"After the Cash Arrives: A Comparative Study of Venture Capital and Private Investor Involvement in Entrepreneurial Firms"
By Dr. Sanford Ehrlich and Dr. Alex De Noble Professors of Management College of Business Administration San Diego State University
and Tracy Moore Dataquick Information Systems San Diego, CA
and Richard Weaver Business Finance Professional San Diego, CA
January 1997
Contact:
Marsha Gear, APR Director of Communications College of Business Administration San Diego State University San Diego, CA 92182 (619) 594-4501 E-mail: [email protected]
Equity investments in entrepreneurial firms continue to grow in number and dollar amounts from both venture capital and private investment sources. Increasingly, these two sources of capital play an important role in the development of new and existing entrepreneurial ventures. Due to the sometimes hurried attempt to turn their dream into a reality, entrepreneurs may fail to consider similarities and differences in the value-added benefits supplied by venture capital firms and private investors.
Accordingly, the purpose of this study was to determine how initial relationships are established and maintained between entrepreneurs and their primary investors. Specifically, we asked entrepreneurs to assess characteristics of the relationship with their primary investor. We then contrasted the results between entrepreneurial firms that had received venture capital funding versus private investor funding. Differences were examined along the following lines:
Levels of investor involvement in entrepreneurial firms
Reporting and operational controls placed on the firm
Types of expertise sought by the entrepreneur
Method and Sample
We began by developing a survey instrument around the above issues and distributing it to a group of entrepreneurs whose firms are located in Southern California. In total, 70 entrepreneurs responded to the questionnaire, of which 47 were included in this study since they had received primary funding from either a VC or a private investor. Over 80% of the firms in this sample consisted of high technology companies operating in the computer, electronics, biotechnology, semiconductor, and medical device industries. Other firms included in the sample were from industries such as film production, pollution control, equipment manufacturing,and material processing.
The 47 entrepreneurs in the sample averaged 13 years of experience in their respective industries and were running companies generating annual revenues ranging from $1 million to over $5 million. In addition, these entrepreneurs had worked with their existing management teams for a period of about 6 years and their companies produced an average of 7 products.
Research Findings
Levels of investor involvement in entrepreneurial firms This study found that entrepreneurs perceive that both venture capitalists (VCs) and private investors (PIs) are involved in similar sets of activities such as interfacing with the investor group, obtaining alternative sources of equity financing, monitoring financial and operating performance, serving as a sounding board to the entrepreneurial team, and formulating business strategy. In evaluating changes in investor involvement, entrepreneurs receiving financing from VCs and PIs reported that greater participation would be welcomed in obtaining alternative sources of debt and equity financing. Additionally, entrepreneurs receiving PI financing desired more investor involvement in activities such as managing crises and problems, serving as a sounding board, and developing professional support groups.
Reporting and operational controls
Entrepreneurs indicated that they had more difficulty in achieving performance targets set by venture capital firms. While VCs set higher performance standards for their investments, they do provide more frequent, detailed feedback than PIs when the firm is not achieving these standards. This form of help may be needed when the firm is experiencing problems. Since PIs may be involved in more outside activities, they may not have the flexibility or time to closely monitor their investments. The more formalized approach of a VC may be needed by entrepreneurs with a strong technical or scientific background and limited managerial experience. VCs appear to be more likely to aid the entrepreneur in establishing appropriate managerial systems and controls. However, experienced managers may feel that the time spent in generating frequent reports takes away time dedicated to other activities and thus they may enjoy the greater flexibility provided by a PI.
Types of expertise sought by the entrepreneur
This study found that entrepreneurs seek expertise through their investors generally in the areas of staffing and financial management. However, VCs provide assistance in selecting the ventureÇs management team significantly more often than PIs. These findings suggest that entrepreneurs with strong managerial experience may prefer PIs because they are less likely to alter the makeup of the team that they have assembled. However, entrepreneurs with technical backgrounds may find that a venture capital firm provides valuable help in accessing and attracting top management personnel with relevant experience.
Implications
Our findings support a popular stereotype that venture capital firms are more likely to place stringent controls on an entrepreneurial venture than private investors. Moreover, venture capital firms require entrepreneurs to report to them on a more frequent basis and supply a higher amount of verbal feedback. While we might expect that entrepreneurs receiving capital from private investors would be comfortable with fewer reporting requirements, our results suggest that these entrepreneurs desire greater involvement from their private investors especially with regard to financial expertise.
Since a quality management team is often cited as a critical prerequisite for a new venture startup, it is reasonable to expect that entrepreneurs would seek advise from their investors in locating and attracting key management personnel to their firms. Our findings suggest that entrepreneurs who have already assembled management teams may not actively pursue venture capital sources because they are less inclined to alter the composition of their existing management team. Those entrepreneurs who seek venture capital should realize that venture capital firms have access to and are able to attract top management personnel from their corporate networks. Also, entrepreneurs receiving funds from venture capital firms appear to be more likely to gain access to additional rounds of capital at critical stages of their firmÇs development. Thus, the decision to seek capital from a venture capital firm or a private investor may hinge upon the need to locate future sources of funds.
If the entrepreneur is interested in obtaining financing from a venture capital firm, it is important to become involved in professional organizations and develop a strong professional network. Private investors can also accessed through these networks, however, the entrepreneur may need to exploit more informal avenues (e.g. friends, business acquaintances) to locate private investment sources.
In sum, an overzealous founder may find that the long run costs may far exceed the short run benefits if there is a mismatch in expectations between the relevant parties. Who the entrepreneur gets his/her money from is just as important as how much capital is obtained initially. The right match can yield a synergistic relationship that can propel the firm to higher levels of excellence. Further studies on this critical relationship between the entrepreneur and the primary investor are needed to increase our level of understanding of the dynamics involved and how these facilitate or inhibit the growth and development of entrepreneurial start-ups.
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