Post-investment risks

As has been stated, a crucial problem in the venture capital business is the information asymmetry between the entrepreneurs and capital providers (Glücksman, 2020). Con-flicts may arise already at the investment stage due to misaligned expectations between the venture capitalists and the entrepreneur’s future roles. Since the roles are subject to contracts, the initial contract is seen as a basis for a successful co-operation. (Isaksson, 2006).

After the initial investment has been made, managing the portfolio companies contains information asymmetrical risks to the venture capitalist, as the entrepreneurial oppor-tunism can take the form of differing goals, changes in behaviour and an unequal distri-bution of essential information. There are also risks associated directly with young firms that may cause information asymmetry toward the venture capitalists, without direct actions from the entrepreneur. (Vinturella & Erickson, 2013).

Figure 5: Post-investment risks 4.1.1 Change in behaviour

A key characteristic of a principal-agent relationship is that the agent has an incentive to decrease effort and to avoid risk (Reid, 1998). The principal is looking for signing a con-tract that will give incentives to optimize effort and share the risk. Both parties are ex-pected to be looking for utility maximizing their own interests, where the venture capi-talist experiences utility as a net effect of the payoff less what the agent is paid, whereas the entrepreneur experiences utility as positively dependent on the received payment less their own efforts. (Reid, 1998).

Change in behaviour is a prominent risk of human aspects in the venture capital business, as the personal attitude of the entrepreneur could change negatively after they have received the capital funding. The entrepreneur could be neglecting and unwilling to make efforts that meet the common goals and interests with the venture capitalist. (Bi-gus, 2002). This potential lack of commitment is a risk that the investor wants to avoid, as it puts the effectiveness of the company at risk (Caselli, 2018).

As earlier mentioned, the venture capitalist often seeks a board position which would indicate attending board meetings. However, if the venture capitalist does not attend board gatherings or otherwise in the strategic decision-making, the entrepreneur is able to act out of sight of the investor to own benefits, creating moral hazard. If the agent can act out of sight of the investor, then it is also possible that he or she can claim high effort without actually having made it if a profitable outcome arises. (Reid, 1998). Since effort

is only potentially observable, not verifiable, the agent cannot be forced to put in effort.

It is, however, possible to incentivize effort. (Cumming & Johan, 2014).

It has been showed that lower degrees of ownership increase the likelihood of the trepreneur to act opportunistically (Bellavitis et al, 2019). After the investment, the en-trepreneur owns less than one hundred percent equity in the venture. By giving up some equity to the investor, the entrepreneur shares the results of efforts with the investor, where the entrepreneurial effort will then be proportional to her percentage of equity in the venture and inversely proportional to the investor’s percentage of equity. (Mishra

& Zachary, 2015).

The moral hazard implications arise as the entrepreneur can act out of sight of the in-vestor, and therefore have the possibility to claim high effort without having done any-thing to support a profitable outcome (Reid, 1998). The entrepreneur could thereby not exert the same level of effort as would have, if the ownership in the venture was one hundred percent. The more equity that is given to the investor, the less will be the effort and desire for the entrepreneur to maximize the investor’s return. This puts forth a need for the venture capitalist to exercise control (Mishra & Zachary, 2015) that, in turn, gen-erates agency costs.

4.1.2 Misaligned interests

One of the most common issues are the different values and goals between the investor and the entrepreneur. Entrepreneurs place a high value on financial returns, but are at the same time interested in autonomy, control and in creating a successful new business.

Thus, they may be hesitant toward a quick exit or to undertake actions that weakens their ownership in the company. (Bodde & John, 2012; Werner et al, 2016). The implica-tions occur if the agent begins serving interests that are misaligned with the investors, such as their own. Conflicts thus take place when the contracting parties have either different motivations or if incentives are implemented that place the parties on opposite sides of each other. (Armour et al, 2009).

Even though the parties are initially aligned on values and goals, this might change dur-ing the process. A powerful and immediate way of exercisdur-ing influence is for the investor to possess government by obtaining a board seat (Bodde & John, 2012), which the ven-ture capitalist usually wants and seeks (FVCA) in order to be able to monitor the business activities and the business development. Investors are, in general, more focused on the exit phase than the entrepreneurs, who tend to focus on enhancing the long-term value of the company. (Vinturella & Erickson, 2013).

The entrepreneur could act in a way that prioritizes own wealth over the company’s wel-fare or keeping the business operational, even though it is not beneficial for the venture capitalist. This will likely affect the company’s operations and decision making negatively and lead to an incorrect valuation at a later stage and therefore needs proper control.

(De Clerq & Manigart, 2007). The disagreements in the value creation are complicated for the venture capitalist, as it has a direct impact on the investment’s IRR (Caselli, 2018).

Misaligned interest can also lead to a hold-up situation, where the entrepreneur benefits from their bargaining power. As has been mentioned, it is the entrepreneur who at the end could ensure the success of the venture but could also in a disagreement with the investor threaten to leave the organization. (Cumming & Johan, 2014).

A further risk for the venture capitalist is if the entrepreneur brings in a new shareholder (Caselli, 2018). In non-syndicated ventures, the entrepreneur could, if in control, sell the right of control further to a third party in the threat of a possible bankruptcy. This trans-action could harm the initial investor as it did not invest in the firm to have decision made by an unknown new investor that could steer the business toward undesired di-rections. (Cumming & Johan, 2014).

4.1.3 Unequal distribution of information

Moral hazard stems from the entrepreneur both being the controlling officer and pos-sessing as well as accessing inside information about the company that is not available

to the venture capitalist. Entrepreneurs have been shown tendencies to resist sharing information with the venture capitalists, as it could lead to them obtaining too much influence in the company. (Werner et al, 2016).

After receiving the investment, the entrepreneur could use the information asymmetry to their benefit by for example misinforming or misleading the investor (Huang et al, 2015). In practice, the entrepreneur could hide the actual status and business progress.

The degree of uncertainty to which entrepreneurs will withhold relevant information and pursue own interests is referred to as agency risks. (Cumming & Johan, 2014). The con-sequences of either misinforming or misleading the investor are especially prominent if the parties operate with a geographical distance between them, as it decreases the ven-ture capitalist’s control over the entrepreneur’s actions by making monitoring harder to accomplish (Huang et al, 2015). As earlier noted, the entrepreneur could also mislead the investor by window dressing the financial statements, making the company perfor-mance look better than what it is (Cumming & Johan, 2014).

The venture capitalist has a fiduciary responsibility to ensure that the capital invested is used for the purposes intended and that all actors are focused on the principal goal of obtaining satisfactory a return on their investment. Under moral hazard circumstances, the entrepreneur has an incentive to overstate business prospects if they do not trust the venture capitalist to provide further financing if the forecasts or targets are not met.

(Gerken & Whittaker, 2014).

4.1.4 Corporate risks

The venture capitalist faces risk, where there is a possibility of losing the investment. The venture investments could be categorized as speculative risks, where the investors face both the possibility of gain but also the possibility of loss. What distinguishes speculative risks from other risks is that speculative risks only exist after an individual has acted upon a decision that has been made with the possible gain in mind. There are also risks that could lead to information asymmetrical implications without the direct actions of the

entrepreneur or an opportunistic behaviour. Entrepreneur opportunism could also arise when the entrepreneur acts in good faith, if the entrepreneur has minor business expe-rience and lacks the ability to run the company as it grows, which could result in mis-managing the invested capital. (Vinturella & Erickson, 2013).

Venture capital is connected to great risk due to a variety of factors stemming from the portfolio companies being naturally more open to higher total risk than more developed corporations (Werner et al, 2016). There might be limited knowledge about the market and the future customers as well as a high uncertainty about the level of potential suc-cess, which leads to a distinctive problem between the entrepreneurs and venture capi-talists in the form of information asymmetry. (Vinturella & Erickson, 2013). Finnish SMEs tend to lack sufficient management skills, particularly in new technology-based firms where entrepreneurs have more technical than managerial knowledge, and thus often lack the skills to develop a successful commercial business. (Lumme et al, 2013).

The portfolio companies usually have new business models and lack financial and cor-porate data due to the short operating history. It is also difficult to obtain comparable market data on new, innovative business plans and the degree of comparability is hard to define (Werner et al, 2016). As data and information are the foundation for invest-ment monitoring, the scarcity of data aggravates the information availability for the ven-ture capitalist. Data scarcity could also, in the worst-case, lead to unintended accounting frauds, such as reviewed in the section of window dressing (Cumming & Johan, 2014).