Entrepreneurial Equity Financing Research: Quo Vadis? – Part I

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This is a summary of “A Review and Road Map of Entrepreneurial Equity Financing Research: Venture Capital, Corporate Venture Capital, Angel Investment, Crowdfunding, and Accelerators” published in Journal of Management, Issue 43(6) (2017), pp. 1820-1853 — by Will Drover, Lowell Busenitz, Sharon Matusik, David Townsend, Aaron Anglin, and Gary Dushnitsky.

Journal of Management (JoM) is a peer-reviewed journal that publishes research in the fields of management, strategy, and entrepreneurship. Papers in annual review issues review a topic to take stock of what has been done in the last decade or two, how that work can be organized within a research paradigm, and how it can guide future research. I find many of the review papers published in JoM to be useful.

This paper reviews 418 entrepreneurship papers published in 16 leading entrepreneurship, management, strategy, and sociology journals between 1980 and 2016 — most being published after 2004. Reviewed papers are categorized as focusing on venture capital (VC), corporate venture capital (CVC), and angel investment, with future research directions identified for crowdfunding and accelerators as well. I will focus on the review section in Part I, and the future research directions in Part II.

Venture Capital

  • VC managers use entrepreneurs’ background and traits as signals when evaluating a venture for investment (as angel investors do). Novice investors focus on the characteristics of individual ENTrs’, seasoned investors focus on team cohesion.
  • VCs tend to invest in ENTrs with whom they share similarities in areas such as educational background, professional experience, or ethnicity.
  • ENTrs’ passion and preparedness (to pursue the opportunity under consideration) improve their chances of getting funded by VCs.
  • VC investors do not value written documents (e.g. business plans) all that much. [The common practice seems to have migrated from static documents such as formal business plans to PowerPoint presentations, and more recently, Slide Decks. You probably should still prepare and continuously update a strategic document such as a business plan (or at the very least a business model canvas). It should also include operational and financial considerations, along with some important, simple, and plausible projections. This would still be considered as evidence of preparedness, as well as clarity and thoroughness in your thinking. However, the ability to talk about various aspects of your business in an interactive discussion/scrutiny, possibly with the aid of a Slide Deck, seems to be where it’s at.]
  • Ethics matter when seeking funding: generally, ENTrs prefer more ethical VCs (except when they REALLY need money, in which case ethics does not matter!).
  • ENTrs are willing to give up more equity when they are funded by reputable, as opposed to unknown VCs (irrespective of ethics).
  • VCs mitigate their investment risk by syndicating their investments with other VCs, spreading their investments to be made to a firm over time (via staging their investments, as opposed to going  all in at once), and using complex combinations of cash-flow and voting rights in term sheets that allow them to exert disproportionate control.
  • VCs’ appetite for control decreases as the performance of the venture improves. [Indeed, very few VCs would dare try to tinker with Google’s or Facebook’s day-to-day decisions after they have become GOOGLE and FACEBOOK.]
  • Institutionalization related to a country’s ENTial finance environment (e.g. rule of law, political stability, accountability, corruption, protection of intellectual property rights) improves VCs’ investments. [It would be more useful if this stream of research could provide some practical findings, e.g. a model of the risk premium required from investments made in less institutionalized environments.]
  • When formal institutions are weak, social networks (including personal connections), particularly those spanning immigrant/expat communities, can act as substitutes that facilitate VC investments.

Corporate Venture Capital

CVC papers were about 10% of the papers reviewed. This is not surprising. I think many large corporations have started or expanded CVC units/subdivisions/firms only in recent years (after the dot.com bust). There is no knowing if academic research would catch up, but I am guessing CVC would become more prominent within the ENTial finance landscape in the near future, likely prompting more academic research into it. This is because it has emerged as a useful tool that complements the internal innovation engines of firms as well as the alliance and acquisition initiatives, while also putting excess cash flows to good use (case in point: if you were a shareholder of Google, would you rather give your money to the government to spend, or invest it yourself, through Google Ventures, to help promising new ventures pursue new technologies that can have a much larger positive impact?). Also, many prominent technology firms like Google, Amazon, Apple, and Intel, among others, have been increasingly broadening their strategic foci and CVC is a great tool to learn about emerging technologies and new ventures that can complement a firm’s business or upend it.

  • At the individual level, CVC research has examined the backgrounds of CVC personnel and the impact of their compensation schemes on subsequent investment practices.
  • Firms often consider CVC as another mechanism as part of their innovation strategy. From the perspective of the parent firm, marginal innovative output, the parent’s absorptive capacity (= how well it can learn and utilize new knowledge), available cash flow, and existence of complementary assets and IP stock matter in making CVC investments.
  • When market uncertainty is high, firms prefer CVC-type investments to M&A (mergers & acquisitions).
  • The likelihood that a firm will undertake CVC activity decreases when the firm has high levels of innovation output or low levels of performance.
  • CVC activity can be pursued with different goals: financial gain, exposure to novel technologies, access to complementary products/services, or entry to new markets and geographies.
  • They can have different organizational structures, e.g. like-VC, or like a business division of the parent. Typically, the former achieves higher financial gains, while the latter achieves higher strategic gains.
  • Past careers of CVC managers shape the views and practices of CVC funds/firms.
  • CVC impacts alliance and acquisition activities of parent firms. Interestingly, an acquirer can pay a higher price when acquiring a start-up that it has funded through CVC in the past.
  • Just like investing in stocks, parent firms can invest like growth vs. value investors [the analogy is mine]. Growth investors in high-risk ventures can lose money in many of their investments, but if they hit the jackpot (= a startup they invested in becomes UBER) they achieve huge returns due to growth. On the other hand, value investors (i.e. firms that invest in startups for technological/strategic gains, as much as financial gains) get a ​technology dividend paid to them. Even if most of the investees go bust, the dividends stay in the parent firm.

Angel Investing

Overall, angel investing is similar to VC in many respects. The main differences are, angels invest their own money (not of a firm/fund), they typically invest smaller amounts at earlier stages (at times even at the seed stage), and personal connections of angels within the entrepreneurial finance landscape as well as the similarity between the angels and entrepreneurs matter a lot. Also, angel investing can be done on the side: it is not uncommon for some professionals, e.g. lawyers, physicians, or even VC managers to be angel investors themselves.

Another important difference is about proximity. Angel investors almost always evaluate and invest in new ventures that are geographically close. For example, most angels in Boston would find it hard, at least operationally, to invest in a promising new venture in Seattle. Although VCs have traditionally done the same, increasingly they are forced to expand their radius of operation to access good deals.

I think two factors will continue to pull angels and VCs in different directions. First, angels conduct their due diligence, make investment decisions, and continue their involvement with invested ventures as part of local angel groups or networks. Their activities range from individual to country club level, and geographically constrained. On the other hand, VCs are increasingly pursuing highly scalable ventures that often offer an online product that targets customer segments in multiple country markets or the global marketplace. This broad scope and premium on rapid growth to become the best in class forces VCs to increasingly cast wider nets for deal flow, seek syndication with foreign VCs, and adopt a business practice where the VC firm/fund operates like international investment banks or consultancies: few, experienced, and reputable partners overseeing a cadre of young graduates from reputable universities who are willing to travel globally in search of the next big thing. It would be interesting to see how this differentiation between angels and VCs would play out to shape the ENTial financing landscape, globally.

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