1
How entrepreneurs-in-residence increase seed investment rates
Prepared For:
Canadian Association of Business Incubation
...
2
arise from the practices of venture capitalists (VCs) who incur transaction expenses ex-ante,
during and ex-post investm...
3
fund-seeking entrepreneur build a relationship able to reduce each transaction cost component
normally encountered in VC...
4
risk, also known as agency risk, has two components (Fama and Jensen, 1983): moral hazard,
arising when the two parties ...
5
and Busenitz, 2003). Developing trust-based relational contracts requires time, which is usually
in short supply during ...
6
continue for the life of the investment. When evaluating an investment opportunity, the VC
views all of these transactio...
7
The role of EIRs
EIRs are recruited by a VC and paid a salary during their internship, which typically
lasts between 12 ...
8
Goodwill trust and competence trust develop by the trustor examining the previous performance
of the trustee, often base...
9
VCs’ perceptions of highly subjective factors, such as the relative importance of the EIR’s
reputation.1
We selected 14 ...
10
------------- Insert Table 2 about here -------------
All selected EIRs were associated with firms where the VC had pre...
11
role of the EIR and the nature of trust development. Subsequent analysis was based on
attempting a more detailed unders...
12
The VCs noted the importance of EIRs in facilitating a positive investment decision by
acting as catalysts in the devel...
13
entrepreneurs do not have the experience… [that] EIRs are expected to have … to enter into the
market, build the right ...
14
VCs also identified how they determined goodwill and competence trust when selecting
and recruiting EIRs based on their...
15
deployed when a seed-investment opportunity arose and the VC had insufficient time to build the
required level of trust...
16
existed. The presence of the EIR therefore increased the “investability” of the venture and the
efficiency of the inter...
17
 where they could more easily understand its mechanisms and goals  was extremely helpful
in later due diligence and b...
18
account for Israel’s higher rates than other countries. The close-knit ICT community in Israel and
the Dan Valley creat...
19
trust-building process over many months. In contrast, investment decisions typically occur far
more quickly, making tru...
20
networking activities. Contracting costs could also be reduced by subsidizing qualified third
parties to facilitate inv...
21
We therefore hope that our exploratory attempt stimulates much further research,
especially to address some of our limi...
22
References
Arthurs, J.D., and L.W. Busenitz. 2003. The boundaries and limitations of agency theory and
stewardship theo...
23
Harrison, R., M. Dibben, and C.M. Mason. 1997. The role of trust in the informal investor's
investment decision: An exp...
24
Rosman, A.J., and H.M. O’Neill. 1993. Comparing the information acquisition strategies of
venture capital and commercia...
25
Table 1. Transaction cost components and impact of an EIR
Investment
Stage
Transaction cost
component
Nature of activit...
26
Table 2. Data on VCs
Interviewee
Local
Fundsize
Numberof
seedventures
(2000/4)
Numberof
EIRs
%ofEIRs
receiving
investme...
27
Table 3. Outline of structured survey questions
Factor discussed Details
VC firm characteristics
Structure, Size
Histor...
28
Table 4. Reasons and explanations for venture failures
Reasons for failures Explanations by our interviewed VCs
Entrepr...
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How entrepreneurs-in-residence increase seed investment rates ...

  1. 1. 1 How entrepreneurs-in-residence increase seed investment rates Prepared For: Canadian Association of Business Incubation Prepared By: Andrew Maxwell MBA P.Eng. 1774 Grosvenor Place, Mississauga, Ontario, L5L 3V8 This article investigates the role of entrepreneurs-in-residence (EIRs) in closing the equity gap born by a lack of venture capital investment in early-stage businesses. We conducted interviews with ten Israeli-based venture capitalists and four EIRs to identify the mechanisms and actions used by EIRs when operating in venture-capital firms, and subsequently in funded ventures, that lead to a greater proportion of funds targeted to seed investments. The findings of our exploratory study suggest that EIRs facilitate investment decisions by acting as catalysts in the development of the relationship between the venture capitalist and the fund-seeking entrepreneur. EIRs can thus prevent some of the problems that preclude venture success through the nurturing of trusted relationships with both fund-seeking entrepreneurs and venture capitalists. Furthermore, ex-ante, during and ex-post investment, through building these trusted relationships, EIRs act as transaction-cost reducers, thus increasing expected return on investments from early-stage ventures. In an attempt to help reduce the equity gap by developing a better understanding of this key phenomenon, these findings provide guidance to rising entrepreneurs as they develop their early-stage businesses, to venture capitalists as they look for investment opportunities, and to governments eager to increase the rate of seed funding. Keywords: Equity gap, seed funding, venture capital, entrepreneur-in-residence, transaction costs, trust Introduction Obtaining venture capital (VC) is critical for high growth potential companies, but is increasingly problematic for seed ventures due to “the economics of the investment appraisal and monitoring processes” (Mason and Harrison, 1992: 377). Mason and Harrison (1995) identify an equity gap attributed to the “evaluation and monitoring costs which must precede and accompany venture capital investments [and] are a significant fixed cost element, which makes it uneconomic for funds to make investments of less than about £250,000” (p. 155). These costs
  2. 2. 2 arise from the practices of venture capitalists (VCs) who incur transaction expenses ex-ante, during and ex-post investment, in order to reduce their perceived risk in the investment (Van Osnabrugge, 2000). Given the fixed nature of these transaction expenses, they constitute a much higher percentage of the investment amount in seed funding compared to investments made in later stages of funding where investments are larger. In this article we explore how entrepreneurs-in-residence (EIRs) can decrease these costs, reduce the equity gap and increase VC funds that flow into early-stage ventures. EIRs are particularly active in Israel, found in 31% of VC firms who invest in seed ventures in the information and communication technology (ICT) sector (Schwarzkopf, 2007). Since 1995, the Israeli economy has had an inflow of US$43 billion in ICT investments including US$16 billion of direct VC investments (Myre, 2005) of which seed ventures represent 8% (Israel Venture Capital Association, 2008). Israeli VCs view the utilization of EIRs in an internship program as a critical mechanism that allows for these high rates of seed funding compared, for instance, to the US with only 4% of VC funds in seed ventures (PWC Moneytree, 2008). Previous research on the role of EIRs has been limited, with only one key study (Rosenblatt and Thelen, 1997) that suggests that an EIR’s role is to both attract more fund- seeking entrepreneurs and improve the likelihood of success of funded ventures. However, since there are other mechanisms (such as the recruitment by VCs of experienced CEOs) that appear to replicate these effects, these explanations alone are insufficient to explain the higher rates of seed funding (and specifically how EIRs reduce the equity gap). This leads to our research questions: What is the role of the EIR in reducing the transaction costs that cause the equity gap that inhibits seed investments? Specifically, how does an EIR working with an Israeli VC and the
  3. 3. 3 fund-seeking entrepreneur build a relationship able to reduce each transaction cost component normally encountered in VC investment? We address this question by exploring theoretically and empirically how investors can reduce their investment risks, especially those born from the relationship risk introduced by allowing a fund-seeking entrepreneur to manage a funded venture. Understanding the nature of the transaction costs introduced into the VC-entrepreneur relationship allows us to characterize how, through the development of mutual trust, an EIR can enable the development of a relational contract that complements the more formal agreement. We adopt a qualitative research method for this exploratory study and draw conclusions on how the presence of an EIR influences the perceptions and behaviors of both VC and fund-seeking entrepreneur. Our interviews with ten Israeli-based VCs and four EIRs allow us to identify how EIRs act as catalysts for investment. We also extract data from our interviews to explain how a VC chooses an EIR who can identify opportunities, overcome VCs’ past investment problems, boost expected returns, and who can nurture trusted relationships with VC partners and the fund-seeking entrepreneur. Our insights can be used to explain how EIRs are able to reduce the equity gap and increase the rate of funding in seed ventures. Reducing investors’ perceived relationship risk A VC making a seed-investment decision must consider the performance risk and the relationship risk rooted in two different domains: the former in the competitive environment, the latter in partners’ co-operation. Performance risk is the likelihood of achieving expected outcomes, given full cooperation by both partners (Das and Teng, 1996). Relationship risk occurs because the investor must engage an entrepreneur to manage the enterprise, whose decisions may not always align with those of the investor (Das and Teng, 2001). Relationship
  4. 4. 4 risk, also known as agency risk, has two components (Fama and Jensen, 1983): moral hazard, arising when the two parties have diverging interests; and adverse selection born from information asymmetry between the two parties. Moral hazard can lead the fund-seeking entrepreneur to take actions that are beneficial to her/him but detrimental to the VC. Adverse selection can lead the fund-seeking entrepreneur to fail to recognize her/his lack of knowledge, which can result in poor decisions. To reduce the relationship risk perceived by the VC to an acceptable level, the VC must achieve a level of confidence in the future behaviors of the entrepreneur. Typically, the VC accomplish this by undertaking due diligence on the previous behaviors of the entrepreneur – seen as an indication of future behaviors, and introducing control clauses into the shareholder agreement (Barney et al., 1994; Fiet, 1995; Kaplan and Stromberg, 2003). However, due diligence and the monitoring of control clauses introduce transaction costs, which reduce the expected return of an investment because limited resources are then diverted away from business development. This reduction in return often reaches the point where the VC’s expected returns cannot be achieved especially in seed investing where these transaction costs are a relatively high percentage of the investment amount. Consequently, the potentially good seed-investment opportunity does not take place. Barney and Hansen (1994) argue that relationship risk can also be reduced by the development of interpersonal relationships to the point where they can substitute for costly controls. These relationships require the development of interpersonal trust (Harrison et al., 1997) that facilitates the development of investor-entrepreneur relational contracts (Casadesus- Masanell, 2004). This suggests that an alternate model for the relationship between investor and fund-seeking entrepreneur might rely more on stewardship theory than agency theory (Arthurs
  5. 5. 5 and Busenitz, 2003). Developing trust-based relational contracts requires time, which is usually in short supply during the direct interactions between investor and fund-seeking entrepreneur. Lewicki and Bunker (1996) note the staged nature of such interactions, suggesting that higher levels of trust, known as identification-based trust, can only be reached when each party understands, appreciates and anticipates the other’s wants. As Flores and Salomon (1998) note, trust development is slow, starting from an anchored position created by each party’s initial trust perception of the other based on their predisposition and initial impression, which, as argued in Shepherd and Zacharakis (2001), is then modified over time by the reciprocal display of trusting and trustworthy behaviors from both parties. In the case of the investment decision, time- constrained VCs do not have the patience to develop such relationships, instead choosing to rely on the introduction of controls and their associated costs. We elaborate on the various cost components introduced by this traditional risk mitigation strategy using transaction cost economics theory, as shown in Table 1. Williamson (1975) identifies three types of transaction costs that reduce market efficiencies and prevent otherwise worthwhile transactions from being completed: ex-ante, negotiation and ex-post. Ex- ante costs are incurred before the transaction is completed, and include those associated with the identification of high potential opportunities and the assessment and selection of opportunities that meet the investment objectives of the VC. Negotiation costs are incurred during the investor- entrepreneur interactions and include significant information gathering and verification, as well as structuring contracts to reduce the likelihood of future risks associated with moral hazard or adverse selection. Ex-post costs are incurred subsequent to the investment and include ongoing monitoring of behaviors and performance against milestones as well as enforcement costs if required. Ex-post costs are typically the largest transaction cost component because they
  6. 6. 6 continue for the life of the investment. When evaluating an investment opportunity, the VC views all of these transaction costs as reducing perceived relationship risk, but also reducing expected ROI. As argued by Shepherd et al. (2005), balancing these costs against the VC’s time (ex-ante, during negotiations, and ex-post) is key, especially considering their resource constraints and the fact that much of the effort allocated ex-ante is not with ventures that become part of their portfolio. -------------- Insert Table 1 about here -------------- Mason and Harrison (1992) identify an alternate approach to introducing costly control clauses to manage relationship risk that involves a trusted third party, helping fund-seeking entrepreneurs understand what VCs are looking for. The role of this third party can be even more impactful if they have a good reputation and their incentives aligned with the venture’s long-term success (Pollock et al., 2004). We suggest that this third party, in the form of an EIR, enables the development of a relationship contract, can reduce each component of the transaction cost (due to that EIR’s likely impact on each cost component, as highlighted in Table 1), and can increase the rates of seed funding. Previous research on the role of EIRs has been limited and tended to either record individual success stories or identify the value of the EIR as increasing the number of opportunities presented to their host VC (Rosenblatt and Thelen, 1997). We propose that the role of the EIR is much more fundamental to relationship development, and that EIRs make possible seed investment decisions that otherwise might not happen due to the perceived high relationship risk.
  7. 7. 7 The role of EIRs EIRs are recruited by a VC and paid a salary during their internship, which typically lasts between 12 and 18 months. They are “high status” individuals (Baron and Markman, 2000) with an outstanding record of accomplishment as either an entrepreneur or technology innovator. They are recruited to increase the quality of opportunities presented to the VC and to enhance the long-term success of the ventures that are funded. During their internship, they develop strong personal relationships with VC partners and are exposed to the VC’s networks, resources and tools. This enables the EIRs to identify emerging market segments and specific business opportunities and resources that may be useful to future funded ventures. In addition, EIRs often utilize their expertise to provide direct assistance to VC portfolio firms facing specific challenges. In developing investment opportunities, some EIRs develop their own ideas from scratch, while others work with external entrepreneurs seeking startup finance. In both cases, the EIR plays a role in the investment process before and after the venture is funded. The specific role played by an EIR varies depending on their background or interest. Also, before becoming directly involved with a specific opportunity, EIRs are likely to first work inside the VC firm where they develop strong trusted relationships with VC partners while attracting opportunities and mentoring fund-seeking entrepreneurs. The relationship the EIR develops with the fund-seeking entrepreneur and their anticipated participation in the venture, post-funding, facilitates a positive investment decision, given the existing relationship the EIR has with the VC. The development of this trust based relationship is based on the development of two types of trust (Das and Teng, 1996): goodwill trust – based on the alignment of intention between two parties wishing to accomplish the same goals fostered when both parties share the same values and norms; and competence trust – based on the ability to accomplish certain goals.
  8. 8. 8 Goodwill trust and competence trust develop by the trustor examining the previous performance of the trustee, often based on the EIR’s reputation and past relationships with investors. Further, when an EIR elects to join the fund-seeking entrepreneur and become part of the venture’s management team, the VC’s confidence in the longer-term performance of the venture is increased. Jacobius (2004) reports on evidence from the VC community that the presence of an EIR in a funded venture is likely to have a direct positive impact on the value of the company at the time of a liquidity event. EIRs’ long-term role in supporting the aligned interests of all three parties is enhanced by their equity participation in the venture and their desire to maintain their reputation. EIRs’ behaviors and roles are explored though our interview-based research method described next. Researchmethod and analysis Our exploratory research was designed to determine how specific mechanisms and actions used by EIRs in VC firms and seed ventures can explain the relatively high proportion of Israeli VC seed investments. Specifically, we wanted to understand how the presence of an EIR in the investment decision process affects the behaviors and perceptions of the entrepreneur seeking funding and, more importantly, the VC. We elected to use a qualitative approach, interviewing key players in a semi-structured format because it permitted us to determine how EIRs operate and what the effects are of their presence. Semi-structured interviews allowed us to generate useful information to address questions such as how the roles of EIRs changed before, during and subsequent to the VC’s investment decision. This approach also enabled us to probe
  9. 9. 9 VCs’ perceptions of highly subjective factors, such as the relative importance of the EIR’s reputation.1 We selected 14 sample subjects through a criterion-based process, a strategy in which particular settings, persons, or activities are selected to provide information that cannot be as easily obtained from random sampling (Miles and Huberman, 1994). We selected the subjects from 57 VC firms operating in the Dan Valley region of Israel, investing in ICT seed ventures, and operating EIR internship programs. These firms were chosen to encompass a variety of VC sizes (in capital) and we chose to interview the primary decision makers (CEOs) of the first 10 VC firms who were available. While the number of VCs interviewed was small, our sampled VCs employed 36 EIRs, had 204 portfolio startup/seed ventures, and raised 41% of the Israeli VC funds in the two years before our research. Their perspectives were based on a great deal of experience with EIRs and we believe they are representative of the Israeli VC industry. Five were satellite offices of Silicon Valley VCs in Israel and five were locally owned VC firms. Our investors were predominantly male (90%) in their fifties with extensive managerial experience; 75% of those we interviewed were repeat entrepreneurs. They all lived in the central region of Israel, had served in the Israel Defense Forces (IDF) and were technologically competent. Our focus on VC’s view of EIRs was motivated by our desire to understand how the presence of an EIR affected the VC’s perceptions of relationship risk and their investment decision-making process. Table 2 summarizes our data on VCs. 1 Qualitative data analysis is common in the sociology literature, for instance, and can be done using two alternative approaches. In the first, interview data is transcribed and segments extracted to support specific view points. In the second, there is a greater attempt to determine the frequency of specific words or expressions, their magnitude and time of occurrence. We chose the former and utilized a common research tool, Microsoft OneNote 2003, with notebook capability to record data. This software allows for continuous sorting and resorting of the data, which can then be re-categorized. The latter approach (used e.g. in a tool like nVivo) was not used because the level of refinement it offers provides unnecessary details for the purpose of our exploratory study.
  10. 10. 10 ------------- Insert Table 2 about here ------------- All selected EIRs were associated with firms where the VC had previously agreed to be interviewed, ensuring that we would gather information on relationships between VCs and EIRs from both perspectives to better understand them. Our EIRs included two in the resident phase and two who had “graduated” with ventures that had received funding during the previous year. While all the EIRs interviewed were in their thirties, they all had similar backgrounds to the investors and had strong ties within a relatively small and inter-connected community. Our semi-structured interviews, in English, lasted about 90 minutes and took place during July and August 2005 in the interviewees’ offices. The interviews were taped and transcribed for analysis, increasing the quality of the data that could be extracted while ensuring participant confidentiality. As highlighted in Table 3, the questions focused on the operating practices and perceptions of EIR internship programs, the challenges of seed investing, and experiences with overcoming seed-funding barriers with the need to consider transaction costs. Specific attention was paid to gathering information about the constructs we had identified in our background research, such as the display of goodwill and competence trust. We gathered information on the importance of reputations of all parties and how the various relationships between them evolved over time. The information we obtained also provided insights on how the presence of an EIR affected the need for additional resources subsequent to funding. ------------- Insert Table 3 about here ------------- Once we had conducted the interviews and transcribed the data, we analyzed the content through multiple iterations, on each occasion looking to explore in depth a different set of factors. Our initial analysis was based on factors from previous research, for instance about the
  11. 11. 11 role of the EIR and the nature of trust development. Subsequent analysis was based on attempting a more detailed understanding of factors observed in an earlier stage of our analysis. We used a simplified coding system on a spreadsheet to gather, sort and record the factors we were investigating. The initial analysis focused on extracting background information about the VC’s prior experience with EIRs (persons and programs), their involvement in formal internship programs, and how they funded such programs. We also determined if the VC planned to continue with these programs and whether or not they would recommend them to others. In our second iteration, we gathered specific data on how the relationships between EIRs and VCs developed over time. Specifically, we assessed whether this was more of a function of the prior reputation of each party and the common background factors or if it was more closely linked to the actual experiences of each party during the interactions that occurred as the relationship developed. In the third iteration, we looked for evidence of increasing relationship complexity, that is, how the complex and time-dependent relationships between all three parties developed. Our focus was to understand how the EIR influenced the relationship between the VC and the fund- seeking entrepreneur and how this affected the investment decision. Based on our understanding of the transaction cost components typically introduced during the relationship to reduce relationship risk, we specifically looked for evidence of specific types of costs and how the presence of the EIR eliminated the need for these costs to be incurred. This led to our final analysis, which focused on how the development of the trusted interpersonal relationships between the three parties facilitated the actual VC investment decision, to provide sufficient insights to answer our research question. EIRs as catalysts for seedinvestments
  12. 12. 12 The VCs noted the importance of EIRs in facilitating a positive investment decision by acting as catalysts in the development of the relationship between the VC and the fund-seeking entrepreneur and increasing the long-term performance of the venture. They noted that the presence of the EIR could prevent the occurrence of problems with invested companies and increase the likelihood of positive investment outcomes for VCs, fund-seeking entrepreneurs and the EIRs themselves. In addition, the EIRs ability to build trusted relationships with both fund- seeking entrepreneur and VC reduce each component of the transaction cost, especially the need for ongoing monitoring and enforcement costs. Practical insights can be derived from our interviews to highlight the catalytic function of EIRs and consequently the characteristics VCs looked for when recruiting an EIR. EIRs could have prevented VCs’ past investment problems. VCs were keen to learn from their previous mistakes and identified a number of problems in previous funded venture, as shown in Table 4. VC’s believed the presence of an EIR inside these ventures would have overcome many problems that prevented venture success. In most cases, these problems created relationship risk that could have been prevented by building higher levels of trust, which required building trust effectively through the involvement of an EIR. As one VC suggested, “people need to have the experience of working together, know how they think, how they work… [and] there is a very high value to that trust.” ------------- Insert Table 4 about here ------------- EIRs boost expected returns. VCs suggested that the primary benefit of including an EIR in an investment decision was based on her/his ability to increase the expected value of the funded venture, based on their knowledge and experience. Quoting one interviewee, “most
  13. 13. 13 entrepreneurs do not have the experience… [that] EIRs are expected to have … to enter into the market, build the right company [and] be successful outside of Israel.” While VCs were often recruited because of their specific experience and knowledge, softer characteristics like trust were not as obvious recruitment criteria. EIRs attract high-potential opportunities. VCs also noted that the EIRs were able to help them attract high-potential opportunities, specifically ones that fit with the VC’s investment preferences. This was primarily a function of the industry’s perception of the EIR as an individual with a “high status” reputation, reinforced by their benevolent behaviors when preparing the fund-seeking entrepreneur for their meetings with the VC. EIRs nurture trusting relationships. VCs highlighted the development of a “referred- trust” relationship whereby a trusted relationship between them and EIRs and between EIRs and fund-seeking entrepreneurs created higher levels of trust between VCs and entrepreneurs. The need to develop this three-way relationship strengthened the VCs’ position on the importance of trust-building ability in recruiting EIRs. A VC noted that “you can talk to them [EIRs], you can evaluate their personality, their vision, their ability to execute and take risk.” The EIR’s ability to establish trusted relationships over time with partners was viewed as being key to the long- term success of the venture. VCs acknowledged both aspects of a trust-based relationship: goodwill trust and competence trust. They noted that competence trust was easier to assess, while goodwill trust required time to develop. VCs understood that the EIR’s ability to develop a trusted relationship with them before the investment gave the VC sufficient confidence to overcome perceived relationship risk and hence invest. As one VC noted, “you trust … EIRs one hundred percent, one thousand percent, day and night.”
  14. 14. 14 VCs also identified how they determined goodwill and competence trust when selecting and recruiting EIRs based on their prior record of performance. VCs acquired information from third parties, either whom they knew or from the EIR’s reputation in a relatively small community. These third parties included VCs’ personal networks, investors in previous EIR ventures or from ventures with whom the EIR had established relationships. VCs noted that goodwill trust, seen as an alignment of intention between two parties (i.e., both parties had the same goals) could only happen as the relationship evolved over time, although it was facilitated by the shared incentive of equity participation. As articulated by a VC, “we are getting into this process of working together, I like his [the EIR] ideas … his ideas fit my own way of doing business and they are also good.” Given the difficulty associated with determining goodwill trust, VCs were more inclined to start a relationship when there was a high level of competence trust as opposed to goodwill trust. VCs also attempted to build trust with fund-seeking entrepreneurs using similar trust-building practices. VCs viewed positively any evidence that EIRs worked well within a controlled environment and required minimal monitoring to ensure compliance, while the need to enforce monitoring policies was seen negatively. This initial assessment then became the anchor point for the VC’s own perception of the EIR’s trustworthiness, which was modified over time based on direct experience. EIRs as transaction-cost reducers Relationship risk is perceived to be very high in the early stage of ventures where inexperienced entrepreneurs seeking funding have had limited time to build a reputation or performance history. As catalysts for seed investments, EIRs were able to reduce the perceived relationship risk and reduce the transaction costs associated with the introduction of risk- reducing control mechanisms. The VC developed a trusted resource, the EIR, who could be
  15. 15. 15 deployed when a seed-investment opportunity arose and the VC had insufficient time to build the required level of trust with the fund-seeking entrepreneur. In further investigating the mechanisms and actions that EIRs used when operating in Israeli VC firms, we found they reduced each of the transaction cost components identified as contributing to the equity gap. We now discuss how the EIRs reduce each of the six components of the transaction cost. EIRs reduce deal identification costs. Part of the EIR’s mandate was to engage with local communities to identify potential investment opportunities and encourage fund-seeking entrepreneurs to contact the VC with whom that EIR was associated. A combination of entrepreneurs’ increased awareness of the VC and a more favorable view of the VC, brought about by the EIR, increased the number of entrepreneurs applying for funding. The association of an EIR with a VC thus encouraged more early-stage ventures to seek financing from that VC, although we found that the actual number of ventures depended on the EIR’s reputation. The presence of an EIR thus resulted in reducing the deal identification component of ex-ante costs. EIRs reduce deal selection costs. EIRs engaged directly with fund-seeking entrepreneurs to help raise their likelihood of receiving an investment by making them “investable”. This action influenced the likelihood that the fund-seeking entrepreneur would be selected to move to the next stage of interaction with the VC. During this process, the EIR (who had already developed a strong relationship with the VC) started to build a personal relationship with the fund-seeking entrepreneur. The development of this relationship was facilitated by the context of their previous interactions, where they worked together to increase the likelihood of receiving investment. This relationship facilitated the disclosure of “private” information, increasing the efficiency of the interaction at an early stage when the greatest level of information asymmetry
  16. 16. 16 existed. The presence of the EIR therefore increased the “investability” of the venture and the efficiency of the interaction, which reduced the deal selection component of ex-ante costs. EIRs reduce contracting costs. Contracting was characterized by discussions that developed into a shareholder agreement as well as an agreement on the percentage of equity each party would receive from the new venture. The presence of the EIR allowed both parties to rapidly conclude an agreement. As a VC noted, “the EIR helped us with domain expertise … helped us in our deal flow. When we found a company he led the due diligence process.” When the EIR proposed to join the funded venture and the fund-seeking entrepreneur agreed, the negotiations were facilitated because the VC could expect the value of the funded venture to be higher than without the EIR on board. The VC also would anticipate a reduced likelihood of moral hazard from the now funded entrepreneur, thus reducing the need for as many monitoring clauses to be incorporated in the shareholder agreement. In addition, the entrepreneur would have more confidence that the VC would continue allocating sufficient resources to the venture. The combination of these factors reduced the contracting component of negotiation costs. EIRs reduce due diligence costs. Due diligence took place during the VC’s selection of which fund-seeking entrepreneurs s/he would issue a term sheet. The existing relationship between the EIR and fund-seeking entrepreneur diminished information asymmetry between the parties. An additional benefit was the perceptions of the EIR providing a third party perspective on the negotiation who would ostensibly not favor either party since the long-term incentives of the EIR were also aligned with the fund-seeking entrepreneur. Further, the anticipated role of the EIR in the venture and introduction of a compensation plan that aligned the objectives of each party reduced the need for as thorough a due diligence as would be necessary if no EIR- entrepreneur relationship existed. As an EIR noted, “the experience of being inside the VC firm
  17. 17. 17  where they could more easily understand its mechanisms and goals  was extremely helpful in later due diligence and board dealings.” As a result, the due diligence component of negotiation costs was reduced. EIRs reduce monitoring costs. The long-term engagement of the EIR in the venture allowed for less complete shareholder contracts that could foresee every eventuality, which reduced the overall level of monitoring required. The presence of the EIR in the venture further reduced the effort required to implement the smaller number of monitoring clauses in the contract. As a result, resources that might otherwise have been used for ex-post monitoring were retained for business development. These factors combined to reduce the monitoring component of ex-post costs. EIRs reduce enforcement costs. VCs expected greater startup compliance due to the relationships that the EIR had established with the fund-seeking entrepreneur and the VC. For fund-seeking entrepreneurs, their established relationships with the EIR enabled them to better understand and carry out the clauses of the shareholder agreement. Therefore, subsequent to the decision to invest, the long-term involvement of the EIR in the funded venture led fewer resources being diverted from business development to enforcement and, as a result, a reduction in the enforcement component of ex-post costs. Concluding remarks Nearly 50% of the ventures using an EIR in our sample were successful in attracting financing. One VC reported that in the four and a half years since his VC firm had started, they had looked at close to 1,500 companies and invested in 24. For business ventures in which an EIR was involved, this ratio improved to two out of five. Nevertheless, the impact of the EIR on the rates of ICT seed investment in Israel should not be considered in isolation. Other factors can
  18. 18. 18 account for Israel’s higher rates than other countries. The close-knit ICT community in Israel and the Dan Valley creates a particularly high level of trust and an innovation culture that permeate the community. This reduces the perception of relationship risk due to factors such as participants’ prior and (concern for) future reputations in the community, strong social networks, and a homogenous cultural and religious background. Frequently mentioned was common institutional background in the Israeli Defense Force. As noted by one VC, “where you were in the army will influence my decision ... [I look for] ... someone who came from a certain background … went through certain things and can do difficult things …” In addition, our interviewees (VCs and EIRs) regarded governmental policies to support the commercialization of research and early-stage venture financing that leverage equity investments as important programs (because most are designed to reduce perceived risk and increase potential returns). Syndication of investments was further regarded as a risk-reduction mechanism that was common between VCs in the Dan Valley. Furthermore, the special investment company created by the VC to fund the EIR is also important in explaining the success of the EIR program. The investment company pays the EIR’s salary out of the VC’s investment fund rather than the management expense ratio, with the investment company folded into the funded seed venture once the deal is done. This funding instrument allows VCs to overcome the constraint placed on them through the imposition of a ceiling on the management expense ratio, which limits the amount of money a VC can spend on management expenses as a percentage of the total investment portfolio. Our research further highlights the importance of transaction costs in creating a barrier to seed investing. We find evidence in the Israeli context that these costs can be reduced by the development of trusted relationships. The introduction of an EIR facilitates the time-consuming
  19. 19. 19 trust-building process over many months. In contrast, investment decisions typically occur far more quickly, making trust development more challenging. The EIR builds a trust repository with the VC and subsequently with the fund-seeking entrepreneur. These relationships built on trust facilitate the investment decision. Further, the manner in which EIRs reduce the various components of the transaction cost provides specific insights that might allow some of the mechanisms used by EIRs to be replicated in order to increase the overall rate of seed investment. Practitioners involved in investing in seed ventures will benefit from a better understanding of the nature of the various transaction cost components they incur when they introduce risk mitigation strategies (i.e., controls). This will encourage VCs to review the costs and benefits of introducing such strategies and may cause them to modify their current risk mitigation practices. Our research identifies how the development of relational contracts can reduce the costs of controls. Investors might identify how they can engage trust catalysts to enhance the number of opportunities in which they achieve the confidence to invest. Further, a better understanding of why investors introduce controls to mitigate risk, and the associated costs these incur, will encourage funders to relax pressure on management expense ratios, where high levels are assumed to be due to VCs’ inefficiency rather than responsible risk mitigation. Governments interested in increasing the number of seed ventures that can attract funding will also benefit from a better understanding of the impacts of transaction costs. Based on our insights, governments can now look at specific strategies to reduce these costs, in addition to the traditional approach of subsidizing equity finance. While governments could encourage the deployment of EIRs, they could reduce, for instance, identification costs by increasing
  20. 20. 20 networking activities. Contracting costs could also be reduced by subsidizing qualified third parties to facilitate investment decisions. Our research should also be of interest to researchers attempting to explore relationship development between organizations and encourage them to broaden their approach to consider both stewardship theory (Arthurs and Busenitz, 2003) and the development of relational contracts (Casadesus-Masanell, 2004) as an alternative to traditional agency theory (Eisenhardt, 1989). Researchers interested in exploring the behaviors of entrepreneurs, their ventures and strategic relationships may benefit from examining the psychology literature on the development of close personal relationships (Rempel et al., 1985) and specifically the characteristics of fund- seeking entrepreneurs and VCs that enable them to build relational contracts. We believe that the application of a transaction-cost model to the investment process provides an opportunity for future research, especially when looking at optimizing transaction costs across different stages of the investment process. Such an approach could build on Shepherd et al.’s (2005) work that looks at the optimization of time utilization by VCs, who spend a percentage of their time identifying new opportunities, negotiating investments and managing current investments. As the costs incurred at each stage have a direct effect on subsequent costs, considering the costs and benefits of incurring transaction costs at each stage of the investment process (and the impact of those costs on the investment decision itself) could be a fruitful research endeavor. Also, evaluating the true impact of EIRs on long-term venture success, whether this was due to their ability to reduce transaction costs, ‘scout’ high potential opportunities, or, as Baum and Silverman (2004) put it, ‘coach’ funded ventures to success, could provide a promising line of research.
  21. 21. 21 We therefore hope that our exploratory attempt stimulates much further research, especially to address some of our limitations. We collected qualitative data on how EIR internship programs function in Israel. As portrayed in Table 2, since 9 out of the 10 VCs interviewed expressed their intent to continue funding EIR programs, exploring these programs elsewhere may be valuable. The values and norms in Israel, especially the homogenous nature of a small and well-connected community, might not be the same in other countries, thus practices may be different and operate on culture-based factors that influence the role of EIRs. Additionally, our conclusions have been limited by our small sample size. Enlarging the number of participants to include fund-seeking entrepreneurs and angel investors could provide more insights. We also undertook the research over a relatively short period, during which investments had already been made. Expanding the time horizon might provide additional insights on the investment decision process itself and on the longer-term impact of initial conditions on venture success. We hope that others join us in the effort to comprehend the causes of the equity gap, to understand how EIR programs help develop relational contracts that reduce transaction costs, and, as a result, to increase the number of seed ventures that VCs can fund.
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  25. 25. 25 Table 1. Transaction cost components and impact of an EIR Investment Stage Transaction cost component Nature of activity Reference Likely impact of an EIR Screening (before deal) Identification Attract interesting opportunities (often through networks) Fried and Hisrich (1994) EIR’s reputation encourages entrepreneurs to approach VC Selection Review of business plan – decision to proceed Harrison et al. (1997) EIR’s knowledge/experience facilitates the selection process Contracting (during deal) Negotiation Extensive information gathering and contract structuring Rosman and O’Neill (1993) EIR’s relationships reduces information asymmetry and likelihood of moral hazard Diligence Information verification and finalization of contract Lawson et al. (1991) Anticipated incentive alignment reduces the need to verify each piece of information Controlling (after deal) Monitoring Ongoing investment of time as needed Sapienza and Korsgaard (1995) Relational contracts and alignment of incentives reduce the need for monitoring Enforcement Hands on control activities of entrepreneur MacMillan et al. (1989) EIR’s role in venture reduces the need for additional resources to control the entrepreneur
  26. 26. 26 Table 2. Data on VCs Interviewee Local Fundsize Numberof seedventures (2000/4) Numberof EIRs %ofEIRs receiving investment Highstatus background Previouslyan entrepreneur ThinksEIRs areagood idea? Willstartan EIRprogram in2006? 1 Yes Small 16 3 100 Technology management Yes Yes Yes 2 No Small 13 1 100 Management Yes Yes Yes 3 No Medium 24 5 40 Technology management Yes Yes Yes 4 No Medium 20 0 0 Technology management Yes Yes Yes 5 Yes Small 9 0 0 Technology management Yes No No 6 Yes Small 9 0 0 Technology management Yes No Yes 7 Yes Medium 18 8 50 Technology management Yes Yes Yes 8 No Large 32 2 50 Management No Yes Yes 9 No Large 40 10 80 Management Yes Yes Yes 10 Yes Small 15 4 50 Management No Yes Yes
  27. 27. 27 Table 3. Outline of structured survey questions Factor discussed Details VC firm characteristics Structure, Size History, Industries Exits Seed investments, Relationship with angel investors Personal questions to interviewee IDF experience: intelligence, computer, combat Experience: technological, managerial EIR program History Unique features Success Lessons learned About EIRs IDF experience, Other experience Knowledge: technology,software, hardware Education Market, Industry Management experience, Investorexperience EIR-based venture characteristics Nature of relationship, Level of trust
  28. 28. 28 Table 4. Reasons and explanations for venture failures Reasons for failures Explanations by our interviewed VCs Entrepreneurial team in- fighting and eventual inability to perform VCs reported that this occurred because they did not make enough effort (during due diligence) to ensure the team was of similar backgrounds and/orhad mutual interests.It is quite common for VCs today to change parts of the team as a condition for investment. Our VCs believed that common backgrounds helped to ensure more goodwill trust among team members. Poor international marketing and sales VCs noted that they look for repeat or experienced entrepreneurs with international marketing and sales experience, even if the first time around they were not successful.By including marketing/sales prowess as part of what constitutes competence trust,the risk of failure is reduced. Entrepreneur’s inability to let go and start anew VCs reported that the most important characteristic they look for in an entrepreneur is the ability to understand and trust product changes dictated by the board. VCs see goal congruence as fueling the goodwill trust that motivates EIRs to accept their decisions.

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