A COMPARISON OF BUSINESS ANGEL AND VENTURE CAPITALIST

A Comparison Of Business Angel And Venture Capitalist-Free PDF

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Although small firms vary greatly in size and function it is the high growth minority of entrepreneurial. firms which account for most of this economic potential Entrepreneurial firms are those with a vision for. growth while also being innovative risk taking and able to change Wetzel Freear 1994 They. typically wish to grow into a substantial firm with fifty or more employees within 5 10 years and are the. primary recipients of external equity finance Wetzel Freear 1994 In the UK Deakins 1996. discovered that these high growth small firms are rare comprising probably only 3 4 of all start ups. while Storey 1994 found that it is these 4 of all start ups which will provide 50 of employment out of. all surviving firms in ten years time Similarly in the US these entrepreneurial firms represent about 4 8. of the one million start ups per year and have accounted for 70 75 of net new jobs Wetzel Freear. 1994 Although these early stage firms are most reliant upon outside financing to foster their growth once. the entrepreneurs personal savings and investments by family and friends have dried up they often have. difficulty in finding this financial support from institutional investors due to their inherently uncertain and. high risk nature, Fortunately there are two types of finance providers business angels BAs and venture capitalists VCs. which do fund some of these high growth firms in the hope of generating high returns which will more than. compensate them for the funding risks Business angels tend to be private individuals who often have. started their own successful firms in the past and are now looking to invest some of their money and. experience gained into a small entrepreneurial firm In today s small firm financing arena BAs are the only. investors who invest primarily in those entrepreneurial firms needing less than 500 000 below 400 000. in the UK the troublesome range of funding cited as the equity gap the range in which most institutional. investors will not fund However the funding importance of BAs has become even greater in recent years. as VCs professional investors of institutional money in the US and the UK have started to shift their. investment focus away from start ups and early stage firms in favor of safer and more mature ventures i e. development finance Sapienza et al 1996, It is now well accepted that the BA market in the UK and the US is the largest single source of risk. financing for entrepreneurial firms exceeding the institutional VC industry Mason Harrison 1996 In. fact estimates in the UK and the US suggest that BAs fund an annual amount of two to five times more. money to entrepreneurial firms than the VC industry Wetzel 1987 Freear et al 1996 Mason Harrison. 1993 Since BA investments are on average of a much smaller size it is also guesstimated that BAs. fund between 30 40 times the number of entrepreneurial firms financed by the formal VC industry Wetzel. Freear 1994 Despite its significant size the potential of the BA market is significantly greater than. current figures suggest Mason Harrison 1993 Due to inefficiencies and underdevelopment in the BA. market many firms with growth potential remain constrained by their inability to locate financial support. even though BAs especially still have additional financial capital allocated for such investments Harrison. Mason 1992, Since many facets of the investment process of BAs and VCs remain unknown it is hoped that a greater. understanding of how and why they choose their particular investments may assist in lessening this funding. problem and unleashing some of the BA market s untapped potential Harrison Mason 1992 This. paper therefore conducts a detailed comparison across the full investment process of the investment. procedures and criteria of these two types of external financiers which are most vital to the survival and. growth of early stage entrepreneurial firms,THEORETICAL FRAMEWORK. The study of small firms in general can be characterized by a lack of theoretical framework as is evidenced. by the many empirically based studies and the few that utilize theory Deakins 1996 Bygrave 1989 But. the ability to employ theory which can accurately predict may very well increase the robustness of research. and render more enlightening results and more insight than ad hoc research studies To formulate a. theoretical base for this research study agency theory will be borrowed from the field of finance and. applied to formal and informal venture capital investing. Separation of Ownership and Control, In most modern corporations and many small and medium sized firms primarily those funded with outside.
equity there is a separation of ownership and control which is utilized to run the organization In such an. arrangement one party the principal delegates work and responsibilities to another the agent who. performs that work on the principal s behalf Jensen Meckling 1976 This separation of decision and. risk bearing functions is common in such organizations in part because of the benefits of specialization of. management and risk bearing,Asymmetries of Information. In such a situation where an agent is contracted to run a firm and make decisions on behalf and in the. supposed best interests of a principal information asymmetries are prevalent between the parties That is. to say that there are certain pieces of information having a material affect on the firm and the contract. which are available to one party and not to the other This information asymmetry can be of concern if the. agent decides to use his her information advantage for his her own advantage rather than for the benefit of. the firm and the principal Since it is often difficult for a principal to ascertain whether the agent is using. his her information advantage for the principal s benefit a number of problems can arise in the running of a. firm in which a principal has already invested and in an entrepreneur s attempt to raise outside equity. finance from potential investors potential principals. The Role of Contracts, Since an agency relationship consists of individuals with differing preferences trying to engage in co. operative effort contracts are employed to limit the agency costs which may arise These agency costs are. as real as other costs and their cost level depends among other things on statutory and common law and. human ingenuity in devising contracts Jensen Meckling 1976 p 357 These contracts written or. unwritten specify rights of the agent performance criteria on which the agents are evaluated and the. payoff functions they face Fama Jensen 1983 Because principal agent theory attempts to determine. the most efficient contract governing the principal agent relationship contracts are the unit of analysis and. any organization is therefore a nexus of contracts Jensen Meckling 1976 Hart 1995a. The Causes of Agency Problems, Unfortunately contracts can not be costlessly written and enforced and this leads to agency problems in. the firm Due to the costs of structuring bonding and monitoring contracts among agents and principals. with conflicting interests the cost of their full formulation and enforcement may exceed their benefits. Fama Jensen 1983 Although the firm s nonhuman assets can be secured relatively easily through. simple contracts this is more difficult for the firm s human assets This means that the problems associated. with asymmetries of information can not be fully contracted away which leads to the two primary causes. of agency problems 1 conflicts in alignment and verification of goals and 2 conflicts in risk sharing. Two Particular Agency Problems, These two conflicts lead to two particular agency problems moral hazard and adverse selection Moral. hazard occurs when the agent does not put forth the effort originally agreed upon in the contract Fama. Jensen 1983 Furthermore since the agent only benefits from returns when the firm is making profit. rather than in a bankrupt state the agent may decide to take on risky investments of given mean return. instead of safer investments Jensen Meckling 1976 The agent may also have personal incentives to. withhold or modify crucial information Conversely adverse selection refers to the misrepresentation by. the agent as to his her abilities The agent may falsely claim to have certain skills when he or she is hired. Adverse selection arises because the principal can not completely observe and verify these skills or abilities. when the agent is hired or whilst in his her employment. Two Approaches to Deal with Agency Problems, The literature identifies two primary approaches to investor firm relations which can shed light on how to.
decrease agency problems in a firm The first the principal agent approach is essentially the classical. agency theory and is primarily concerned with determining the optimal contract between principal and. agent Jensen Meckling 1976 To formulate such an optimal contract the approach advocates pre. investment screening and due diligence of the firm so that asymmetries of information decrease and a better. contract can be negotiated However the second approach the incomplete contracts approach states that. contracts are always incomplete therefore it is really the ex post allocation of control which is more. important rather than ex ante screening and contract writing Hart 1995a 1995b Although both. theoretical approaches advocate risk reduction at each stage of the investment process each places greater. emphasis on different stages of this process,The Principal Agent Approach. When dealing with the potential effects of moral hazard and or adverse selection the principal can limit. divergences from his her own interests by incurring screening costs to reduce the asymmetries of. information between the principal and agent More comprehensive contracts can then be formulated to. influence the agent s behavior These contracts can either be behavior or outcome based In the former the. appropriate behaviors of the agent are stipulated to limit any devious behavior by the agent and the. principal will incur monitoring costs behavior based observation to ensure the agent behaves as was. agreed upon Such contracts are feasible if the principal can observe and verify the agent s behavior. However in the latter the principal may not be able to observe the agent making the behavior based. contract not feasible and so the principal will establish appropriate contractual incentives for the agent. reliant upon the agent s performance outcome based contracting Jensen Meckling 1976 These are. the two main ways the principal agent approach aims to limit contractually an agent s ability to pursue. his her own agenda and so provide important checks and balances on the agent s behavior Both these. options for controlling agency costs have their advantages and disadvantages although both involve. information gathering and contract formulation This trade off possibly on a continuum between the costs. of measuring behavior and the costs of measuring outcomes and transferring risk to the agent is the heart of. principal agent theory Thus there are a number of unavoidable agency costs in the principal agent. The Incomplete Contracts Approach, In the incomplete contracts approach it is assumed that writing a good contract is itself costly Thus the. contract will always be incomplete and therefore the ex post allocation of power is what really matters. This is different from the principal agent approach which assigns all contracting costs to the cost of. observing variables and assumes that if all these variables are observable by both parties then they can be. contracted on costlessly However in reality contracting costs can be sizeable Hart 1995a There are. three main explanations for why writing contracts is costly making them incomplete the presence of. transaction costs bounded rationality and asymmetric information. In the transaction cost approach it is argued that the costs of contracting on an unlikely event may well. outweigh the benefits due to four ex ante costs which are particularly important Spier 1992 First the. cost of thinking about and planning how to deal with all the different eventualities that may arise during. the contractual relationship Second the cost of negotiating with others about these plans Third it may be. very difficult and costly to write a contract which when it is violated and in dispute is clearly verifiable by. a third party such as a judge Hart 1995b Fourth there are ex post legal costs incurred in addition to. the ex ante writing costs in actually having this contract verified and enforced by a third party Spier. 1992 Sappington 1991 In fact because exotic contracts are hard to evaluate and enforce contracts in. reality tend to be simpler and less sensitive to environmental differences. A second explanation for incomplete contracts bounded rationality argues that agents either have only. limited ability to evaluate elaborate contingencies or are not able to foresee unlikely contingencies Spier. 1992 Hart 1995a, A third explanation for incomplete contracts is asymmetric information This approach argues that a person. may refrain from including a certain clause in a contract so as to signal his her type Spier 1992 One such. example is given by an athlete negotiating a contract with a particular team The athlete s agent may. advise him to refrain from asking for an injury clause because the team manager would infer from such a. request that the athlete is more accident prone and would make the terms of the contract worse Spier. angels BAs and venture capitalists VCs across the full investment process To make the study more robust a theoretical base is adopted based on agency theory to form research hypotheses which propose that BAs and VCs in the UK may use different approaches to limit potential agency risks in their

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