- Top of page
- Theory and Research Issues
- Research Design
- Results and Discussions
- Discussions and Conclusion
In this study, we examine the control and incentive mechanisms of domestic and foreign venture capital (VC) firms in China. Primary findings show that most VC firms use staged capital infusion, value reassessment based on subsequent performance, and other tools reflecting the flexible and dynamic characters of the investment systems and rarely replace management team. On the other hand, domestic VC firms are less active in monitoring, less likely to retain veto rights, and less likely to introduce stock options into target firms and for all employees. They are also less motivated to provide value-added services than their foreign counterparts. Instead, they concentrate their monitoring and participation on the financial aspects of the invested ventures. We discuss these findings and suggest directions for future research.
Although venture capital (VC) industry in China is in its infancy, it is now growing at a rapid rate. The development of VC industry provides an important source for Chinese entrepreneurs to solve problems associated with inadequate systems of corporate governance and the lack of long-term financing for restructuring and growth (White, Gao, and Zhang 2005; Zhang 2001). VC has played an increasingly important role, helping small and medium-sized start-up businesses in China (Fung, Liu, and Shen 2004). Given the potential existence of divergent interests between VC firms and their portfolio firms, VC investments are also characterized by high risks such as volatile returns, lack of information, and agency problems (Promise and Wright 2005; Sahlman 1990). Thus, VC involvement in entrepreneurial firms also includes monitoring while providing managerial, technical, and capital assistance to venture management (Kaplan and Strömberg 2004, 2003, 2001; Hellmann and Puri 2002; Gorman and Sahlman 1989; MacMillan, Kulow, and Khoylian 1989). However, due to the lack of knowledge and experience, the interfirm governance (control and incentive) mechanism of the Chinese venture capitalists is not always effective.
Many entrepreneurs believe that venture capitalists provide little more than money, yet studies of VC activity show that venture capitalists are actively involved in their portfolio companies (Engel 2004; Kaplan and Strömberg 2004; Bygrave and Timmons 1992). Though VC investments are associated with high risks (Promise and Wright 2005; Moore and Wustenhagen 2004), venture capitalists have provided both capital and management expertise that facilitate the development of entrepreneurial firms in China (Liu and Chen 2006; Zhang 2001). The discontinuity in the business environment during China's transition shifted the old equilibrium, in the course of what Schumpeter (1950) famously called “gales of creative destruction.” An important force— private entrepreneurs—has emerged and shaken the foundations of the state monopoly. However, newly established small businesses face the liability of newness. The growth of entrepreneurial firms is severely constrained by their limited access to financial resources. Many entrepreneurs actively seek the support of venture capitalists.
Agency problems arise when venture capitalists invest their capital in entrepreneurial firms. Given that agency problems may arise as asymmetric information potentially exists, which makes it difficult for the venture capitalists to monitor the entrepreneur's actions, the codevelopment between venture capitalists and entrepreneurs depends on the venture capitalists' abilities of screening, monitoring, and involvement. Thus far, nonetheless, few studies have focused on how venture capitalists use control and incentive mechanisms to enhance the firm performance and achieve higher returns in the transitional context such as China. In the emerging VC market in China, venture capitalists offer a form and style of financing that has not been provided elsewhere in the spectrum of financial services available so far in terms of the combination of a certain length of commitment with greater involvement and a degree of influence over the companies in which equity stakes are taken (Zhang 2001). Therefore, studies on the emerging codevelopment phenomenon are important, which may have insightful implications to both theory and practice.
In this study, we conduct an exploratory study, drawing on agency theory, to examine the initial development of VC in entrepreneurial firms in terms of both control and incentive mechanisms. In particular, we identify critical factors that affect the periodic investments by venture capitalists. Our study contributes to the VC literature by providing pieces of evidence based on the first in-depth interviews and survey of major domestic and foreign venture capitalist firms in China.
Theory and Research Issues
- Top of page
- Theory and Research Issues
- Research Design
- Results and Discussions
- Discussions and Conclusion
Agency theory (Fama and Jensen 1983; Jensen and Meckling 1976) provides a useful theoretical lens for understanding the relationship between venture capitalists and VC-backed entrepreneurs. In practice, venture capitalists incur costs when they monitor and infuse capital. From this perspective, venture capitalists are concerned that entrepreneurs' private benefits from certain business activities or strategies may not be perfectly correlated with shareholders' best monetary return (Hellmann 1998). According to previous VC studies (e.g., Amit, Glosten, and Muller 1990; Barney et al. 1989), potential dishonest entrepreneurs may increase the agency costs by deliberately withholding information that is critical equitable contract negotiation. Thus, venture capitalists weigh potential agency and monitoring costs when determining how frequently they should reevaluate projects and supply capital.
The power of suppliers of finance can be exerted through the control and incentive mechanisms they introduce in their relationships with entrepreneurial firms, notably through the return targets they set and the reporting requirements they impose. Though this has tended to be a neglected area in the VC research, it is expected that as VC markets develop, more precise return targets and more detailed reporting requirements are formulated. For example, accounting information flows are typically required on a more regular and more detailed basis than are statutory requirements for quoted companies. Venture capitalists' accounting information demands are designed to deal with moral hazard and information asymmetry problems and provide safeguards through bonding arrangements (Mitchell, Reid, and Terry 1995; Sweeting 1991a).
In practice, venture capitalists can use various mechanisms to encourage entrepreneurs to perform better and to reveal accurate information (Kaplan and Strömberg 2004; Sahlman 1990). In this study, we concentrate on both control and incentive mechanisms that have been used by venture capitalists to enhance the performance of entrepreneurial firms and achieve higher returns through the reduction of agency costs. In transition economies, the development and operation of a VC market are influenced by the incentives and governance mechanisms in place in individual VC firms and the process by which firms make their investments (Karsai, Wright, and Filatotchev 1997).
In an extensive review of the VC literature, we identify five critical factors associated with the two mechanisms, which may also affect the codevelopment of venture capitalists and entrepreneurs in China. The control mechanism includes three factors: monitoring, staged investment, and the allocation of ownership and control rights. The incentive mechanism involves two factors: the shares of stock rights by entrepreneurs and employee stock options. According to our conceptualization, agency costs are the primary concerns of these identified factors. These costs include the opportunity cost to both venture capitalists and entrepreneurs, such as contracting costs, monitoring costs, and lost time and resources for the venture capitalists as well as entrepreneurs. If venture capitalists need to “kick the tires” of the plant, read reports, and take time away from other activities, these costs can be substantial. In practice, VC investment is not a one-time deal but VC funding occurs in discrete stages, following the three-step investment: selection, contracting, and monitoring, as described by Kaplan and Strömberg (2001) and Promise and Wright (2005). Each time capital is infused, contracts are rewritten and renegotiated, lawyers are paid, and other associated costs are incurred. The following discussions will focus on how the control and incentive mechanisms may help reduce the agency costs by venture capitalists.
Monitoring. Agency costs increase as the tangibility of assets declines, the share of growth options in firm value rises, and asset specificity grows. Due to information asymmetry between venture capitalists and entrepreneurs, the control mechanism becomes extremely important. Effective monitoring may help reduce the agency costs. Sahlman's (1990) extensive field research, for example, described VC in terms of the control mechanisms employed by venture capitalists to manage the agency costs. Research from developed VC markets provides a number of important insights into the monitoring of investees. Three control mechanisms are common to nearly all VC financing: (1) the use of convertible securities (e.g., Kaplan and Strömberg 2003); (2) syndication of investment (Lerner 1994); and (3) the staging of capital infusion (e.g., Kaplan and Strömberg 2003; Gompers 1995). If the monitoring provided by venture capitalists is valuable, certain predictions can be made about the structure of staged capital infusion.
During the screening process, venture capitalists review business plans of young companies and design contracts with entrepreneurs that minimize potential agency costs. Once the initial investment is made, agency costs are associated with the intensity of monitoring and involvement. The intensity of monitoring activities by venture capitalists may vary. Differing levels of involvement in VC investments are related not to the nature of the operating business, but to the choice exercised by the VC firm itself as to the general style it wishes to adopt (MacMillan, Kulow, and Khoylian 1989). Using matched pairs of lead venture capitalists and chief executive officers (CEOs) in investee companies, Sapienza and Gupta (1994) found that the frequency of interaction between the venture capitalists and entrepreneurs depended on the extent of the CEOs' new venture experience, the venture's stage of development, the degree of technological innovation, and the extent of goal congruence between the CEO and the venture capitalist. In general, the intensity of monitoring increases, especially in the early stage of the investment and when problems occur (Kaplan and Strömberg 2004; Elango et al. 1995; Gompers 1995; Lerner 1995, Barry 1994; Sapienza 1992).
The central issue regarding monitoring is that venture capitalists must balance the costs of constructing elaborate governance mechanisms against the benefits (Barney et al. 1989, p. 64). MacMillan, Kulow, and Khoylian (1989, p. 37) suggest that “a relevant issue in need of examination is the opportunity cost of [greater] involvement,” suggesting that greater involvement may not always be cost-effective. The need for formal supervisions or elaborate governance mechanisms may increase the agency costs of VC-backed firms. Barney et al. (1989) found that elaborate governance mechanisms used by venture capitalists were more likely to be associated with high agency risks and business risks. Other scholars (e.g., Fried and Hisrich 1994; Hatherly 1994; Sweeting 1991a) also emphasize the importance of flexibility, suggesting that formal power needs to be used sparingly in order to retain effectiveness. Because monitoring is costly and cannot be performed continuously, the venture capitalists usually periodically check the project's status and preserve the option to abandon. Thus, the duration of funding and hence the intensity of monitoring should be negatively related to expected agency costs.
Staged Investment. Staged capital infusions are the most potent control mechanism a venture capitalist can employ to manage agency risk (Sahlman 1990). The staging of capital infusions allows venture capitalists to gather information and monitor the progress of firms, maintaining the option to periodically abandon projects. Staged investments as a funding strategy used by venture capitalists have been emphasized in a number of previous studies (e.g., Fried and Hisrich 1994; Bygrave and Timmons 1992; Sweeting 1991b; MacMillan, Siegel, and Subbanarasimha 1985). When such a mechanism is employed, prospects for the firm are periodically reevaluated. The shorter the duration of an individual round of financing, the more frequently the venture capitalist monitors the entrepreneur's progress and the greater the need to gather information.
The role of staged capital infusion is analogous to that of debt in highly leveraged transactions, keeping the owner–manager relations on a “tight leash” and reducing potential losses from bad decisions. As the proportion of intangible assets, ratio of market to book value, and investment in research and development (R&D) increases in an entrepreneurial firm, venture capitalists will direct more attention to supervising the venture and choosing the investment stage, the interval of different investment stages, and the scale of each investment (Gompers 1995). While the duration of a particular round is one potential metric for the intensity of monitoring, the size of each investment, total financing provided, and numbers of financing rounds are also important measures of the staged investment structure.
Allocation of Ownership and Control Rights. Voting rights, which measures the impact of the relative power between venture capitalists and entrepreneurs on the company's decision-making (strategic decisions in particular), are another effective control mechanism. Given that the potential conflicts between VC investors and entrepreneurs may happen, business strategies are decided by majority vote under most circumstances. In a randomly selected 50 VC investment contracts from Aeneas Foundation managed by Harvard Management Company, Gompers (1997) found that VC investors tended to rely more on contracting to clearly allocate control rights, separate them from ownership rights, and impose more oversight.
Voting rights normally correspond to the board seats, but it is often not strictly aligned in VC-backed ventures. As described by Kaplan and Strömberg (2001), “voting rights, board rights, and liquidation rights are allocated such that, if the company performs poorly, the venture capitalists obtain full control. As company performance improves, the entrepreneur retains or obtains more control rights. If the company performs very well, the venture capitalists retain their cash-flow rights but relinquish most of their control and liquidation rights.”Kaplan and Strömberg (2003) found that VC firms enjoyed majority voting rights in 53 percent of the cases where entrepreneurs meet the performance milestones set forth by venture capitalists.
In addition, the allocation of control rights in a VC-backed firm is also highly associated with the reputation of the VC investor and the actual performance of the entrepreneurial firm. Using a large sample of 1,076 firms that had initial public offering (IPO), including those receiving VC and those without receiving VC, Baker and Gompers (1999) found that (1) numbers of inside directors increased as the shares and control power of CEO increased. After receiving VC, however, seats of inside directors decreased, especially when VC investors have a high reputation; and (2) the higher the cash flow a start-up generated, the more likely founders remained as CEO regardless of how many seats inside directors had in the board.
Shares of Stock Rights of Entrepreneurs. Entrepreneurs holding equity shares may have an incentive to improve firm performance because they can get a positive payoff only when the firm performs well. Shares of stock rights held by entrepreneurs and management of a VC-backed firm vary depending on their time with the firm and the firm's post-investment performance. Early-stage companies confront more difficulties to have their performance measurements meet the predetermined milestones, mainly because of high growth uncertainty, incomplete management team, and the lack of experience. VC investment contracts usually allow entrepreneurs and management to hold more shares when the firm performs well and reduce their shares when the firm performs poorly. In a study of 213 VC investments in 119 portfolio start-up companies by 14 VC firms, Kaplan and Strömberg (2003) found that the difference of the average stock rights held by entrepreneurs and management under different states of performance was 8.8 percent. This difference increases to 12.6 percent in those receiving the first round of VC.
Employee Stock Option. With the introduction of the concept of employee stock option in China, more venture capitalists and entrepreneurs have come to realize its importance. In an analysis of 402 publicly traded corporations, Cyr (1998) found that companies that received VC investment tended to use more incentive stock option and employee stock purchase plans than those that did not receive VC investment. Moreover, the more the VC firm was involved in a company before its IPO, the more likely the company adopted a widespread use of stock options. The overall performance of companies that received VC investments was apparently better than those without VC financing three years after IPO. Among the companies with higher involvement rates by venture capitalists, those widely adopting employee stock purchase plans showed better performance (stock price) than those that adopted it in a smaller scope, three years after IPO. We expect that employee stock option as an important incentive mechanism may play an important role to enhance firm performance.
The discussion so far highlights various control and incentive mechanisms. Though limited attention on VC market in transitional China has not offered sufficient justification to formulate hypotheses, we nevertheless expect that these mechanisms are related to the reduced agency costs and improved performance. In search for empirical evidence in a setting with significant implications for theory and practice yet has largely been overlooked, we set out to conduct an exploratory survey study. In the next section, we discuss research design, data collection, and report results of our interview and survey.
Discussions and Conclusion
- Top of page
- Theory and Research Issues
- Research Design
- Results and Discussions
- Discussions and Conclusion
To the best of our knowledge, this paper represents the first study to examine the control and incentive mechanisms of VC firms in curbing agency problems in entrepreneurial ventures in an environment undergoing a rapid economic reform. Facing market imperfections and information asymmetry, venture capitalists face a general adverse selection problem in screening investment proposals and managing venture financing, and typically place great emphasis on detailed scrutiny of all aspects of a business. Scrutiny of accounting and financial information, including sensitivity analysis, is of particular importance, especially in later-stage transactions where such information may be expected to be more robust (Wright and Robbie 1996). However, in an environment characterized by complexity, ambiguity, particularistic relationships, and uncodified information, such as the current stage of the Chinese market (Tan 1996), the key elements in the VC process would appear to relate to monitoring and managing the investment process, as shown in our study.
In the case of China at this stage in transition, to the extent that the market consists of more inexperienced domestic VC players and more experienced foreign VC players, differing requirements may be anticipated (White, Gao, and Zhang 2005; Zhang 2001). For many VC firms, difficulties are posed in screening the capabilities of management who typically have not operated in a market environment before and information may be particularly subjective. There may also be concerns about the availability of appropriate managerial expertise, both of the entrepreneurs making proposals and the venture capitalists who are to conduct monitoring, at least in the short to medium term.
A comparison of domestic and foreign VC firms vis-à-vis their investees in China provides insights into not only the nature of the relationship between VC firms and investees but also insights into the stage of development of China's VC firms. In a recent study, Zhang and Jiang (2002) found a number of key differences, supporting those uncovered by Bruton and Ahlstrom (2002). Their efforts are supported by our results. From our interviews, we find that foreign venture capitalists are more concerned with agency risks, resulting in more VC involvement and more frequent interactions between the VC and CEO. This is consistent with previous findings of the impact of agency risk (Sapienza and Gupta 1994).
Traditionally, it is important for VC firms to place great importance on offering strategic guidance to investees, particularly with managing crises and problems. There may, however, be differences between types of firms in their perceptions about these roles and their ability to undertake them, particularly in the case of state sector venture capitalists (Zhang 2001). Uncertain market conditions are expected to be linked to the use of a wide range of monitoring devices, with close relationships being especially important. Moreover, the rapidly changing environment in transitional markets places considerable importance on timely receipt of information concerning problems, as well as on effective and flexible responses. Our findings suggest that though many entrepreneurs accept veto rights as a “shadow threat” that indirectly affects decision-making and would never be used, the presence of the option in the contract is easily construed as a threat to employment security and a lack of trust on the part of the VC firms. For venture capitalists as well as entrepreneurs, it is crucial to establish mutual trust and confidence. It is in both parties' interests to maintain top management stability because frequent CEO turnover may be considered a sign of organizational crises, which may compromise firm value (Lerner 1995). In addition, when the macroeconomic environment is poor, for instance the setback among Internet companies in 2000 and 2001, simply replacing management is not an effective solution.
To put our findings in perspective, we highlight several patterns. First, Chinese venture capitalists are less active in their monitoring of investee management than are foreign venture capitalists. For example, foreign firms require financial reports more frequently. Almost all foreign venture capitalists require monthly financial reports, whereas only two-thirds of domestic venture capitalists require reports in such frequency. Furthermore, foreign venture capitalists are more likely to retain veto rights. On the other hand, both domestic and foreign venture capitalists face the same challenge in interacting with management in new ventures. Many local entrepreneurs are extremely reluctant to allow “outsiders” (including venture capitalists) into the firm. They tend to perceive such outside involvement as a potential loss of control or power. This perception has been exacerbated by the media, which has tended to position “capital” and “knowledge” (venture capitalists and entrepreneurs, respectively) as opponents rather than as working toward a common goal and mutual gain.
Second, domestic venture capitalists exercise weaker influence over their investee management decisions than do their foreign counterparts. For example, they use staged investment in the same round of financing less frequently than foreign venture capitalists. They are also less likely to make financial arrangements of entrepreneurs' contingent on the venture's performance. Domestic venture capitalists have just started to introduce stock option plans into new venture firms and often only among top management, whereas foreign venture capitalists almost always introduce stock options into target firms and for all employees.
Finally, domestic venture capitalists provide much less to entrepreneurs in terms of value-added services. Foreign venture capitalists usually take part in board meetings at least once per quarter (and often monthly), whereas less than half of the domestic venture capitalists participate so frequently. Indeed, an underlying difference between these types of firms is that domestic venture capitalists in general do not see addressing operational issues as an important part of their role as investors. Instead, they concentrate their monitoring and participation on the financial aspects of the investee firms.
One reason for some of these differences is that domestic venture capitalists are much less experienced than their counterparts in foreign firms. This can partially explain their more restrained involvement in investee firms—they do not have the experience to justify taking a leading role in many top management issues. It also explains the limited value-added services they provide to entrepreneurs. Although capital can be raised rather quickly, the experience and expertise to invest, monitor, and support start-ups takes much longer to develop.
It should be noted that foreign venture capitalists also tend to invest at earlier stages than domestic VC firms. Starting in mid-2001, when new investment funds became scarcer and domestic VC firms came under pressure to generate profits, this divergence became even more pronounced. As a result, venture capitalists in China have shifted their priority from the development stage to later stages such as growth and pre-IPO. Various external factors may play a confounding role, such as government policies in different regions and the investment strategies of venture capitalists in different regions. VC investments based in northern cities such as Beijing are concentrated in post-development stage ventures, whereas those based in southern cities such as Shanghai are commonly focused on start-up-stage investments. Meanwhile, foreign venture capitalists are also making structural adjustments and becoming more focused on realizing returns sooner. They are increasingly wary of inherently risky and uncertain projects. As they are the primary source of venture funds, the shift represents a contradiction between the desires of the government for venture capitalists to nurture early-stage high-tech firms and the logic of the market represented by VC firms' decisions. Such emerging issues and changes should inspire future research that compares and contrasts venture capitalists in different regions and industries.
In sum, this study represents one of the first thorough investigations of the investment experience of domestic and foreign venture capitalists in China. Our findings suggest that venture capitalists give entrepreneurs certain motivations as well as strict boundaries in their investments. In addition, the use of staged capital infusion, value reassessment based on subsequent performance, and other tools reflects the flexible and dynamic character of the investment systems. To reach more definitive conclusions, however, more future research efforts are called for. In particular, future research can examine how environmental changes in Chinese transition economy continue to pose a profound impact on VC strategies and style and how the VC firms, especially more experienced overseas VC investors, proactively enact their environment (Levinthal and March 1993). Such a “coevolutionary” perspective is likely to offer added insights for academic research and practice (Tan and Tan 2005).
We close the paper by citing the remark by the senior manager of Acer Venture Capital Fund:
. . . [E]ntrepreneurs are drivers, while VC investors are passengers. If the vehicle is not heading to the right direction, or it is driven too fast or too slow, the passengers' interests, as well as those of the drivers, will likely be hurt. Thus VC investors need to impose reasonable monitoring and control while giving the drivers certain level of discretion and autonomy. We do not want to have our eyes closed and fall asleep on the back seat, nor do we want to end up sitting in driver's seat. We want to enjoy a smooth ride, and exit at the destination of our choosing. Finding and maintaining the balance between the two competing goals, however, has never been a smooth ride.
The vibrant and dynamic landscape in China is crowded with fast-moving vehicles, enthusiastic drivers, and motivated passengers anxious for an exciting journey. We hope the preliminary evidence presented in this paper will inspire future research interest to offer more insights and lessons that these drivers and passengers desperately need.