Incentive problems and Reciprocal Behaviour in Venture Capital/entrepreneur Dyads: The effect of Inequity-aversion, Trust, and Social Norms Dr Richard Fairchild (School of Management, University of Bath) University of Bath School of Management, Working Paper Series 2009.08 This working paper is produced for discussion purposes only. The papers are expected to be published in due course, in revised form and should not be quoted without the author’s permission.
Transcript
Incentive problems and Reciprocal Behaviour in Venture Capital/entrepreneur Dyads: The effect of Inequity-aversion,
Trust, and Social Norms
Dr Richard Fairchild (School of Management, University of Bath)
University of Bath School of Management, Working Paper Series
2009.08 This working paper is produced for discussion purposes only. The papers are expected to be published in due course, in revised form and should not be quoted without the author’s permission.
University of Bath School of Management Working Paper Series
capitalists and entrepreneurs have developed contracts that attempt to overcome these
problems and align the parties’ interests (Klausner and Litvak 2001, Triantis 2001,
Tykvova 2007).
More recently, it has been recognised that venture-backed performance may also be
affected by behavioural and emotional factors. The performance of venture
capitalist/entrepreneur dyads may be affected (positively or negatively) by reciprocal
feelings of fairness, trust, empathy and spite (Busenitz et al 1997, Cable and Shane
1997, Sapienza and Koorsgard 1996, De Clerq and Sapienza 2001, Shepherd and
Zacharakis 2001, Utset 2002).
Indeed, De Clerq and Sapienza (2001) coin the term ‘relational rents,’ referring to the
value-creating potential of fairness and trust in venture-backed firms. However, these
authors note that “no in-depth analysis has been made of how relational rents might be
created for both parties in the venture capitalist-entrepreneur dyad.”
This observation motivates our analysis. In particular, we develop a behavioural
game-theoretic model of venture capital contracting in order to analyse the combined
impact of fairness and trust on agency problems and venture performance. Our model
develops the literature in two major ways. First, it presents a formal game-theoretic
4
analysis of the effects of fairness and trust on venture performance, hence addressing
the lacuna identified by De Clerq and Sapienza (2001). Second, we identify that
fairness and trust may be related, and therefore, we provide the first formal analysis of
the combined effects of fairness and trust.
Our model consists of three stages; a financial contracting stage (in which a venture
capitalist and an entrepreneur negotiate over their respective equity shares), followed
by a performance stage (in which the entrepreneur exerts value-adding effort in
developing the business). The entrepreneur’s effort affects the probability of success
of the venture. In the final stage of the game, the venture capitalist can force re-
negotiation of the financial contract (in order to reallocate the equity stakes in the
venture capitalist’s favour).
When developing our analysis, we demonstrate that our model has the following
ingredients;
a) Double-sided moral hazard, in the form of the E’s shirking incentives at the
effort stage, and the VC’s hold-up threat at the ex post stage.
b) Fairness norms, which affect the VC’s equity offer, and the E’s effort
incentives.
c) VC trustworthiness, relating to the risk faced by the E that the VC will force
ex post re-negotiation of the contract in her favour.
We further demonstrate that factors b) and c) combine to mitigate the double-sided
agency problem, and improve firm performance.
Before proceeding to our model, we now provide a brief review of the key literature
relating to each of our ingredients.
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1.1. Double-sided Moral Hazard in Venture Capital.
The early financial contracting models (e.g., Baker and Gompers 1999) assumed a
pure principal-agent relationship in which the venture capitalist, as principal, suffers
from moral hazard problems from the entrepreneur, as agent. However, Smith (1998)
argues that, since both parties contribute wealth-creating efforts, the performance of
the venture may be subject to double-sided moral hazard problems.
Some researchers have developed double-sided moral hazard models (e.g., Houben
2002, Casamatta 2003, Fairchild 2004, Repullo and Suarez 2004) whereby the
entrepreneur and the venture capitalist both supply value-adding effort. The double-
sided moral hazard problem exists due to the parties’ incentives to shirk.
In this paper, we consider a different form of double-sided moral hazard. In our
model, the E contributes value-creating effort. Hence, the VC faces moral hazard in
the form of entrepreneurial shirking. After the E has exerted effort, the VC can force
ex post renegotiation of the equity stakes. Hence, the E faces moral hazard in the form
of the VC’s ex post hold-up threat.
Indeed, Smith (1998) argues that “the most prominent risk to entrepreneurs is
opportunism. The potential for opportunism arises from the possibility that the VC
will attempt to renegotiate with the entrepreneur at a point in the relationship when
the entrepreneur has diminished bargaining power.”
The VCs ex post hold-up threat is receiving increasing attention in the literature (see
eg; Smith 1998, Repullo and Suarez 2003, Chemla et al 2004, Skeie 2004, Gebhardt
and Schmidt 2006, Bigus 2002, Utset 2002). These researchers note that certain
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features of the VC contract provide the VC with increasing bargaining power over
time1. This provides the VC with leverage to force ex post renegotiation of the
financial contract in her favour.
The VC’s ex post hold-up threat weakens the E’s ex ante effort incentives. Some
researchers (eg; Fairchild 2004) have argued the VC may therefore voluntarily use
contractual methods to commit not to act opportunistically ex post, in order to
strengthen the E’s ex ante incentives. In contrast to contractual solutions, our model
analyses the role of VC trustworthiness in mitigating the VC hold-up problem.
1.2. Emerging Research on Fairness and Trust in Venture Capital
The existing financial contracting models assume that entrepreneurs and venture
capitalists maximize utility based on narrow self-interest. However, behavioral
economists recognize that relationships may be affected by psychological factors,
such as feelings of fairness and reciprocity (Bolton 1991, Rabin 1993, Fehr et al
1999, 2001, 2002, 2004, Bolton and Ockenfels 2000, Anderhub et al 2001), empathy
(Sally 2001), and trust (Berg et al 1995, Bolle 1995, Huang 2000, Bacharach et al
2001). Furthermore, these feelings may affect the outcomes of negotiations and
performance.
VC researchers are beginning to develop conceptual models of the impact of fairness
and trust on VC contracting and performance. These researchers compare agency
theory (Barney et al 1994) with procedural justice theory (Sapienza and Korsgaard
1996, Sapienza et al 2000, De Clerq and Sapienza 2001, Shepherd and Zacharakis
1 Smith (1998), Bigus (2002), Repullo and Suarez (2003), and Utset (2002) all note that the VC’s staging of financing enables the VC to increase her bargaining power over time, resulting in the ex post hold-up threat. In Skeie’s (2004) model, the VC’s increased bargaining power, and the ex post threat, arises form the common feature of vesting of equity payments to the entrepreneur.
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2001). The agency theory approach emphasises mechanisms to control venture
capitalist and entrepreneurial self-interested opportunistic behaviour. In contrast to
agency theory, procedural justice theory focuses on the perceived sense of fairness in
making decisions.
Lehtonen et al (2004) note that procedural justice theory may be particularly relevant
to the VC/E relationship. The VC/E relationship may be subject to feelings of
unfairness and mistrust. VCs often complain that entrepreneurs are reluctant to share
information (Sapienza 1989). A person’s willingness to share information and
provide timely feedback may signal his openness and honesty (Sapienza and
Korsgaard 1996). According to PJ, the more one party perceives a procedure to be
fair, the greater they will trust the other party.
Increased trust and communication between entrepreneurs and venture capitalists can
create ‘relational rents’ (De Clercq and Sapienza 2001). Open and frequent
communication between the entrepreneur and the venture capitalist may result in an
increase in perceptions of fairness and trust, thus mitigating agency problems
(Shepherd and Zacharakis 2001).
Procedural justice theory can also be employed to consider the VC’s ex post hold-up
problem. An increase in a person’s perception of fairness may lead to an increase in
commitment to decisions, performance, behaviour and attitude (Kim and Mauborgne
1991, 1993). This increased commitment, and feelings of fairness, may mitigate the
venture capitalist’s opportunistic post-investment threat of early exit (Shepherd and
Zacharakis 2001, Utset 2002).
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1.3. General Game-theoretic Research on Fairness and Trust
In recent years, behavioural economists have begun the task of developing formal
and Schmidt 1999) and trust (e.g; Berg et al 1995).
In general, these researchers have modelled fairness by assuming that agents not only
consider their own payoffs in absolute terms, but also in relative terms (that is,
compared to other agents’ payoffs). Formally, fairness is modelled by including both
absolute and relative payoffs in the players’ utility functions.
In this paper, we focus on Fehr and Schmidt’s (1999) model of inequity-aversion.
This approach combines envy and altruism; each player dislikes unequal payoffs,
either in his own, or the other player’s, favour. Fehr and Schmidt model this as
follows. A player suffers a utility loss either if her opponent has a higher or a lower
payoff. As a result, players take actions to equalise payoffs2.
Fehr and Schmidt develop a series of models of reciprocal fairness in a principal-
agent context, where reciprocal fairness may induce high wage offers from
management to workers, and high effort levels by workers in response. Further, FS
test their models experimentally. They provide evidence of reciprocal fairness.
Models of fairness can be developed to include social norms. Huang (2000) considers
the effect of a fairness norm on the equilibrium of a two-player ultimatum bargaining
2 Other fairness models include Becker (1974) who considers pure altruism, Bolton (1991) who
analyses enviable fairness, and Rabin (1993), in which a player’s reaction to another player’s unfair
behaviour depends upon whether that behaviour is intentional. He considers players’ reciprocation of
perceived nice or nasty behaviour, and he derives a “fairness equilibrium.”
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game. Interestingly, he relates fairness to anger as follows; “In psychological games,
the impact of anger on payoffs depends on endogenously determined equilibrium
beliefs about behaviour. The less likely that a party believes that it is going to be
offered the smaller part of an unequal division, the more anger that party will suffer if
such an offer is made. Conversely, the more likely a party believes that it will be
offered the lesser share of an unequal division, the less anger it will suffer if such an
offer is made.”
Our modelling approach to fairness draws upon Fehr and Schmidt’s inequity-aversion
approach, together with Huang’s (2000) social norm methodology.
Behavioural economists have identified several methods for modelling trust. The
general trust game is based on reciprocity of behaviour (e.g, Berg et al 1995 and
Maccabe et al)3. In contrast, Al-Najjur and Casadessus-Masanell (2001) develop a
principal-agent model in which trust is a characteristic of a player, rather than a
reciprocal response.
Our approach to trust is closest to Al-Najjur and Casadessus-Masanell (2001). That is,
in our model, we simplify the approach to by not considering reciprocal trust.
Instead, we focus on VC trustworthiness as a characteristic. That is the VC’s
behaviour depends on her type (trustworthy or untrustworthy), and is not a reaction to
E’s behaviour (that is, the VC does not exhibit reciprocal behaviour).
3 The reciprocal trust game, as developed by Berg et al (1995) and Maccabe et al, is designed as
follows. The first player (the trustor) chooses whether to send money to the second player (the trustee).
The second player then chooses whether to invest this money in a value-adding project. Finally, the
second player then decides how much of the value created to return to the first player. Experimental
evidence of the first player’s willingness to send money, and the second player’s willingness to return
money, provides support of reciprocal trust.
10
Our model compares with Al-Najjur and Casadessus-Masanell (2001) as follows.
They develop a model of trust in agency contracts, whereby an agent chooses an
effort level and then the principal chooses a wage from a bounded interval. The
authors consider two types of principal; trustworthy and self-interested. In contrast to
our model, the self-interested principal chooses the lowest possible wage in the
interval, while the trustworthy principal chooses the lowest possible wage such that
the agent’s participation constraint is just satisfied. In contrast, in our model, the VC
makes an initial equity proposal to the E, and then the E exerts effort. The trustworthy
VC does not force ex post renegotiation of the equity allocation. The trustworthy VC
does. Furthermore, in contrast to Al-Najjur and Casedessus-Masanell (2001), we
consider the combined impact of fairness and trust.
The rest of the paper is organised as follows. In section 3, we present the model, and
solve for the effect of the fairness norm and VC ability on the VC’s equilibrium
equity proposal and the players’ equilibrium effort levels. In section 4, we consider
the effect of the fairness norm and VC ability on equilibrium venture performance. In
section 5, we discuss policy implications emanating from our model. Section 6
concludes with a discussion of future research.
2. The Model
We consider a venture capitalist/entrepreneur financial contracting game in which an
entrepreneur (E) has an idea for an innovative project, and approaches a venture
capitalist (VC) to obtain funding. The E and the VC firstly negotiate over the financial
contract (specifically, they negotiate over their respective cashflow rights in the form
of an equity allocation). After agreeing the contract, the E exerts effort in forming the
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business and creating value. Specifically, the E’s effort affects the probability of
success for the business (hence, at this stage, we consider moral hazard in the form of
E’s shirking). After the project outcome is realised, the VC has an opportunity to
force re-negotiation of the contract in order to re-allocate the equity stakes in her
favour (the VC’s hold-up threat).
We model the negotiation stage as an ultimatum bargaining game in which the VC
makes a take-it-or-leave-it offer of equity to the E (this embodies the idea that the VC
has the bargaining power). The equity offer affects the entrepreneur’s effort
incentives. Furthermore, the VC’s ex post hold-up threat reduces the E’s ex ante effort
incentives. We demonstrate that fairness and trust mitigate these moral hazard
problems. Fairness induces the VC to offer a higher equity stake, which mitigates the
E’s shirking problem. VC trustworthiness reduces the ex post threat, which further
strengthens the E’s effort incentives.
Our model incorporates the effects of fairness and trust as follows. The E and the VC
are drawn randomly from a population consisting of ]1,0[∈r inequity-averse (fair)
VCs and r−1 self-interested VCs; r reciprocating Es (that is, these Es are concerned
with fairness, and react to unfair treatment with anger or spite) and r−1 self-
interested Es. We denote these types as and with iE ,iVC },,{ FSi∈ where refers
to a self-interested type, and
S
F refers to a fair type.
In our model, fairness and trust are related as follows. We assume that all of the
inequity-averse VCs are trustworthy. Furthermore, a proportion of the self-
interested VCs are trustworthy; and a proportion
t
t−1 are untrustworthy. We consider
three possible levels of trust; none of the self-interested VCs are trustworthy, half of
the self-interested VCs are trustworthy, or all of the self-interested VCs are
12
trustworthy; }.1,21,0{∈t This enables us to consider the combined effects of
increasing societal fairness and trust on venture performance in a clear and tractable
way.
Since the VC is drawn at random from a population of r fair and r−1 self-interested
VCs, the probability of the VC being trustworthy is ).1( rtrT −+= We refer to T as
the expected level of trustworthiness in society. The relationship between societal
fairness and trust is as follows. If ,0=t .rT = Since none of the self-interested VCs
are trustworthy, there is a direct, one-to-one, relationship between increasing societal
fairness and increasing trust. If ,21
=t ,2
1 rT += with ]1,
21[∈T when
When for any level of fairness
].1,0[∈r
,1=t 1=T .r Since all VCs (fair or self-interested)
are trustworthy, the level of fairness is has no effect on societal trustworthiness.
The timeline of the game is as follows;
Date 0: The Matching Stage: A VC and an E are drawn and matched randomly from
the population. Each player’s fair or self-interested type is revealed to the other
player. If the VC is revealed to be fair, then the E knows that the VC is trustworthy.
However, we assume that if the VC is revealed to be self-interested, her
trustworthiness is not revealed until date 4.
Date 1: Financial Contracting Stage: The VC makes a take-it-or-leave-it proposal
relating to the E’s and the VC’s relative equity stakes4. Specifically, the VC offers the
4 Hence, we have chosen to model equity bargaining as an ultimatum game, with VC as proposer, and E as respondent. This captures the idea that the VC has the bargaining power.
13
E a proportion ]1,0[∈α of the date 3 realised project value ,~V with the VC retaining
the balancing proportion .1 α−
Date 2: Post-contractual Value-creating Stage: The E exerts effort .e Effo t is costly,
and we assume that the cost of effort is ;2eC β= esents increasing marginal
cost of effort.
r
this repr
The project has two possible date 3 outcomes, success, in which case the project
provides date 3 income ,R or failure, in which case the project provides income zero.
The E’s effort level affects the probability of success .P We model this as follows;
the probability of success is ,eP γ= while the probability of failure is
Therefore, at date 2, the expected value of the project is
.1 P−
.eRV γ=
Date 3: Project outcome stage: At this stage, the outcome of the project (success or
failure) is revealed.
Date 4: The Ex Post Renegotiation Stage: After the project’s outcome has been
achieved, the VC has the opportunity to force renegotiation of the equity stakes in the
financial contract, making a new take-it-or-leave-it offer. We assume that only the
untrustworthy type carries out this threat, whereas the trustworthy type does not.
2.1 Analysis of the Game
We note that our game consists of three sequential decisions; a) the VC’s date 1
equity proposal, b) the E’s date 2 effort decision, and c) the VC’s date 4 re-
negotiation decision. We solve this game using the standard game-theoretic approach.
That is, we employ backward induction, whereby we solve for the equilibrium
decisions in reverse order, as follows.
14
First, we solve for the VC’s ex post date 4 re-negotiation decision, taking as given the
VC’s date 1 equity proposal and the E’s date 2 effort decision. Then, we move back to
date 2 to solve for the E’s effort decision, still taking as given the VC’s date 1 equity
proposal. Finally, we move back to date 1 to solve for the VC’s equity decision, hence
deriving the equilibrium of the entire game.
2.2: The VC’s date 4 re-negotiation threat.
At date 4, the E has already exerted effort, and the outcome of the project has been
realised. If the project failed, realising income of zero, the VC’s re-negotiation threat
is irrelevant.
If the project succeeded at date 3, then, by assumption, the trustworthy VC does not
force re-negotiation, and the E and the VC receive their respective equity allocations,
Rα and ,)1( Rα− as agreed at date 1. If the VC is untrustworthy, then, since the E
has already exerted effort, and the outcome has already been achieved, the VC will
take all of the equity, providing the E and the VC with respective payoffs of zero and
R
..R
2.3: Date 2 Effort Stage/date 1 Equity Stage.
For presentation purposes, we present our analysis of these two decisions together in
this sub-section (still using backward induction).
Since the E and the VC are drawn randomly from the population at date 0, we note
that there are 4 possible combinations of types in the VC/E dyad. We proceed to
solve the game by considering the different combinations. Furthermore, we now
formalise a payoff structure, which is necessary in order to solve the game.
15
2.4. Benchmark Case: SS VCE +
We refer to the dyad in which both players are self-interested as the benchmark case,
since this reflects the standard view in economics that agents are strictly self-
interested (homo oeconomicus).
We consider the following expected payoff5 function for the self-interested E;
.2eeRtE βαγ −=∏ (1)
The first term represents the E’s equity share6 α of the expected project income
,eRPRV γ== multiplied by the probability }1,21,0{∈t at SVC trustworthy. The
E can observe that the VC is self-interested, but not whether the VC is trustworthy or
untrustworthy. With probability ,t the SVC is trustworthy, and, therefore, the E will
retain his agreed equity share throughout the game. With probability ,1 t− E has
matched with an untrustworthy SVC who forces re-negotiation at date 4, taking all of
the equity. The second term of the payoff is the E’s cost of effort.
In order to so
th is
lve for the VC’s optimal date 1 equity proposal, we define the VC’s
payoff, as follows;
.eRVVC αγα ==∏ (2)
sing equations (1) and (2), we obtain our first result.
U
5 This represents the E’s expected payoff as at date 2 (when he makes his effort decision). At this stage, the E knows that the VC is self-interested, and so knows that she is trustworthy with probability t. 6 This equity share was already agreed at date 1.
16
Proposition 1: In the benchmark case, SS VCE + (both players are self-interested),
s the VC’s equilibrium equity proposal i ,5.0*=α and the equilibrium expected
project value is .4
22γ Rtβ
V = Therefore, ,0)0( ==tV
,8
)21(
22
βγ RtV == .
4)1(
22
βγ RtV ==
roof: See Appendix.
roposition 1 reveals that, in the standard case where both players are self-interested,
P
P
the VC offers half of the equity to the E, retaining the other half for herself.
Intuitively, the VC faces a trade-off between giving equity to the E to motivate
entrepreneurial value-creating efforts, and retaining equity for herself. If the VC kept
all of the equity, the E would exert zero effort, and no value would be created (the VC
would hold 100% of a project with zero value). If the VC gave all of the equity to the
E, the E’s effort levels would be maximised, but the VC would hold a zero percentage
equity stake in a high-valued project. The VC maximises her payoff by providing
50% of the equity to the E, and retaining 50% herself. Note that this is the VC’s
optimal equity offer regardless of the level of trust. Increasing levels of trust simply
increases the ‘peak’ in the VC’s payoff at 5.0*=α .
3.2.2.1 Either type of E or matches with a fair VC
e define the fair equity proposal,
FE( )FE ).( FVC
,Fαα =W as the proposal that equalises expected
payoffs. Furthermore, we define the fair (reciprocating) E’s payoff as follows;
17
.)])(1())(([ 2eeRrtrt FFE βγαααα −−−+−−=∏ (3)
This payoff has been constructed as follows. Firs re
rackets. The first term represents the E’s equity stake when the is trustworthy,
t, consider the terms in the squa
b SVC
minus a term representing the reciprocating E’s disutility from receiving an equity
allocation α that is different from the ‘fair’ proposal .Fα The sec term is the E’s
equity stake of zero minus the E’s disutility from receiving an equity allocation less
than the ‘fair’ proposal. The term
ond
r represents the social fairness norm (as in Huang).
The last term is the E’s cost of effort.
Using (1), (2) and (3), we obtain our second main result.
type of E ( or
the VC’s equilibrium equity proposal is
Proposition 2: If the fair VC matches with either ,SF EVC +
),FF EVC + ,32
=Fα and the equilibrium
expected project value is .3β
V By assumption, stworthy.
Proof: See appendix.
22γ R= is tru
itions 1 and 2 reveals that the fair VC offers more equity to the
than the self-interested VC. Recall that the fair VC acts to equalise the players’
payoffs. Intuitively, the fair VC’s equity offer of
FVC
Comparison of propos
E
32
=Fα compensates the E for his
18
effort costs. Further comparison of the propositions reveals that expected firm value is
higher when the VC is fair (combined with either type of E) than when both players
are self-interested. VC fairness is indeed value-enhancing, since the higher equity
2.5. ).(
offer increases the E’s effort incentives.
Finally, we consider the case where the VC is self-interested, but the E is a fair
reciprocator;
SF VCE +
).( SF VCE + Our result is as follows;
Proposition 3: In the dyad, the VC’s equilibrium equity proposal is SF VCE +
],1,)1(32
1min[*tr
r+
+=α and the equilibrium expected project value is
}.0],)1(26β3[max{
22
rtrRV −+=γ
a) When ,0=t *α is irrelevant, since 0=V for any equity offer. Since all of the self-
interested VCs are untrustworthy, the E exerts zero effort for any equity offer, and no
value is created.
b) When ,21
=t ]6
,2
[*∈ when 51α ].1,0[∈r Therefore, ]
12,
8[
ββV ∈ when
].1,0[∈r The expected value of the project decreases as societal fairness increases.
2222 γγ RR
c) When ,1=t ]32,
21[*∈α Therefore, ].
3,
4[
2222
βγ
βγ RRV ∈ when ].1,0[∈r In contrast
to b), the expected value of the project increases as societal fairness increases.
Proof: see appendix.
19
Proposition 3 reveals that the self-interested VC’s equity offer is affected by her
and is
rther affected by the extent of the societal fairness norm.
zero the self-interested VC offers half of the equity to
e E (as in the dyad; see proposition 1) for any level of trust As the
fairness norm increases towards 1, then (if
anticipation of the reciprocating E’s reaction (in terms of E’s effort level),
fu
If the fairness norm is ),0( =r
SS VCE + .t
;1=t
ases
th
all members of the population are
trustworthy), the optimal equity offer incre towards the fair VC’s equity offer
.3
*=α For lower levels o e optimal equity offer increases more sharply, to
compensate the r ing E for higher re-negotiation risk).
Similarly, in the SF VCE + dyad, the effect of fairness
2f th
eciprocat
,t
r on firm value is moderated
.t ,1=tby the level of trust then firm value ranges from If β
γ 22 RV =4
when
(as in proposition 1
0=r
), to γβ3
22 RV = when 0=r (as in proposition 2). That is, if all
equity offer to the fair E is merely affected by the societal fairness norm. When the
fairness norm is zero, the self-interested VC acts as she would when matching with a
self-interested E. As the fairness norm approaches unity, the self-interested VC’s
equity proposal is forced towards the fair VC’s proposal.
members of the population are trustworthy, then the self-interested VC’s optimal
Comparison of proposition b) and c) provide interesting results regarding the
relationship between fairness, trust and venture performance when the E is fair. If VC
trustworthiness is too low, then no equity offer between zero and unity can induce the
E to exert effort, due to the high re-negotiation risk. Hence, firm value is zero.
20
If the level of VC trustworthiness is in a medium range, firm value is actually
reducing in the fairness norm. The intuition is that, as the fairness norm increases, the
reciprocating E feels more indignation at the high renegotiation risk, and reduces his
effort level.
If the level of VC trustworthiness is sufficiently high, firm value is increasing in the
fairness norm.
The results of propositions 1, 2 and 3 are compared in diagram 1.
Fairness, Trust and Venture Performance
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Fairness
Vent
ure
Perf
orm
ance
Diagram 1.
The diagram shows the following. When and match (proposition 1), or
and match, venture performance is independent of fairness (horizontal lines).
Wh and match, venture performance is decreasing in fairness for low VC
trustworthiness (proposition 3b), while it is increasing in fairness for high VC
trustworthiness (proposition 3c).
SE SVC SE
FVC
en FE SVC
21
2.6. Expected Venture Performance.
In order to consider the effects of societal fairness and trust on venture performance,
we define an expected venture value prior to an E or a VC being drawn from
e population. Hence,
)(VE
th
}0],)1(23[
6max{.)1(
34)1()(
2222222 rtrRrrRrRtrVE −+−++−=
βγ
βγ
βγ (9)
Equation (9) may be thought of as an index of expected VC performance.
From propositions 1,2 and 3, we note the following;
Proposition 4:
a) When ,0=t .3
)(β
γ RrVE = Therefore, 22
]3
,0[)(β
γ RVE ∈ when ].1,0[∈r22
;2
t 1
=b)When
}.0],)1(43[
6max{.)1(
38)1()(
2222222 rrRrrRrRrVE −+−++−=
βγ
βγ
βγ Therefore,
]3
,8
[)(VE ∈ ].1,0[∈ 2222
βγ
βγ RR when
c) When
r
;1=t
}0],)1(23[
6max{.)1(
34)1()(
2222222 rrRrrRrRrVE −+−++−=
βγ
βγ
βγ
]3
,4
[)(2222
βγ
βγ RRVE ∈Therefore, when ].1,0[∈r
22
Hence, for a given level of trust, the performance index is positively related to societal
fairness. For a given level of fairness, the performance index is positively related to
trust. The performance index is maximised when fairness (and trust) is maximised.
We present the effects of fairness r and trust on expected venture value in
the following graph.
t )(VE
Fairness, Trust and Performance Index
0.000
0.050
0.100
0.150
0.200
0.350
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Fairness
Perf
orm
ance
Inde 0.250
0.300
x
Diagram 2.
The lowest line represents zero trustworthiness amongst self-interested VCs,
The middle line represents
.0=t
.21
=t
.1=t
The top line represents maximum trustworthiness
amongst self-interested VCs,
Recall that societal trust is
.)1( trrT −+= Referring to equation (9), if then,
when then and
,0=t
,0=r ,0=T ;0)( =VE that is, if all self-interested VCs are
23
untrustworthy, then a zero fairness norm (there are no fair VCs, and all VCs are self-
esults in zero societal trust, and zero expected value. When interested) r ,1=r
.3β
)(22γ RVE =
If then,1=t 1=T for all values of ;r all VCs (fair and self-interested) are
trustworthy. Now, referring to equation (9), when ,0=r ;4β
,1=r
)(22γ RVE = and when
.22γ RE
3)(
βV =
Therefore;
roposition 4: a) For a given level of self-interested VC trustworthiness, an increase
the so ness c
fairness norm, an increase in VC trustworthiness increases venture performance. c)
d i rease in fai
trustworthiness. D) Venture performance is maximised at maximum fairness norm
which maximises trustworthiness.
t expected venture value is increasing a) in the level of the fairness norm
s a result of two effects; the self-interested VC is driven to offer a higher equity
P
in cial fair norm increases expe ted venture value. b) For a given level of
Venture performance is increased by combine nc rness and
We note tha
(a
stake to the E, and the proportion of fair VCs in the economy increases and dominates
(who both offer more equity, and are trustworthy for sure)), and b) in the level of VC
trustworthiness. An interesting point to note is that, for any level of fairness below
one, the expected venture value is increasing in the level of trust. This is the opposite
24
case to the VC’s optimal equity offer, where the optimal equity offer was decreasing
in the level of trust. Recall that eth VC needed to offer the E higher equity as
ustworthiness reduced in order to compensate the E for the increased re-negotiation
inputs into our model, societal fairness and trust.
here is much evidence (Camerer, 2003) that fairness norms vary considerably across
m bargaining games, Roth et al (1991) found
uch similarity in sharing norms amongst subjects in America, Israel, Japan and
ch et
l (2001, 2002) compared experimental ultimatum bargaining results for
ith subjects in the US, and found much more self-
tr
risk. Diagram 2 suggests that this increased offer is not sufficient to prevent expected
value falling as trust diminishes.
3. Practical and Policy Implications.
We now employ our game-theoretic model to consider practical and policy
implications, with reference to existing research. We considered the combined effects
of fairness and trust on venture performance. We obtained the following results;
3.1. Societal Fairness and Trust.
First, we discuss the exogenous
T
cultures.7 Using experimental ultimatu
m
Yugoslavia. In contrast, Buchan et al’s (1997) ultimatum bargaining experiment
demonstrated a strong sharing norm amongst subjects in the collectivistic culture of
Japan, compared with more self-interested behaviour in America. Finally, Henri
a
Machiguenga farmers in Peru w
interest in Peru.
7 For a detailed discussion of this point, see chapter 2 of Camerer’s (2003) excellent text-book on behavioural game theory. We provide a brief review here.
25
Camerer (2003) also discusses the trust experiment of Buchan et al (2000). These
authors found that Chinese investors were the most trusting and trustworthy, while the
Japanese were the least.
Therefore, the evidence suggests that fairness and trust is greatly affected by culture.
Lehtonen et al (2004) relate culture and venture capital performance, stating that “we
propose that a culture (geographical context), which does not call for high fairness
and justice (of actions) will increased the risk of opportunistic behaviour on the part
of the VC…. . This could provide Es with a method to evaluate the risk of
articularly between Es and VCs, would be beneficial for
In our model, an increase in societal fairness resulted in the VC offering a higher (and
btly
opportunistic behaviour based on geographical location.”
As a policy implication, our model demonstrates that measures to increase trust and
fairness in society, and p
venture performance (and economic growth). As a practical example, we suggest that
business school education (for example, at MBA level) of VCs and Es should
emphasise the beneficial role of fairness and trust in negotiations and contracting8.
On an empirical level, researchers should test the relationship between different
societies’ fairness-norms and venture capital contracting and performance.
3.2 Fair and unfair cashflow rights
In our model, increasing societal fairness resulted in fairer cashflow terms (in the
form of the equity allocation between the VC and the E). In this section, we consider
specific examples of fair and unfair cash-flow rights.
fairer) equity stake to the E. In reality, the allocation of cash-flow rights su 8 Indeed, ethics courses at business schools often employ repeated prisoner’s dilemma experiments to ‘educate’ the students about fairness, trust and cooperation (Gibson 2003). These could be extended to entrepreneurship classes.
26
depends upon the type of financial instruments employed (for example, equity versus
convertibles), and the conditions that the VC may negotiate into the contract, such as
unitive covenants (including anti-dilution and liquidation provisions) that subtly
irstly, we consider the research into fair and unfair financial instruments (eg;
cause it provides them with an
t Es should attempt to
dian VC markets when compared to the US. That is,
common equity places the entrepreneur and the VC ‘on the same team’.”
p
affect cashflow rights over time.
F
Hoffman and Blakey 1987, Tucker 2004, Cumming 2005).
Hoffman and Blakey (1987) argue that VCs usually invest in redeemable preferred
stock or debentures. VCs like this type of instrument be
equity stake in the case of success, and it provides them with debt (and first claim to
the cash flows) if the company fails. The authors provide this advice to entrepreneurs,
“if you have a choice, try to get the VCs to accept a capital structure that consists
entirely of common stock, because it is simpler and keeps the balance sheet clean.
Chances are, however, that you won’t get them to agree to this unless your bargaining
position is extremely strong.”
Tucker (2004) also argues that convertibles, widely used by the VC industry,
represent an unfair financial instrument, and argues tha
negotiate an equity-based financial structure. Cumming (2005) demonstrates that US
VCs make extensive use of convertibles, whereas Canadian VCs mainly hold equity
contracts. The traditional agency argument is that convertibles can be used by VCs to
control moral hazard problems relating to E’s opportunistic and shirking behaviour.
However, Cumming (2005) suggests, as an interesting counter-argument, that the use
of equity may signal a trusting and fair VC/E relationship. He states, “The high
proportion of straight common equity contracts in Canada suggests that relatively
more trusts exist within Cana
27
Next, we consider the unfair terms that may be attached to the parties’ cash-flow
rights, such as anti-dilution and liquidation provisions (or ‘ratchets’). VCs employ
these provisions to protect their investment. Hoffman and Blakey (1987) advise
entrepreneurs, “VCs’ concern over preserving their capital is legitimate. At the same
time, you should review these provisions carefully to make sure that they are fair to
you and any other founders.”
Research has suggested (Hoffman and Blakey 1987, Tucker 20049) that such “unfair”
punitive covenants should be excluded from any VC/E contract, since they may have
the effect of reducing the E’s equity stake over time, potentially damaging fairness
and trust in the VC/E relationship.
In summary, in terms of cash flow rights, it may be argued that performance-
e effects of social fairness and trust on the fairness of
ommunication between VCs and Es could affect
enhancing fairness and trust can be promoted by the VC’s avoidance of convertibles,
instead focussing on mutual allocation of equity to the VC and E, and by eliminating
onerous punitive covenants, such as anti-dilution rights and ratchets.
4. Future Research
Our model has focussed on th
cash-flow rights and venture performance. However, Kaplan and Stromberg (2000)
identify that VCs and Es negotiate over both cash flow rights and control rights in the
contract. Further, Cable and Shane (1997) argue that non-contractual factors, such as
personal relationships and regular c
cooperation and performance. Therefore, we argue that increasing societal fairness
9 Tucker is an entrepreneur, who obtained VC funding for his venture. In 2004, he conducted a small survey of Es regarding fair and unfair cash-flow and control rights.
28
may lead to fairer cash-flow and control rights, and fairer non-contractual behaviour,
hence enhancing performance.
We now discuss directions for future research, relating to fair control rights, and fair
C relates to staged financing, whereby VCs provide
ture rounds of financing if the E achieves certain milestones. Finally, VCs may
98).
lthough these control rights may be seen as protecting the VC’s investment, they
he VC/E relationship. Indeed, a debate exists in
e literature whether control rights and fairness/trust act as complements or
tionship. For example, the VC
non-contractual factors in the VC/E relationship.
4.1: Fair and Unfair Control Rights.
VCs and Es negotiate over their control rights in the venture. Researchers argue that
VCs may need to protect their investment through such control provisions as
performance/forfeiture provisions (Hoffman and Blakey 1987). Another control
mechanism employed by the V
fu
negotiate a ‘firing’ clause in the contract, whereby they can remove the E if the
venture fails to meet certain targets (Hellmann 19
A
may be destroy fairness and trust in t
th
substitutes in enhancing venture performance. Cable and Shane (1997) imply that they
are complements (increasing control leads to increase in trust and venture
performance). On the other hand, Shepherd and Zacharakis (2001) argue that control
and trust/fairness may be substitutes. An increase in control may actually destroy
feelings of fairness and trust, adversely affecting venture performance.
Tucker (2004) argues that the E often signs over significant negative control rights,
leaving him with a feeling of lack of control in the rela
29
may negotiate to include restrictive covenants in the contract. These ensure that
approval must be sought from the VC when taking most operational decisions. This
may damage trust, adversely affecting venture performance.
Tucker also argues that a fair VC will produce detailed term-sheet running to several
pages, so that much of the negotiation can be conducted before each party legally
commits to each other. On the other hand, an unfair VC produces a brief term-sheet,
leaving much room for future interpretation. The author further argues that VCs often
employ over-zealous lawyers who build in investor protections that are not needed, or
nship.
ommunication provides a potent method of signalling fairness. VCs typically invest
new, highly risky ventures, characterised by large asymmetric information
have been specifically excluded in discussions between the VC and the E. “The result
is a package of documentation which at best offers the investor all the protection they
need while ensuring the E has the authority to run the business; and at worst,
promotes a bureaucratic approach to operational management, reminiscent of many
much larger corporations.”
4.2: Fair and Unfair Non-contractual Factors.
We should consider non-contractual factors, not specifically related to cash-flow
rights or control rights. According to procedural justice theory, procedures that
increase the players’ perception of fairness can lead to increased cooperation. Cable
and Shane (1997), and Lehtonen et al (2004) place emphasis on relationship-building
and open and frequent communication as methods of increasing perceptions of
fairness and trust in the VC/E relatio
C
in
30
problems (Houben 2003). Es normally possess superior knowledge regarding the
chnical aspects of the venture, while the VCs have superior information regarding
l.
deep and extensive conceptual analysis of the
ffects of behavioural factors (particularly reciprocal fairness and anger) on the
over time. Utset begins with the view
te
the potential market conditions. According to standard agency theory, VCs and Es
possess incentives to mis-state or with-hold their private information10. Therefore,
timely and open communication of accurate information may increase the VC’s and
E’s mutual perception of fairness11.
4.3 Dynamic Fairness and trust VC/E Mode
In our model, fairness and trust are exogenously-given inputs which induces fairness
in cashflow terms, and possibly (but not modelled) fair control rights and fair non-
contractual behaviour (such as increased communication and relationship-building),
which, in turn, enhances cooperative efforts and performance. We do not consider the
dynamic effects on perceptions of fairness and trust over time in the VC/E
relationship.
Utset (2002) provides an inspirational basis for a future research agenda on this
dynamic relationship. He provides a
e
dynamic relationship between the VC and the E
that the VC, as principal, needs to protect her investment from the self-interested
behaviour of the E. Hence, he argues that the VC structures the contract to retain
control over the E’s equity stake and the exit decision.
However, Utset notes the dynamic and complex nature of the relationship.
10 See Cable and Shane (1997) and Lehtonen et al (2004) for an extensive discussion of the parties’ incentives to mis-state or with-hold information. 11 We argue that this may be analogous to our cash-flow model. In our model, increased fairness-norms resulted in a self-interested VC offering a more generous equity stake to the E, and the E responding with more cooperative value-adding effort. Similarly, increasing fairness-norms may induce self-interested VCs or Es to reveal more (truthful) information, with the same positive effects on cooperative efforts and performance. Future research will develop our model in this direction.
31
“While the control mechanisms adopted by the VC play an important role in
ptimistic expectations of VC
may begin
observe increasing VC opportunism and unfair behaviour. As his initial,
e…..
Under certain behavioural assumptions, the E will have an incentive to retaliate
. Conclusion
protecting their investment, they also give VCs great leeway to act
opportunistically…”, and because Es make ex ante transaction-specific investments,
“the VC can threaten to fire the E or use some other form of leverage to appropriate a
greater share of any potential surplus. This si the classic opportunism scenario.”
Utset incorporates behavioural considerations into the analysis. Firstly, he discusses
how Es may enter into a VC contract with over-o
trustworthiness and fairness. As the relationship develops over time, the E
to
overconfident, expectations become deflated, the E may then retaliate with increasing
anger and spite.
As Utset states, “The level of divergence of the E’s original expectations matters,
since it casts a shadow affecting VC/E relationships during the life of the ventur
.
against the VC, even if doing so comes at a cost to the E.”
We believe that an important future step in the venture capital research is to develop a
dynamic behavioural model that captures the E’s retaliatory behaviour.
5
32
We have developed a behavioural game-theoretic model of venture
capital/entrepreneur contracting and performance that demonstrates that stronger
fairness-norms result in an increase in the equity stake offered by the VC to the E,
which, in turn, induces higher entrepreneurial effort, and improved venture
erformance. We have also discussed the effects of other unfair contractual terms,
s, short-term
mployment contracts, tranched financing). Further, we have noted that non-
ontractual factors, such as regular communication and empathetic personal
n promote fairness, trust and venture performance.
ur model provides a basis for future research. The first challenge is to formally
e will incorporate
p
such as unfair cash-flow provisions (anti-dilution provisions, ratchets, convertibles),
and unfair control rights (such as performance/forfeiture provision
e
c
relationships ca
O
model these fair and unfair cash-flow and control rights. For example, how do we
incorporate the fair and unfair features of equity and convertibles, as identified by
Cumming (2005) and Tucker (2004), into a behavioural fairness model?
Secondly, we have taken fairness as an exogenous initial input into the game, which
subsequently affects equity allocation, effort levels, and performance. However, the
VC/E relationship is dynamic and inter-temporal. As Utset (2002) and Tucker (2004)
note, fairness and trust can be damaged over time. We suggest that future researchers
develop a dynamic model, with fairness endogenously derived throughout the game.
Finally, we have focussed on reciprocal fairness, taking trust and trustworthiness as an
exogenous characteristic of the players. In future research, w
reciprocal trust into our behavioural game-theoretic approach to venture capital
contracting.
Appendix.
33
1. Proof of propositions:
Proof of Proposition 1:
We derive the date 2 optimal effort level of E by solving ∏∂0=S ∂e
noting that SE knows that the VC is self-interested (and is therefore trustworthy with
probability ).t We obtain the self-interested E’s optimal effort level, given that he
has matched
E in equation (1),
with the self-interested VC, as follows;
.*2βαγRte = (A.1)
e note that, from equation (1), 02 <−=∂∏∂
βe
EW for all Therefore, the optimal
indeed maximises
.e
.E∏ effort level given in (A.1)
Given (A.1), the expected value of the project is
.2β
γeRV == 22αγ Rt (A.2)
We now m S ' optimal equity
knows that she has matched with a self-interested E.
Therefore, substituting quation (A.1) into (2), and solving
ove back to date 1 to solve for the trustworthy VC s
proposal, given that SVC
e ,0=∂∏∂α
VC we obtain the
34
as stated in proVC’s optimal equity proposal, ,5.0* =α position 1. Further, we note
that 02 <−=∂ βα
VC for all .222 ∏∂ γ Rt
α Th rerefo e, this optimal equity proposal is
deed payoff-maximising.
ubstituting this result into A.2, we obtain the results in proposition 1.
Proof of Proposition 2:
e VC is fair (that is, her ob is to equalise payoffs), by definition, her
equity proposal is
in
S
Since th jective
.Fαα = Furthermore, she is trustworthy for certain;
(A.3)
.1=t
Therefore, equation (1) (the self-interested E’s payoff) and equation (3) (the fair E’s
payoff) both reduce to
Solving
.2eeRFE βγα −=∏
,0=∏∂ E we obtai∂e
n the optimal effort level for either type of E;
.2
*βγα RF= (A.4) e
Substituting (A.4) into (A.3), either type of E’s payoff (given the proposal )Fαα =
becomes
.4
222
βγα R
EF=∏ (A.5)
35
From (A.3), we note that 02 <−=∏∂
βE . Therefore, the optim∂e
al effort level given
in (A.4) is indeed payoff-maximising.
ubstituting (A.4) into (2), the payoff becomes
sVCF 'S
.2
)1(22
βγα
αRF
FVC −=∏ (A.6)
roposalEquating (A.5) and (A.6), we obtain the fair (payoff-equalising) equity p ,
.2=Fα N
3ote that this fair equity proposal compensates the E for his effort costs.
Substituting this result into ,eRV γ= we obtain the results in proposition 2.
Proof of Proposition 3:
Substituting
,32
=Fα into (3), and solving ,0=∏∂
∂e
E we obtain the fair
eciprocating) E’s optimal effort level;
(r
.2
]32)1([*
βγα Rrrte −+= (A.7)
Again, for .022
∂ 2 <−=∏∂ E βe
The effort level in (A.7) indeed ism (3), we note that
payoff-maximising.
36
We substitute this result into ,eRV γ= and then substitute into (2). Solving
,0=∂∏∂α
VC we obtain the optimal equity proposal given in proposition 3. We note
that ,02
2
<∂∏∂α
VC Therefore, the optimal equity proposal is indeed payoff-maximising.
Substituting this optimal equity proposal back into (A.7), and then into
,eRV γ= we
obtain the equilibrium firm value given in proposition 3.
dmati, A. and P. Pfleiderer, 1994, Robust financial contracting and the role of
enture capitalists, Journal of Finance 49, 371-95.
nderhub, V., S. Gachter and M. Konigstein, 2001, Efficient contracting and fair play
a simple principal-agent experiment. Available at
ttp://ideas.repec.org/p/zur/iewwpx/018.html
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A
v
A
in
h
37
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