted sub-
stantial control rights and received the bulk of these rights when smaller firms had limited
cash reserves and lacked immediate access to public financing. The studies revealed that
alliances that assigned greater control rights to larger partners underperformed in terms
of meeting subsequent development milestones. Equally important, underperformance
was substantial when agreements had been signed in poor capital market environments.
Discussion of the findings with industry executives supported the interpretation of the
negative impacts of large firm bargaining power on new ventures. Interesting observations
also surfaced regarding agency problems within large companies’ business development
groups. Some executives noted that given long time horizons of alliances and frequent job
changes of new business development managers, one of the few proxies for success of their
activities was the toughness of the deals they negotiated. As a result, some business devel-
opment officials extracted as many control rights as possible, regardless of how the allo-
cation of these rights might influence the joint welfare of the alliance. These findings
suggest that career dynamics within CVC units can have significant implications for the
structure of deals, the evolution of mutually beneficial relationships with new ventures,
and the outcomes of these relationships.
Some research also suggests that conflicting interests and incentives within many
industry-leading companies may influence failures in the development and commercial-
ization of new technologies (Christensen, 1997; Leifer et al., 2000; Hill and Rothaermal,
2003). This is likely to be an important influence on the track records of smaller partners
in realizing strategic benefits from CVC relationships (Hellmann, 1998). Capturing these
benefits often requires significant efforts in navigating the complex structures and organ-
izations of larger partners which may not act with unified intent. This suggests a need for
researchers to study management of CVC-based relationships at a process level, an area
which has received little attention to date.
An important variable that can determine new ventures’ capacity to capture value from
CVC relationships is ‘absorptive capacity’ (Zahra and George, 2002). New ventures are
usually lopsided in their skills and knowledge bases, having only limited knowledge in one
or two areas. New ventures need to develop and sustain a capacity to identify potentially
valuable knowledge from their CVC collaborations, capture that knowledge, assimilate it
and use it strategically by building new capabilities and upgrading existing ones (Lim and
Lee, 2006). Building and honing absorptive capacity can be a costly and time consuming
process. In turn, this requires entrepreneurs to stay focused on the knowledge flows
emanating from their CVC partnerships and on identifying the most salient types of
knowledge. Doing so demands managerial foresight as well as an understanding of the
potential trajectory of an industry’s evolution. It also necessitates ensuring the rapid and
effective flow of knowledge throughout the firm’s operations, either through internal
R&D activities or the use of licensing, alliances or similar means.
Building an effective absorptive capacity does not ensure the creation of value, however.
Zahra and George (2002) emphasize the need for having appropriate systems and pro-
cesses that transform knowledge into products and goods. Zahra et al. (2006a) argue that
new ventures have to develop a ‘knowledge conversion capability’ (KCC) for this purpose.
KCC denotes a new venture’s capacity to transform research and scientific discoveries into
successful products that are quickly and efficiently commercialized. It centers on envi-
sioning, conceiving and articulating ways in which knowledge inflows can be creatively
used and then integrating and embedding this knowledge into innovative products, goods
and services that create value. Having and using KCC, therefore, can enable new ventures
to exploit knowledge inflows from their CVC relationships.
Another important task for entrepreneurs is to integrate knowledge inflows from CVC
relationships with the knowledge their new ventures have. Integration is more than a
simple addition or combination of different types of knowledge. Oftentimes integration
requires rethinking the nature, content, structure and potential uses of knowledge.
Performing each of these activities takes time and entails risks for entrepreneurs and their
companies. Integration also requires attention to organizational political issues, dealing
with diverse views of knowledge, and different cognitive models that new ventures’
employees and managers have. As a result, efforts at integrating internal and external
knowledge might slow new ventures’ quest for successful commercialization and may even
backfire as the distinctive quality of internal knowledge is lost. Still, integration can yield
new and radically innovative knowledge that could be used to leapfrog existing products
and the technological paradigms that underlie them.
Achieving productive collaborations with CVC investors

What can entrepreneurs and new venture managers do to extract the strategic benefits
from CVC relationships while mitigating the risks of harmful behavior by larger partners?
Even when trust exists between parties, the threat of opportunism cannot be totally
eliminated. Therefore, we focus our attention on those situations where perceptions of
prospects for joint gains are sufficient to motivate both parties to expend the energy neces-
sary to develop and sustain collaborations.9 We explore the merits of four approaches:
contracting, unbundling of alliance activity, board membership, and proactive relation-
ship management. We also provide some evidence of new ventures using these approaches
to reduce the gap between the potential and realized gains from CVC relationships.
Contracting
The venture capital literature provides extensive treatment of how investors use financial
contracting to mitigate agency concerns about new ventures (Sahlman, 1990; Kaplan and
Stromberg, 2002). Contract negotiations can also provide new ventures with opportun-
ities to mitigate agency concerns about CVC investors and to test the prospects for cooper-
ative behavior (Cable and Shane, 1997). Lerner and Merges (1998) identify several areas
where new ventures generally maintain control rights: process development, alliance
expansion, termination of other than focal projects, sub-licensing, ownership of patents
and core technology, and board seats. New ventures often cede control of management
of clinical trials, final product manufacture, marketing and decisions to shelve focal
projects. Clearly, contracting can provide some protection to new ventures. These firms
can also succeed in renegotiating contracts, which may reflect uncertainty reduction about
alliance value and growing trust between parties (Lerner et al., 2003). Yet, it is important
to recognize the costs and limits of contracting. Complex agreements and protracted
negotiations can drain cash and managerial resources of new ventures. Defense of
negotiated rights can prove costly, and prospects of success will differ across intellectual
property protection regimes (Cohen et al., 2001).
Katis and Young (2004) interviewed eight veterans of CVC investments, half from each
side of these relationships. Responding managers were unanimous in their views that the
burden for capturing value from potential strategic benefits lay with new ventures and that
they should recognize the need to invest time and travel expenses to accomplish this. They
also noted that it was vital to proactively cultivate relations with multiple supporters at
business unit levels and that this should begin during the search for potential CVC
investors. One executive said, ‘Don’t assume that just because the CVC program invested
in you that the rest of the company understands your business. You have to articulate and
communicate your value proposition to particular business units.’ Another manager cited
a young company which assigned a relationship manager to work with CVC officials and
business units. He talked weekly with them to exchange information on product and cus-
tomer activity. These findings reinforce the growing belief in the literature that new ven-
tures have to work hard at keeping an on-going dialog with multiple key managers in CVC
investor companies.
Unbundling of alliance activity into multiple projects

This approach can mitigate the risks of appropriation of intellectual property. It also
offers a basis for moving from a one-time contracting approach to a broader relationship
mindset. This mindset develops as partners collaborate, work through their perceived and
real differences and achieve a greater understanding of mutual interests. This process can
reduce information asymmetries while building collaboration and mutual trust (Cable
and Shane, 1997; Dyer and Singh, 1998).10 One executive of a new venture put it this way:
‘An alliance is a broad-based agreement that we will collaborate over a very broad set of
issues. So it is more than just one project, more than one program, more than just one
technology where we have similar interest areas’ (Alvarez and Barney, 2001, p. 147).
Board membership
Board membership or observer status can expose CVC investors to discussions about the
strategy that the new venture will follow. It may also give CVC investors valuable insights
into technology and market developments, barriers to the firm’s attempts to commercial-
ize the technology, and conflicts within the top management team. This first-hand expo-
sure can be important for recognizing and interpreting tacit knowledge.
However, Gompers and Lerner (2001) identify several drawbacks to board membership
by established companies. Membership exposes the investor company to potential legal
liabilities. Entrepreneurs are often uncomfortable with corporate representatives on their
boards. Entrepreneurs also fear the appropriation of proprietary technology and competi-
tive information or misuse of this information, for example to pre-empt the younger firms’
plans or subsequent merger negotiations. While non-disclosure agreements can address
some of these concerns, they seldom eliminate them. The more potent antidotes for moral
hazards are common interests and mutual trust.
Proactive relationship management

Trust develops over time, based on frequent and mutually beneficial exchanges. Trust
requires credible commitments as well as a mindset that encourages collaborative and
supportive behavior. A new venture seeking long-term, profitable relationships with a CVC
investor should therefore demonstrate a willingness to build this relationship.
Two types of trust are recognized in the literature. The first is calculative and is based
on a party’s assessment of the potential risks and returns of collaboration. New ventures
can induce this type of calculative trust through careful contracting and negotiation, as
we have suggested earlier. The second type of trust is relational in nature. It rests on lateral
communication, frequent and honest disclosure, and mutual sharing of information and
other resources. In developing and sustaining relational trust, calculations are slowly
augmented by a belief that one party will not take advantage of the other’s vulnerabilities
and will not exercise its powers to coerce the other into acquiescence or compliance.
Rather, emphasis is on developing mutual understanding that fosters joint problem
solving and information sharing. Relational trust generates social capital between the
entrepreneurial firm and CVC partner (Maula et al., 2005).
To be effective in building relational trust, a new venture has to be skilled in identify-
ing relevant groups and actors within the incumbent’s organization and in its communi-
cating with them. Frequently, these actors are placed in the CVC unit and interact with
business unit managers and others in the corporation (Gompers and Lerner, 2001).
Members of the CVC unit have a vested interest in keeping track of what the ventures in
their portfolio are doing and how well they are progressing in serving their goals. This can
set the stage for frequent communication between new ventures and CVC providers’ staff.
Developing relational-based trust is a time consuming process that is fraught with

uncertainties. First, the risk of opportunism might decline but it certainly persists.
Opportunism is likely as long as actors have access to different types of information, hold
different perceptions of process or outcomes, or pursue different goals. Second, members
of the incumbent’s CVC unit are under significant pressures to share their findings with
those in their strategic business units, possibly compromising their positions with their
portfolio ventures. Information about what new ventures plan to do with their technol-
ogy or in markets could be of great value to incumbents as they explore ways to protect
their established positions. Sharing that information could compromise the position of
the CVC unit (or staff) in their communications or other interactions with new ventures.
Third, the membership and objectives of the CVC unit are subject to major and some-
times frequent changes (Gompers and Lerner, 2001). Companies may change objectives
about what they want to achieve through their CVC program and the metrics used in
evaluating that unit. These changes introduce uncertainty into the communications
process, making relational trust more difficult to sustain over time. Fourth, young com-
panies have obvious limits on how much time and how many resources they can devote
to relationship management.
To summarize, our discussion makes clear that entrepreneurs should ‘trust but verify’ the
intent and actions of their CVC providers. Transactional cost analysis would favor for-
malized, strict monitoring which is difficult to conduct especially where there are consid-
erable power, information and resource asymmetries among parties. New ventures may not
be well staffed or have the resources to monitor CVC providers on a consistent basis. These
ventures cannot rely solely on trust, especially when a powerful partner can capture their
knowledge and intellectual property and use it to advantage. However, excessive trust can
blind venture managers to the potential opportunism of CVC providers. This absolute trust
can have dysfunctional effects that can undermine the very existence of the new venture
itself. The astute entrepreneur has to balance trust with some of the formal mechanisms we
have just discussed to ensure the protection of the venture’s intellectual property, realizing
that the best protection lies in causal ambiguity where the CVC provider cannot decipher
what the new venture is doing (Zahra and Chaples, 1993). Embedding innovations and
intellectual property into the new ventures’ systems, internal processes and organization is
another important means to achieving this goal. Overall, our discussion shows that both
trust and transaction-based monitoring are necessary when uncertainty is high and
outcomes of the relationship are subject to interpretation and change. Transaction and
relational governance therefore could be effective complements, not substitutes.
Discussion
CVC investments offer opportunities for incumbents and new ventures to collaborate and
acquire new skills and capabilities. Adopting the perspective of the entrepreneur and
her/his new venture, we have highlighted the importance of CVC for gaining access to
financial resources, complementary assets and market information. CVC investments also
provide an important signal of a new venture’s legitimacy and viability. We have argued
that the congruence of goals of new ventures and incumbents are a crucial requirement for
a ‘win–win’ partnership between these parties (Table 16.1). Yet, the stakes are too high for
both parties to assume that good intentions will lead to satisfactory and sustainable results.
New ventures have to work to curb incumbent partners’ potential opportunism through
contracting, patenting, licensing, legally binding non-disclosure agreements, selective

board membership decisions, syndicated investments, and making credible investments in
building and sustaining their relationships with their CVC partners. Our discussion
suggests several implications for entrepreneurs and new ventures, as discussed next.
Implications for managerial practice

Our discussion highlights the importance of several managerial actions that can improve
new ventures’ gains from CVC. Notably, there is a need for due diligence in selecting CVC
partners. We have outlined several criteria that entrepreneurs can apply in this process but
it is worth reiterating the need to go beyond numbers. It is important for entrepreneurs to
probe CVC investors’ motives, goals, track records, personnel and overall credibility.
Entrepreneurs are busy people who often err by favoring speed over gaining insights into
their partners. Clouded by the ‘illusion of control’, some entrepreneurs may come to
believe that they can ‘fix’ problems as they arise. This is not always possible, especially
when valuable information about a company’s proprietary technologies, skills, trade
secrets, weaknesses and strategies leaks to outsiders.
Entrepreneurs also need to communicate the goals of their new ventures clearly to
potential CVC providers. It is equally important to seek clarifications about their CVCs’
partners’ goals related to investing in their new ventures. Even though these goals are
likely to change over time, understanding them initially sets the stage for a clearer and
more congruent alignment of goals. Entrepreneurs therefore need frequently to reassess
their goals and those of their partners to ensure an effective fit.

We believe that research opportunities on the various benefits of CVC for new ventures
abound. Yet, as we reviewed the literature, we could only find a few studies on the topic –
highlighting the need for better theory development and testing in this fertile area. Clearly,
we need to move beyond anecdotal evidence and case-based research and apply a more
systematic and theory-grounded approach (Maula, 2001). Thousands of CVC deals have
been completed in the US and elsewhere, offering a broad basis to theorize about cond-
itions under which they can create value for investors and new ventures. Agency, strategic
contingency, institutional and knowledge based theories could offer a foundation for
examining these conditions and delineating the effect of CVC on new ventures and
investors. Theory building and testing could substitute individual case studies to begin to
provide reliable generalizations that can guide effective managerial practice. Fortunately,
recent published research on the topic shows a great deal of attention to careful theory
building and empirical testing (Dushnitsky and Lenox, 2005; 2006).
Future researchers would also benefit from examining how new ventures select their
CVC partners. As stated throughout this chapter, there are multiple criteria for new
venture managers to consider as they evaluate potential CVC investors and it is useful to
determine the relative importance of these criteria across industries, different stages of the
ventures’ evolution, and time periods. How do venture managers rank the tangible and
intangible attributes of potential CVC investors? How do these rankings relate to indus-
try and strategic variables and the preferences and skills of entrepreneurs? Answering
these questions can improve our understanding of how entrepreneurs choose CVC
providers and how they begin to build their relationship with them.
Throughout this chapter, we have discussed several legal and relational ways that new
ventures can curb the opportunism of their CVC partners. It would be useful to develop
theories that allow us to predict the viability of these approaches under different
industry and competitive conditions. Empirical studies that identify and clarify these
conditions would also enrich the literature. Are these approaches complementary? Do
they substitute for each other? If so, when and how does this influence the relation-
ship between new ventures and incumbents? What are the types of social capital that
determine this substitutability? Maula et al. (2005) highlight different roles for social
capital in the context of CVC, and future researchers would benefit from exploring
these roles.
Recent analyses also suggest that the capabilities of CVC partners have important
implications for new ventures’ knowledge acquisition and learning (Zahra, 2006a). For
instance, ventures that obtain funding from well established technological leaders are
more apt to learn a great deal more about technology commercialization than those ven-
tures that have technologically weaker partners. These preliminary findings indicate a
need to delve more deeply into CVC partners’ knowledge and capabilities and how they
might influence new ventures’ learning. These results extend and revise the prevailing
wisdom by showing that these ventures also learn from their relationships with established
companies. This learning, in turn, depends greatly on the social capital and absorptive
capacity of new ventures and entrepreneurs’ willingness to build trusting relationships
with their CVC partners (Zahra, 2006a).
Understanding potential partners’ skills and knowledge requires due diligence by new
venture managers who have to analyze the capabilities of CVC providers. Therefore, man-
agers might seek the feedback of other ventures that received CVC support from a given
provider, inquire about the ease by which knowledge and skills were transferred, any
barriers that limited such transfers, and the quality of skills and information transferred.
Partners’ reliability in keeping their promises regarding skill and resource transfers should
be a central issue. New venture managers can also use formal and informal competitive
analysis techniques to gather and assess information about partners’ reliability in sharing
their knowledge. New ventures often need help with strategic planning, marketing and
manufacturing capabilities and established companies typically possess competent staff
who perform these activities. New venture managers should openly discuss with potential
CVC providers the extent to which they are willing to share their knowledge and the
appropriate forum in which this sharing is likely to occur.
Finally, future research would benefit from applying and testing the relationships sug-
gested in Table 16.1 and the applicability of the relational approach we discussed through-
out this chapter. Complementarities vs. competition between CVC providers and new
ventures could influence the potential payoff from exploratory vs. exploitative investments
that incumbents make. Several research questions arise from considering Table 16.1 and
deserve attention. For instance, does the timing of investment (late vs. early) influence
the payoff from exploratory vs. exploitative CVC funding? How do new ventures ensure
complementarity when making CVC decisions? When does complementarity give way to
competition between the CVC provider and the venture receiving funding? Conversely,
when does the relationship between these two groups change from competition to com-
plementarity? Empirical studies along these lines can enrich our understanding of the
payoff from CVC for providers and new ventures.
Conclusion
Entrepreneurs and their ventures stand to gain a great deal from CVC relationships. Even
though some CVC relationships provide a setting in which opportunistic behavior could
flourish, others serve as an important means of legitimization and an effective conduit for
knowledge sharing and organizational learning. As we have presented throughout this
chapter, opportunities for collaboration and learning increase significantly with new ven-
tures’ use of legal and trust-based mechanisms to protect their intellectual property and
curb their partners’ potential opportunism. Using the approaches we have outlined in this
chapter, CVC investments could evolve into ‘win–win’ relationships for new ventures and
their established corporate partners.
Acknowledgements
We acknowledge with appreciation the comments of Hans Landström, Markku Maula,
Don Neubaum, Harry Sapienza and Patricia H. Zahra on earlier drafts of this chapter.
The first author also expresses his gratitude for financial support of The Research
Programme for Advanced Technology Policy (ProACT) of the Ministry of Trade and
Industry and the National Technology Agency, Tekes (Finland) and the Glavin Center for
Global Management at Babson College. The second author expresses his appreciation for
financial support as holder of the Paul and Phyllis Fireman Charitable Foundation Chair
at Babson College.
Notes
1. While CVC activity dates from the 1960s (Rind, 1981), we focus on the previous decade because invest-
ment levels, sectoral focuses of activity, and program characteristics differ significantly from prior periods
(Gompers, 2002; Dushnitsky and Lenox, 2005).
2. Estimates of investment are derived from analyses of the Thomson Venture Economics database and
exclude indirect and certain direct activity. They may also understate substantial activity by Asian firms
(Haemmig, 2003).
3. Allen and Hevert (2007) provide evidence on direct performance of CVC programs.
4. Some observers view the possibilities we describe as real options (McGrath, 1997). While option logics are
broadly consistent with our treatment, their underlying assumption of a right but not obligation to take sub-
sequent actions is not fully representative. In many instances, exploratory investment does not convey a con-
tingent claim to pursue additional strategic benefits. This is often subject to negotiation among the parties.
Also, there are numerous examples of renegotiation of alliance agreements by investees (Lerner et al., 2003).
5. This assumes bounded rationality of investors in establishing and applying criteria for strategic relevance
of targets. A Corporate Strategy Board (2000) study indicates that this may be the case for a subset of best
practice companies. However, it also cites misaligned criteria and inconsistency and lack of rigor in screen-
ing and monitoring processes as major challenges for the wider population of CVC programs.
6. Opportunism discourages the flow of information between new ventures and incumbents, thus depriving
established companies of a vital source of information about pending technological and other competi-
tive changes. When the threat of opportunism is high, new ventures may withhold information or share it
selectively with their CVC investors. New ventures can also induce causal ambiguity by omitting key details
about their technologies. When their technologies are vastly different from those of the incumbents, ambi-
guity becomes real and incumbents cannot ascertain cause–effect relationships. There are serious implica-
tions for new ventures’ efforts aimed at reducing incumbents’ potential opportunism.
7. While differences in strength of intellectual property protection regimes (Cohen et al., 2001; Dushnitsky
& Lenox, 2005) may influence young firm attitudes in low goal congruence situations, limited evidence is
available. Kann (2000) finds that industries with stronger intellectual property protection have more CVC
programs with early-stage investment missions; however, his data do not extend to views of investees or to
characteristics of deals.
8. The broader alliance literature provides evidence of value creation: positive average wealth effects around
announcement dates, heterogeneity of results across samples, and wealth creating learning effects for firms
which make repeated use of R&D joint ventures (Chan et al., 1997; Anand and Khanna, 2000). Whether
these results extend to CVC-based alliances and the issues of division of gains among partners remain
empirical questions.
9. CVC investments in low goal congruence situations often may not meet this condition. This is an issue of
adverse selection, which we treat earlier in the chapter. Syndicated investment with venture capitalists or
other CVC programs may mitigate risks of hold up or appropriation of intellectual property by a single
corporate investor (Maula and Murray, 2000), but this does not address how to generate positive strategic
benefits from a relationship.
10. This relates to the role of relational capital in obtaining productive outcomes from alliances. In a survey
of 212 managers who had been involved in alliances in technology intensive industries, Kale et al. (2000)
found positive relationships among relational capital, integrative conflict management behavior, organ-
izational learning, and protection of proprietary assets. They did not address CVC-based alliances per se
or economic significance of outcomes for partners.
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PART V
IMPLICATIONS
17 Implications for practice, policy-making and
research
Hans Landström
In this Handbook of Research on Venture Capital we have tried to show the ‘research front’
of our knowledge on venture capital – what we know about venture capital – but, the
chapters also clearly indicate what we do not know. This final chapter is intended to
provide some suggestions for researchers, doctoral candidates and masters students on the
future direction of our understanding about venture capital as well as trying to answer
the question: where are we going in venture capital research?
In the previous chapters we have tried to learn from earlier knowledge in the respect
that we try to communicate to reflective entrepreneurs, venture capitalists and policy-
makers what conclusions can be drawn from research on venture capital and how our
knowledge can be applicable to their field of activities and the understanding of venture
capital. Therefore, in the second section of this chapter we will try to answer the question:
what advice can be given to practitioners and policy-makers?
Where are we going in venture capital research?

Although research on venture capital has been in progress for a quarter of a century and we
now have a great deal of knowledge that did not exist 10–15 years ago, many unanswered
questions remain. The authors of the chapters in the book have all tried to pinpoint these
questions and provide some indications of where venture capital research is going.
Venture capital research in general

Based on the arguments by Van de Ven and Johnson (2006) on ‘engaged scholarship’ and
Ghosal (2005) on ‘positive organizational scholarship’, Harry Sapienza and Jaume
Villanueva (Chapter 2) exhort venture capital researchers to immerse themselves in the
phenomenon of venture capital and foster increased stakeholder cooperation in order to
broaden as well as deepen our theoretical knowledge and the methods used in our studies,
in addition to addressing important questions that enrich theory and practice in a mean-
ingful way. Sapienza and Villanueva make the following recommendations for future
studies on venture capital:
● Stay close to the phenomenon and study ‘big’ issues.

● Develop learning communities among academics and the venture ecosystem.
● Study phenomena over time via multiple theories and methods.
● Seek a balanced, humble view that reaches beyond rational self-interest.
● Explore the ethical and affective aspects of decision-making.
● Explore the bright side of entrepreneurship and its value creating correlates.
Focusing on the geographical aspects of venture capital, Colin Mason concludes in

Chapter 3 that the geographies of venture capital have been largely ignored by scholars in
415
entrepreneurship and finance and have only attracted limited attention from economic
geographers. Thus, there is a more or less ‘open field’ of research to explore, and Mason
prioritizes five topics for future research:
● In business angel research there is a need to ‘put boundaries on our ignorance’,

for example, better quality statistical information on the local distribution of
business angels, the characteristics of business angels in different locations, and
so on.
● Make use of databases that enable researchers to explore a greater range of
geographical questions.
● Move from the macro-scale and quantitative data, to the micro-scale and qualitative
data.
● There is a need to clarify the connection between venture capital and technological
clusters.
● A very great deal of our knowledge reflects what happens in dynamic regions such
as Silicon Valley and Boston, but we need to recognize venture capital practices
in other regions.
In Chapter 4 Gordon Murray discusses the relationship between policy and research,
and the somewhat contradictory link between policy-makers’ wish to know how to
change or improve systems in order to achieve tangible and cost effective outcomes,
preferably quickly, and the many scholars who feel comfortable taking a purely theoreti-
cal interest in venture capital finance. However, we have seen an increase in the interest
in ‘policy-oriented research’ and Murray suggests some domains in which we need
further knowledge:
● The existence of the equity capital gap. Does an equity capital gap exist and, if so, at
what levels of finance, who is affected, and are there adverse material consequences?
● The efficiency of government actions. Which government actions are most effective
in stimulating venture capital investments?
● Business angels are seen as an alternative to institutional venture capital. Is this
assumption empirically valid? By what means can business angels succeed in early-
stage market conditions? How can business angels and venture capitalists most
effectively work together to support potential ventures?
● ‘Hybrid’ venture capital programs. By what means should public/private ‘hybrid’
venture capital programs be evaluated?
● Internationalization of venture capital. The venture capital industry has become
globalized, and more comparative studies are needed. How can emerging economies
learn from current venture capital experience?
In addition, Murray addresses and follows up on the discussion introduced by Sapienza

and Villanueva in Chapter 2 and encourages collaboration between policy-makers
and scholars in the field of venture capital. But this is not an easy task – policy-makers
frequently prefer inter-disciplinary teams that address big issues with strong evaluative
and executive recommendations and it is not easy for academic researchers to meet these
needs while still being able to undertake studies capable of scholarly validation via peer
Implications for practice, policy-making and research 417
review – which requires a high level of trust building and mutual understanding between
academics and policy-makers, something that is still largely in its infancy.
Institutional venture capital

In Part II of the handbook several authors elaborated on institutional venture capital. In
Chapter 5 Douglas Cumming, Grant Fleming and Armin Schwienbacher examined the
structure and governance of different types of venture capital organizations. Regarding
future research themes they offered the following suggestions:
● Internationalization of venture capital – the internationalization of the industry

raises a number of new research questions, such as, how will venture capital markets
evolve around the world, how does internationalization impact on venture capital
firm structure and management, and will the growth of new markets with different
legal systems lead to different styles of venture capital investing?
● Business culture and venture capital fund structure. The venture capital model is
mainly based on an Anglo-Saxon (especially US) business tradition. As the venture
capital industry becomes more international, venture capital must merge with other
business cultures, which may question existing models and constitute a dynamic
basis for interesting research in the future.
● Emerging fund structures. The professionalization of the venture capital industry has
led to new structures, for example, the venture capital fund-of-funds and listed
venture capital funds, but we still need more research on these emerging structures –
their development, characteristics and performance.
In Chapter 6, which deals with venture capitalists’ pre-investment process, Andrew

Zacharakis and Dean Shepherd call for more research on: (1) decision heuristics – heuristics
can be efficient for time constrained venture capitalists, but we need to know more about
how and when to use it, and (2) biases in venture capitalists’ decision-making – we need to
gain further insights in order to minimize the potentially negative impact of decision-biases.
In addition, despite the fact that the research on venture capitalists’ investment activities
has been more and more theoretically based – mainly relying on strategy research – there is
a need to move beyond theories of strategy and explore other theoretical frameworks,
for example, in psychology and sociology, as well as investigating how decision-making
criteria might differ across both the venture capital process and the venture’s develop-
ment stage.
Dirk De Clercq and Sophie Manigart in Chapter 7 reviewed and synthesized our
knowledge of venture capitalists’ activities after the investment has been made. Regarding
the post-investment phase they suggest that future research should further elaborate on
how the heterogeneity of venture capitalists’ monitoring and value-adding activities
depends on the combination of (1) venture capitalist characteristics, (2) characteristics
of the entrepreneur and the venture, and (3) the institutional and social environment in
which both parties are embedded. In addition, research should build further on the liter-
ature pertaining to how value is added in the venture capitalist–entrepreneur relationship,
and in particular, how the exchanges of specific knowledge and the process of such
exchanges affect investment performance. Finally, our knowledge would benefit from
comparing how the context and process-related issues of monitoring and value-adding
activities may differ across different investor types, for example, institutional venture
capitalists, business angels and corporate venture capitalists.
Chapter 8 follows up on this discussion, and Lowell Busenitz argues that research
on venture capitalists’ value-adding has addressed rather broad questions and the studies
have produced mixed results. According to Busenitz, we need to move beyond these broad
questions and he suggests further research into several areas. First, we need to know
more about (1) the internal governance structures that venture capitalists bring to the
ventures – not least the activities on the board of directors in the venture capital context,
(2) the provision of compensation to founders and top management teams and its
consequences, and (3) the role of venture capitalists’ reputation and certification in the
subsequent rounds of financing and in the IPO process. Second, research has only started
to probe the question of the relationship between venture capital and the emergence of
new industries – more work needs to be done – for example, we need to know more about
questions such as: does venture capital investment lead to more innovations in society?
What role does venture capital play in the emergence of new industries?
A similar argument is offered by Benoit Leleux in Chapter 9, who states that, despite
several studies on venture capitalists’ value-adding activities, it is difficult to find consensus
in the results, and one important issue in this respect is the problem of measuring financial
returns on venture capital investments in early stage, privately held ventures. Leleux con-
cludes that we need a great deal more research on measuring venture capital performance.
In her review of our knowledge on early stage venture capital, Annaleena Parhankangas
concludes in Chapter 10 that after decades of research we still have limited knowledge
about venture capital investments in early stage ventures. Parhankangas makes the
following suggestions for future studies:
● There is a declining trend worldwide in venture capital investments in early stage

ventures, but we don’t know the reasons behind it. Therefore, we need studies to
identify changes in the incentive systems and governance structures within the
venture capital industry that may explain the relative decline in investments in early
stage ventures.
● It could be argued that the financial needs of early stage ventures can be best
addressed by a combination of different financial sources – public funding, informal
investors and early stage venture capitalists – and we need research that addresses the
complementarities and synergies between different sources of early stage financing.
● There seem to be regional differences and different traditions between countries in
the finance of early stage ventures, and we need to explore how venture capital
could appear in different contexts.
● The greatest challenges for venture capitalists investing in early stage ventures are
cognitive in nature – the perception of risks and trying to make sense of the chaotic
environment surrounding new ventures. Therefore, research on early stage venture
capital benefits from borrowing from research fields such as human cognition and
information processing mechanisms.
The private equity and management buy-out market is discussed by Mike Wright
in Chapter 11, where he identifies some gaps in earlier knowledge related to (1) the
development of private equity and buy-out markets, and (2) the life-cycle of buy-outs:
The development of private equity and buy-out markets:
● Changes in deal characteristics over time, for example, comparative analyses of

different time periods.
● International aspects of private equity and MBOs, for example, the influence
of contextual factors in the growth of the market as well as focus on the inter-
nationalization of private equity firms.
● Source of MBOs – in this respect neglected areas of research are the linkage
between early stage venture capital funds and buy-out funds as well as buy-out
investments and the succession problems facing many family firms.
The buy-out life cycle:
● Organizational forms of financiers – private equity firms can take several organi-
zational forms, and we need more knowledge on how different organizational forms
impact on the buy-out life-cycle.
● The added value brought about by MBOs.
● Exiting MBOs, that is issues concerning the ability of private equity firms to realize
the gains from their investments.
Informal venture capital

Looking more closely at informal venture capital in Part III of the Handbook, Peter Kelly
highlights in Chapter 12 a number of issues that need to be tackled in business angel
research. According to Kelly, we need to know more about:
● The early funding gap, that is the gap between the funding achieved by the three Fs
(founder, family and friends) and business angel finance as well as the role and
impact of public sector funding instruments in this context.
● Following the Global Entrepreneurship Monitor research initiative, we need to
undertake business angel demographic studies beyond developed economies.
● The complementary nature of business angels and venture capital funds – are they
complementary, and if so, in what way?
● Latent angels – individuals who have not yet made their first investment – seem to
be an immense untapped potential in the informal venture capital market, and we
need to know how to encourage them into the market.
Kelly argues that researchers on the informal venture capital market need to broaden
their theoretical frameworks and include fields such as psychology and sociology, and
highlights some methodological issues for future research.
In Chapter 13, Allan Riding, Judith Madill and George Haines provide a review and syn-
thesis of our knowledge regarding the decision-making process employed by business
angels when making investments in new proposals – a central and long-standing theme of
interest for researchers on informal venture capital. The authors suggest that:
● We still do not possess a comprehensive model of how business angels make their
investments – the investment process.
● We need to know more about how decision criteria used by business angels can
change as the investment process unwinds.
● Business angels are actively involved in the firms in which they invest, and we need
to know more about the relationship between the investment process and post-
investment involvement.
● Business angels are usually not the only financier of a new venture – it is a mix of
business angels, founders, banks, government money and even institutional venture
capitalists – and we need to know more about how different financiers of new
ventures interact.
Riding, Madill and Haines also address some methodological issues of research on
informal venture capital, and they argue that we need: (1) more theoretically based
studies (not least when it comes to modelling the investment decision process); (2) more
demand side research (seen from the entrepreneur’s perspective); and (3) in order to sort
out the definitional problems that exist in informal venture capital research, we need to
decompose the informal venture capital market into relevant segments, and by elaborat-
ing on these segments contribute to the understanding of how different types of infor-
mal investors differ in significant ways, including how they make their investment
decisions.
Jeffrey Sohl focused his chapter (Chapter 14) on a special feature of the business angel
investment process – business angel portals – that are introduced in order to enhance the
efficiency of quality deal flow and increase the availability of capital. Business angel
portals have received considerable attention in previous research, but Sohl argues that
many facets of angel portals remain misunderstood and thus require further research, for
which he makes the following suggestions:
● It is important to understand why some angel portals may be appropriate for certain
regions and not for others as well as the role of angel portals in regional economic
development.
● The relationship between angel portals and institutional venture capitalists – are
there market complementarities or not?
In common with Riding, Madill and Haines in the previous chapter, Sohl suggests
longitudinal methodological approaches in order to track changes in various portals
over time. As seems to be the case for business angel research in general, Sohl advocates
more theoretically based research on business angel portals and suggests that theories
such as the effectiveness of group structures, the interplay of group dynamics,
social capital and social networks could provide an interesting basis for such theoreti-
cal development.
Corporate venture capital

Part IV of the book concerns the corporate venture capital market, and in Chapter 15
Markku Maula demonstrates that both the research and the practice of corporate venture
capital have become increasingly sophisticated and that earlier research has answered
many previously puzzling questions. However, several avenues for further research
remain, and Maula emphasizes that the following issues need to be addressed:
● Analysis of benefits over costs under different circumstances, such as various firm
and industry level determinants and different corporate venture capital strategies.
● The impact of corporate venture capital on the performance of corporations.
● The management of corporate venture capital operations, including investment
processes, the use of corporate resources to facilitate corporate venture capital
activity, knowledge integration from corporate venture capital investments, and
internal performance measurement.
However, as shown by Shaker Zahra and Stephen Allen in Chapter 16, research on
corporate venture capital that adopts the entrepreneur’s perspective has been sparse and
fragmented, and the authors highlight the need for better theory development and
testing within the area, that is theory building and testing could substitute for individ-
ual case studies in order to provide reliable generalizations that can guide effective
managerial practice. Furthermore, the authors suggest the following topics for future
research:
● New ventures’ selection of corporate venture capital partners and due diligence by
new venture managers in order to gather and assess information about potential
corporate venture capital partners.
● Legal and relational ways in which new ventures can curb the opportunities of their
corporate venture capital partners.
● The influence of corporate venture capital partners’ knowledge and capabilities on
the new ventures’ learning.
● The relationship between corporate venture capital investors and new ventures.
What advice can be given to practitioners and policy-makers?
Implications for policy-makers

Venture capital has been regarded as an influential factor in the creation of new firms and
dynamics in the economy. This positive view has prompted governments around the world
to see venture capital as an essential ingredient in their policies to facilitate entrepreneur-
ship, innovation, employment and economic growth. This interest in venture capital has
not least been shown in lagging regions where venture capital has been seen as a measure
to change the prevailing situation into something positive – increasing growth and wealth
in the region. However, as argued by Mason in Chapter 3, the mere availability of venture
capital is not the solution, more needs to be done, for example:
● Venture capital must be combined with talented individuals and role models.
● Providing capital is not the only role of venture capitalists, and thus creating
venture capital funds staffed by managers who lack the value-added skills of
venture capitalists will be ineffective.
● Trying to artificially create a regional pool of venture capital is likely to be unsuc-
cessful – venture capital is only attracted to places with novel ideas and talented
individuals – thus policy-makers should concentrate on developing their region’s
technology base, encourage venture creation and growth and enhance the business
support infrastructure.
Murray devotes the whole of Chapter 4 to venture capital policy issues, and policy-
makers can learn a great deal from it. In order to conclude the chapter, Murray argues
that despite the enormous growth in the amount of venture capital in many countries
in recent decades, we cannot find the same level of success in public involvement in
new venture financing. However, we have to remind ourselves that governments do not
face an easy or unambiguous task: governments have to determine if they wish to inter-
vene in order to correct market imperfections or realign incentives in a manner congru-
ent with their policy goals; and government is usually involved in the least attractive areas
of a financial market – the public becomes involved due to the absence of private
investors. In addition, we still lack knowledge as to the appropriate role of government in
venture capital activity, both in terms of theoretical understanding and the diversity of
exemplar programs from which to benchmark progress. However, there seems to be
growing academic consensus that sanctioning government intervention is a decision
that should be taken with considerable caution and perhaps only when private venture
capital markets are obviously failing. Murray provides some guidelines that policy-
makers may consider:
● Institutional or informal venture capital programs should harness private investors’

interests and experience as agents of government program goals.
● There are trade-offs between venture capital and business angel program outcomes.
Policy makers should be explicit as to the ‘value’ of different objectives when both
launching and evaluating programs.
● There are major economies of scale and scope in venture capital fund activities.
● The level of unmanageable uncertainty in the very early stages of venture develop-
ment may be such that it may not be sensible to allocate resources by market alone –
venture capital should be seen as only one of a range of financing options.
● The premium for managerial and investor experience is high – program designers
need to reflect on how such tacit knowledge may be best harnessed to address
the challenges of early-stage investments.
● All new venture capital programs involving public funds should have a formal
evaluation model built into the program at the design stage.
● The US provides a role model for venture capital worldwide. Much of the stock of
knowledge in the US may be valid and relevant outside North America, although
certain aspects will not be usable in other contexts. It is implausible that a global
venture capital industry will, over time, be dependent on one absolute and exclusive
model of success.
Elaborating on Murray’s comment about the US venture capital market as a role

model, Leleux showed in Chapter 9 that the European venture capital market experienced
a serious decrease in the rate of returns in the mid-2000s – the average 10-year investment
horizon returns for early stage investments became negative on a per annum basis,
and the performance of all venture capital classes was an unimpressive 5.3 per cent.
A comparison with US venture capital market data revealed that the differences between
European and US performance figures in terms of early-stage deals were the largest
reported in the last 20 years, indicating that the US and European venture capital markets
are at very different stages of development.
It is often assumed that institutional venture capital is an important contributor to the

advancement of innovation and the emergence of new industries. The assumption is that
venture capital is intimately involved in the development of entirely new industries –
without venture capital investments these industries would not have been developed.
However, in Chapter 8 Busenitz states that we still know very little about the impact of
institutional venture capital in this respect, and he argues that, although there is evidence
that venture capitalists invest in technology-based ventures that pursue an innovative
strategy, it does not mean that they prefer to back the exploration of new technologies.
On the contrary, most venture capitalists tend to become involved in later stages of devel-
opment where capital requirements are larger and the distance to exit and pay-off is
shorter. Especially, venture capitalists seem to be particularly helpful in the transition
from the exploration of new technologies to their commercialization on the market. Thus,
evidence suggests that venture capitalists seem to be reluctant to become involved in
funding new ventures that are not part of an industry that is perceived to be developing,
and in that respect, one can question the view of venture capitalists as drivers, or creators,
of entirely new industries – indeed, this rarely seems to be the case. It would be more accu-
rate to say that venture capitalists help to finance newer industries that are on the rise and
show some growth rate.
In Part III (Chapters 12 to 14) we discussed the informal venture capital market. From
the survey it was evident that the informal venture capital market is fraught with
inefficiencies, causing two kinds of capital gaps (Sohl, 2003): (1) primary seed gap, that is
the difficulty in finding business angels and the lack of ‘investor ready’ quality deals in
very early stages of development; and (2) secondary post-seed gap, that is due to the fact
that the institutional venture capital industry migrates to later stage and larger sized deals,
there is a gap between business angels and the institutional venture industry for ventures
in the early stages of growth. However, Sohl (ibid.) indicates that business angels are
increasing their investments in this secondary post-seed gap, redistributing the risk capital
that exacerbates the primary seed capital.
Sohl argues in Chapter 14 that policy can play a role in enhancing the flow of early stage
equity capital and contribute to establishing a more efficient market. In particular, Sohl offers
the following recommendations for policy-makers in the field of informal venture capital:
1. Public policy can play a role in fostering and nurturing the links between innovators,
entrepreneurs and business angels.
2. Support research in order to increase understanding of the informal venture capital
market.
3. Develop educational programmes targeting the supply (latent and existing business
angels) as well as the demand (entrepreneurs) side.
4. Public policy monetary incentives should focus on enhancing the flow of early stage
equity capital to entrepreneurial ventures.
More specifically, looking at the lack of efficiency in the informal venture capital
market, different kinds of business angel portals have been established since the mid-
1980s. A business angel portal is ‘an organization that provides a structure and approach
for bringing together entrepreneurs seeking capital and business angels searching for
investment opportunities. The primary goal of angel portals is to increase the efficiency
in the early stage market’ (Sohl, Chapter 14, p. 348). Lessons that can be learned from
early attempts to develop business angel portals are that they have been important in
increasing the awareness of angel investing and the role played by business angels in the
early stage financing of entrepreneurial ventures. But, on the other hand, in many cases
early business angel portals have experienced difficulties in (1) finding a sufficient number
of investors to join the networks; (2) identifying high quality deals (‘investment ready’
deals); (3) finding funding for the operation for the portal; and (4) an inability to create
sufficient awareness of the existence and value of the networks.
Adapting to changing market conditions and experiences from earlier attempts to
increase the efficiency of the market have led the informal venture capital market to
assume several organizational structures, and in his chapter Sohl examined six types of
business angel portal: matching networks, facilitators, informal angel groups, formal
angel alliances, electronic networks and individual angels. According to Sohl, these angel
portals should adopt some basic features:
● Angel portals should maintain an informal structure, be based on a regional model,

provide a face-to-face interaction between business angels and entrepreneurs and
strive to provide a quality deal flow for their members.
● The three portal types ‘informal angel groups’, ‘individual angels’, and ‘matching
networks’ are best suited to investing in the primary seed gap, whereas the ‘formal
angel alliances’ and to some extent the ‘matching network’, are best positioned for
investment in the secondary post-seed gap.
● Portals must remember that they are collections of business angels who make an
individual investment decision and not institutional venture capitalists who manage
a pool of capital.
Implications for venture capitalists and entrepreneurs

Several chapters in the handbook focus on the relationship between the entrepreneur
and institutional venture capitalist. In particular, there is an interest in understanding how
value-adding is created in the relationship. In Chapter 7 for example, De Clercq and
Manigart try to open the ‘black box’ in order to understand the creation of value-added
in the entrepreneur–venture capitalist relationship. In their chapter they emphasize the
role of knowledge and learning, and their conclusions are:
● Venture capitalists’ specialization in terms of the industry and development stage

has a positive effect on the performance of portfolio firms.
● Knowledge exchange between venture capitalists plays an important role in generat-
ing positive investment outcomes, including (1) the aggregated knowledge held by the
individual venture capitalists in one and the same venture capital firm as well as (2)
the knowledge exchange that takes place within venture capital investment syndicates.
● Knowledge exchange between the venture capitalist and entrepreneur indicates
that the potential outcomes from this relationship may be highest when the two parties
hold complementary knowledge that enhances each other’s expertise and skills.
However, it is necessary for the two parties to establish effective knowledge sharing
routines – both in the form of formal (for example board of directors) and informal
(for example by means of the telephone and personal meetings) communication.
In addition, value-adding is a process-related issue, and De Clercq and Manigart

recognize the importance of establishing strong social relationships between the venture
capitalist and entrepreneur:
● There seems to be a positive relationship between venture capitalists’ trust in their

portfolio firms and their perception of the firms’ performance, but too much trust
may potentially have a negative effect on performance.
● In addition, the level of goal congruence between the partners is an important
aspect of the value-adding process, while the commitment of venture capital-
ist and entrepreneur to their mutual relationship may increase the value that is
created.
● Research suggests that process-related issues, such as trust and commitment, may
facilitate venture capitalists’ ability to add value to their portfolio firms, that is good
relationships may lead to more specific insights into how an investment can be opti-
mized and therefore enhance the potential to add value.
Over the years a great deal of research has investigated the key drivers of performance
in venture capital-backed deals. The results are mixed and it is difficult to find consensus
regarding venture capitalists’ value-adding activities and their effect on venture perform-
ance. However, both Leleux in Chapter 9 and Parhankangas in Chapter 10 review
earlier findings of factors that seem to influence venture performance, and following
the reasoning of Leleux we can divide the key drivers of performance into three
categories: (1) venture capital-controlled investment factors; (2) environmental factors;
and (3) decision-making processes (see Figure 17.1).
In Part IV of the handbook we turn our attention to corporate venture capital. In
Chapter 16 Zahra and Allen argue that entrepreneurs and their new ventures could gain
Venture capital-controlled investment factors

– larger funds (up to a point)
– high quality deal flow and syndication deals
– control mechanisms
– specialization strategy
– earlier performance of venture capital fund
– timing and duration of investment
– reputation of fund and general partners
– value-added services
– multistage investment PERFORMANCE
Environmental factors
– availability and status of public markets for IPOs
– overall economic cycle
– tax, regulatory and legal environment
– availability of investors
Venture capitalist decision-making processes
– the screening, evaluation and selection of new
venture investments
Figure 17.1 Key drivers of performance in venture capital-backed ventures

a great deal from an investment by a corporate venture capital provider. Such an invest-
ment offers opportunities for the new venture to collaborate and acquire new skills and
capabilities. Corporate venture capital partners seem to have important implications for
new ventures’ knowledge acquisition and learning, but in order to achieve a ‘win–win’
partnership the authors highlight the fact that the congruence of new ventures’ and
incumbents’ goals are of crucial importance. The entrepreneur can take several actions to
improve the gain from corporate venture capital, for example:
● Due diligence in selecting corporate venture capital partners (and probe their
motives, goals, track records, personnel and overall credibility),
● the entrepreneur also needs to communicate the goals of the ventures clearly to
potential corporate venture capital investors, and
● as goals and motives change over time, the entrepreneurs need to reassess their goals
and those of their corporate venture capital partners frequently in order to ensure
an effective fit.
References
Ghosal, S. (2005), ‘Bad management theories are destroying good management practices’, Academy of
Management Learning & Education, 4(1), 75–91.
Van de Ven, A.H. and P.E. Johnson (2006), ‘Knowledge for theory and practice’, Academy of Management
Review, 31(4), 802–21.
Index
ABC – study of angels (attitudes, behaviors, facilitators 355, 357–8

characteristics) 52–3, 315, 316 formal angel alliance 355, 359–60
absorptive capacity 403 individual angels 355, 361
Access to Capital for Entrepreneurs Act 2006 informal angel groups 355, 358–9
138 matching networks 355–7
accounting measures of financial performance Apple Computer 47, 71, 167
230, 232 Archimedes Fund 364–5
added value 18, 240 Argentina 323
activities heterogeneity 212 Arthurs, J.D. 80
early stage venture capital 265–7, 270 Asia 14–15, 16
innovation and performance implications early stage venture capital 254, 270
219 government policy 139, 144
post-investment phase 193–4 informal venture capital market 352
private equity and management buy-outs post-investment phase 197, 201
300–304, 307–8 private equity and management buy-outs
service 171–2 281
adverse selection 196–7 structure of venture capital funds 160
corporate venture capital 386, 401 see also Asia-Pacific
early stage venture capital 262, 263 Asia-Pacific 157, 158, 159, 172, 173
innovation and performance implications Asquith, P. 295, 302
221 asset-based financing 298
private equity and management buy-outs attribution bias 264
296 Audretsch, D.B. 120
Africa 281 Auerswald, P.E. 115, 121
agency risks 258, 260 Australia 14, 352–3
agency theory 72–3, 80, 199, 206–7, 321–2 Aussie Opportunities 360
business angels and investment decision business angels 316, 318
making 333, 337, 340 Business Angels Party 356
corporate venture capital 401 early stage venture capital 261
early stage venture capital 272 Enterprise Angels 352–3
innovation and performance implications Founders Forum 352, 358
221 government policy 130, 132
performance of investments 239 Industry Research and Development Board
post-investment phase 209 167
private equity and management buy-outs Innovation Investment Fund Programme
306 133, 166, 167–8
Ajzen, I. 335 Pre-seed Fund 134
Allen, S. 62, 393–410, 421 Private Equity and Entrepreneur Exchange
alternative assets portfolio 250 360
altruistic motivation 318 Austria 226, 261, 290, 293
Alvarez, S.A. 401, 402 Avdeitchikova, S. 91
Amatucci, F.M. 333, 335
Amazon 188 Balkin, D.B. 223
American Research and Development 11, 34, Banatao, D.P. 98
71, 156 bank venture capital funds 164–5
Amess, K. 302 Bannock Consulting Ltd 374
Amit, R. 119, 257–8, 356 Barney, J. 188, 401, 402
angel portals 139–40, 353–61 Baron, R. 185, 188
electronic networks 355, 360–61 Barr, P. 184
427
Belgium 13, 16, 137, 261, 290, 293 business associate referrals 336
Benjamin, G. 318 business culture 174, 417
Berg, A. 307 Business Development Bank 103
Bhide, A. 80 business introduction services 54
biases 185, 186–8, 189 business volume measures 230–31
attribution 264 buy-back options 132
mental model 186 buy-in/management buy-outs (BIMBOs) 283
BIC economies 116 buy-ins 290, 291, 299–301
biotech industry 396, 400, 401, 402 buy-outs:
Birch, D.J. 3 worldwide 292
Birkinshaw, J. 237, 381, 385 see also leveraged buy-outs; management
Birley, S. 263, 267 buy-outs
birth of venture capital 10–11 Bygrave, W. 6–7, 15, 31–6, 78, 121, 135, 323,
Black, B. 14, 166, 172, 241 332
board of directors 18, 197, 221–2, 405 early stage venture capital 254, 264
Bottazzi, L. 259–60 innovation and performance implications
bounded rationality 221 226, 227
Branscomb, L.M. 115, 121
Brazil 114, 323, 371 Cable, D. 69, 79, 81, 198
Bruining, H. 301 Canada:
Bruno, A. 15, 21–3, 27, 177, 179, 253–4 business angels 316, 318, 319, 327, 333, 337,
Bruton, G. 304 338
Bürgel, O. 114–15, 120 early stage venture capital 261
Busenitz, L. 60, 73, 80, 185, 188, 219–34, 267, geographical perspective 87, 88, 90, 91, 93,
418, 423 95, 96
business angels 9, 52, 55–8, 59, 71, 315–29 government policy 137
agency theory 321–2 informal venture capital market 349
attitudes, behaviours and characteristics Labor-Sponsored Venture Capital
317–19 Corporation (LSVCC) 93, 130, 168
conceptual and theoretical reflections 73, 74, Opportunities Investment Network (COIN)
77, 80, 82 349
decision-making process 319 structure of venture capital funds 165
demographic research 323 Venture Capital Association 103
early stage venture capital 256, 257 see also Ottawa
experience 325–6 Capital Alliances 103
FFFs (family, friends and fools) 323 capital gains tax 12, 36
funds 360 government policy 137
geographical perspective 86, 89, 90–91, 92, performance of investments 242
104, 106 structure of venture capital funds 166
government policy 135, 144 capped return for public investors 133
individual 355, 361, 362, 424 capped returns to the state 132
informal venture capital market 347, 353–4 captive venture capitalists 6, 7, 92, 161, 164–5,
location 87–8 169
market scale 317 Celtic House 97, 103, 104
methodological approaches 327–8 Center for Research in Securities Prices 19, 315
networks 54, 125, 141, 317, 336 Center for Venture Research 348
post-investment phase 214 Central and Eastern Europe 144, 281, 284–6
public financiers 324 certification 136, 224–5
public policy 320 Chandler, G.N. 230, 233
signaling theory 322–3 chemicals industry 396, 398
social capital 322 chief executive officers 201, 221–2, 295, 301, 303
venture capital funds 67, 324–5 Chile: CORFU 133
see also angel portals; formal angel alliance; China 14, 114, 174, 261
informal venture capital; investment corporate venture capital 371
decision making; ‘virgin angels’ pre-investment process 182–3
Index 429
private equity and management buy-outs entrepreneurial firms’ perspective

281 400–402
Cisco Systems 102 importance and growth 396–7
classical venture capital funds 6, 7, 254 objectives, focus and contribution 393–6
see also institutional venture capital proactive relationship management 405–6
Cochrane, J. 245 strategic benefits 402–3
cognitive dimensions 207, 322 corporate venture capital as strategic tool
cognitive processes 272, 273–4 371–89
co-investing 18 cyclical history 378
Compaq 377 definition 372–3
compensation 222–3, 265 industry and firm level drivers of investment
complementarity 325 378–80
complementary technologies 398 learning motives 375–6
Compton, C. 11 option building motives 376–7
computer industry 43 performance 382–6
conceptual and theoretical reflections 66–84 resource leveraging motives 377–8
dominant focuses 72–3 co-specialization perspective 393
early contributions 68–9 Cotter, J.F. 298
‘engaged scholar’ view 75–8 covenants:
entrepreneurship literature 66, 73–5 contractual 265
expansion along several dimensions governing venture capital limited
69–72 partnerships 163–4
conflict 267, 398 negotiation 162
conjoint analysis 71, 178–9, 180–81, 183, 187, Coveney, P. 88, 318
243 cross-national variations 260, 262
consummation 334, 339–41, 343 cultural factors 269
content-related issues 181–3, 193–4, 203–6, Cumming, D. 60, 155–74, 267, 303, 417
213
contingent pay 222–3 DalCin, P. 333, 335, 336, 340, 341
contingent valuation techniques 248–9 De Clercq, D. 60, 193–214, 233, 240, 268,
contract repudiation 259 417–18, 424–5
contracting 18, 404 De Noble, A.F. 336
contractual covenants 265 deal/deals:
control mechanisms 238–9 appraisal 262–4
convertible securities 197 characteristics, changes in over time 305
Cook, D.O. 295 evaluation 98–9, 177
Cornelius, B. 19–20 flows 98, 177, 237–8, 353
Corporate Executive Board 381 generation 262, 269, 292–6
corporate governance 303 -makers 325
corporate law variations 270 opportunities 284
corporate venture capital 6, 7–8, 9–10, 43–51, origination 177, 336
67, 165 resurgence 289
external 7, 372, 373 screening 177, 269
fund 159 sourcing 335–6
history and research 43–4 structure 177, 339–41
internal 7, 372 DeAngelo, L. 295, 298
Rind, K. 44–51 decision:
see also corporate venture capital from accuracy 189
entrepreneurs’ perspective; corporate aids 244, 264
venture capital as strategic tool criteria 181, 183
corporate venture capital from entrepreneurs’ -making:
perspective 393–410 criteria 24–5
board membership 405 expert 184
contracting 404 process 127, 243–4, 319, 425
corporate investor perspectives 397–400 see also investment decision-making
-policies see pre-investment process: decision major risks 257–8

policies monitoring and adding value 265–7
definition of venture capital 5–10 recent trends 258
corporate venture capital 7–8, 9–10 structuring of investments and investment
informal venture capital 8–10 portfolios 264–5
institutional venture capital 5–7, 9–10 theoretical and methodological
Dell 377 considerations 272–3
Deltaray Corporation 34 EASDAQ 13
demand 256 economic cycle, overall 242
enhanced 374, 398 educational capability 182
for private equity 285 educational programs 364
-side factors 100, 127, 284, 341 educational seminars 356–7
demographic research 323 Einhorn, H. 189
Denmark 261, 290, 293, 350–51 Eisenhardt, K. 185
Business Development Finance 129 electronic networks 355, 360–61
Business Innovation Center 351 electronic sector 43
Business Introduction Service 351 Elitzur, R. 340
Loan Guarantee Scheme 134 emerging fund structures 417
National Agency of Industry and Trade emerging technologies 398
351 Employee Share Ownership Plans 302
Department of Labor 12 Employers’ Retirement Investment Security
Desbrierers, P. 301 Act (ERISA) 12
development of industries 19 ‘Prudent Man Rule’ 12
DeVol, R.C. 102 endowments 160, 268
Dibben, M. 338 ‘engaged scholar’ view 68, 75–8, 82
Digital Equipment Company 11 ‘positive organizational scholarship’ view
Diller, C. 268 78–81
Dimov, D.P. 122, 141, 233, 260, 268 Engel, D. 238, 239
direct public involvement 129–30 entrepreneur 179, 212
disruptive technologies 398 as agent 196–8
Dolvin, S. 224 early stage venture capital 262, 264, 267
Doriot, G. 11, 34, 179 innovation and performance implications
dot.com boom and bust 15, 114, 186, 188, 289, 221
360, 443 perceived impact 399
downside protection 133–4 practice, policy-making and research
Draper, Gaither and Andersen 11 implications 424–6
due diligence 177–8 /venture capital evaluations 231
business angels and investment decision entrepreneurial activity, growing status of
making 336–7, 339 126–7
corporate venture capital 401 entrepreneurial knowledge sharing 326
early stage venture capital 263 entrepreneurial team quality 263
informal venture capital market 366 entrepreneurship 66
DuPont 43 conceptual and theoretical reflections
Dushnitsky, G. 378–9, 382, 385, 393 74–5
Duxbury, L. 333, 339 literature 73–5
scholars 272–3
early stage venture capital 253–74 environmental factors 241–3, 425
characteristics 258–60 equity 298
classification based on development stage enhancement schemes 131, 133–4
255–7 gap 86, 117–18, 140
deals, appraisal of 262–4 programs 125
exit strategies and performance 267–8 ratchets 300–301
fund raising 260–62 see also private equity
institutional context and management Ernst, H. 385
269–71 Ettenson, R. 69–70
Index 431
Europe 6, 7, 10–11, 13–14, 15, 16, 25, 40 FFFs (family, friends and fools) 9, 52, 53, 257,
Angel Academies 364 306, 323, 328, 329, 342
business angels 315, 324 Fiet, J. 74, 264, 321, 339
corporate venture capital 372, 374, 381 financial considerations 179
early stage venture capital 254, 258, 259–60, financial goals 374
267, 269 financial institutions and investment 14
geographical perspective 93–4 financial intermediator, venture capital as
government policy 114, 116, 121–2, 126–8, 19
133, 135, 139, 141, 144 financial motivation 318
informal venture capital market 357 financial objectives 375
performance of investments 238–9, 240, 242, financial returns (direct and indirect)
243, 245, 246 172–3
post-investment phase 197, 198, 201 Finland 91, 261, 290, 293, 351
private equity and management buy-outs business angels 316, 318, 324
281, 282, 287, 289–92, 298, 300 INTRO Venture Forums 351
Seed Capital Scheme 134 Investment Industry program 129
structure of venture capital funds 157, 158, Matching-Palvelu 351, 353, 354
159, 160, 166, 172, 173 Sitra PreSeed Finance 351
Young Innovative Company Scheme 138 first resort investors 135
see also Central and Eastern Europe first stage financing 255, 256, 257
European Investment Bank 134 Fishbein, M. 335
European Investment Fund 133, 135 fixed management fee 162
European Private Equity and Venture Flanders, R. 11
Capital Association (EVCA) 248, 250, Fleming, G. 60, 155–74, 268, 417
381 Florida, R. 97, 101, 108
evaluation: flow of venture capital 19
business angels and investment decision Flynn, D.M. 266
making 339 Fong, K.A. 98
criteria 269–70 Ford, H. 315
early stage venture capital 262 formal angel alliance 355, 359–60, 362, 424
of proposal 334, 343 formal networks 264
strategy (mental model) 184–5 formal venture capital 87, 325
exit 334, 343 see also institutional venture capital
events 342 France 13
private equity and management buy-outs early stage venture capital 261, 270
304, 308 Fund for the Promotion of Venture Capital
routes 284 (FPCR) 134
strategies 267–8, 270 geographical perspective 94
timing of 270 government policy 137
expected rates of return 342 Jeune Entreprise Innovante 138
experience 179, 182, 189, 203–4, 262, 268, Nouveau Marché 13, 289
325–6 post-investment phase 201
expert decision-making model 184 private equity and management buy-outs
exploitation 225–7, 398–9, 400 290, 291, 292, 293, 301
exploration 225–7, 398–9 Second Marché 289
exposure 162, 398 SOFARIS 133–4
Freear, J. 77, 91, 318
facilitators 355, 357–8 Fried, V.H. 273
Fair Market Value 248 front end incentives 137
Farrell, A.E. 342 Fulghieri, P. 170
Federal Express 167 fund:
Federal Reserve 51 -level perspective 236, 244–5
Bank of Boston 11 -of-funds 173
Feeney, L. 339 operating costs 134
female entrepreneurs 322, 323 performance 270–71
raising 260–62 Gompers, P. 121, 189, 332, 342, 405

reputation 240 performance of investments 238, 239, 241,
returns 232 242, 243
size 123–4, 260, 268 structure of venture capital funds 160, 162,
‘funds of funds’ 134–5 163, 170, 171, 172
Google 23, 188
gains, realization of 286 Gorman, M. 39, 177, 254
game theory 207 Gottschalg, O. 239, 242, 245
Gaston, R. 88, 318 governance 18, 220–22
‘gatekeepers’ see investment advisors government:
Gavious, A. 340 investment schemes 166
Genentech 71 sponsored fund 161
General Electric 43 venture capital funds 165–9
General Motors 43, 47 venture capital organizations 6
general partners 92, 169, 170 see also government policy
experience 239 government policy 113–46
reputation 240 ‘equity gap’, longevity of 117–18
geographical perspective 23, 86–109, 265, fund size, insufficient 123–4
268 information asymmetries 119–20
informal venture capital market 87–92 market failure 116–17, 118
policy implications 108–9 minimum fund scale 121–3
see also institutional venture capital: performance of investments 243
geographical analysis; public involvement in private venture capital
internationalization 141–3
George, G. 403 R&D spillovers 120
Germany 13, 14, 353 United States exemplar, influence of 121
BTU program 138 see also informal investors (business angels);
Business Angel Network Deutschland institutional venture capital
(BAND) 353 grandstanding 170, 172, 189, 199, 239
business angels 316, 318, 338 Greece 261
corporate venture capital 385, 387 Grilichese, Z. 120
early stage venture capital 261 growth markets, high 263
Euregional Business Angel Network 356 guaranteed underwriting of investment losses
geographical perspective 87, 94, 96, 97, incurred by limited partners 132
101 Gulliford, J. 91
government policy 114–15, 120, 130 gut feeling (intuition) 180, 189, 264, 337
innovation and performance implications
226 Haines, G. Jr 61, 332–45, 419–20
Neuer Markt 13 Hall, J. 179
private equity and management buy-outs Halpern, P. 295
284–6, 289, 290, 291, 292, 293 Hand, J. 244
structure of venture capital funds 160, 162, hands-on investors 200
171 Hanks, S. 230, 233
Ghoshal, S. 68, 75, 78–80, 415 Harris, R. 302
Gifford, S. 69, 139, 211 Harrison, R. 5–6, 8–9, 16, 54, 89, 91–2, 136
Gilson, R.J. 14, 121, 139, 142, 166, 172, 241 business angels 317, 319, 320, 322
Gladwell, M. 328 investment decisions by business angels 336,
Global Entrepreneurship Monitor 9, 135, 323 337–8, 339, 340, 341, 342
globalization 23 Hatch, J.E. 340
Glofson, C. 16 Hatherly, D. 301
goal 256 Hatton, L. 243
congruence 207, 209–10, 401 Hauser, H. 97
financial 374 Hay, M. 318, 321, 340–41
incongruence 196, 214 hedge funds 307
strategic 374 Hege, U. 172, 238, 240, 270
Index 433
Hellmann, T. 172, 399 informal networks 264

Henderson, J. 381, 399, 402 informal venture capital 8–10, 51–62, 325
herding phenomenon 186 ABC of angels 52–3
heuristics 185–6, 188, 189, 190 geographical perspective 86–7
representative 186, 264 market scale 52
satisficing 186, 190, 264 policies and information networks 53–4
Hewlett Packard 381 Wetzel, W. 54–9
hidden action 257 see also informal venture capital market
hidden information 257 informal venture capital market 87–92, 347–67
Higashide, H. 267 Australia 352–3
High Voltage Engineering Corporation 11, 34 business angels, location of 87–8
highly innovative technological ventures 31, 33 Canada 349
Hill, C. 302–3 Denmark 350–51
Hill, S. 237, 385 early business angel network 353–4
Hisrich, R.D. 273 Finland 351
Hitt, M. 307 Germany 353
Hochberg, Y. 237 location, role of in investment decision 89
Hofer, C. 179 locational preferences 88–9
Holthausen, D. 304 locations of actual investments 89–92
Hong Kong 14 policy implications 363–5
Houghton, S. 189 Singapore 352
Hsu, D.H. 200 Sweden 350
Hunt, S. 332 United Kingdom 349–50
Hurry, D. 204 United States 348–9
Hussayni, H.Y. 16 see also angel portals
hybrid venture capital 144 information:
asymmetry 119–20, 139–40, 195–200
IBM (International Business Machines) 11, 38, business angels and investment decision
47, 377 making 341
importance of venture capital 3 early stage venture capital 257, 260, 262,
inactive investors 200 264, 265, 269, 272
independent funds 159 innovation and performance implications
independent limited partnership 6 221
independent venture capital firm 161 performance of investments 242
India 14, 269, 371 post-investment phase 199, 209
indirect intervention 128–31 private equity and management buy-outs
industry: 296–7, 306
diversity 265 networks 53–4
level evidence 245–6 processing 183–5, 273–4
performance and correlation with other technology 396, 401, 402
asset classes 250 infrastructure to complete deals 284, 285–6
infant industry argument 131 initial market development 288
informal angel groups 355, 358–9, 362, 424 initial public offerings 13, 14, 40, 43, 50
informal investors (business angels) 9, corporate venture capital 402
135–41 early stage venture capital 270
business angels as policy focus 136 geographical perspective 104
early stage venture capital 257 innovation and performance implications
first resort investors 135 224, 233
institutional investors, complement to 135–6 performance of investments 249
networks, portals, match-makers and post-investment phase 199
information asymmetries 139–40 private equity and management buy-outs
targeting business angels as co-investors 304, 306
138–9 public markets 241
targeting business angels as individuals structure of venture capital funds 166,
136–8 172
innovation and performance implications negotiation, consummation and deal

219–34 structure 339–41 post-investment
accounting measures of performance 230 involvement 341–3
compensation 222–3 decisions 170
exploration and exploitation 225–7 durations 239–40
governance 220–22 portfolios 265–6
new industries 227–9 readiness arguments 140
reputation and certification 224–5 regulations 125
subjective measures of performance 230, risks in new technology-based firms 119
233 strategies 18
venture outcomes as measure of types 171–2
performance 233 investment factors, venture capital-controlled
institutional venture capital 5–7, 9–10, 16–42, 237–41, 425
212, 214, 272 investor:
Bygrave, W. on 31–6 availability 243
conceptual and theoretical reflections 74 -led buy-outs (IBOs) 283
early contributions 16–17 membership 353
early stage venture capital 269–71 tax benefits 137
geographical analysis 92–105 Ireland 137, 261, 290, 293
definitions 92–3 Israel 44, 48
demand-side factors 100 early stage venture capital 269
geographical concentration of investments Nitzanim-AVX/Kyocera Venture Fund
95–9 48
location factor, venture capital as structure of venture capital funds 160,
99–100 171
location of investments 93–5 Yozma program 132, 133, 166
long distance investing 100–101 Italy 174, 261, 290, 291, 292, 293
geographical perspective 86
government policy 124–35 Japan 14, 44, 48
direct public involvement 129–30 business angels 316, 318
entrepreneurial activity, growing status of early stage venture capital 261
126–7 International Angel Investors 357
‘equity enhancement’ schemes 133–4 Nippon Angels Forum 359
‘funds of funds’ 134–5 post-investment phase 204
indirect or ‘hybrid’ public/private models private equity and management buy-outs
130–31 281, 284–6, 292
intervention typologies 128–9 structure of venture capital funds 160, 162,
public-funded incentives in hybrid funds 171
131–4 JDS-Uniphase 102, 104, 105
Intel 167, 377, 381 Jeng, L. 142, 160, 241, 242, 243
Capital 371, 376, 380 Jensen, M.C. 287, 294
internal rate of return 122, 132, 249–50, Johnson, P.E. 75–8, 415
263 Johnstone, H. 88
internationalization 173, 305–6, 417 Jungwirth, C. 226
Internet investing 97
intuition see gut feeling Kandel, G. 170
investment: Kann, A. 374, 398, 400
advisors 12 Kanniainen, V. 170
‘bubble’ 95 Kaplan, S. 197, 270
decision-making by business angels performance of investments 239, 240, 241,
332–45 245
deal sourcing and initial screening private equity and management buy-outs
335–6 295, 297, 298, 300, 302, 303
decision criteria 337–9 Kaserer, C. 268
due diligence 336–7 Katis, N. 404
Index 435
Keeley, R.H. 177 limited partnerships 92, 160–65, 170, 173

Keil, T. 80, 372, 374, 381, 383, 385 early stage venture capital 269
Keilbach, M. 120 independent 6
Kelly, P. 61, 135, 136, 315–29, 340–41, 419 structure of venture capital funds 169
Kenney, M. 101, 108, 227 venture capital limited partnerships
Keuschnigg, C. 170 Linux 377
Kieschnick, R. 295 Lisbon Agenda 116
Kleiner Perkins 35 listed closed-end funds 156
Knigge, A. 303 listed venture capital funds 173–4
knowledge: ‘living dead’ 233
-based industries and market failure 118 Ljungqvist, A. 242, 245
-based view 394 local area networking 227
conversion capability 403 localized nature of investing 97–8
economy 118 location factor, venture capital as 99–100
exchange 204–6 location of investments 93–5
implicit, tacit 239 location, role of in investment decision
inflows 403 89
spillovers 107 locational preferences 88–9
Korea 182, 281, 323, 387 locations of actual investments 89–92
Korsgaard, A.M. 267, 270 long distance investing 91–2, 100–101
Kotha, S. 385 longevity in private equity and management
buy-outs 304
Landström, H. 3–62, 91, 335, 341, 342, 415–26 long-run investment returns 122
business angels 318, 319, 321, 322 love money see FFFs
Larcker, D. 304 Lowenstein, L. 294–5
leadership experience 182 Lumme, A. 341
leadership potential 263
learning motives 375–6 McGrath, R. 30
learning new markets and technologies 374 MacIntosh, J.G. 267
least innovative technological ventures 31, 33 MacLean, J. 340
legal protections 271 MacMillan, I.C. 15, 26–31, 179, 254
Lehn, K. 295 Macmillan Report 117–18
Lei, D. 307 McNally, K. 7, 372, 373–4
Leleux, B. 60, 236–51, 381, 399, 402, 418, 422, macro perspective (industry level) 236
425 macroeconomic conditions 242
Lengyel, Z. 91 Madill, J. 61, 104, 332–45, 419–20
Lenox, M.J. 378–9, 382, 385 Malaysia 14
Lerner, J. 8, 54, 332, 342 management 179
corporate venture capital 400, 404, 405 buy-ins 283, 296, 302, 303
government policy 113, 140, 142 buy-outs 61, 290, 293, 419
performance of investments 238, 239, 241, geographical perspective 94, 108
242, 243, 245 see also private equity and management
structure of venture capital funds 160, 162, buy-outs
163, 164, 166–7, 170, 172, 173 early stage venture capital 269–71
leveraged build-ups 283–4 -employee buy-out 283
Leveraged Buy-Out Associations 300 managerial practice and corporate venture
leveraged buy-outs 239–40, 282–3, 287–8, 295, capital 407
297–8, 301–3, 305, 307–8 ‘managerial-oriented venture capital research’
leveraged recapitalizations 302 17
leveraging own complementary resources Manigart, S. 16, 60, 193–214, 240, 268, 340,
377–8 417–18, 424–5
leveraging own technologies and platforms 377 Marais, L. 302
Lichtenberg, F.R. 301–2 Margulis, J. 318
limited liability partnership fund 128 market 262
limited liability partnership structure 138 characteristics 179
enhancement 374 moral hazard 196–7

failure 114, 116–17, 118 business angels and investment decision
growth, rapid 288–9 making 340, 341, 344
-level learning 375–6 corporate venture capital 386, 401
potential 179 early stage venture capital 264, 272
risks 258, 260 innovation and performance implications 221
scale 52, 317 Motorola 381
size hurdles 263 multistage investment 241
Marriott, R. 122 Murfin, D.L. 373
Martin, R. 97, 100 Murray, G. 59–60, 113–46, 260, 306, 402, 416,
Mason, C. 5–6, 8–9, 16, 54, 59, 86–109, 136, 422
415–16, 421 Muzyka, D. 181
business angels 317, 319, 320, 322
investment decisions by business angels 336, Nahata, R. 240, 241
337–8, 339, 340, 341, 342 NASDAQ 14
Mast, R. 373 National Research Council Laboratories 102
match-makers 139–40 National Science Foundation 34
matching networks 355–7, 362, 424 negotiation 334, 343
Matthews, T. 97, 103 business angels 339–41
Maula, M. 7, 62, 371–89, 393, 395, 402, 408, of covenants 162
420–21 pre-investment process 178
Mayer, C. 160, 162, 171 private equity and management buy-outs
Megginson, W. 224, 269 296–7
mentoring 341, 343 Netherlands 201, 261, 289, 290, 293
merchant venture capital funds 6–7, 254 Netscape 100
Merges, R.P. 400, 404 networks 139–40
metaphorical kaleidoscope 69–70, 72, 73, 81, ties 322
82 new industries development guide 227–9
Mexico 323 new techologies 12
Meyer, G. 180, 190 New Zealand 113
mezzanine finance 300 early stage venture capital 261
Microsoft 377 government policy 130, 132
Microsystems International 102 Mentor Investor Network Events for
Middle East 371 Business Angels 359
minimum fund scale 121–3 Seed Co-investment Fund 138–9
Mitel Corporation 102, 104 Venture Investment Fund 133, 166
Moesel, D.D. 264 Newbridge Affiliates Programme 103
monetary incentives 364–5 Newbridge Networks 102, 103, 104, 105
monitoring 71 Nikoskelainen, E. 303
corporate venture capital 374 Nokia 102
early stage venture capital 265–7, 270 Venture Partners 380
heterogeneity 212 non-serial angels 338
performance of investments 239 Nortel 104, 105
post-investment phase 193–4, 197–8, Networks 102
199 North America 144
private equity and management buy-outs see also Canada; United States
300–304 Northern Telecom 102
value-added in venture Norway 261, 290, 293, 316, 318, 322
capitalist-entrepreneur relationships Novell 377, 381
194–203 Nye, D. 269
information asymmetry 195–200
value adding 200–203 operational role 201
Moog, P. 226 operational skills 263
Moore, K. 88, 318 Opler, T.C. 295, 302
Moorehead, J. 243 Oppenheimer 47, 48
Index 437
opportunism 199 United States 11–13

option: worldwide venture capital 14–15
building motives 376–7 see also corporate; informal; institutional
reasoning 30 planned behaviour theory 335, 344
to acquire companies 376 policy:
to enter new markets 376–7 capturing 180–81, 182
to expand 374 implications in informal venture capital
Oracle 377 market 363–5
Organisation for Economic Co-operation and -oriented venture capital research 19
Development (OECD) 130, 137 Politis, D. 322
organizational forms of financiers 302, 306–7 population ecology literatures 182
Orser, B. 344 Porter, M. 307
Ottawa 89, 98, 102–5, 107, 109 portfolio:
Venture Capital Fair 103, 105 companies 212, 268, 270
overconfidence 187–8, 244, 264 size 171
theory 162
Pareto improvements 166 Portugal 290, 293
Parhankangas, A. 61, 253–74, 418, 425 ‘positive organizational scholarship’ view 67,
pari passu funding 131 78–81
partnership agreement 162 post-investment 177
Peck, S.W. 298 activities 18
pensions funds 12, 14, 36, 160, 162 involvement 334, 341–3
early stage venture capital 269 phase 193–214
performance of investments 243 content-related issues 203–6
performance 18 process-related issues 206–11
corporate venture capital as strategic tool see also monitoring and value-added
382–4 relationships 99
determinants 384–6 potential financial distress costs 295
early stage venture capital 268 Poulsen, A. 295
fee 162 Powell, W.W. 97, 101
gap 238–9 practice, policy-making and research
implications see innovation and performance implications 415–26
implications corporate venture capital 420–21
of investments 236–51 entrepreneurs 424–6
fund level perspective – return general research 415–17
performance 244–5 informal venture capital 419–20
generic issues with industry performance institutional venture capital 417–19
measurement 246–50 policy-makers 421–4
industry level evidence 245–6 venture capitalists 424–6
see also value drivers Prasad, D. 322, 336–7
persistence 239–40 Pratt, S. 255
prior 262 pre-investment process: decision policies 18,
subjective measures 230, 233 177–90
Perry, S.E. 298 conjoint analysis and policy capturing
Persson, O. 19–20 180–81
Peters, H. 333, 338 espoused decisions of venture capitalists 179
Phan, P. 302–3 theory development and content tested using
pharmaceuticals industry 396, 398 experiments 181–3
pioneers in venture capital research 3–62 theory development in process and
birth of venture capital 10–11 experiments 183–9
definition of venture capital 5–10 verbal protocol analysis 179–80
Europe 13–14 preferred convertible stock 265
importance of venture capital 3 PriceWaterhouseCoopers 250
state-of-the art venture capital research primary seed gap 347–8, 362, 363, 423, 424
59–62 private equity 5, 128
early stage venture capital 254, 256 rational model 186

geographical perspective 108 regional aspects 19
government policy 128 regional gaps 86
performance of investments 239, 245, 250 regulatory environment 242–3
see also private equity and management relational capital perspective 394–5
buy-outs relational dimension 207, 322
private equity and management buy-outs relationship orientation 270
281–308 relation-specific investments 205
adding value 307–8 Renneboog, L. 296, 297
deal characteristics, changes in over time 305 reputation 202, 224–5, 240, 264
deal generation and antecedents 292–6 research 364
definitions of buy-outs 282–4 and development 120, 302, 374
Europe 289–92 see also practice, policy-making and research
factors influencing 284–7 implications
international aspects 305–6 resource:
life-cycle behaviour and organizational -based theory 182, 272
forms of financiers 306–7 dependence theory 194
monitoring and adding value 300–304 endowments 194
screening and negotiation 296–7 leveraging motives 377–8
sources 306 Reynolds, P.D. 114
structuring 298–300 Richardson, M. 242, 245
United Kingdom 288–9 Rickards, T. 181
United States 287–8 Riding, A. 61, 319, 332–45, 419–20
valuation 297–8 Rind, K.W. 15, 44–51
worldwide buy-outs 292 Riquelme, H. 181
proactive relationship management 405–6 risk capital, informal 55
procedural justice theory 73, 207, 272 risk reduction 265
process-related issues 193–4, 206–11, 213 risks 256, 258, 260
commitment 210–11 Riyanto, Y. 172–3
goal congruence 209–10 Robbie, K. 300
social interaction 208–9 Robinson, R. 265, 317, 319
trust, role of 208 Rockefeller family 47
product: Romain, A. 243
attributes 262 Roure, J.B. 177
feasibility 179 Ruhnka, J.C. 255, 265
/service characteristics 179 rules of thumb see heuristics
uniqueness 263 Russia 44, 48, 114
proprietary deal flow 240
proprietary products 263 S&P 500 245
‘Prudent Man Rule’ 12 Sætre, A. 322
public financiers 324 Sahlman, W.A. 15, 37–42, 69, 177, 198, 254,
public investor co-investing with private 300
investors 133 Sapienza, H.J. 19, 59, 66–84, 201, 208, 233,
public involvement in private venture capital 267, 270, 415
141–3 Sarbanes-Oxley Act 288
public markets, availability and status of SBA Dun’s Market Identifier data 317
241 Scandinavia 166, 327
public policies 166–7, 320 see also Denmark; Finland; Norway;
public to private transactions 288, 291, 294, Sweden
295, 296, 297, 306 Schatt, A. 301
public-funded incentives in hybrid funds Schildt, H.A. 383
131–4 Schoar, A. 163, 164, 239, 240, 245
scholarship and roles of researchers 77–8
quasi-debt 298 see also engaged; positive organizational
quasi-equity 298 Schulze, W. 306
Index 439
Schwienbacher, A. 60, 155–74, 259–60, 270, software companies 398

417 Sohl, J.E. 61, 347–67, 420, 423–4
screening 237–8 business angels 320, 323, 324
business angels 335–6, 338 government policy 118, 135, 136, 141
early stage venture capital 262, 264 investment decisions by business angels 333,
pre-investment process 178, 180 335, 336
private equity and management buy-outs Sorenson, O. 101
296–7 Sørheim, R. 318
second-tier stock markets 125 source of funding 256
secondary post-seed gap 347–8, 362, 363, sourcing of potential deals and first
423–4 impressions 334, 343
Securities and Exchange Commission 249 South Africa 261
seed stage 255, 256, 258, 260, 264 South America 144
self-interest 79–80, 81 Spain 261, 290, 291, 292, 293
self-oriented motivation 318 spatial clustering of firms 96–7
semiconductor industries 401, 402 staged capital infusions 241, 265
Seppa, T. 200 staged investing 197
serial investors 318, 325, 338 Stark, M. 339
Severiens, H. 359 start-up stage 255, 256, 257
Sevilir, M. 170 state-of-the art venture capital research 59–62
Shane, S. 69, 79, 81, 198 Stedler, H. 333, 338
shareholder rights 259 Stein, J.C. 298, 303
Shepherd, D. 60, 69–70, 177–90, 233, 244, 263, Stevenson, H. 37–8, 41, 80, 244–5
417 stewardship theory 80, 199
short distance investments, dominance of stock market 14
90–91 strategic goals 374
Siegel, D. 301–2 strategic objectives 374, 375
Siegel, R. 373, 384 strategic role 201
Siemens 47 strip financing arrangement 282
signaling theory 322–3 Strömberg, P. 197, 239, 240, 241, 300
business angels 324, 336–7 structural dimensions 207, 322
corporate venture capital 386 structure of venture capital funds 155–74
early stage venture capital 272 financial returns (direct and indirect) 172–3
structure of venture capital funds 169–70 future research directions 173–4
Silicon Valley 11, 97, 102, 106, 107 government venture capital funds 165–9
Band of Angels 359 institutional venture capital markets
government policy 116, 121 development 156–60
Silver, D.A. 373 investment types and value-added service
Simon, M. 189 171–2
Singapore 14, 44, 261, 316, 318, 352 limited partnerships 160–65
Business Angel Network Southeast Asia structuring of investments and investment
(BANSEA) Mentoring Program 352 portfolios 264–5
Singh, H. 295 structuring in private equity and management
Small Business Administration 12 buy-outs 298–300
Small Business Investment Companies 12, 51, Stuart, T.E. 101, 402
131, 156 style drift 164, 171–2
Smart, G. 74, 180, 183 ‘super-angels’ 91
Smith, A. 298, 302 supply of opportunities 285
Smith, D.F. Jr 97, 101 supply side factors 127, 341, 345
Smith, D.G. 264 Surlemont, B. 243
snowball sampling 317 Sweden 13, 16, 52, 261, 289, 290, 293, 350
social capital 322 business angels 316, 317, 318, 324
social environment 212 geographical perspective 87–8
social interaction 207, 208–9 Sweeting, R. 208, 266
Söderblom, A. 122 Switzerland 226, 261, 290, 293
Sykes, H.B. 373, 384–5 Enterprise Investment Scheme 137–8

syndication 18, 101, 205, 237–8, 265 geographical perspective 87, 88–9, 91, 92,
business angels 326 93–4, 95, 96
early stage venture capital 270 government policy 114–15, 117–18, 120,
126–7, 130–32, 135, 137
Taiwan 14 High Technology Fund 134–5
tax 125 informal venture capital market 349–50
hypothesis 294 Local Investment Networking Company
incentives 53–4 349–50, 354
law variations 270 London Business Angels 139, 359
technology boom 43 Macmillan Committee on Finance and
Technology Capital Network 58, 357 Industry 320
technology clusters 102–5, 107 post-investment phase 201
telecommunications industry 396, 399, 402 private equity and management buy-outs
temporal variations 260, 262 281, 284–6, 287–90, 292–3, 295–304
Thompson, S. 302 regional venture capital funds 134, 135, 136
Thomson Financial: Venture Expert Database Scottish Co-Investment Fund 139, 365
106–7 Scottish Enterprise Business Growth Fund
Thurik, A.R. 126 365
timing 177, 239–40 Small Business Service: Early Growth Fund
of cash flows 134 139
preferred 399–400 structure of venture capital funds 160, 162,
Timmons, J.A. 6–7, 16, 31, 34, 121, 226, 227, 166, 171
254, 264 Venture Capital Trust 93, 168
Titman, S. 295 United Parcel Service 381
Toms, S. 289 United States 3–7, 10–15, 23, 25, 38, 40–41, 43,
transaction cost hypothesis 294 46, 50, 52–4
transaction-based analyses 395 128 Innovation Capital Group 357
trust 207, 208, 322 Angels Forum 359
business angels and investment decision BlueTree Allied Angels 359
making 338, 339, 340 Boston Chamber of Commerce 11
calculative 405 business angels 315, 317–18, 320, 323–5,
informal venture capital market 358 327, 336, 338
relational 405–6 Civilian Research and Development
Tyebjee, T.T. 15, 21–6, 27, 177, 179, 253–4 Foundation 48
corporate venture capital 372, 383, 387, 396,
uncertainty 269 401, 407
under-investment 199 early stage venture capital 253–4, 258, 260,
undervaluation hypothesis 295 261, 267, 269–70
United Kingdom 13, 14, 16, 53, 54 eCoast Angels 358
3i 13, 131 Funding Match 360
Advantage Business Angels 359 geographical perspective 87–91, 93–7, 99,
Alternative Investment Market 13 101, 103–5, 108
business angels 316, 317, 318, 319, 320, 327, government policy 115, 122, 124, 126, 128,
337, 338, 342 130–31, 135, 137, 139, 142–3
Business Enterprise Scheme see Enterprise informal venture capital market 348–9, 357,
Investment Scheme 358, 361
Business Start-Up Scheme see Enterprise innovation and performance implications
Investment Scheme 221, 225
Cambridge 97, 102 Mid Atlantic Angel Group 360
corporate venture capital 373–4 National Venture Capital Association 245
Department of Trade and Industry Informal New England Industrial Development
Investment Demonstration Projects 350 Corporation 11
early stage venture capital 261, 263, 270 performance of investments 238–9, 241, 246,
Enterprise Capital Fund 138 247, 249
Index 441
post-investment phase 197, 198, 201, 212 venture growth 230–31

Power of Angel Investing 364 venture outcomes 231–2, 233
pre-investment process 182 venture team 179
private equity and management buy-outs venture-specific learning 376
282, 287–8, 295, 297–8, 301–3, 305–6 verbal protocol analysis 178, 179–80, 181
Robin Hood Ventures 360 Villanueva, J. 19, 59, 66–84, 415
SBIC 133, 166 ‘virgin angels’ 318, 325, 326
Small Business Administration 131, 167, von Burg, U. 227
316
Small Business Innovation Research Wadhwa, A. 385
Programme 167, 168 Walz, U. 303
structure of venture capital funds 155, 159, Warga, A. 295
160, 164, 165, 172 Wassermann, N. 269
Tech Coast Angels 359 wealth transfer from other stakeholders
Venture Capital Network 350 hypothesis 295
Walnut Ventures 358 Weir, C. 295–6, 297
see also Silicon Valley Weiss, K. 224
university spin-outs 257 Welch, I. 295
Wells, P. 142, 160, 241, 242, 243
valuation 269, 270, 297–8, 340 Westinghouse 43
early stage companies 247–8 Wetzel, W.E. Jr 8, 15, 51–2, 53, 54–9, 90,
methods 263 315–17, 327, 341, 356
processes 263 Wiklund, J. 122
value drivers 237–44 Williams, T. 298
decision making processes 243–4 Winchester Disk Drive 37–8, 41
environmental factors 241–3 Winters, T.E. 373
venture capital-controlled investment factors Wizman, T. 295, 302
237–41 Wong, C.F. 266
value-added see added value worldwide buy-outs 292
Van de Ven, A.H. 75–8, 415 worldwide venture capital 14–15
Van Osnabrugge, M. 79, 135 Wright, M. 16, 61, 281–308, 418–19
business angels 317, 319, 321 Wrigley, N. 108
investment decisions by business angels 332, Wu, T.W. 295
333, 337, 338, 341
Van Pottelsberghe de la Potterie, B. 243 Xerox Corporation 43, 44, 47
Venkataraman, S. 108–9
venture capital limited partnerships 156, 158, Yahoo! 100
161, 168, 169, 171, 172 Young, J.E. 255, 265
Venture Capital Network 54, 58 Young, S. 404
informal venture capital market 348–9,
356 Zacharakis, A. 60, 177–90, 244, 263, 417
see also Technology Capital Network Zahra, S. 62, 301, 393–410, 421
Venture Economics 18, 31, 33, 35, 250 Zook, M.A. 97, 99–100, 108

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HANDBOOK OF RESEARCH ON VENTURE CAPITAL

Handbook of Research on Venture

Edward Elgar Publishing, Inc.

A catalogue record for this book

Library of Congress Control Number: 2007921138

ISBN 978 1 84542 312 4 (cased)

List of contributors vii

PART I VENTURE CAPITAL AS A RESEARCH FIELD

1 Pioneers in venture capital research 3

PART II INSTITUTIONAL VENTURE CAPITAL

5 The structure of venture capital funds 155

PART III INFORMAL VENTURE CAPITAL

14 The organization of the informal venture capital market 347

PART IV CORPORATE VENTURE CAPITAL

15 Corporate venture capital as a strategic tool for corporations 371

17 Implications for practice, policy-making and research 415

Stephen A. Allen, Babson College, USA

Mike Wright, Nottingham University Business School, UK

In today’s modern economy a country’s or region’s competitiveness lies in its capability to

comments on my chapters. In addition, I am grateful to Professor Olle Persson at Umeå

The importance of venture capital

The aims of the book

Figure 1.1 Number of articles on venture capital

As a consequence, our knowledge is heavily influenced by the US context and model of

Venture capital – what are we talking about?

1. Venture capital, which is primarily devoted to equity or equity-linked investments in

Venture capital will usually be regarded as an active and temporary (5 to 10 years)

As indicated in the definition by Mason and Harrison, an institutional venture capital

Figure 1.2 The venture capital process

Table 1.1 Corporate venture capital

Corporate Venture Capital

Source: Adapted from McNally (1994, p. 276)

Informal Comprised of private individuals who invest risk

Informal Defined as any investments made in start-ups other

Figure 1.3 Definitions of ‘business angels’ and ‘informal investors’

Institutional venture Corporate venture

Reality and research

The birth of venture capital

The development of venture capital in the US

The diﬀusion of venture capital to Europe

Venture capital worldwide

The pioneers who created the research field

Research on institutional venture capital

Some early contributions

The emergence of research on institutional venture capital

Table 1.3 Topics in managerial venture capital research

Topics of research Pioneering studies

Table 1.4 Topics in market-oriented venture capital research

Topics of research Pioneering studies

Figure 1.4 Researchers on institutional venture capital

Pioneers of institutional venture capital research

of them in order to present their reflections on their own contribution to knowledge, as

BOX 1.1 TYZOON TYEBJEE

comprised a telephone survey of 46 venture capitalists in California, Massachusetts and

Interview with Tyzoon Tyebjee

BOX 1.2 IAN MACMILLAN

● Laissez-faire involvement – the venture capitalists exhibited limited involvement.

Interview with Ian MacMillan

Picture 1.3 William Bygrave, Professor of Entrepreneurship, Babson College, USA

BOX 1.3 WILLIAM BYGRAVE

Interview with William Bygrave

But did that study not produce even more results?