Moral Hazard In Venture Capital Finance: More Expensive Than You Thought
Hans-Peter Burghof
University of Hohenheim
Marie Lambert
University of Liege – HEC Management School
Julius Tennert
University of Hohenheim
April 30, 2016
Abstract:
We uncover interdependence of agency cost and market uncertainty. We find that agency conflicts tighten in a world of uncertainty and accelerate agency cost. The interdependence adds a time-series dimension to the evaluation of agency cost. We provides evidence that a large proportion of agency cost only emerge from the treatment of market uncertainty. This makes agency cost in venture capital projects more expensive than previously thought.
We analyze the continuation decision of the venture capital in a real options framework. In case of high agency concern, the value of the real option is partially transferred to the entrepreneur. Venture projects that are exposed to high agency conflicts hence are relatively more affected by threats of market uncertainty.
Moral Hazard In Venture Capital Finance: More Expensive Than You Thought – Introduction
Determining the prospects of venture projects is particularly complex since young firms bear high uncertainty about the acceptance and persistence of their new business ideas. While venture projects pass several stages of exploration and development they are exposed to various unforeseen contingencies. For example, technological progress, trending consumer behavior or governmental regulation can boost the firm’s business model or completely destroy it.
Commonly, venture capitalists (VC) use stage financing to control the risk of a project (Amit et al., 1998; Gompers, 1995; Sahlman, 1990). This gives the venture capital the opportunity to evaluate the venture project at several stages of its development and to update the prospects about its future success. He will continue the funding of the project if future prospects are sufficiently favorable or abandon it otherwise. The decision making of the venture capital can be analyzed in a real options framework (Hsu, 2010; Li, 2008). Each prior round of financing gives the VC the option, but not an obligation, to continue the project (Li, 2008). At each stage the VC decide whether to immediately commit funds for the further development of the project or to hold the current option to invest and defer the continuation decision (Li, 2008). In a world of uncertainty, the option to invest is economically more valuable than immediate investment because it offers the VC the flexibility to act upon informational updates (Dixit & Pindyck, 1994; McDonald & Siegel, 1982; Trigeorgis, 1996). Delaying investments hence increase the value of investments made by the venture capital as he bases his decision on higher quality information. Recent research shows that VCs generate value from the real option deferring the initiating and continuation of venture projects when market uncertainty is particular severe (Li, 2008; Li & Mahoney, 2011). However, in case of high agency concern, the value of the real option is partially transferred to the entrepreneur inducing high cost to the VC. So far, literature has mostly focused on the conflicts of interest coming either from information asymmetries or external uncertainty without taking into account their interdependence (Amit et al., 1998; Gompers, 1995; Neher, 1999; Li, 2008; Li & Mahoney, 2011). In contrast, we argue that agency conflicts tighten in a world of uncertainty and accelerate agency cost. Our approach suggests that the treatment of external uncertainty forces the VC to continue the project instead of giving him the opportunity to defer the continuation decision. In case of high agency cost, our empirical approach demonstrate that the value of the real option is transferred to the entrepreneur when the project is treated by market uncertainty. This makes agency cost in venture projects more expensive than previously thought.
The paper proceeds as follows. Section II gives an overview about related theoretical models. Section III provides our hypotheses. Section IV presents a formal model. Section V adds an empirical approach. Section VI briefly concludes.
Agency Cost in Venture Capital Finance
The literature typically defines the entrepreneur to be financially constraint. This limits the investor’s feasible claim and allows for strategic behavior of the entrepreneur. Neher (1999) suggests that staged capital infusion is a potent instrument to deal with hold-up. When human capital of the entrepreneur is critical for the success of the firm, investor’s claim may not be credible. The entrepreneur can renegotiate the claim after the initial investment of the venture capital is sunk, but before his work is completed. Physical assets purchased have little value to the VC without the entrepreneur. This idea refers to the inalienability of human capital (Hart & Moore, 1994). When the entrepreneur has incentive to renegotiate investor’s claim ex-post, the VC is ex-ante not willing to finance the project. Stage financing can overcome the commitment problem. Initial rounds of financing will be small enough to prevent investor’s claim from further bid downs. Through his work, the human capital of the entrepreneur gradually embodies in valuable physical assets that depict collateral for later stage financing rounds.
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