Venture Capital Investment

An Agency Analysis of UK Practice

Gavin Reid

• Publisher: Routledge
• Year: 2002
• eBook ISBN: 9781134681341
• Topic: Business
• Subtopic: Business General
• Index: Business

Gavin Reid presents a systematic analysis of what drives investor-investee relations in venture capital markets. In the first analytical work to use a unified framework, he draws upon a modern and general approach to contracting relations, namely principal-agent analysis. This book establishes a clear theoretical framework involving risk management, information handling and the 'trading' of risk and information. Using powerful modern theory as a general and coherent frame of reference to analyse an extensive body of new evidence, the author shows how top investors manage risk and monitor investees, and examines the best relationship between investor and investee. Exploring the principles governing high-risk/high-return investment, this is a unique insight into the turbulent world of the venture capitalist.

Part 1
BACKGROUND

1
THE ANALYSIS OF VENTURE CAPITAL PRACTICE

1.1 INTRODUCTION

This book reports upon an investigation into UK venture capital practice. The distinctive features of this investigation are that it was structured around a single analytical principle, agency analysis, and that it was solidly rooted in evidence. The agency approach, more fully characterized as principal-agent analysis, concentrates on two features of contracting relations between investors and investees, namely, risk and information. The use of evidence focuses on primary source data obtained by direct contact with investors and investees. Thus a single principle, with its two constituent elements of risk and information, is applied to a well-grounded body of evidence on investor-investee relations.

The conclusions reached, and the methods by which this was done, are, I believe, of significance to both the analyst (be she a specialist in economics, accountancy, or finance, etc.) and the practitioner (be he a venture capitalist, business angel, financier, or banker, etc.). Put briefly, they are that the considerable complexity of contracting relations between investors and investees can be simplified down to the principle that skills and knowledge in risk management are traded for skills and knowledge in business management until both parties have exhausted all opportunities for further exploiting skills and knowledge. This having been done, the relationship between investor and investee is, in a particular sense, best or optimal.¹ The methods by which these conclusions, and the implications thereof, were reached were complex, and involved a blend of analytical principles and empirical methods. In this book, both are extensively explored, in order that the conclusions reached may be fully substantiated by argument, convincingly supported by evidence, and extensively illuminated by example.

The book is made up of four parts: background, evidence, cases and analysis. Background covers the nature of venture capital, principles and methods of investor-investee analysis, and the theory of principal and agent (expressed geometrically). Evidence considers the devices used to gather data (‘instrumentation’) from investors and investees, the methods deployed in working ‘in the field’, and the main characteristics of investors and investees. Cases develops analytical case studies for three different types of principals: an independent, a banking subsidiary, and a public institution. The investees referred to were active in timber processing, point-of-sale (POS) technology, diagnostic testing and biotechnology. Analysis engages in a cross-site exploration of four topics: risk management, information demand, information development, and the exchange of risk and information. The book closes with an epilogue, tying together the main argument, followed by appendices detailing the full instrumentation used in the empirical work.

This chapter itself is designed to provide the reader with complete orientation for the book as a whole. As well as exploring its purpose, main argument and contents, as above, it introduces the full range of ideas that are to be treated in greater detail in the ensuing chapters. First, investee and investor are introduced. The former is typically a mature small firm (MSF)² in the UK context, with sales of about £12½m. The latter is a venture capital investor (VCI), investing about £1m. in each investee. Second, the key analytical concepts of principal-agent analysis are introduced, focusing on issues like moral hazard, bond posting, monitoring, and information asymmetry. Third, the empirical background and investigative methods are considered, covering the main statistical characteristics of investors and investees, and the use of interview techniques in the field. The chapter ends with a brief concluding section.

1.2 FAST-GROWING MATURE SMALL FIRMS (MSFs)

The available evidence on life-cycle effects in small firms (e.g. Reid 1993) suggests that something prevents rapidly growing mature small firms (MSFs) from maintaining their growth trajectories. A commonly cited reason for this is a shortage of finance capital (see Mason and Harrison 1991b). If an attempt is made to solve this problem by increasing the level of debt, a number of constraining influences come into play. Higher gearing increases exposure to risk, and may create vulnerability to debt-servicing crises. Debt itself may only be advanced by the banks to the extent that the entrepreneur can demonstrate that collateral exists, and this may set an upper limit on the gearing ratio. Debt default may be dealt with severely by the bank, who may offer no option of debt-rescheduling in a time of debt-servicing crisis, but may simply call in the loan pre-emptively to stop collateral being dissipated, thus forcing liquidation. If debt finance is seen as a logical option, offering as it does the advantage of keeping the entrepreneur’s property right in his business intact, it is an option which is exercised with prudence by the borrower, and is handled with caution by the bank. If the shortage of finance capital to prolong or sustain growth is not sought in the form of debt finance, outside equity finance becomes an attractive alternative.

It may come in the form of support from a ‘business angel’ in the local business community, who has seen a promising small firm growing vigorously before his very eyes, but who hears of problems of financial capital shortage which look likely to limit future growth prospects for it. In the UK, at least, it is not yet well understood how these ‘business angels’ or informal investors work, partly because it is difficult to identify them in the business community. What evidence is available so far (e.g. Mason and Harrison 1994) suggests they provide small packets of funding, to a limited number of local firms, investing only periodically, and requiring relatively little in the way of formal vetting of proposals. Finally, there is a more formal side to venture capital investment, arising when substantial levels of equity provision are provided to mature small firms (MSFs) from funds which are managed by financial and industrial experts, very often on behalf of an upstream client like a pension fund, multinational enterprise or merchant bank (see Sahlman (1990) for the US context).

It is this last named form of provision that is the focus in this book, with the UK venture capital industry over the period 1988–94 providing the empirical basis of the discussion. I will appeal largely to two specific bodies of evidence: first, a panel of the UK venture capital industry for the years 1988, 1990 and 1992; and secondly, a cross-section of twenty pairs (or ‘dyads’) of investors and investees in 1993.³ The latter sample includes the principal investors in the UK venture capital industry (accounting for three-quarters of the total provision), each of which is paired with one or more typical investees. The panel data provide the evidence on trends in the industry, and enable us to characterize the average or typical venture capital investor and investee in Part 2 below. The cross-section data enable detailed individual case studies (‘within site’) to be reported upon, as in Part 3, as well as comparative analysis (‘cross site’), as in Part 4.

1.3 VENTURE CAPITAL INVESTORS (VCIs)

Venture capital involves the provision of equity finance to firms which are typically small in size and unquoted. They provide an opportunity for ‘gain through growth potential’, contingent on acquiring finance to permit new investment. Normally, the investor will expect to earn an adequate investment return within a few years through one of a variety of exit routes, for example stock market flotation, sale to a trade buyer or sale to management. While the USA has been the major location for the development of venture capital, in recent years the growth in venture capital funds in the UK has been dramatic (see Table 1.1).

Growth of funds invested rapidly grew from £325m. in 1985 to a peak of £1,647m. in 1989. After a slight falling away of investment after that, it recovered well. Indeed, in the UK most of the leading financial institutions have created venture capital funds (see BVCA Directory) and a range of autonomous organizations has also emerged. It is also interesting to note that many of the staff managing these funds have trained as professional accountants.⁴ Their demands for accounting information can therefore be expected to reflect a high level of expertise. Indeed previous studies have indicated that accounting information is a key component in any decision-making process whose purpose is to commit funds (Tyebjee and Bruno 1984; Macmillan et al. 1985). It is therefore likely to be an important aspect of the ongoing assessment by venture capital investors (VCIs) of investment outcomes.

Table 1.1 Total venture capital investment, 1985–93

A number of researchers have shown that the post-investment relations between VCIs and investees can be close and constructive. They involve the VCI giving advice, utilizing business contacts and facilitating finance, in addition to monitoring performance in a variety of ways (Gorman and Sahlman 1989; Macmillan et al. 1988). Studies have shown that venture capitalists do vary in their interaction with investees, altering the extent of their involvement in response to their perception of the need for assistance (Macmillan et al. 1988; Sweeting 1991a). While differences in the VCI/ investee relationship and in the extent of contact between them are apparent, the reasons for these variations have not been deeply explored. The agency approach to the study of external investor-investee relations has stimulated increasing interest, and as a basis for analysing small firms has already shown promise (Eisenhardt 1989a; Sapienza 1989). It has therefore been suggested that the VCI/MSF relationship would be amenable to this type of analysis (Harrison and Mason 1992; Mitchell et al. 1992).

1.4 PRINCIPAL-AGENT ANALYSIS

An applied version of principal-agent analysis has been adopted in this book to provide a framework for the analysis of the investor-investee relationship. In a principal-agent relationship, one party (the agent) acts on behalf of another party (the principal). The agent is not fully supervised, and has a measure of independence, which she may be tempted to exploit to avoid risk and to shirk on effort. The principal therefore tries to construct a contract which will give the agent an incentive to share risk efficiently and to optimize her effort (Reid 1987: ch. 9). The use of the principal-agent model in accounting research was initiated by the likes of Baiman (1982) and consolidated in textbook treatments like Strong and Walker (1987). Applied principal-agent analysis has been used on the client-VCI relationship by Sahlman (1990). Here, we take the analysis one step further down the tier of superior-subordinate relations, and look at the VCI’s relation to the investee. Since the work of Chan et al. (1990) the established risk framework has been that the VCI can be treated as a risk-neutral principal, and the investee as a risk-averse agent. Much further work has since been accomplished along these lines (e.g. Gompers and Lerner 1994; Admati and Pfleiderer 1994). A special interest has also emerged in explicit modelling of information and communication, especially as regards its control implications (e.g. Gordon et al. 1990; Cohen et al. 1992).

Despite this flourishing of theoretical work, the empirical character of the VCI/MSF relationship is still Very poorly understood. This cannot be resolved by the use of secondary source data: it requires paying deliberate attention to the details of real contracting practices. The purpose of this book is to provide the reader with exactly such detail, and to explore for him or her its practical implications for risk-sharing and incentive alignment.

At the post-investment stage a principal-agent (or ‘agency’) relationship exists between the VCI and the investee (MSF). The VCI assumes the role of principal and the investee firm’s directors the role of agent. Their relationship places the principal in a position where the problem of moral hazard has to be addressed. The directors of the investee firm, actin...

Table of contents

• COVER PAGE
• TITLE PAGE
• COPYRIGHT PAGE
• FIGURES
• TABLES
• PREFACE
• ABBREVIATIONS
• PART 1: BACKGROUND
• PART 2: EVIDENCE
• PART 3: CASES
• PART 4: ANALYSIS
• EPILOGUE
• APPENDICES ON INSTRUMENTATION
• REFERENCES