Governance of the Investor-Entrepreneur Relationship 1
Chapter 1: Introduction
The Problem of Cooperation in the Financing Relationship
Any human being must voice disgust against the misuse of the world’s scarce
resources because such misuse is done more or less to his or her detriment. As Michael
Jensen and William Meckling (1994) put it, “the challenge of our society, and all
organizations in it, is to establish rules of the game that tap and direct human energy in
ways that increase rather than reduce the effective use of our scarce resources” (Jensen
& Meckling, 1994, p. 4). An investigation into the realm of venture capital contracting
theory and practice by Steven Kaplan and Per Strömberg (2003, 2001), extending prior
works by Gordon Smith (1998), William Sahlman (1990), Paul Gombers (1998), and
Bernard Black and Ronald Gilson (1998), revealed that current venture capital financing
is based on a logic of control and sanctions, which is a non cooperative logic (Axelrod,
1984), and may even prove destructive to cooperation if Leifer and Mills (1996), and
Larson (1992) are to be believed. Given that cooperation is obviously superior to non
cooperation and individual action at achieving virtually all goals in any domain
(Maitland, Bryson, & Van De Ven, 1985), and that cooperation has proven more
important than the financial capital itself in venture capital financing (Timmons &
Bygrave, 1986; Shepherd & Zacharakis, 2001), the findings by Kaplan and Strömberg
(2003) raise some serious concerns as to the social efficiency of current practices in
entrepreneurial finance.
One could justifiably suspect that contemporary practices in venture capital
financing constitute a misuse of money, time, knowledge and human energy and may
need a profound change, simply because they are uncooperative in essence. Since
Governance of the Investor-Entrepreneur Relationship 2
science is the art of evidencing appearances, the problem of cooperation in the financing
relationship is worthy of further consideration. The purpose of this introductory chapter
is to display our research problem, the purpose statement of the study and the overall
structure of the dissertation.
1.1 The Research Problem
The importance of cooperation in collective endeavors and the difficulties
associated to its achievement have been appealing to the quest of many academics and
researchers. Theory and research have extensively addressed “the fundamental problem
of cooperation” (Ouchi, 1980, p. 130), which can literally be summarized as follows:
Cooperation has superior value-creation and protection potential in social relationships,
but cooperation is also very difficult to achieve, because parties allegedly always pursue
their individual self-interest to the detriment of common goals. A central issue in facing
the fundamental problem of cooperation is how cooperation can cost-effectively be
generated in relationships of various natures.
Many research mainstreams have emerged with regard to the production of
cooperation. Economists (and, to an extent, game theorists) have suggested that “parties
cooperate or abstain from cooperating based purely on a calculation of the expected
returns to themselves” (Maitland et al., 1985, p. 59) and that cooperation can only be
induced by specific mechanisms devised by parties to protect themselves against
opportunistic behaviors from their partners (Williamson, 1975, 1983, 1985).
Sociologists on their part have supported that “the sufficient condition for cooperation is
some mechanisms for allocating tasks and rewards between the parties in a way that is
Governance of the Investor-Entrepreneur Relationship 3
perceived to be equitable” (Maitland et al., 1985, p. 59). Social exchange theorists and
organizational theorists as well pretended that trust and reciprocity, sustained by social
control mechanisms such as ostracism and reputational labeling are important trigger
mechanisms to cooperation (Granovetter, 1985, 1992; Komorita, Hilty, & Park, 1991;
Larson, 1992; Lyons & Mehta, 1997; Shane & Cable, 2002).
The various solutions recommended by extant theories hold in one way or
another, but we believe that the extent of cooperation induced by the various
mechanisms and procedures advocated by various research mainstreams differs a great
deal, and that the effects that various recommended mechanisms and procedures have
on partners are also different. However, and regrettably, research and theory have
remained mute on the extent of cooperation generated by each pretended solution to the
fundamental problem of cooperation in general; and more so in the field of
entrepreneurial finance. Research has not even assessed the effectiveness and social
impact of individual solutions.
Our research problem is therefore to investigate the extent of cooperation
yielded by economic mechanisms for governing Investor–Entrepreneur relationship and
their implications for the society. The aim of the research derived from this substantive
topic is to generate an in-depth understanding of the outcomes and limitations of the
economic approach to governing Investor–Entrepreneur relationships.
Despite the increasing interest in cooperation and the ways for producing it in
the Investor-Entrepreneur relationship, it is somewhat surprising that very few empirical
studies have actually been conducted on the topic. Studies of the venture capital
Governance of the Investor-Entrepreneur Relationship 4
financing relationship mostly focus on financial contracting theories, under the main
assumption that contractual arrangements limit conflicts and secure smooth cooperation
in the financing relationship. Less heed is paid to the outcomes of the financial contracts
like one would normally expect, inasmuch as common sense teaches us that even a gold
medal has its reverse side.
The Investor-Entrepreneur contractual relationship is generally approached
through two main theoretical lenses. The principal-agent paradigm (Amit, Glosten, &
Müler, 1990; Fiet, 1995; Sahlman, 1990; Sapienza & Gupta, 1994) is used to approach
the financial contract for reducing conflicts and aligning the investor’s and
entrepreneur’s interests through incentives, in order to coerce cooperation. Control
theories are used to approach the financial contract as an instrument for allocating
control and revenue rights in ways that provide incentives for cooperative behaviors
from the entrepreneur and the investor alike (Aghion & Bolton, 1992; Dewatripont &
Tirole, 1994; Fluck, 1998; Hart & Moore, 1994, 1998).
Other research mainstreams focus less on financial contracting and rather offer
theoretical models for enhancing cooperation in the financing relationship. The
prisoner’s dilemma metaphor (Cable & Shane, 1997) is used to demonstrate how
entrepreneurs and investors decide to cooperate or to defect. The procedural justice
theory (Sapienza & Korsgaard, 1996) is mobilized to demonstrate how monitoring and
control of behaviors and outcomes of actions can be replaced by the ultimate assessment
of procedural observance, in an intent to reduce bones of contention, and secure smooth
cooperation in the Investor-Entrepreneur relationship. There are also frameworks
combining agency theory, game theory and social justice theory to demonstrate how
Governance of the Investor-Entrepreneur Relationship 5
cooperation is generated through building trust and confidence in the financing
relationship (Shepherd & Zacharakis, 2001). Some authors also make use of network
theory to model the process by which cooperation is generated through social
constraints and control (Larson, 1992; Shane & Cable, 2002). Finally, a value creation
approach has been adopted to demonstrate how relational rents can be created in the
Investor-Entrepreneur relationship and become the incentive that keeps the cooperative
relationship ongoing and prosperous (De Clercq & Sapienza, 2001).
Contemporary governance of the Investor-Entrepreneur relationship focuses on
safeguarding against opportunistic exploitation by the other partner through: (1)
Contractual incentives and bonding mechanisms (agency theory); (2) purposive
allocation of control and revenue rights as incentives to cooperative behaviors (control
theories); (3) reliance on social constraints and sanctions as disincentives to non-
cooperative or opportunistic behaviors (social network theories). All these theoretical
perspectives are directed toward opportunism. For this reason we group the main
mechanisms whose effectiveness will be tested in this study under the umbrella term of
Opportunism-oriented Mechanisms of Governance (OMEGs), which include
monitoring, transaction procedures, and reliance on the market for reputation. These
mechanisms will be defined in the next section.
Most of the theories mentioned above lack empirical evidence and those that
were empirically tested were tested through experimentation, using students as subjects.
That poses the problem of the empirical validity of these studies and the generalizability
of their findings (Alpert, 1967; Enis, Cox, & Stafford, 1972; Khera & Benson, 1970). In
addition, the majority of these studies have eluded to carry out an exegesis of the
Governance of the Investor-Entrepreneur Relationship 6
assumption of self-interest that underpins their conception and the mechanisms they
recommend. Such omissions led theses theories to a somewhat philosophical
superficiality that has undermined their significant implications for the society. The
rationale behind this doctoral dissertation is to fill some of the shortcomings of the
extant literature mentioned above and its purpose is shaped for this goal.
1.2 The Research Importance and Audiences
The importance of venture capital financing has been widely evidenced and
demonstrated. Venture capital plays an energizing role in the entrepreneurial process,
offering fundamental value creation that triggers and sustains economic growth and
revival (Bygrave & Timmons, 1992) and its contribution to the improvement of human
conditions is visible through the number of big businesses which had far-reaching
impact on human day-to-day life. Big names like Apple Computer, Intel, Federal
Express, Lotus Development, Compaq, Digital Equipment Corporation, IBM, and
Microsoft, to name a few, which have originated from venture capital incubation, have
positively impacted growth and job creation (Schmidt, 2003; Shalman, 1990;) and are
now significantly contributing to philanthropic efforts worldwide . The evidenced role
of venture capital in the creation of public companies is another indicator of its
contribution to the good functioning of capital markets and the benefits the world reaps
from them, in terms of wealth creation and distribution (Barry, Muscarella, Peavy, &
Vetsuypens, 1990). The role and influence of investors on the performance and strategy
of venture capitalist-backed firms have also been empirically evidenced (Strömberg &
Kaplan, 2002; Wijbenga, Postma, Van Witteloostuijn, & Zwart, 2003) and stressed on
Governance of the Investor-Entrepreneur Relationship 7
(Gifford, 1997; Gomez-Meija, Balking, & Welbourne, 1990; Gompers & Lerner, 1999;
Gorman & Sahlman, 1989).
First, we believe that venture capitalists and other investors-agencies need to
know the hidden outcomes and externalities of their actions in order to ascertain that
they are using the world’s scarce resources in the best possible ways. Such knowledge
would help them improve practices and secure not only their productive efficiency, but
their allocative efficiency as well.
Second, inasmuch as cooperation is known to be superior to non cooperation,
generalizing cooperation in social relationships become an important matter for policy
makers, for regulatory purposes and for the design of appropriate institutional mega-
structures. Policy makers would find an interest in our focus on empirically testing the
efficiency and effectiveness of existing cooperation driver mechanisms.
Third, the research community would have an interest in examining the outcomes
and shortcomings of some of the institutions that science and theories recommend, and
be more cautious in the future when making practical recommendations and suggesting
institutional design.
1.3 The Research Purpose
The purpose of this two-phase, sequential mixed methods research (Creswell,
2003) is to assess the extent of the cooperation yielded by governance mechanisms in
use in venture capital financing and the effectiveness of these mechanisms in inducing
Governance of the Investor-Entrepreneur Relationship 8
stable cooperation in the financing relationship. This was done first by obtaining
statistical, quantitative outcomes from a sample, and second by probing these outcomes
against the insight drawn from conversation analysis of participants’ interventions
during the open discussion over the research questions and hypotheses that followed the
experiment (post-experimental enquiry). The understanding is ultimately deepened
through ethnographic content analysis using expert-key informants. Our intent is to
better understand the relationship between OMEGs and the extent of cooperation in the
Investor-Entrepreneur relationship, and ultimately use this understanding to suggest
ways for improving theory and practice.
1.3.1 The First Phase of the Study
In the first phase, two quantitative components of the research used quantitative
research questions and hypotheses, first to relate monitoring, transaction procedures and
reliance on the market for reputation, the detached independent variable, to the extent of
cooperation, the dependant variable; and second to compare groups in terms of the
extent of cooperation caused by each of those mechanisms while controlling the ethical
belief (control variable) for 234 young entrepreneurs and professional investors equally
mixed in a laboratory experiment in Limbe, west coast of Cameroon.
The extent of cooperation is generally defined as the degree of stability of the
willingness and commitment of each party to pursue mutually compatible interests in
the relationship rather than act opportunistically, for the sake of the success of the
relationship (adapted from Das & Teng, 1998).
Governance of the Investor-Entrepreneur Relationship 9
Monitoring, the first independent variable is generally defined as any controlling
and supervising activity or mechanism aiming at detecting and sanctioning deviance and
variance from the established norms in a relationship.
Transaction procedures, the second independent variable, generally refer to
complex procedures and conditionalities specifically devised to penalize non-
cooperative behaviors or low performance, or to subordinate the continuation of the
relationship to the achievement of predefined milestones.
Reliance on the market for reputation, the third independent variable, generally
refers to the preoccupation and concern of a partner to keep a vibrant image of a
credible and highly respected actor in the industry and the society he or she is living in.
Ethical belief, the intervening variable, generally represents the extent to which a
partner values ethics in business as a core principle governing her or his behaviors.
In this first phase of the study, our objective is to focus on either the following
research question or the following research hypotheses, for each component of the study
in order to “eliminate redundancy” (Creswell, 2003, p. 109).
The First Component. It is the descriptive study that will provide answers to
the following questions using descriptive statistics. The central research question is
“what is the extent of cooperation induced by Opportunism-oriented Mechanisms of
Governance (OMEGs) in the Investor-Entrepreneur relationship?” Secondary research
questions are: (1) “What is the extent of cooperation induced by monitoring in the
Ricevi informazioni sui nostri servizi, sulle offerte e non perdere news e consigli su università e lavoro.
