For a sustained period of time, researchers in a number of countries have contributed to our growing stock of knowledge of the informal venture capital phenomenon. From all accounts, we know that the “typical” private investor is a reasonably wealthy middle-aged male with “entrepreneurial street smarts.” Informed judgment also suggests that informal venture capital is the largest source of equity finance aside from funds provided personally and from friends and family (”love money"). Being largely invisible to the eye, it also appears that is difficult for entrepreneurs and investors to “find each other,” although numerous business introduction services and other facilitation mechanisms have been developed to address the search problem. However, in describing the phenomenon as ”informal" and as a “market,” we are making certain presumptions about the nature of the underlying transactions that bind entrepreneurs and investors together.

The central focus of both transaction cost economics and agency theory is the issue of how to structure the relationship between parties to mitigate the potential impact of opportunistic behavior, particularly on the part of the entrepreneur. Opportunism is an ever present threat in situations where it is not possible to: i) constantly observe agent behavior; ii) accurately discern underlying cause and effect relationships; and iii) establish the true intentions and capabilities of either party to the transaction. Prescribed remedies for curbing the potential for self-interest seeking behavior to occur include: i) incorporating safeguards in contractual form; ii) closely monitoring agent behavior; iii) careful attention to the design of the incentive system; and iv) requiring that entrepreneurs post bonds (invest their own funds) as a demonstration of their good faith. Our focus is on understanding what factors shape the form of the contractual deal struck between investor and entrepreneur. The intuitive appeal of these perspectives is the underlying premise upon which both are based, namely that the context within which economic relationships is structured matters. There is widespread acceptance of the notion that contractual frameworks are necessarily incomplete (Hart 1995) but that they do perform an important function in terms of establishing transactional parameters (Landström, Manigart, Mason & Sapienza 1998).

While there is a growing body of research in entrepreneurial finance that relies on either or both of these perspectives for guidance, we must be mindful of a number of potential limitations in extending either into the domain of informal venture capital. The received body of research underpinning the development of both relied on samples of publicly-traded firms with widely diffused shareholding structures. Unlike shareholders in large public companies, external control mechanisms are largely ineffective as private investors face demonstrably inefficient markets for both their equity stakes and suitably qualified replacement markets for entrepreneurial talent (Walsh & Seward 1990; Cable & Shane 1997). Moreover, entrepreneurs typically retain larger equity stakes than is the case for most corporate executives and, like investors, appear not to be motivated solely by the pursuit of economic self-interest. These limitations notwithstanding, in this study, we considered there was merit in testing the “bounds of extendibility” in a fundamentally different market context.

In developing our model, we maintain that private investors face governance challenges in situations where high levels of uncertainty prevail. In a general sense, we maintain that there are two major sources of uncertainty for investors: i) incomplete knowledge of the firm transformation process; and ii) incomplete knowledge on how to structure and manage an investment in a privately-held firm. We also expect that specific attributes of the investment itself will have a bearing on the form and content of the contractual deal struck between the parties ex ante. Each element of the model will be discussed in turn.

A substantial body of received research has tried to establish linkages between various attributes of the founding team, “entrepreneurial traits,” and subsequent venture performance. While no consensus has been reached in terms of the type of experience that matters most in building a entrepreneurial venture, three major themes have been cited in the literature which seem to ”improve the odds" measurably: i) previous experience in the new venture setting; ii) relevant industry experience; and iii) a base of business or general management experience. For their part, private investors also bring a base of experience of their own to the table and are attracted to situations where their background holds out promise of translating into value-added benefits for the venture. It is not the absolute level of experience of either party that would appear to matter but rather the extent to which one party, the entrepreneur, has an information advantage vis-à-vis the investor(s). In other words, in situations where the entrepreneur has a greater base of personal experience to draw upon than the investor(s), the potential for opportunistic behavior to occur increases and/or the ability for such behavior to be detected by investor(s) impaired. One possible means of mitigating this risk is for investors to include contractual safeguards ex ante. It follows that:

Hypothesis 1: The greater the level of new venture experience of the entrepreneur/team relative to that of investor(s), the more comprehensive the contractual deal struck ex ante.

Hypothesis 2: The greater the level of relevant industry experience of the entrepreneur/team relative to that of investor(s), the more comprehensive the contractual deal struck ex ante.

Hypothesis 3: The greater the level of general management experience of the entrepreneur/team relative to that of investor(s), the more comprehensive the contractual deal struck ex ante.

As with any other activity, investors learn the “art of the deal” by “doing deals.” Investors who have completed numerous private equity transactions have, in all likelihood, experienced successes and failures (van Osnabrugge 1998) and hence are increasingly aware of the most important issues to cover off in the contractual deal they strike with the entrepreneur. Relative to their less experienced colleagues, one would expect a more parsimonious approach with respect to crafting the contractual deal, hence:

Hypothesis 4: The greater the number of investments made by an investor, the less comprehensive the contractual deal struck ex ante.

By inclination, private investors are attracted to situations where they can make value-added contributions to the venture’s development (Mason, Harrison & Allen 1995). Aside from being a key non-financial motivation, active involvement is also a means by which investors can mitigate the risk of opportunistic behavior going undetected. Active involvement implies, however, that the transactional parameters be specified clearly, hence:

Hypothesis  5: The more effective active involvement in the venture development process is viewed by investors as a means for managing risk, the more comprehensive the contractual deal struck ex ante.

Syndication affords the opportunity for investors to diversify risk and benefit from the combined base of experience of a group of individuals. It seems reasonable to suggest that the combined base of experience of a syndicate is broader and deeper than is the case for an individual investing on their own and, as a result, the degree of information asymmetry between a syndicate and the entrepreneur/team is lower. Consistent with the view of transaction cost economics and agency theory, we should expect to see less comprehensive contractual arrangements with syndicates as opposed to solo investors. Having said this, on a practical level the need to reconcile the different views of a number of individuals and their desire to “make their mark” on the form of the contractual arrangement struck (Landström, Manigart, Mason & Sapienza 1998). The implication of this observation is that we should expect to find that deals involving syndicates are more comprehensive in nature. There is no reason to expect that one interpretation outweighs the other in terms of significance, hence:

Hypothesis 6: There is no relationship between the manner in which the investment is made (solo or syndicate) and the comprehensiveness of the contractual deal struck ex ante.

With respect to size of investment, controlling for opportunism is costly. In fact, venture capital funds maintain that the costs of “doing deals” is largely fixed irrespective of size. When larger sums of capital are at risk, we would expect investors to pay more attention to contractual detail. Having said this, private investors display a propensity for investing relatively smaller sums of capital at formative stages of venture development in anticipation of follow-on financing provided from venture capital funds. In so doing, they also maintain options to abandon the project if circumstances warrant. It seems reasonable to suggest that the level of business and agency risk faced by investors should decline over time as the venture builds momentum and additional information on the venture’s performance is available to investors. A logical investor response to the risks faced would be to incorporate relatively more contractual safeguards early on when especially small sums of capital are at risk. It follows that:

Hypothesis 7: The larger the amount invested, the more comprehensive the contractual deal struck ex ante.

Hypothesis 8: The smaller the amount invested, the more comprehensive the contractual deal struck ex ante.

Both transaction cost economics and particularly agency theory, maintain that the relative level of the equity stakes of the parties matters. Specifically, the potential for opportunistic behavior to arise is acute in situations where the level of equity stake retained by the entrepreneur is relatively small as compared to that of investor(s). Put another way, we would expect investors to attend to contractual detail when they bear relatively higher costs arising from self-interest seeking behavior on the part of the entrepreneur. It follows that:

Hypothesis 9: The higher the equity stake retained by the investor, the more comprehensive the contractual deal struck ex ante.

Received research supports the view that private investors hear about potential opportunities from a variety of different sources, some of better quality than others (Freear, Sohl and Wetzel 1994). While tending to rely more on themselves than others to assess agency risk, informative deal referrers whose judgment is trusted by the investor serve to reduce the agency risk even further. To the extent that information provided by referral sources is valued by investors, we should expect that:

Hypothesis 10: If the opportunity has been referred on by a source that is both trusted by the investor and who has personal knowledge of the proponents involved, the less comprehensive the contractual deal struck ex ante.

In the absence of efficiently operating external mechanisms of control (Walsh & Seward 1990), one can reasonably argue that investors must rely, to a large extent, on their relationship with the entrepreneur to deal with the inevitable challenges associated with building a business. Received research supports the view that private equity transactions are infused with a high degree of interpersonal trust between the parties from the outset. While both the transaction cost economics and agency theory perspectives work from a presumption of distrust, we would expect to see that where high levels of interpersonal trust prevail that:

Hypothesis 11: The greater the level of trust between the investor and entrepreneur, the less comprehensive the contractual deal struck ex ante.

An important motivation for a substantial minority of investors is the opportunity to be involved in the venture in some employment capacity (Coveney & Moore 1994). In effect, an investor-employee is well placed to assume the role of “on-site monitor” with greater ability to observe and direct the entrepreneur’s behavior in desired ways. It follows that:

Hypothesis 12: The presence of an investor in an employment capacity will mitigate the need to build in comprehensive contractual safeguards ex ante.

As a basis for hypothesis testing, a survey instrument was developed and distributed in late 1997 and early 1998 to active private investors who had completed at least one investment. The survey was pilot tested on a group of respondents from our own established network of contacts prior to soliciting the commitment of four business introduction services to distribute the survey on our behalf. In addition to providing general background information, respondents were asked for detailed information on the most recent investment they had completed for the first time. In so doing, we wanted to introduce a random element to our research design and mitigate the impact of recall bias. Responses were scrutinized on the basis of date and size of investment and on the size and composition of the board to ensure that investors were commenting on unique deals. Data plots were also carefully scrutinized to identify outliers. In total, we obtained 106 usable responses.

The level of experience of the management team and investor(s) in: i) new ventures, ii) a relevant industry, and iii) general management positions was assessed on the basis of ratings from investors to identical qualitative statements on a five-point scale from “no experience” to “extensive experience” and anchored by “some experience.” “Relative” experience measures were developed by dividing the rating accorded the team by that of the investor(s). Investor experience was evaluated on the basis of number of investments completed lifetime to date. To gauge the merit of close investor involvement, respondents were asked to indicate their level of agreement on a five-point scale to the statement: “Frequent and informal interaction with the management is a very effective way to manage risk.”

Investment style was classified on the basis of how the equity was invested and measured on an ordinal scale as follows: i) on my own, ii) as part of a syndicate of private investors, or iii) as part of a syndicate including a venture capital fund. Respondents were also asked to provide details of the distribution of capital contributions and equity stakes in the venture. To assess the nature of the referral source used, investors were asked to indicate their level of agreement on a five-point scale to the statement: “This opportunity was referred to me by a trustworthy source who knew of the individuals involved.”

A multi-dimensional construct of interpersonal trust was developed incorporating the dimensions of integrity, competence and openness (Mayer, Davis & Schoorman 1995). Based on a five-point scale, investors were asked to indicate their level of agreement to the following statements: i) “The entrepreneur/team was open and honest in disclosing all relevant information to investors” (openness); ii) “I trusted this entrepreneur/team to deliver on their promises” (competence); and iii) “I trusted this entrepreneur/team would take decisions in the best interests of all shareholders” (integrity). The presence of an investor in an employment capacity (full or part-time) was captured as a dummy variable.

The dependent variable, contractual governance effort (CONTRACT), was measured on the basis of a prescribed list of twelve contractual provisions developed in consultation with investors, network administrators and a lawyer who is actively involved in private equity transactions. For all of the provisions, respondents were asked to indicate on a three-point scale the perceived importance of including each as part of the shareholder’s agreement and a dummy variable was created to indicate whether the provision was actually included in the deal they were commenting on. Our dependent variable measure was calculated by assigning arbitrary weights to the importance rankings (“irrelevant” = 0.25; “somewhat important” = 0.50; “very important” = 1.00) and multiplying each by the value of the dummy variable that captured inclusion. On this basis, the measure could range from 0 (no provisions) to 12 (all provisions included and all rated “very important to include”).

We relied on multiple regression analysis and observed standardized beta coefficients as a basis for hypothesis testing. In an effort to aid subsequent analysis two control variables were introduced into the model (travel time to venture and stage of development). Aside from the usual caveats on our ability to generalize from results obtained from a sample drawn from an invisible population, we sought to contain the effects of self-selection, self-rating and respondent recall biases by employing a broadly inclusive sampling approach, building in checks in the instrument itself to identify rating irregularities and by having respondents comment on their most recent deal.

Taken as a whole, our typical respondent had completed eight private equity transactions to date. Almost a quarter of the respondents surveyed had completed more than ten deals lifetime to date with one individual reporting fifty investments. Almost 70% of the deals reviewed involved syndicates of predominantly private investors but in a small number of investments, venture capital funds. On average, for investing £100,000 of their own capital, entrepreneurs retained 53% equity interest in their ventures and raised a further £320,000 externally, one-third of which was provided by our respondent. Almost three-quarters of the deals reviewed involved investments at seed and start-up phases of development. In almost 40% of the cases reviewed, at least one investor was employed in the venture in some capacity.

In Table 1, we present the results of regressing twelve predictor and two control variables against the dependent variable, contractual governance effort (CONTRACT). Seven of the twelve standardized beta coefficients have the expected signs, and of these, five were also statistically significant. Our model explains almost 40% of the observed variance in the dependent variable.

Of the three relative experience variables only one, relevant industry experience, exhibits the expected sign and is statistically significant. Interestingly, what attracts an investor to a specific proposal, an individual with an extensive base of relevant industry experience, also appears to be an important source of concern to control for by calling for more contractual safeguards up front. One possible interpretation for the observed negative (and small) coefficients for new venture and general management experience is that it is precisely in these areas where private investors are especially well placed to make value added contributions to the venture’s development based on their own extensive base of experience. On this basis, we support hypothesis 2 and reject hypotheses 1 and 3.

Contrary to expectations, we found that more experienced investors incorporated more contractual safeguards up front than their less experience colleagues. While statistically insignificant, two possible explanations can be offered. Further analysis revealed that experienced investors exhibited a tendency to participate in larger deals. With greater capital at risk, there is a clear motivation to attend to contractual detail. Our findings are also consistent with the work of van Osnabrugge (1998) who maintained that with experience, investors become more cautious contractors. On this basis, hypothesis 4 is rejected. Consistent with a body of received evidence (Mason, Harrison & Allen 1995), our respondents considered active involvement to be an especially effective means of managing risk. However, active involvement implies more explicit attention to the elements of the contract up front as evidenced by the statistically significant and positive beta coefficient consistent with hypothesis 5.

Deals involving a syndicate appear to be much more explicit in nature with respect to the contract developed with the entrepreneur on the basis of the observed positive and highly significant beta coefficient. In part, this result is not altogether surprising as syndicates typically underwrite larger deals, thus in a collective sense investors have more capital at risk. Our findings also support the view advanced by Landström, Manigart, Mason & Sapienza (1998) that syndicated deals can become quite complex in nature as each participant in the syndicate seeks to “make their mark” on the form and content of the contractual deal. On this basis, we reject the null hypothesis 6.

In terms of investment size, larger deals do imply more comprehensive contractual arrangements as evidenced by the positive beta coefficient although this finding was not statistically significant and, thus hypothesis 7 is supported in sign only. Consistent with hypothesis 8, highly explicit contracts appear to be required when especially small sums of capital are at risk. In such circumstances, one might maintain that the experience of investors is most valued and needed and their close involvement with the venture most wanted by the entrepreneur. In this respect, contracts appear to perform a necessary function to clarify the rights and responsibilities of the parties to the transaction.

We also found strong support for a central tenet of agency theory that the larger the stake of the investor in the venture, the greater the implied costs to be borne by them as a result of opportunistic behavior on the part of the entrepreneur. In such situations, investors appear to place greater emphasis on the on the form and content of the contractual deal as evidence by the positive and highly statistically significant observed beta lending strong support for hypothesis 9.

How investors hear about deals appears to be an important influence on the eventual structure of the contractual arrangement between investor(s) and entrepreneur. In situations where a deal has been referred from a source that knows of the proponents involved and whose judgment is trusted by the investor (s), fewer contractual safeguards were included ex ante. Based on the observed beta coefficient, strong support is provided for hypothesis 10.

In terms of internal consistency, our multi-dimensional construct of trust proved to be robust (Cronbach a = .81). While infused with a high level of interpersonal trust from the outset, virtually no relationship is observed between our trust construct and CONTRACT. While displaying no direct effect, we examined whether trust had a moderating impact on any of the other predictor variables in our model by introducing an interaction term between trust and individual predictors in a step-wise fashion. We found that trust did not moderate any of the other observed relationships. On this basis, we reject hypothesis 11.

The presence of an investor in an employment capacity does not appear to reduce the need for contractual specificity up front as evidenced by the positive beta coefficient contrary to expectations. It appears that attention needs to be paid to separate the roles of “investor” and “entrepreneur” particularly in situations where a syndicate is involved. On this basis, we also reject hypothesis 12.

By attaching the modifier “informal” to describe the market, researchers imply that investors adopt a laissez faire attitude with respect to structuring their economic relationship with the entrepreneur and that deals are made with “few strings attached” and based “on a handshake.” In view of the uncertainties involved, the costs associated with undertaking extensive due diligence, and the legal and professional fees to document the deal, one could argue that it makes little sense to craft comprehensive contractual arrangements up front in any event. Unlike the findings of one study (Mason, Harrison & Allen 1995) where a significant minority of respondents (30%) reported that no investment agreement was drawn up at the time of investment, our study supports the view that a degree of formality does exist in this market. Only one of our respondents reported including none of the specified contractual safeguards and an additional six others had incorporated fewer than three as part of their contractual deal with the entrepreneur. In Table 2, we provide a summary of the mean importance rating for each specified contractual provision together with the proportion of respondents that actually did incorporate it as part of the deal with the entrepreneur.

With remarkable consistency, the greater degree of importance an investor attaches to including a given safeguard, the more likely it will be included as part of the shareholder’s agreement. As Landström, Manigart, Mason & Sapienza (1998) point out, one of the major uses for written contracts is to establish the “transactional parameters” of the deal. From our analysis, there appears to be five issues that are “non-negotiable” in nature, uniformly considered as very important control mechanisms to direct the entrepreneur’s behavior, and almost always included by investors as a “transactional parameter” of the deal: i) veto rights over acquisitions/divestitures; ii) prior approval for strategic plans and budgets; iii) restrictions on management’s ability to issue share options; iv) non-compete contracts required from entrepreneurs upon termination of employment in the venture; and v) restrictions on the ability to raise additional debt or equity finance. For the most part, these “non-negotiable” contractual safeguards give investors a say in material decisions that could impact the nature of the business or the level of their equity holding in the venture. Non-compete contracts are, in effect, a means of maintaining a tie between the entrepreneur and the venture, thus protecting investors from what has been termed “competitive opportunism” (Barney, Busenitz, Fiet & Moesel 1994).

On the other hand, there appear to be a number of contractual provisions to which investors attach relatively low importance and thus might be considered “negotiable” in nature including: i) forced exit provisions; ii) investor approval required for senior personnel hiring/firing decisions; iii) the need for investors to countersign bank cheques; iv) management equity ratchet provisions; and v) the specification of a dispute resolution mechanism in writing up front. Each of these “negotiable” contractual safeguards was included in fewer than 40% of the deals reviewed. It appears that investors build in a measure of managerial discretion and tolerate a degree of contractual ambiguity with respect to the timing of exit and the manner in which future disputes are resolved. Interestingly, a little over one-third of the deals included ratchets (38.7%) or dispute resolution mechanisms (36.8%). To the extent that ratchets are viewed as a means for “tying an entrepreneur to a set of projections,” it appears that most investors prefer to establish a clear equity split up front and thereby avoiding possible future arguments about whether or not performance does indeed exceed or fails to meet established targets and, for that matter, the basis of calculation of the benchmarks themselves. The importance of the working relationship between the parties is also evident in the relatively low number of deals that incorporate a specified means for resolving future disputes up front.

While contractual safeguards may provide some measure of comfort for investors that the entrepreneur will act in their best interest, considering a provision as “important to include” is not the same thing as “willingness to invoke it” as a means of protecting one’s interest. Strict formality would imply that an investor would look primarily to the agreement to assert their rights when problems are encountered with the entrepreneur ex post. The findings of this study, like much of the received work in the informal venture capital field, portrays a much more positive, proactive and “hands on” commitment made by investors to the development of the business in which they invest (Landström 1992). From the outset, investors want to be actively involved in situations where they can make a value-added contribution and in so doing, manage risk. Moreover, it appears that investors are looking to the relationship with the entrepreneur to deal with the inevitable setbacks and problems to be encountered in the future. Rather than being viewed as a protection mechanism per se, contractual safeguards appear to be a means by which mutual behavioral expectations of all parties to the transaction can be clarified (Landström, Manigart, Mason & Sapienza 1998). Having said this, of what utility are the transaction cost economics and agency theory perspectives in the domain of informal venture capital? It is to this issue that we now turn our attention.

On the face of it, there is an obvious intuitive appeal for relying on both as the central concern of each, albeit with differences in relative emphasis, is on developing a structure for economic transactions that promotes the interests of all parties to the exchange while curbing the potential for opportunistic behavior to occur. The key distinguishing feature of each is the manner in which arrangements can incorporate the necessary degree of flexibility going forward to adapt to changed circumstances. For transaction cost economists, the adaptation problem is best solved through careful attention to contract design and to the development of a formal mechanism to resolve future disputes. For agency theorists, flexibility is best achieved through the design of the incentive system up front. Having said this, we highlighted a number of reasons that may call into question efforts to extend either theoretical perspective into the domain of informal venture capital. Both perspectives rely on two key assumptions that may not necessarily hold for private equity transactions, namely that: i) parties to an exchange will display a tendency to pursue their own self-interest to the detriment of the other party, thus leaving little room for trust to prevail between them; and ii) individuals are motivated solely by economic considerations. Moreover, we argued that both perspectives also appear to be better suited to addressing the governance challenges faced by investors in large publicly-listed firms characterized by widely diffused shareholding structures. How did each of these perspectives measure up when empirically put to the test? We shall discuss each of the perspectives in turn.

Crafting a contractual arrangement that is highly specific in nature, covers all possible contingencies, outlines a formal basis for resolving disputes going forward, is legally enforceable and inexpensive for the transacting parties is no small order when talking about private equity transactions. Our sense is that such an approach is best suited to transactions of short duration, where tangible product is exchanged and suitable replacement options can be identified. In all respects, private equity transactions do not display these attributes. On the basis of our study, the underlying purpose for a contract appears to be in establishing a framework for how the parties will work together going forward as opposed to strictly being a mechanism to protect one’s interests as shareholders. Our sense is that private investors intend to be and are more actively involved with their investee companies in a broader range of capacities than is typically the case for shareholders in publicly-traded firms. Clarifying roles and responsibilities from the outset appears to be a major motivation for developing the contract in the first place. Moreover, we observed that a degree of contractual ambiguity appears to be tolerated up front by investors, notably in terms of the manner in which future disputes are resolved. From the outset, the relationship between the parties appears to be more positive and trusting in character than the inherently adversarial one implied by transaction cost economists. Whether investors rely on contractual safeguards and enforce their rights legally when a rough patch is experienced was beyond the scope of this study. The utility of the transaction cost economics perspective would increase immeasurably if future research were to demonstrate that private investors actually rely on contracts to assert and defend their rights as shareholders. Our sense, however, is that private investors look to the relationship that develops between them and the entrepreneur to resolve difficulties as they are encountered, a view that does not resonate strongly with the spirit implied by transaction cost economists. To the extent that this line of reasoning holds, we conclude that transaction cost economics may be of limited utility in the domain of informal venture capital.

Designing an incentive system in such a way that all parties to the exchange will behave in a manner that promotes the interests of all shareholders does resonate quite strongly with entrepreneurial ventures. However, like transaction cost economics, agency theorists portray the relationship between the parties as inherently adversarial in nature as it is difficult to ascertain the veracity of claims made by agents about their level of competence and behavioral intentions towards the principal. Moreover, there is an assumed hierarchy of power that always favors principals (investors) over agents (entrepreneurs). We did find strong support for a central tenet of agency theory namely a positive relationship between investor equity stake and attention to contractual detail. We also found that a great deal of importance is attached to contractual safeguards that in some manner may have a bearing on the relative equity stakes of the parties to deal going forward. Importantly, deal referrers appear to be especially well placed to reduce the perceived level of agency risk associated with a given deal if they can provide investors with assurances about the proponents involved and investors trust their judgment. Having said this, contractual arrangements appear to be necessarily incomplete and a degree of contractual ambiguity is tolerated by investors. Based on this study, we would submit that one particular strand of agency theory research, the incomplete contracts approach (Hart 1995), appears to be very well suited to the domain of informal venture capital. In this respect, we agree with the conclusion of van Osnabrugge (1999) that more research should be initiated relying on this particular stream of agency theory. Future research efforts can build upon this study in a number of ways. It is to this issue that we now turn our attention.

There are a number of potentially fruitful directions for future research that arise from this study. First, the survey instrument developed could be used as a basis for replicating this study on different samples within the UK and, importantly, from other countries. Second, this study proceeded on the basis of an important implied assumption, that the views of investors matter more. While investors can choose whether to invest or not, there is reason to believe that serial entrepreneurs may be especially well placed to negotiate equity finance “on their terms.” Moreover, some authors (Sapienza & Gupta 1994) have maintained that entrepreneurs should actively take steps to protect their interests as in some respects they effectively take on the role of principals themselves with respect to their relationship with investor(s). Third, by their very nature it appears that syndicated deals are inherently complex. More research is needed to better understand the dynamics of syndication and the underlying process by which participants reconcile their views in determining the form and content of the contractual deal. Fourth, longitudinal research is required to determine how parties to a private equity transaction cope with adversity post investment. When do investors find it necessary to assert their rights and how do they choose do so? Fifth, private equity transactions imply a strong relational component; future research efforts should seek to integrate insights from other theoretical approaches such as procedural justice (Sapienza & Korsgaard 1996).

For the less active and, in particular, the substantial pool of investors who have yet to complete their first equity transaction, this study has afforded a number of significant insights. By tapping into a reasonably large base of deals, we were able to provide a reference point for individuals to “benchmark” their approach to deal structuring with that of their active peers in the market. In so doing, we discovered, however, some fundamental differences in approach dependent on “who” was investing and “how” the capital was invested. The most active element of the market were significantly more concerned about and contractually controlled for management actions that could impact the size of their equity stake in the venture and, to a lesser extent, the timing of exit, than their less experienced counterparts. Moreover, as a negotiating tactic, the most active investors appear to favor the use of ratchet mechanisms to tie the entrepreneur’s stake to a set of projections and are more inclined to tie them to the business by way of a non-compete contract. If there was a lesson to be learned from this study it is this, less active investors appear not to have drawn as clear a distinction between the roles of “investor” and “manager” and tended to seek contractual control over what might be considered more operational issues up front. Participating in syndicates does appear to afford the opportunity to participate in larger and more deals, however, there appears to be a challenge investors to reconcile their position vis-à-vis each other in addition to that between themselves and the entrepreneur.

For entrepreneurs, this study begins to highlight the importance of some of the factors investors take into account in determining how to structure their contractual relationship with you. Informal venture capital does come with “strings attached.” In part, the contract between you and the investors should be viewed as a framework for co-operation between the parties particularly as investors are inclined to be very actively involved in the development process in any event. Approaching more experienced investors and/or syndicates implies a tighter focus being placed on issues related to ownership structure and team composition. In such situations, entrepreneurs appear to have little negotiating latitude vis-à-vis investors, however, they are afforded a greater zone of managerial discretion by them. The shape of the contractual deal also appears to be influenced by what we might term the “investor’s paradox.” On the one hand, investors seek to back people with relevant industry experience, but, on the other hand, their own lack of experience in the same industry is a primary source of concern for them to control for contractually. “Which investor to approach” appears to be not nearly as important an influence on the structure of the contractual deal as “how to approach them.” This study has highlighted the importance of making the approach through a referral source that knows you and whose opinions and judgments are trusted by the investor. The key question for entrepreneurs when deciding how to approach is not “who do you know” but rather “who trusts you.”

For policy-makers and, by extension, managers of business introduction services and other facilitating organizations, this study has tapped into the experience of a broad range of respondents on a deal specific basis. By enhancing our understanding of how the relationship between investor and entrepreneur is structured and more importantly by identifying some of the key factors that shape these choices, we are better placed to develop educational and training materials for two significant groups, investors who have yet to complete their first deal (“virgin investors”) and entrepreneurs who are contemplating raising equity finance. Learning from experience may inspire some virgin investors to make their first investment, particularly if they are able to learn from experience first hand by investing as part of a syndicate with experienced investors. We are under no illusion, however, that providing deal specific information to entrepreneurs will, in and of itself, redress the widely-held perception that the terms of exchange are “inherently unfavorable” for entrepreneurs. Finally, the findings of this study raise the question of what the role of business introduction services should be. It appears that investors especially value deal referrers who can, in some way reduce the agency risk they face with respect to a particular deal through their knowledge of the proponents involved and who can inspire confidence among investors as to their abilities to pre-screen deal flow for them. In view of the sheer volume of deal flow many business introduction services are exposed to and resource constraints that impair the ability of many to develop and retain a sufficient base of managerial talent, this is a tall order indeed.

CONTACT: Peter Kelly, Institute of Strategy & International Business, Helsinki University of Technology, Post Office Box 9500, 02015 Espoo, Finland; (T) +358 9 451-3089; (F) +358 9 451-3095; peter.kelly@hut.fi

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