Recent Research I: Why Do Entrepreneurs Make the Choice to Pursue Venture Capital?

At some point, most start-up businesses require an infusion of outside capital to grow into a profitable enterprise. This infusion often comes in the form of venture capital (VC) investment, which provides capital and some degree of managerial guidance in exchange for an equity stake in the company. Venture investment can be a blessing for entrepreneurs looking to survive the risk-filled early stage of firm development and to professionalize their business, but it also reduces the entrepreneur's incentive to create a highly profitable company. The entrepreneur loses some of the freedom to govern the company as he sees fit, and once the company makes a successful exit, the venture investors will claim their share of the profits.

 

Despite the visibility of the VC industry, only 10 percent of start-ups receive VC support. The remaining 90 percent turn elsewhere for outside funding, often from commercial banks. Bank loans do not come with the same strings attached as venture investment, but borrowers do not have access to the managerial and industry guidance that may be available through venture firms. Entrepreneurs are forced to make it on their own but are allowed to govern their company as they see fit and collect a greater share of the profits.

 

In the current issue of the Journal of Business Venturing, Jean-Etienne de Bettignies and James Brander of the University of British Columbia's Saunder School of Business investigate the decision-making process of entrepreneurs faced with the choice of pursuing VC or securing a bank loan. The decision, they find, hinges on the value of input from the venture firm. Without this input, bank financing would always be preferable to venture investment. Entrepreneurs, however, cannot be sure of the value of VC guidance from the outset. They must offer a sufficient incentive to venture firms to be highly involved, but doing so will decrease their own incentive to perform.

 

The authors find that VC investment is most appropriate when the value of entrepreneurial input is low. If this is the case, VC firms can be given a large enough equity stake in the company to provide an incentive to be heavily involved in company development. If the value of entrepreneurial input is low, then reducing the ownership of the entrepreneur is less likely to hamper the company's growth. Companies that depend on the input of the individual entrepreneur may fare better with bank financing.

 

Their model also suggests that venture investment is most desirable when the industry of the start-up company aligns with an area of expertise for the VC firm. Without that kind of alignment, the VC firm may not be able to provide sufficient input to make the equity tradeoff worthwhile. The authors argue that the need for specialized VC knowledge is the reason that certain industries, such as software and biotech, have become dominant in venture investing. These industries require a great deal of specialized managerial knowledge, increasing the value of VC input.

 

This model may be useful for states seeking to improve high-tech start-ups' access to capital. Since public organizations often lack the specialized knowledge of high-tech industries possessed by private venture capital firms, it may be more beneficial to use state funds to offer and improve access to loans than to make public equity investments. Alternatively, state equity programs could be divided into separate programs that serve individual industries, staffed by experienced industry veterans.

 

Purchase "Financing Entrepreneurship: Bank Finance Versus Venture Capital" at: http://www.sciencedirect.com/science/journal/08839026