Empirical study of a venture capital relationship

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Empirical study of a venture capital relationship Julia A. Smith

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Cardiff Business School, Cardiff University, Cardiff, UK

Received 22 October 2003 Abstract Revised 2 June 2004 Accepted 16 November 2004 Purpose – The paper aims to examine five assumptions of agency theory: that both investor and

investee make rational decisions; future outcomes are predictable; both act in their own best interests; the investee has an information advantage over the investor; and the investee is work- and risk-averse. Design/methodology/approach – An agency framework is used to analyse the relationship between a venture capital investment house and one of its investees. Empirical evidence is provided on the nature of this relationship. Additional evidence of the post-investment performance of both parties is provided, to examine whether the contractual arrangements are conducive to good performance. Findings – There is general support for the assumptions of agency theory, and the framework is found to provide a useful basis for analysing the relationship between a venture capital investor and investee. Research limitations/implications – The paper uses case studies of one investor and one investee, and so is limited by data, coupled with a qualitative analysis. Further quantitative work should use a larger sample and statistical or econometric methods, to support the findings. Practical implications – The empirical evidence shows that an investor who is alert to such problems as agency theory implies may take steps to control adverse effects, e.g. through improved management accounting systems for monitoring and control. Originality/value – The paper gives evidence on the internal management practice of venture capital investors and investees, linked to publicly available performance measures. Thus it provides an insight into practice which will be of interest to investors, investees and academic researchers alike. Keywords Venture capital, Accounting information, Risk management Paper type Case study

Introduction This article uses empirical evidence, gathered through face-to-face interviews in the field, to investigate the applicability of agency theory to a venture capital setting. For our purposes, the principal is taken to be the venture capital investor, and his agents the companies in which he invests. The broad premise on which this work is based is that, once the investee has passed on some of his risk to the investor, post investment, then information asymmetry between the contracting parties might lead to the investee shirking on effort (Laffont and Rochet, 1998). Thus the investor’s investment may be at risk, and he must seek methods to attenuate this downside (Reid, 1998). Typically,

Accounting, Auditing & Accountability Journal Vol. 18 No. 6, 2005 pp. 756-783 q Emerald Group Publishing Limited 0951-3574 DOI 10.1108/09513570510627702

The author is grateful to: Professor Gavin C. Reid, Director of the Centre for Research into Industry, Enterprise, Finance and the Firm (CRIEFF), Department of Economics, University of St Andrews, for access to the data on which this article is based, and for his useful comments in the initial drafting stages; the Esme´e-Fairbairn Charitable Trust and the Carnegie Trust for sponsoring the research; the directors of the investor and investee companies for their invaluable contributions during the fieldwork stage of the project; and to two anonymous referees for their useful feedback and suggestions.

agency theory would suggest increased monitoring and control, and this may be done, for example, through enhanced management accounting information systems (Reid et al., 1997; Mitchell et al., 1998). Post investment, it is possible to examine the performance of the two parties to the contract, by reference to publicly available financial data. This gives us a means of examining the success (or otherwise) of the relationship between investor and investee (Reid and Smith, 2003).

Venture capital relationship

757 Background In recent years, venture capital has been discussed increasingly frequently in the literature, as the industry has matured, first in the USA and, more slowly, in the UK[1] Initially, this focussed on survey results (Arnold and Moizer, 1984; Bygrave et al., 1988; Gorman and Sahlman, 1989) and the mechanics of venture capital contracting (Barney et al., 1989; Admati and Pfleiderer, 1991; Sahlman, 1991, 1994; Gompers, 1994). However, latterly, the relationship between investor and investee has been examined within an agency framework, with the venture capital investor acting as principal, and his investee company or companies as agent(s) (Mitchell et al., 1992; Sapienza and Gupta, 1994; Gifford, 1995; Bergemann and Hege, 1998; Reid, 1998, 1999; Kaplan and Stromberg, 2003)[2]. It is the latter approach with which we are concerned. The nature of the principal-agent relationship assumes that the principal is the lead player (Jensen and Meckling, 1976; Fama, 1980). He attempts to control the relationship, by the input of resources and by employing agents to work on his behalf. As he requires reassurance that his resources are being utilised to their best advantage (Fried et al., 1998), we might expect him to install a system of monitoring and control. However, he will not always be around to oversee the actions of his agent(s). The agent, on the other hand, will receive a payoff for working on behalf of the principal. If this were to be in the form of a fixed amount, then the agent might be tempted to exert only minimum effort; without additional incentive, there is nothing to be gained by doing more than is necessary. Thus moral hazard will arise; with an absent principal, the agent relaxes and works to a sub-optimal degree. There are steps that can be taken to attenuate the problems of information asymmetry and moral hazard that can arise in a principal-agent relationship (Fama, 1980). In order to maximise the outcomes of such a relationship, the principal can set in place systems such that the agent has an incentive to work for the good of the partnership. For example, the management team of a business organisation, as principal, might introduce profit-related-pay, in order to induce its employees, as agents, to work more efficiently. Or they might encourage budget participation, in an effort to reduce budgetary slack (Nouri and Parker, 1996). In a venture capital setting, “ratchets” could be used to elicit further effort[3]. Specific agency problems might occur if we treat an investee company as the agent of a venture capital investor. The investor typically will know more about financial management and risk handling than will the personnel of the businesses in which he chooses to invest. On the other hand, the investee firm’s owner-manager will know more than the investor possibly could about the running of his or her own business, about the firm’s target market, and about the industry as a whole (Trester, 1998), leading to information asymmetries (Leland and Pyle, 1977). A principal acting without full information might wish to install systems to monitor the agent’s actions (Rankin and Sayre, 2000), in order to prevent any shirking on effort[4]. In the case of a venture capitalist and its investee firm, this might be done

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Figure 1. Pre-deal situation

Figure 2. Post-deal situation with no sharing of risk or information

by the investor placing a director on the Board of the investee, or by requiring the reporting of improved accounting information (Mitchell et al., 1998)[5]. Figures 1-3 depict graphically three scenarios involving the investor (principal) and investee (agent). Figure 1 shows the typical pre-deal situation. Investor and investee conduct their business independently of one another: the investor works within his own specialist areas of financial management and risk handling, while the investee concentrates on production technologies and market information, among other things pertinent to the running of their firm. There is no sharing of the information (or risk) between the two, as no contract yet exists. Immediately post-deal, the investor will impose a system of monitoring and control, in order to maintain a close watch on their investment in the investee firm (Figure 2). The investee feeds back information to the investor, in terms of minutes of board meetings, financial and other managerial reports. At the same time, the investee expends effort on behalf of the investor, by ensuring that his business continues to be a successful working enterprise. Some deals may never move beyond this stage, as the tight contractual relationship is sufficient for everyone’s needs. However, in close “hands-on”[6] venture capital deals, we might expect to see the relationship developing along the lines depicted in Figure 3. This shows a clear overlap


759 Figure 3. Post-deal situation with sharing of risk and information

of skills and information of both investor and investee; in exchange for risk-sharing and other benefits, the investee provides more information to the investor about products, markets and strategies, and exerts more effort on the principal’s behalf. At this stage, we might also expect to see the investor take a seat on the board of the investee firm. In reality, actual contracts will probably fall somewhere between the two situations of Figures 2 and 3. Although the size of the darker shaded area in Figure 3, representing shared risk and information, may be very small, there will probably never be a complete overlap. Too much information is as unhelpful as too little, and the investor, it could be argued, has little need for precise information on how each new product is to be manufactured (Sweeting and Wong, 1997). Instead, selected, or summarised, information may be sufficient to imply an increased measure of trust between the two parties and, henceforth, to a contract approaching optimality and, subsequently, increased performance[7]. Taking the framework of agency theory as the basis for an analysis of venture capital contracting is not, however, without its problems (see Bruton et al., 1997, 2000). There are a number of key assumptions which, it can be argued, will not hold in such situations. For example, some authors have tried recently to advance alternative theoretical frameworks within which to analyse the venture capital-entrepreneur relationship[8]. Nevertheless, an agency framework is a useful basis from which to start and, as such, we shall use it to examine empirically such a relationship. Then, having examined the evidence available, we shall be in a position to determine whether or not such an approach is helpful to our understanding of venture capital contracting deals. Agency theory – assumptions and problems Baiman’s (1982) survey summarises the major assumptions of the principal-agent model. These are that: individuals will act rationally; individuals can predict the outcome of all future contingencies; any such contingencies are observable by the contracting parties, and can therefore form part of an enforceable contract; an individual will act in his or her own best interests; the agent has an information advantage over the principal; and the agent is both work- and risk-averse. These

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assumptions lead to identifiable problems, when trying to apply an agency framework to a venture capital deal situation. We take these assumptions of agency theory as the basis for our discussion below.

Assumption 1. Both investor and investee will make rational decisions In order to make rational decisions, it has been argued (Simon, 1955, 1978; Hollis, 1987), one must have sufficient information and computational ability to be able to evaluate, compare and select a preferred course of action from potentially numerous alternatives. Limited availability of information and lack of analytical skill can give rise to the more constrained “bounded rationality” (Cyert and March, 1963). Some agency problems can be overcome by modelling as decision-trees or linear programs (Zacharakis and Meyer, 2000) with resource constraints. However, the extent to which this happens in practice is uncertain[9]. The second point related to rationality is that of computational ability, which should not cause problems to a venture capital investor. Typically, the investment company will have a team of specialists in finance, accounting or economics, who can quite readily assess the potential impact of a particular investment, using relatively sophisticated techniques and forecasting software. The investee is likely to be more disadvantaged, in a computational sense, especially if he is an entrepreneurial inventor who has designed a new product, but who has little or no management skill or experience. In such a case, his utility may be measured in terms other than the traditional economic goal of profit maximisation. For example, it may be more important to this individual to seek investment from a company which would allow him to retain a controlling share in the company; or he might look for an investor who could provide experience in and access to global markets.

Assumption 2. Future contingencies are predictable and observable As we have seen, perfect information allows us to make perfectly rational decisions, knowing what the outcomes will be, and what degree of utility we can expect to achieve. However, this neglects to consider the existence of risk and uncertainty. For example, when an investor makes a decision to invest, there is a risk that the company will fail. There is also uncertainty about what the outcome will be if it succeed. Attitudes to risk are likely to differ (Shankman, 1999), which may lead to differences over preferred courses of action. Thus a certain degree of negotiation may need to take place in order for principal and agent to agree on a strategy. When analysing the effect of a new investee on existing investments, the investor will have in mind the overall risk of his investment portfolio (Donaldson, 2001); just as an investee company will have to weigh up the benefits of capital investment in a new project. Agency theory would suggest that all possible consequences of additional investments should be analysed pre-investment. However, it is unlikely that all future contingencies can be incorporated into a contract at deal inception (Trester, 1998). While many standard terms can be included in venture capital contracts, the nature of entrepreneurial ventures means that events will occur that have not been covered in the deal, and the venture capital investor cannot always judge in advance how management might react post-deal completion (Wright and Robbie, 1998).

Assumption 3. Both investor and investee will act in their own best interests In a situation where the entrepreneur is the firm, and therefore holds the sole interest, then any actions he takes on behalf of the firm will be closely aligned to his own personal goals (Jensen and Meckling, 1976). Here, though, we are treating the investee firm as the agent, which has its own implications. A firm typically has many stakeholders, each of which has his or her own interests to further. A further complication is then, as Fama (1980) suggests, the decision as to whether or not we should treat the managers of the firm separately to the risk bearers. Second, in a principal-agent relationship, the principal usually initiates the relationship, by looking for an agent to carry out specified tasks (Jensen and Meckling, 1976). With venture capital, however, it tends to be the investee who first seeks out the investor (Sweeting and Wong, 1997). Thus we have a proactive agent assuming more responsibility than we might usually expect. One way to address this is, for example, to put in place extra systems to improve monitoring (Alchian and Demsetz, 1972; Mitchell et al., 1998). Incentives might be offered to investees to improve motivation, for example by giving convertible stock options (Trester, 1998). And the degree of risk to which the agent is subject could be carefully assessed and imposed by the investor, in order to induce the maximum effort possible (Laffont and Rochet, 1998), with the intention of achieving the most satisfactory outcome for both parties (Sapienza et al., 1996). Assumption 4. The investee has an information advantage over the investor It is obvious that neither party can make so-called rational decisions if they do not have full knowledge about the other’s information. However, there are ways in which each could become more knowledgeable about the other’s skills and information. For example, as we have seen above, enhanced systems of monitoring can be installed (Alchian and Demsetz, 1972; Mitchell et al., 1998). This will improve the flow of information from investee to investor. In return, the investor might put a non-executive director on the investee’s board, in order to pass information back to investees, as and when required. Clearly, there will be costs involved in undertaking each of these actions. However, if the benefits outweigh the costs, and the outcome is a Pareto improvement, then certainly at least one party will be happy. And hopefully, as the aim is to generate mutual benefits, the other will also experience some additional utility. Assumption 5. The investee is both work- and risk-averse Typically, the type of business that is seeking venture capital investment is run by a highly-motivated, entrepreneurial personality, who has started a company from scratch and has often worked very long hours to make the business a success. However, there is a suggestion that the sharing of risk can allow agents to “take their foot off the pedal” and ease up on effort, once someone else is sharing the burden (Spremann, 1987). Hollis (1987, p. 22) describes a rational being as a “bargain-hunter” who “never pays more than he must, and never gets less than he could at the price”. Bearing in mind that we are assuming that parties will be seeking to maximise utility, we must also consider whether there is a point at which leisure time offers greater utility than profit maximisation to an individual. Previous writers have discussed the problems of a risk-and work-averse agent in a business setting. For example, payment of a fixed wage gives an agent who is work averse an incentive to shirk on effort (Baiman, 1990). Bøhren (1998, p. 747) observed that “in order to optimise the mix


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between high wealth and low effort, the agent uses private information without any ethical restrictions”. Or an entrepreneur might decide to divert investment funds away from the company for his or her own private consumption (Bergemann and Hege, 1998). The onus is on the two contracting parties to agree, when designing the contractual relationship, just how much money should be given, in return for defined levels of risk, with explicit inducements and rewards available for attaining goal congruence. Determining the nature of investor-investee relations Arguably, the best way to investigate the nature of investor-investee relationships in a venture capital context is by empirical investigation. Given the sensitive nature of the topics to be investigated, it was felt that the ideal method for gathering the data should therefore be by face-to-face interviews with the people involved in structuring and monitoring the deal, as well as with the directors of relevant investee companies. The questionnaires for both venture capital investor and investee[10] were kept similar deliberately, in order that a comparison might be made of the different attitudes of each party to the contract. Further, they were designed explicitly to address known problems of agency theory, given the body of evidence that exists to support such an approach (Barney et al., 1989; Gifford, 1995; Sapienza, 1989, 1992; Sapienza and Gupta, 1994). Interviews with one director from the investment house, and the financial director of the investee company were undertaken at their places of work. The assumption was made that the investor interviewed would reflect the “house style” of his investment company in the responses he gave. Each meeting was conducted by one researcher as interviewer, and an additional researcher as rapporteur, who wrote up the minutes of the meetings on return to the office. The venture capital investor (VC) (Aberdeen Development Capital plc, henceforth Abtrust) on which this case is based had four funds under management with a total valuation of funds invested of £45 million. The firm was established in 1986 in the North-East of Scotland in the UK, and had a preference for investments to be made locally, though it did not express any preference as regards industry sector. The smallest, largest and average investments made at the time of interview (1993) were around £100,000, £500,000 and £300,000, respectively, for about ten proposals accepted per year. The preferred timescale for investment was between five and seven years, with a required internal rate of return on investments of 35 per cent, and preferred exit by means of a trade sale. The investee was a locally based company (Rollstud Ltd) who called themselves “the market leaders in the manufacture of studbolts and precision components for the offshore industry”, which included the oil, petrochemical and engineering industries. Rollstud commenced trading in 1990, as the result of the management buyout of its predecessor, which had been manufacturing since 1978. Abtrust had been brought in at this time to assist in the management buyout. Additional debt and extensive overdraft finance had also been provided by the Bank of Scotland. Further equity injections were being sought as growth capital to expand the company’s overseas markets. By 1992, Rollstud had reached a turnover level of £4 million, with net profits of £217,000. There were 55 full-time employees working in the company in 1993, and management held 55 per cent of the voting share capital. The rate of return at the time of interview was 34 per cent, which fell between the 30-35 per cent range required by Abtrust at exit. The

evidence from the remainder of the questionnaire will now be used to test the assumptions of agency theory discussed above. Assumption 1. Both investor and investee will make rational decisions In an effort to determine how well Abtrust was able to identify potential rewards, its director was asked about the effects of a new investee on their overall risk management, and whether or not, when screening potential new investees, they had in mind how they might fit in with their existing portfolio. He explained: “We try to find a balance between each sector. We have a large exposure to the oil and gas service industries, because of our location, but we try not to be over-exposed to any one sector.” He was then asked to what extent he thought possible outcomes were more or less likely. He expected “99 per cent of all cases [to] exit by means of a trade sale”. As well as the sectoral balance he mentioned above, he was also looking to “achieve a balance through each of our funds” (Fama and Miller, 1972). He thought he could afford to be quite confident about the outcomes of investments because “since we tend to invest development capital, we think we have a slightly lower risk profile than most”. Where there was a possibility that some outcomes might not occur as expected, the investor could take certain actions to minimise potential bad results. For example, he could balance riskier investments with more secure projects. Abtrust said that “it definitely happens” and that they would “look at the overall fund, and the return to shareholders within that fund” when considering investments. They would also steer clear of perceived riskier sectors, such as new starts, and the computer software industry. In addition, when constructing new proposals, they would look at the company’s predictions “in a lot of detail” and would analyse these predictions using sensitivity analysis. All of this constitutes the so-called “due diligence” for which venture capitalists are renowned. The director of Rollstud was asked whether he thought the outcome of his relationship with the VC had an element of chance or luck in it. He answered “no, the business is fairly steady”. In other words, he felt quite confident that he could predict how his business would progress. He also thought there were actions that could be taken to limit or modify the firm’s exposure to risk. For example, this might involve “market research on our products, and company research on competitors, including the value of the market share they have”. Thus this investor and entrepreneur were both able to minimise uncertainty. The VC used probability analysis to evaluate potential returns from each portfolio pre-investment. While Abtrust were unable to have full and complete information about the potential outcomes, as rational decisions would require, they did make an attempt to minimise the uncertainty, through careful choice of sectors, specialisation in investment types, and careful due diligence before investment. In terms of computational ability, there is no doubt that Abtrust were able to assess the potential outcomes of investments. In the early stages, when meeting the investee for the first time, they had requested a tour of the premises, guided by “someone who understands the technology and is able to explain it in layman’s terms”. The director further added that “we get all the information needed to give us the opportunity to analyse the company. When this is done we normally have a number of questions to ask. For example, board minutes reflect union and labour difficulties, so we pursue this


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further.” Technically, Abtrust then used sensitivity analysis to assist in their assessment of investment opportunities. As regards Rollstud, there is evidence to suggest that computational skills were high. Table I shows which methods were used by the investee to decide on capital investments, all of which had already been used by the company pre-investment. The first three, payback, internal rate of return and net present value, were thought to be highly important. Projects were expected to generate enough return to pay back “as quickly as possible”. Most typically, this would mean “four years for a major investment”, but it “could be as short as two years” for a minor project. The discount rate used to appraise proposed capital investments was 2 per cent over the ruling bank base rate; slightly higher than the overdraft charge levied by the firm’s bank of 1.75 per cent above base. Of less importance, but also used, was the less common accounting rate of return. As far as assumption 1 goes, we have two main concerns: (1) do the parties have access to information about the potential outcomes of the involvement; and (2) do they have the computational ability to analyse such information. We know from the basic data sheet that Abtrust required a rate of return (ROR) of 35 per cent on investments, and that the preferred exit route was by means of a trade sale. We also know that the Rollstud was aiming for an ROR at exit of between 30 and 35 per cent, and were at the time happily within this range at 34 per cent. Therefore, both were quite clear about expectations, and were comforted that the expected ROR was at about the level required. In terms of ability to analyse the information, Abtrust clearly had all of the relevant skills. The credentials of their directors included degrees in business, experience in running companies in manufacturing and engineering sectors, amongst others, and professional accounting qualifications. Rollstud had achieved outside recognition for their products, in terms of internationally recognised quality standards, so they were able to assess product developments as well as anyone. The finance director interviewed was well qualified and had a good grasp of the more technical aspects of financial analysis. The above suggests that both parties were able to make rational decisions. They were able to predict the expected outcome from the investment, and had the relevant Importance of method to the investee company, in its own capital investment appraisals Method used by the investee company

Table I. Methods for deciding on capital investments

Payback Internal rate of return Net present value Accounting rate of return Qualitative assessment

Low

Yes Yes Yes Yes No

Note: All of these methods were in place prior to the investor’s intervention

Moderate

High U U U

U

skills to enable them to analyse the available data. In addition, they were each able to improve their knowledge about potential outcomes through careful screening of new investments, from the Abtrust’s point of view, and by maintaining steady business in known markets, from Rollstud’s point of view. Thus assumption 1 appears to hold for this case.


Assumption 2. Future contingencies are predictable and observable Once a possible investment opportunity has been identified, the next course of action is to anticipate the possible future environments that may affect the outcomes of the projects (Uher and Toakley, 1998). The state of the macro-economy may have a significant impact on the outcome of an investment. For example, there may be an economic boom or recession, high inflation, or new Government legislation. While some factors can be anticipated with some certainty, there are many others which are subject to uncertainty. Here, the attitudes to risk of those involved in capital investments can influence the decision as to whether or not an investment should proceed. To a certain degree, therefore, assumption two is contingent on the parties’ attitudes to risk and uncertainty: how likely are they to believe that possible outcomes will occur? Under the first substantive heading in each questionnaire, the respondents were asked a series of questions to ascertain their attitudes to risk[11]. First, when asked to evaluate a fictional project with an immediate return of £10 million, with a probability of ten per cent, or a return of zero, with probability of 90 per cent, Abtrust’s Director valued the project at zero, adding that he “wouldn’t even consider the risk”. The fact that the outcome might or might not be successful was considered to be “very” important, in his evaluation of the project. In another example, rather than choose the option which offered an expected return of £1.2 million for sure, the actuarial value, the Director chose instead the option which offered a 90 per cent chance of obtaining £1 million over a 10 per cent chance of £3 million. Abtrust showed, by the answers given to these two questions, that they were able to state a preferred option between a situation that contained an element of risk with a potentially high payoff, compared to a certain return equal to the actuarial value of the riskier alternative (Zacharakis and Meyer, 2000). Thus they were willing to accept an element of risk in the magnitude of their return. But they were less likely to be gamble on an option that might return zero. Instead of gambling on the 10 per cent possibility of obtaining £3 million, the Rollstud’s director would choose the sure prospect of £1.2 million. When asked to value a prospective order with a maximum payoff of £1 million and a minimum payoff of zero, and whether he gets the order depending on the toss of a coin, he valued the potential order at its actuarial value of £12 million. So the entrepreneur too evaluated projects at actuarial values, making his decisions using a weighted-average value of the prospective outcome. Rollstud were therefore able to make a qualified judgement as to what might be the future outcome of an investment decision. We have seen that Abtrust avoided the riskier end of the market by focusing their investments on development capital, rather than on, say, seed corn funding for new starts. They also avoided perceived high-risk sectors. This director did acknowledge that “we are in the risk business, and our shareholders understand that there are risks involved”, but they did as much as they could to improve the security of outcomes and to lower the risk involved, e.g. through diversified portfolios[12]. In doing so, they

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thought that the possibility of a good outcome could, to some degree, be balanced against the possibility of a bad outcome. In general, the Rollstud’s director thought that his was a low-risk company and he tended not to concentrate on risk and chance when contemplating new projects. In his opinion, Abtrust would tend to over-estimate the risk inherent in Rollstud’s business. The investee thought that the fact that Abtrust would share some of their business risk was an important factor in seeking their involvement. Rather than receive a fixed per centage of the worth of the firm at exit, or, as was the case, a figure based on a standard share valuation formula, they thought it would be attractive to arrange for a fixed sum payoff in return for Abtrust’s involvement, thus reducing the uncertainty of their final payoff. However, Abtrust’s reaction to such a proposition was negative. Instead, they preferred to leave in place the incentive of a percentage return, presumably in the belief that a fixed sum payoff might reduce the investee’s effort. Neither Abtrust nor Rollstud could be described as particularly risk-loving. Abtrust made relatively risk-averse decisions, avoiding high-risk investments and stating preferences for fairly secure outcomes. Rollstud was considered to be a low-risk investment, with stable business and predictable returns. We saw, under assumption 1, that both parties tried to minimise uncertainty about the future and, indeed, had good information about potential outcomes. While future contingencies might not necessarily be classified as directly observable, both parties took steps to ensure that uncertainty, and the effects of unpredictable events, were minimised. Thus there is some evidence in support of assumption 2. Assumption 3. Both investor and investee will act in their own best interests Capital investment is made to enable an organisation to realise its strategic goals, and so is concerned directly with forward planning and long-term forecasting. Strategic planning might include a company mission or a philosophy (Mintzberg, 1979), within which the organisation strives to achieve specific goals. In a venture capital investor-investee context, the possibility of goal incongruence can arise, in which case agency theory is applicable (Arthurs and Busenitz, 2003). On the one hand, the investee firm’s directors are seeking to maximise their own personal income. On the other hand, the institutional investor, acting on behalf its upstream clients, is seeking to maximise shareholder wealth. Agency problems of information asymmetry and moral hazard can lead to non-optimising contracts between parties (Reid, 1998), and the issue then arises as to how to move from a sub-optimal position to one in which goal congruence may be achieved. The questionnaire was designed to determine the ways in which the contract between investor and investee was designed to achieve maximum efficiency. This was done first by asking whether it was based more on trust or understanding (Harrison et al., 1997), or whether it was primarily tightly legally defined. Then, each was asked what they hoped to gain most out of the relationship and how, if at all, they thought it could be improved, for example, through incentivised contracts (Milde, 1987)[13]. Abtrust would typically explain, at the outset, the investor’s objectives, when negotiating contract terms with a potential investee: When structuring the deal, we try to explain what our objectives are in the first place, how our involvement will work, and we give them our accounts. We are a commercial organisation attempting to maximise returns to our shareholders.

At the same time, Rollstud’s company literature stated: The basic philosophy of [company name], a privately owned company, is to provide a fast, reliable service of a competitively priced, quality assured range of products. Our personnel focus all their attention on ensuring that our customers are given the highest level of quality, service and support. The company remains committed to offering the highest quality standards of its products to its customers.

Abtrust’s director was then asked if he thought that the investee was motivated to have them involved in their business through a desire to share risk. Abtrust thought that “they are more motivated by the benefits that having an institutional shareholder brings. They want to maximise their personal future benefits”. To maintain motivation, therefore, the investors made sure that “in every situation the entrepreneur has more to lose” which, in some cases, included their own home. Rollstud’s director did feel, however, that an important factor in their decision to seek venture capital investment was the fact that the investor would share some business risk. The investor, in seeking to maximise the return on its investment, relies on its investee companies to generate the returns required, and needs to put in place various methods for ensuring that investees do not shirk on effort once an investment has been made. Investees, however, have their own reasons for wishing to achieve and maintain a high level of return. Presumably seeking to maximise personal wealth (note that the company was privately owned), Rollstud set out a strategy for achieving company growth, by focusing on the high quality end of the market. In negotiating contract terms with an investee, the VC thought there had to exist formal legal documents, which set out the parameters for everyone concerned. But in addition, they thought it important that there was an understanding between themselves and their investees of the working relationship, which they considered to be “hands-on” with a “level of trust”, working “as a partnership”. In summarising the ideal relationship with an investee, this Director said: We set out the minimum expected requirements and have an idea on potential returns. We like to think we are friendly partners; flexible, understanding, and supportive when things are not going as well as planned. We are nice guys, and are very anti contentious Board meetings. It is important that we think we’re going to get on with people before we invest. We have a very friendly relationship at the start.

While Abtrust thought that the contract was a combination of mutual understanding and legal documentation, it is interesting to note that Rollstud thought it to be much more tightly legally defined. In addition, he thought there was scope for moving towards an optimum contract, rather than already being at such a point. His explanation was that they hoped to expand the export side of the business, opening bases overseas, and that they would “need extra equity for that”. This is not to say that the contract was non-optimal, but rather that the funds on offer from the investor were not currently sufficient to meet the needs of its investee. They did note, however, that they did not feel they were competing with other clients of the venture capital investor for more favoured treatment. The VC agreed that they would not give most favoured treatment to their most efficient investees. On the contrary, they would “tend to spend most time on companies who were under-performing or provide the worst information”. As might be expected, they found that the “best performers tend to provide the best information”. Although,


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therefore, the time spent on each investment differed, as they attempted to limit the downside risk, they thought that investees would be unaware of how much time was spent with other investees, and so this would not affect their behaviour. It was also thought that they would, in any case, understand that their investor had to “help the companies with problems”. Abtrust’s director thought that the motivation of its investees was to seek to maximise personal gain. Rollstud’s actions would appear to confirm this, judging by the performance-linked equity scheme in place at the time. As well as receiving annual dividends based on profit, as the director explained, “salaries are reviewed annually, based on performance”. Further, Rollstud’s director thought that it would be more attractive to receive an agreed fixed sum from the VC in return for their involvement than to receive a proportion of the value of the firm at exit. This supports the assumption that Rollstud’s director was seeking to achieve personal goals; his preference was for a return that might allow him to reduce effort, to the potential detriment of the firm, while still personally receiving a fixed return. Rollstud also retained the right to confidentiality over certain aspects of their business. These related primarily to the future development of the company, any internal managerial problems and, in particular, personnel problems at a senior level. For example, the director explained that “if overall performance is satisfactory, but one area is not, it’s up to the board to sort it out without the venture capital investor’s involvement”. This telling comment is a sign that the company were slightly uneasy about relinquishing too much control, and is perhaps a clue that negative aspects would be held back from the investors. Abtrust were obviously looking for optimal returns to their shareholders, spending more time on poor performing investments, and pointing out that “our first decision is always purely commercial, based on expected returns”. Therefore, if the investee was performing well, the VC would tend to leave them alone, without much intervention. Abtrust’s director realise that sometimes the information given to him by the investee might not convey what the VC wanted to know. As the director explained, “it does arise, and then we try to do something about it. It means we have to go back with more questions, which increases the time spent on them”. Finally, the VC put in place measures to look after their investment, explaining that “we protect ourselves, with the potential to take some greater control. We nearly always try to get an annual dividend to pay financing costs”. To summarise, therefore, while both parties obviously had a vested interest in attaining the mutual goal of a maximised rate of return, they clearly also had in mind protection of their own stakes. Rollstud retained the right to some confidentiality, and the investor maintained control through financial instruments. Thus we conclude that each is acting ultimately in their own best interests, and assumption 3 is supported. Assumption 4. The investee has an information advantage over the investor Rollstud made an effort to be honest with Abtrust, and would attempt to communicate to the investor the level of risk surrounding their business. Nevertheless, they found that the investor typically would overestimate the risk inherent in their firm. When asked to explain why, the investee’s director said he thought that it was because “they require a high return on their funds, by the very nature of being a venture capitalist”, and that they had “parameters to work to from head office”. The investee thought that

the most important attribute they brought to the relationship with the VC was their knowledge of the markets for their products. For example, they had spotted new areas where they hoped to expand their product range, and said they wanted “to expand exports and open bases overseas, especially in the Far East”. When considering whether or not to invest in the investee, Abtrust had obtained data on the company, in order to find out what they were looking for in terms of investment: “we work out projected returns”, he said, “it’s a mechanical exercise, and we negotiate around that. We don’t go in with any preconceptions”. While the director of the Abtrust thought that the investee “nearly always has a technological advantage”, he did not think that this extended to their also having an advantage over financial controls and information systems (Mutch, 1999). The review of the capital investment decision, and the monitoring of that investment, require regular information, which Abtrust received from investees, and which included the minutes of all Board meetings. They also expected a “full and frank exchange of ‘need-to-know’ information”. The director of Abtrust summarised the accounting information that the investee was expected to provide as follows:


769

Monthly management accounts are insisted upon – including profit and loss account, balance sheet and any supplementary information, presented in a format agreed between the investee and ourselves. We also request in advance the projected profit and loss account, balance sheet and cash flow for the year. We require the minutes of all Board meetings and this all forms part of the terms and conditions of the initial offer and investment.

In practice, the investee had produced an annual profit and loss account, cash flow, balance sheet and master budget, both before and after the venture capital investor’s involvement. The only change that the investor had stipulated had been for an additional measure of headcount to be provided on an annual basis. Methods used by the firm to assess their own performance are summarised in Table II. Here, Abtrust exerted considerable influence over Rollstud’s accounting information system. Reporting measures of performance was clearly important to the

Measure of Method used by investee firm to assess own Method of assessment assessment reported to investor performance introduced by investor Sales Ratio of sales to investment (i.e. “investment turnover”) Return on investment Net profit Ratio of net profit to assets (i.e. “net profitability”) Cash flow Wage bill Stock levels Headcount Overtime

Yes

No

Yes

No No Yes

No No Yes

No No Yes

No Yes No Yes Yes Yes



Table II. Methods of assessing firm’s performance

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investor. Prior to investment, the only measure used by the investee to gauge performance was a simple indication of sales, or turnover. However, Abtrust required much more detail than this, and imposed stricter reporting on Rollstud. In addition to sales, therefore, Rollstud found themselves, post-investment, having to report net profit, cash flow, stock levels, headcount and overtime. All of these would give the investor a much more detailed idea of how the firm was performing at an operational level. Once these initial controls were imposed from the start of the relationship, little or no further change in reporting information was required by the investee. As the VC said: The companies, on a time basis, are fairly consistent with what they provide, and don’t change unless asked to do so. If things go badly then we see them more often.

Although the VC had no direct access to the Rollstud’s accounting systems, he could, and would, recommend appropriate advice, and would also monitor the company’s accounting controls: “we talk to auditors for comments and to ‘get comfort’ that the information is reliable and accurate”. As a quid pro quo, the VC would swap information with their investees. For example, if he had an investee that sold office furniture, he would speak to other investee companies who might have a demand for their product. As such, he thought of his company as being very much a “contact source”. The investee thought that the information they provided to the VC was reasonably accurate as regards the market, financial data and personnel data, but perhaps subject to slight distortion as regards the product and production methods. The VC said that “companies are naı¨ve on corporate finance, how financing can be structured and how institutional shareholders and banks behave”. The investee’s director generally agreed, saying that his own company knew more than its investors about technology, markets, technical staff and supply sources; but believing that knowledge was similar about managerial staff, budgets, capital structure, business strategy, management accounts, financial accounts and capital investment. In terms of the day-to-day running of the company, and the technology employed, it is clear that Rollstud had an information advantage over Abtrust. Thus there is support for assumption 4. The evidence therefore suggests that an element of information asymmetry did exist, and that conditions were such that moral hazard could arise. Assumption 5. The investee is both work- and risk-averse Where the principal knows little about his agent, that agent then has the opportunity to shirk on effort (Alchian and Demsetz, 1972; Fama, 1980). The next section of the questionnaire therefore inquired into the methods by which information was gathered, stored and used within both organisations. In order to attenuate problems like moral hazard, arising from information asymmetry, agency theory suggests that the principal impose systems of monitoring and control, to make sure that he is better informed about his agent’s actions, and thus reduce the risk inherent in his involvement (Alchian and Demsetz, 1972). The final section of each questionnaire therefore looked at the trading of risk and information between investor and investee. Rollstud thought that it would be attractive for an agreed fixed sum to be paid to them by the venture capitalist in return for their involvement, rather than to receive a

proportion of the value of their firm at exit, based on their standard share valuation formula. However, Abtrust’s director said that they “wouldn’t even contemplate a fixed sum”, because of the demotivating effect this might have on the investee. He further thought that Abtrust’s willingness to bear some risk affected the effort level of investees, saying that “we tend to find that effort increases because there is a new shareholder to whom they are responsible . . . they are personally motivated because of the benefits available”. Rollstud’s director concurred that, while they found that they could relax more in the running of the business, because the venture capitalist was sharing some business risk, their motivation did increase to a degree post-investment. This investor was “keen for management teams to be identified”, and liked to discuss right up front any financial bonuses and/or share options that might be brought in to enhance effort. Ratchets, a once-popular device for linking share entitlement to profit performance, were thought to be “a thing of the past”. Instead, Abtrust would protect themselves by incorporating a clause that gave them the potential to take greater control in certain circumstances. While the VC seemed to think that the investee was not work averse, there is some evidence to suggest that the investee might have reduced effort slightly post-investment: they found that they had been able to relax more in the running of the company since Abtrust’s involvement; and they would prefer to receive a fixed sum rather than proportion of the value of the company at exit. There is stronger support for the assumption that the investee was risk-averse. First, his responses to the two potential investments discussed under assumption 2 show the director’s more cautious nature. Next, he considered his company to be relatively low-risk, and thought that the VC over-estimated the risk in his business. Finally, he took active steps to limit or modify his risk exposure, thinking it an important consideration that the VC was now sharing some of the burden of risk. Thus assumption 5 is supported. Post-investment performance The interview data discussed above were taken from meetings in 1993. Since then, how have investor and investee progressed in terms of performance? We are able to track financial performance through published sources, most notably the FAME (see ratio definitions in the Appendix (Bureau van Dijk, 2000)) database of company reports. Further, this also enables us to undertake peer group analysis, to assess company performance by comparison to other businesses operating within the same sector. Median figures have been taken as the best comparator, as average figures show such a high standard deviation as to make the analysis meaningless[14]. Investor profitability Table III contains financial statistics for Aberdeen Development Capital plc from 1994 to 1999, whose name was changed to the Abtrust Scotland Investment company in 1999. The first observation is that the 12-month period to May 1999 is quite different to those of earlier years. Without further investigation, it is difficult to propose reasons for this marked difference. However, 1999 saw changes, not only in name, but also in the company’s registered office, memorandum and articles of association, and in its share capital. For this reason, it can be reasonably assumed that the new Abtrust Development Capital plc is a distinctly different company to its predecessor. Therefore, the following analysis will concentrate on the years 1994 to 1998 only. We are, in any


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a

5/99 5/98 5/97 5/96 5/95 5/94 12 months 12 months 12 months 12 months 12 months 12 months £000 £000 £000 £000 £000 £000

Profit and loss account Profit (loss) before taxation 21,716 8,285 5,029 787 511 403 Peer group 777 308 1,211 1,014 705 631 Retained profit (loss) 23,008 6,722 4,254 32 26 60 Peer group 205 65 280 183 95 74 Balance-sheet Net tangible assets 44,009 47,074 40,352 35,944 31,006 27,519 Peer group 29,758 26,856 29,784 28,816 30,161 28,221 Shareholders’ funds 44,009 47,074 40,352 35,944 31,005 27,515 Peer group 8,384 11,852 17,382 17,898 18,657 18,838 Profitability ratios Return on shareholders’ funds (%) 2 3.90 17.60 12.46 2.19 1.65 1.46 Peer group 12.54 8.25 13.77 11.66 5.74 5.41 Return on capital employed (%) 2 3.90 17.60 12.46 2.19 1.65 1.46 Peer group 6.79 4.04 8.64 7.36 3.72 3.72 Return on total assets (%) 2 3.79 17.14 12.14 2.14 1.62 1.44 Peer group 3.55 2.34 5.39 4.58 2.74 2.48 Interest cover 2 170.60 638.31 148.91 132.17 – – Peer group 2.70 2.08 4.45 4.30 3.07 2.79 Financial ratios Current ratio 1.13 1.28 1.10 1.44 14.22 9.10 Peer group 1.44 1.49 1.56 1.49 1.39 1.39 Liquidity ratio 1.13 1.28 1.10 1.44 14.22 9.10 Peer group 1.39 1.39 1.49 1.43 1.34 1.36 Gearing (%) 0.00 0.00 0.00 0.30 0.31 0.22 Peer group 30.48 37.29 25.16 24.06 22.79 26.58 Solvency ratio (%) 97.17 97.39 97.39 97.76 98.24 98.40 Peer group 62.81 62.12 72.01 69.31 68.51 61.14 b QuiScore 68 91 87 – – – QuiRating c Stable Secure Secure – – – Notes: Formulae for the financial ratios are contained in the Appendix; b “The QuiScore indicates the likelihood of company failure in the year following the calculation, based on research and statistical analysis that compared failed companies with those that have continued to trade” (Qui Credit Assessment Limited, 1999); c“The QuiRating provides a yardstick to establish routine unsecured trade credit limits. It is also useful for establishing the capacity of suppliers” (Qui Credit Assessment Limited, 1999); d peer group median results are given for comparison, where available, in italics, underneath Abtrust’s results. The peer group criteria are: Maximum number of directors ¼ 15; legal form ¼ Public (Plc); SIC Code ¼ 6523 – Other financial intermediation not elsewhere classified. n ¼ 1445 Source: Bureau van Dijk (2000)

a

Table III. Financial statistics for Aberdeen Development Capital plc (1994-1999)

case, most particularly interested in the period immediately following investment in Rollstud. First, if we take the figures available from the profit and loss account, we see a massive increase in profit before taxation from £403,000 in 1994 to £8.3 million in

1998, bucking the peer group trend. Likewise, retained profit increased over the same period from £60,000 to £6.7 million. Again, this contrasts with the peer group’s performance. Turning to the balance sheet, we also note that net tangible assets and shareholders’ funds showed a steady increase from £27.5 million in 1994 to £47 million in 1998. This is in contrast to the peer group figures, which show little change over time. Note that this investment company had no liabilities to speak of, so net tangible assets are equal to shareholders’ funds. So, in terms of profit and balance sheet measures, Abtrusts’ performance post-investment in Rollstud was significantly enhanced, and was good in relation to its peer group. Investor ratio analysis Turning now to the profitability ratios, return on shareholder’s funds (ROSF ¼ profit before tax divided by shareholders funds) and return on capital employed (ROCE ¼ profit before tax divided by net assets) give identical results. To a degree, return on total assets (profit before tax divided by total assets) is also similar for this company. In 1994, ROSF and ROCE, expressed as percentages, were each 1.46 per cent. By 1999 this figure had risen impressively to 17.6 per cent. Essentially, these measures show the return earned by the firm on the equity funds invested by its shareholders, the upstream investors. The company has experienced huge increases (< 1,122 per cent) in the returns they are generating. Further, in relation to its peer group, within only a few years it had overtaken the median returns substantially: in 1998, ROSF was 17.60, compared to 8.25; ROCE was 17.60 compared to 4.04; and return on total assets was 17.14, compared to 2.34[15]. Interest cover measures profit before interest divided by interest paid. It gives an indication of longer-term solvency and financial risk, by assessing the ability of the firm to meet its interest payments from profits. Figures were not available for Abtrust for 1994 and 1995. However, in 1996, they were able to meet their interest commitments 132 times over, rising to 638 times over by 1998. The peer group figures were well below this in every year. Clearly, interest cover was not a problem to them at this stage, and nor might we have expected it to be. Finally, we turn to the financial ratios used to assess performance. First, the current ratio (current assets divided by current liabilities), also sometimes known as the working capital ratio; and the liquidity ratio (current assets less stock, divided by current liabilities), also known as the “acid test” or quick ratio. Both, again, are identical for Abtrust, given the structure of its funds, and measure the ability of the firm to meet its short-tem liabilities from its short-term assets. As the company is more interested in the supply and investment of long-term equity capital, then short-term returns are less likely to be so important. However it is worth observing that, with ratio figures of more than one throughout, although being somewhat below the peer group median figures, in general, at no point would Abtrust have been unable to meet its short-term commitments[16]. The gearing ratio, in this case, measures long-term liabilities plus short-term loans and overdrafts, divided by share capital plus reserves, and is expressed as a percentage. Given the nature of Abtrust’s business, the company holds very little debt and so is likely to have a very low gearing ratio, which is clearly shown in Table III. In 1994 gearing was 0.22 per cent. By 1997 it was zero, at which level it remained for the following two years. The peer group had median gearing levels of between 24 per cent and 37 per cent across our time period. The last financial


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ratio we have available is the solvency ratio, expressed again as a percentage. This takes share capital and reserves divided by fixed plus current assets. As an investment company, Abtrust would be expected to have a high solvency ratio, and it does, never falling below 97 per cent over the period 1994-1999. In this sense, it has performed better than its peer group, where the solvency ratio was never more than 72.01 per cent.

774

Investor credit assessment The final assessments we have of Abtrust’s performance are those calculated by Qui Credit Assessment Limited’s (1999) formula. The QuiScore calculation is based on statistical analysis of a random selection of companies, and identifies those factors which combine to give the greatest predictive power of business success or failure. In 1997, Abtrust had a QuiScore of 87; in 1998, it was 91. The highest possible figure is 100. This puts Abtrust into the “secure” band, suggesting that failure would be very unusual and that the company had safe prospects. The relative instability during 1999, discussed earlier, meant the company falling into the second, “stable” band with a QuiScore of 68. While not in any particular trouble, further investigation would be required to determine the reasons for this drop in performance, thought the restructuring of the company must have played a large part. Investee profitability Financial statistics and associated peer group statistics, where available, for Rollstud are contained in Table IV. We are able to gauge more from the profit and loss account than we could from Abtrust’s reports, thanks mainly to more complete reporting; though turnover is not disclosed, as Rollstud – a medium-sized company – takes advantage of the abbreviated accounts provisions for smaller firms made in the Companies Act (1985). If we start again with the profit and loss account, we can see quite clearly that, post-investment, gross profit increased from £1.4 million in 1995 to £1.8 million over the 12 months to May 1999. Profit before taxation and retained profit also showed an increase between 1994 and 1999, of 51 per cent and 57 per cent, respectively. However, there was an unexplained drop during 1996 to show a retained profit of just under £60k, the lowest figure over the six-year period. While it is not immediately obvious why this occurred, the gross profit figure for 1996 is lower than that in both 1995 and 1997, so it can only be assumed that either turnover was unusually low or cost of sales particularly high for the period. However, this does not preclude payment of dividends during 1996 which, at £73k, were the highest this year than at any other time during the period under consideration. While this does not explain why profit before taxation should be so much lower, it does show that Rollstud was still able to make regular dividend payments. In fact, immediately post-investment, the company made dividend payments of £48k in 1994, rising to over £60k per annum for each year to 1999. The only relevant figures available for the peer group are for profit before tax, which shows that Rollstud’s performance was not out of line with that of the rest of the sector. Turning to the balance sheet items, we notice that net tangible assets have increased steadily year on year, except for 1996; an increase in short-term loans and overdrafts during this year, along with some new hire purchase payments, led to a subsequent decrease in net tangible assets. However, this trend was reversed during the following years. Shareholders’ funds, which comprise issued capital and total reserves, again

a

32.60 6.98 30.56 4.88 9.42 2.90 6.62 2.08 1.31 1.34 1.07 0.85 79.26 78.89 28.90 38.83 47 Normal

1.56 1.22 1.11 0.76 51.31 65.48 40.27 37.21 59 Normal

1,051,945 2,795,000 986,147 2,223,000

1,151,058 2,833,000 1,093,675 2,948,000 29.22 3.89 27.76 3.51 11.76 1.51 6.40 1.61

1,681,220 n.a. 321,501 195,000 62,941 n.a. 146,115 n.a.

5/98 12 months

1,845,144 n.a. 319,530 64,000 66,645 n.a. 107,528 n.a.

5/99 12 months

1.34 1.45 1.09 0.95 55.81 65.25 32.81 37.51 55 Normal

43.14 13.42 40.60 9.52 14.15 5.43 9.68 3.99

892,649 2,543,000 840,032 2,012,000

1,636,258 n.a. 362,402 348,000 66,697 n.a. 155,857 n.a.

5/97 12 months

1.23 1.49 0.92 0.91 99.66 72.35 29.96 35.81 – –

30.58 17.06 28.87 10.09 8.24 5.68 6.79 4.04

724,552 2,895,000 684,175 2,182,000

1,392,062 n.a. 209,188 339,000 73,095 n.a. 59,800 n.a.

5/96 12 months

1.32 1.30 1.00 0.85 42.70 72.37 31.80 33.70 – –

43.84 15.69 41.24 13.56 13.94 6.27 14.64 5.56

823,175 2,079,000 774,387 1,624,000

1,449,065 n.a. 339,465 334,000 63,891 n.a. 140,417 n.a.

5/95 12 months

1.22 1.42 0.91 0.87 21.20 53.27 26.45 33.33 – –

34.02 11.09 28.73 6.51 9.00 3.95 7.09 3.09

734,400 1,963,000 620,333 1,362,000

– n.a. 211,016 141,000 48,038 n.a. 68,686 n.a.

5/94 12 months

Notes: aFormulae for the financial ratios are contained in the Appendix; b “The QuiScore indicates the likelihood of company failure in the year following the calculation, based on research and statistical analysis that compared failed companies with those that have continued to trade” (Qui Credit Assessment Limited, 1999); c “The QuiRating provides a yardstick to establish routine unsecured trade credit limits. It is also useful for establishing the capacity of suppliers” (Qui Credit Assessment Limited, 1999); d Peer group median results are given for comparison, where available, in italics, underneath Rollstud’s results. The peer group criterion is: SIC Code ¼ 2874 – Manufacture of fasteners, screw machine products, chains and springs. n ¼ 46 Source: Bureau van Dijk (2000)

Profit and loss account Gross profit Peer Group Profit before taxation Peer Group Dividends Peer Group Retained profit Peer Group Balance-sheet Net tangible assets Peer Group Shareholders’ funds Peer Group Profitability ratios Return on shareholders’ funds (%) Peer Group Return on capital employed (%) Peer Group Return on total assets (%) Peer Group Interest cover Peer Group Financial ratios Current ratio Peer Group Liquidity ratio Peer Group Gearing (%) Peer Group Solvency ratio (%) Peer Group QuiScore b QuiRating c

Financial measure


775

Table IV. Financial statistics for Rollstud Limited (1994-1999)

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showed the same blip during 1996. Although it is not obvious why this should have occurred, it is worth noting that a change in share capital was made during the year to 1997, and that this was probably being anticipated during the preceding period. Finally, as regards the profit and loss account, Rollstud went on to make substantial retained profits in each year, from £68,686 in 1994 to £107,528 in 1999. The balance sheet statistics show equally favourable increases over time. Net tangible assets were valued at £734k in 1994, but had risen to £1.15 million in 1999. The drop in net tangible assets between, 1995 and 1996 is explained mainly by an increase in short-term loans and overdrafts, especially as regards hire purchase and lease purchase items. Shareholders’ funds rose too from £620k to over £1 million by 1999, dropping during 1996 at the time of the capital re-structuring. The peer group figures show a fairly steady upward trend over the same period, though reflect the fact that Rollstud is obviously a relatively small company in this sector. Investee ratio analysis The profitability ratios are interesting. The return on shareholders’ funds was consistently over 29 per cent. Recall that Abtrust required a return of 30 per cent by the time of exit, so Rollstud was on course to achieve this. At some points, ROSF had even exceeded 43 per cent. The return on capital employed, which takes net assets as its denominator, was slightly lower throughout, but still never fell below 27 per cent. In terms of return generated on total assets, Rollstud generally continued to perform better than it had done in 1994. And finally, there was no problem with meeting interest cover, as the company could afford to make interest payments no less than six times over in each year. For each of these ratios, Rollstud exhibited considerably better performance than its peer group, over the same time frame. As current liabilities would normally be met from current assets, we would expect a firm’s current ratio to exceed 1:1, and a figure of 2:1 is often said to be desirable. However, what does and does not pass for a “good” current ratio is very much sector specific. In Rollstud’s case, the current ratio was 1.22:1 in 1994 and, never falling below this, stood at 1.56:1 by 1999. These figures are relatively close to the peer group median, although 1999 stands out more obviously as being a “good” year. The liquidity ratio given is the “acid test” or “quick” ratio, which takes stock out of the equation, and is a more precise estimate of the firm’s ability to settle quickly its current debts. A ratio of greater than 1:1 would probably suffice. Rollstud starts with a ratio that might be regarded as just a little too low, at 0.91:1, but is generally performing well, with a liquidity ratio of 1.11:1 by 1999. Furthermore, if we compare liquidity to the peer group figures, Rollstud has performed considerably better: the peer group median never reaches 1:1. The gearing ratio is an indicator of the firm’s longer-term solvency. A high level of debt would tend to mean that there was high financial risk associated with the enterprise, and a gearing ratio of over 100 per cent would be considered to be on the high side. Again, this can depend on the sector. Only in 1996 did Rollstud approach a level of gearing of 100 per cent; at all other times it was below 80 per cent. Again, comparing this to the peer group, if we consider higher gearing to be undesirable, then Rollstud has performed better, in general, over time. As a point of interest, the average gearing ratio, over the same time, ranged from 125 to 300 per cent. The solvency ratio, which measures share capital and reserves divided by fixed and current assets, is

another measure of long-term solvency and, for Rollstud, ranges from around 26 per cent to 40 per cent. Certainly, at least for the first few years following investment, Rollstud was in a comfortable position vis-a`-vis its peers. Investee credit assessment Rollstud’s QuiScore figure was 55 in 1997, 47 in 1998 and 59 in 1999, which places it clearly within the middle, “normal” band of QuiRatings. Thus it fell within the range of companies, some of whom might be expected to fail, but many of whom would not. Therefore it exhibited a slight element of risk, but was generally thought to be a fairly safe investment, in line with its own Director’s analysis of the company. To conclude this assessment of Rollstud’s performance, we cannot neglect the unexpected figures for 1996. The major change that is obvious from the financial accounts is the structure of the company’s issued capital. Up until 1995, this was listed as £300,900. From 1996 onwards, it was £191,800. Following further investigation, this can be explained by the company’s Articles of Association, which state the dates on which preference shares should be redeemed (31 May 1995 – 109,100 shares at £1.50 each; and 31 May 1996 – 109,100 shares at £1.50 each). The Articles illuminate by stating: “on the dates fixed for any redemption the Company shall pay to each registered holder of Preference Shares the amount payable in respect of such redemption and upon receipt of that amount each such holder shall surrender to the Company the certificate for his shares . . . in order that they may be cancelled”. The increase in gearing between 1995 and 1996 can be explained further by the concurrent increase in short term loans and overdrafts from £281,906 to £641,476. However, it is worth noting that, even if we accept a slight slump in performance for 1996, the years following make up for any earlier deficit. Summary of performance The above data show that both investor and investee continued to enjoy improved performance following their involvement with one another. Abtrust’s house style, applied across its investment portfolio, leads us to infer that the nature of its relationship with its investees was not detrimental to performance. However, what is harder to gauge is the extent to which this relationship actually enhanced performance, if at all. Unfortunately, without statistical tests for cause and effect, it is impossible to do so here. Instead, we must rely on the qualitative evidence that is available. We know that the investor exhibited a particular “house style” of investment which was relatively “hands-off”, in terms of its involvement with the typical investee. And we also know what changes were imposed by Abtrust, in terms of the reporting they required by Rollstud. Perhaps we can put down the non-exceptional performance exhibited above to the fact that this relationship was closer to that of Figure 2 than Figure 3; i.e. while monitoring and control do exist, and effort is exerted by the agent on behalf of the principal, there remains some way to go before the full and free sharing of information is achieved. Conclusion This article has centred around five assumptions of agency theory, which were investigated by reference to empirical evidence from a case study of a paired venture capital investor and one of their investee companies. Support was found for each of our


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assumptions, to varying degrees. As far as assumption 1 was concerned, both investor and investee showed an ability to make rational decisions. They both sought relevant information, and had the computational skills necessary to analyse and interpret this information. For assumption 2, future outcomes were predicted using probabilities and sensitivity analysis, and uncertainties were minimised through the choice of lower risk involvements. The evidence for assumption 3 suggests that each party acted first and foremost in their own best interests, though it was acknowledged that similar goals were being sought. The investee did exhibit an information advantage over the investor, for certain areas, in support of assumption 4. And finally, under assumption 5, we have seen that the investee was risk-averse, and there is some, albeit slight, support for the assumption that he may have relaxed or reduced effort post-investment. While both Abtrust and Rollstud continued to experience good performance post-investment, certainly by reference to their respective peer groups, there are perhaps grounds for saying that this might have been even better. Profits did increase, and financial ratios showed some improvement, but perhaps not as much as we might have expected. So, while the relationship between the two organisations appears to be working for them, enabling performance to improve over time, perhaps there are certain features of their relationship that could be changed to lead to even better performance. In their favour, they both had an overall aim of maximising return. Wherever possible, they would also both try to minimise risk. Abtrust did this through diversification and by refusing to let themselves be over-exposed to any one particular sector, avoiding especially those sectors considered to be more high-risk than others. Rollstud minimised risk by, for example, conducting market research before committing large outlays to new product development. However, they retained information (Rollstud) and control (Abtrust) to their own best interests, thereby exhibiting at least an element of goal incongruence. Both respondents exhibited certain characteristics which, it may be argued, might inhibit optimal performance. Their tendency to veer from being risk neutral to risk averse might sometimes mean that they would miss out on potentially higher returns. For example, Rollstud would have preferred the certainty of receiving a fixed sum on exit from the deal. Neither company would conduct detailed statistical analysis to forecast future payoffs of particular investments. Instead, they preferred to rely on their own judgements, feelings and personal assessment. And while they both acknowledged that each had an information advantage over the other, in terms of their functional specialisation, there was no effort to increase the flow of information to reduce such asymmetries. As we have seen, the only real change imposed by Abtrust on Rollstud was in terms of the means by which they reported company performance to the investor, rather than in the ways in which they managed their business. Perhaps Abtrust might have helped to improve Rollstud’s performance even more by using their organisational skills in risk and financial management to impose more rigorous management accounting practices on their investee. For this particular case, an analysis of principal and agent has been helpful in structuring the nature of the relationship between investor and investee. The subsequent performance of both parties was analysed within this context. While post-investment performance was generally good, it might have been better, had the

two parties stuck more rigidly to the framework suggested by agency theory; for example, if Abtrust had imposed stricter controls and taken a more “hands-on” role or, in other words, if they moved closer towards the relationship implied by Figure 3. The two companies analysed here obviously placed a large emphasis on having a harmonious working relationship, perhaps somewhat to the detriment of performance. There clearly still exist, to a certain degree, agency problems of asymmetric information. However, they seem to have avoided the pitfalls of moral hazard, even observing an increase in the agent’s motivation post-investment. Perhaps this is due to the close, friendly and supportive relationship developed. It might also be due to the fact that, as Arthurs and Busenitz (2003, p. 148) note: . . . after the VC has invested in the new venture, it appears that agency concerns rapidly decline followed later by some potential upsurges.

Both companies seem to be happy enough with the contract and deal they structured, and performance is probably better than it would have been without investment. This paper has attempted to explain how a particular “house style” of investment can impact on performance, both of investor and investee. As such, a couple of major assumptions have been made. First, we assume that the style adopted by Abtrust is employed throughout its investment activities. Second, we assume that Rollstud behaves in a similar way, providing similar information, to each of its investors. In order to analyse just how good performance was, we have also considered comparative statistics for other companies in the relevant sectors over the period. What we have shown here, therefore, is how a relatively risk averse investor and investee can together form a relationship which enables them to work together towards mutual goals and enhanced organisational performance. Notes 1. Wright and Robbie (1998) contains a useful summary of the literature available to date on venture capital. On a related theme, Baiman (1982) conducts a survey of agency research in managerial accounting. 2. The role of agency theory in capital markets relationships is discussed in Bricker and Chandar (2000). 3. For example, a ratchet might offer the investee additional equity, in return for their reaching a specified performance target (Reid, 1998). 4. For a more detailed analysis of the problems and issues associated with agency theory, see Bamberg and Spremann (1987). 5. Reid (1998) has analysed venture capital investment within an agency framework, considering risk management, the development of information systems post-contract, and the “trading” of risk and information between the two parties to the contract. 6. i.e. where the venture capital investor has a very close and active working relationship with his or her investee company. 7. See Bergemann and Hege (1998) who create a “dynamic agency model” of venture capital financing, concluding (p. 703) that “the optimal contract . . . provides intertemporal risk-sharing between venture capitalist and entrepreneur”. 8. See, for example, Davis et al. (1997), who contrast agency theory with stewardship theory. The latter need not be inconsistent with agency theory, in that “stewards are motivated to act in the best interests of their principals” (Davis et al., p. 24). However, as Arthurs and


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10. 11. 12. 13.

14. 15. 16.

Busenitz (2003, p. 146) found, “stewardship theory is inadequate to explain most of the . . . [venture capitalist-entrepreneur] relationship because it implicitly assumes the subordination of the steward’s (entrepreneur’s) goals”. Although recent evidence suggests relative sophistication in the appraisal of investments by investors (Reid and Smith, 2002). Questionnaires are available from the author on request. See Milde (1987) on risk preferences and expected utility. See McMenamin (1999, Ch. 6) on “Risk and return”, for a discussion of portfolio theory. Bergemann and Hege (1998) give a detailed and technical discussion of what might be included in an “optimal contract” between venture capital investor and investee. See also Blickle (1987). For example, peer group average net tangible assets were £466m in 1999, with a standard deviation of 4,797,090,000, compared to Aberdeen Development Capital’s assets of £44m. Average figures for these ratios were 12.16 (st. dev: ¼ 96:56), 5.07 (st. dev: ¼ 64:22) and 0.09 (std. dev: ¼ 46:48), respectively. Note that the figures for 1994 (9.10) and 1995 (14.22) were unusually high. This can be explained in part by the fact that no dividends were paid during these years; but also by the fact that current liabilities (the denominator of both equations) increased over time, from £442,000 in 1994 to £1.3 million in 1998.

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Milde, H. (1987), “Managerial contracting with public and private information”, in Bamberg, G. and Spremann, K. (Eds), Agency Theory, Information and Incentives, Springer-Verlag, Berlin, pp. 39-59. Mintzberg, H. (1979), The Structuring of Organisations, Prentice-Hall, Englewood Cliffs, NJ. Mitchell, F., Reid, G.C. and Terry, N.G. (1992), “Some agency aspects of venture capital investment behaviour”, working paper, Centre for Financial Markets Research, University of Edinburgh, Edinburgh. Mitchell, F., Reid, G.C. and Terry, N.G. (1998), “Venture capital supply and accounting information system development”, Entrepreneurship Theory & Practice, Summer, pp. 45-62. Mutch, A. (1999), “Critical realism, managers and information”, British Journal of Management, Vol. 10, pp. 323-33. Nouri, H. and Parker, R.J. (1996), “The effect of organizational commitment on the relation between budgetary participation and budgetary slack”, Behavioural Research in Accounting, Vol. 8, pp. 74-90. Rankin, F.W. and Sayre, T.L. (2000), “The effects of performance separability and contract type on agent effort”, Accounting, Organizations and Society, pp. 683-95. Reid, G.C. (1998), Venture Capital Investment, Routledge, London. Reid, G.C. (1999), “The application of principal-agent methods to investor-investee relations in the UK venture capital industry”, Venture Capital, Vol. 1 No. 4, pp. 285-302. Reid, G.C. and Smith, J.A. (2002), “How do venture capitalists handle risk in high technology ventures?”, in Epstein, M.J. and Manzoni, J.-F. (Eds), Performance Measurement and Management Control, Vol. 12, Studies in Managerial and Financial Accounting, Elsevier Science, Amsterdam and JAI Press, Greenwich, CT, pp. 361-79. Reid, G.C. and Smith, J.A. (2003), “Post-investment performance appraisal (PIPA): the impact of venture capital investment on small firm performance”, Journal of Private Equity, Vol. 7 No. 1, pp. 36-49. Reid, G.C., Terry, N.G. and Smith, J.A. (1997), “Risk management in venture capital investor-investee relations”, The European Journal of Finance, Vol. 3, pp. 27-47. Sahlman, W.A. (1991), “Aspects of financial contracting in venture capital”, Journal of Applied Corporate Finance, Vol. 1, pp. 23-36. Sahlman, W.A. (1994), “Insights from the venture capital model of project governance”, Business Economics, July, pp. 35-7. Sapienza, H. (1989), “Variations in venture-capitalist – entrepreneur relation: antecedents and consequences”, unpublished PhD thesis, University of Maryland at College Park, College Park, MA and UMI Dissertation Services, Ann Arbor, MI. Sapienza, H. (1992), “When do venture capitalists add value?”, Journal of Business Venturing, Vol. 7, pp. 9-27. Sapienza, H. and Gupta, A. (1994), “Impact of agency risks and task uncertainty on venture capitalist-CEO interaction”, Academy of Management Journal, Vol. 37 No. 6, pp. 1618-32. Sapienza, H.J., Manigart, S. and Vermeir, W. (1996), “Venture capitalist governance and value added in four countries”, Journal of Business Venturing, Vol. 11, pp. 439-69. Shankman, N.A. (1999), “Reframing the debate between agency theory and stakeholder theories of the firm”, Journal of Business Ethics, Vol. 19, pp. 319-34. Simon, H.A. (1955), “A behavioural model of rational choice”, Quarterly Journal of Economics, Vol. 69, pp. 99-118.

Simon, H.A. (1978), “Rationality as process and as product of thought”, American Economic Review, Vol. 62 No. 2, pp. 1-16. Spremann, K. (1987), “Agent and principal”, in Bamberg, G. and Spremann, K. (Eds), Agency Theory, Information and Incentives, Springer-Verlag, Berlin. Sweeting, R.C. and Wong, C.F. (1997), “A UK ‘hands-off’ venture capital firm and the handling of post-investment investor-investee relationships”, Journal of Management Studies, Vol. 34 No. 1, pp. 125-52. Trester, J.J. (1998), “Venture capital contracting under asymmetric information”, Journal of Banking & Finance, Vol. 22, pp. 675-99. Uher, T.E. and Toakley, A.R. (1998), “Risk management in the conceptual phase of a project”, International Journal of Project Management, Vol. 17 No. 3, pp. 161-9. Wright, M. and Robbie, K. (1998), “Venture capital and private-equity: a review and synthesis”, Journal of Business Finance & Accounting, Vol. 25 No. 5&6, pp. 521-70. Zacharakis, A.L. and Meyer, G.D. (2000), “The potential of actuarial decision models: can they improve the venture capital investment decision?”, Journal of Business Venturing, Vol. 15, pp. 323-46. Further reading Tybejee, T.T. and Bruno, A.V. (1984), “A model of venture capitalist investment activity”, Management Science, Vol. 30, pp. 1051-66. Appendix. Formulae for financial ratios Current ratio current assets/current liabilities Liquidity ratio (current assets-stock)/current liabilities Solvency ratio (expressed as %) (share capital þ reserves)/(fixed þ current assets) Gearing (expressed as %) (long term liabilities þ short term loans and overdraft)/(share capital þ reserves) Interest cover profit before interest/interest paid Return on Shareholder Funds (expressed as a %) Profit before tax/ shareholders funds Return on Capital Employed (expressed as a %) Profit before tax/net assets (fixed þ current assets 2 current liabilities) Return on Total Assets (expressed as %) Profit before tax/total assets (fixed þ current assets)


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