The venture capitalist-entrepreneur relationship

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The venture capitalist–entrepreneur relationship: control, trust and confidence in co-operative behaviour DEAN A. SHEPHERD and ANDREW ZACHARAKIS (Final version accepted 6 February 2001) This article acknowledges the importance of achieving confidence in partner co-operation within the venture capitalist (VC)–entrepreneur relationship. The entrepreneur and the VC need to balance the level of control and trust building mechanisms so that the optimal level of confidence in partner co-operation can be achieved. The study proposes that the entrepreneur can build trust with the VC (and vice versa) by signaling commitment and consistency, being fair and just, obtaining a good fit with one’s partner, and with frequent and open communication. Open and frequent communication acts as a catalyst for the other trust building mechanisms. This theoretical framework acts as a counter weight to most previous studies on the VC–entrepreneur relationship that have emphasized control mechanisms in order to build partner co-operation without sufficient consideration of how this might effect trust and how trust and control jointly effect confidence in partner cooperation.

Introduction Co-operative relationships between venture capitalists (VCs) and entrepreneurs are necessary for the success of VC backed startups (Steir and Greenwood 1995, Sapienza and Korsgard 1996, Cable and Shane 1997). Timmons and Bygrave (1986) propose that the co-operative relationship between a VC and an entrepreneur are more important to the success of the business than the capital itself. While it appears that co-operation provides significant benefits it does not characterize all VC–entrepreneur relationships (Sahlman 1990). Sapienza and Korsgard (1996) propose that entrepreneurs have an incentive to be unco-operative with the VC by withholding information (e.g. technical details that make it difficult for the VC to fully evaluate the business for future funding (Bowden 1994)). There is also an incentive for entrepreneurs to put a positive ‘spin’ on (overstate) the performance of the business and/or underplay the importance of detrimental information when communicating with the VC (Bowden 1994). While the information provided by entrepreneurs is typically discounted by VCs, investments of venture capital (including later stage Dean A. Shepherd, College of Business, Campus Box 419, University of Colorado, Boulder, CO 803090419, USA; e-mail: [email protected]; Andrew Zacharakis, Babson College, Babson Park, MA 02157-0310; e-mail: [email protected] Ventur e Capital ISSN 1369-106 6 print/ISSN 1464-534 3 online Ó http://www.tandf.co.uk/journals DOI 10.1080 /1369106011004276 3

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funding) are directly related to the entrepreneur’s initial projections (Sahlman 1990) as are decisions regarding whether to replace the entrepreneur with professional management (MacMillan et al. 1989) or dilute the entrepreneurs stake in the company (Hoffman and Blakely 1987). To a certain extent VCs are dependent upon the entrepreneur for information and the entrepreneur has the opportunity to act as a gatekeeper actively managing this information boundary to their own self-interest. Apart from the potential of opportunistically managing the information boundary between the new venture and the VC, the entrepreneur also has an incentive to be opportunistic in their use of resources (i.e. while entrepreneurs prefer their ventures to be successful there is a wide variability between entrepreneurs’ consciousness and devotion to the venture (Amit et al. 1990a). For example, promises originally made in earnest may become more onerous and the entrepreneur might start focusing on other activities (Cable and Shane 1997) or using funds to conduct those activities that provide them the greatest pleasure. In other words, the funds being used by the entrepreneurs are more costly to the VC than they are to the entrepreneur (Sahlman 1990). Therefore there is an incentive for entrepreneurs to be unco-operative.1 There is also an incentive for VCs to pursue opportunistic behaviour at the expense of co-operation (and the expense of the entrepreneur). VCs typically do not receive a return on their investment until after the limited partners (those that invested in the VC fund) have received their return. Such an arrangement may tempt VCs to harvest a venture (and obtain their profits) rather than reinvest in the venture’s future products and development (Sahlman 1990). In order to invest early the VC may pressure the entrepreneur to seek short-term profits (Gomez Mejia et al. 1990) even to the detriment of long-term profitability and/or the VCs may under invest in the venture (Gorman and Sahlman 1989, Bygrave and Timmons 1991, Cable and Shane 1997). The VC (who is diversified among a number of portfolio companies) stands to benefit from the above strategy to the detriment of the entrepreneur (who typically has his/her financial returns dependent upon the success of this single venture). VCs can offer a venture value over and above the money (see Timmons and Bygrave 1986, Sapienza 1992, Sapienza et al. 1996) for examples of the non-financial benefits that VCs can offer their portfolio ventures). VCs may act opportunistically and insufficiently invest these non-financial resources into the firm. The above suggests that while co-operation between the entrepreneur and VC is important there exists incentives for both parties to be opportunistically unco-operative. Currently, little is known about what makes these relationships work (Bowden 1994, Sapienza and Korsgard 1996, Cable and Shane 1997). Therefore it is important to understand the processes that generate confidence that the partner will behave in a cooperative manner. Confidence in partner co-operation refers to the perceived level of certainty that its partner will pursue mutually compatible interests in the relationship, rather than act opportunistically (adapted from Das and Teng 1998). Confidence in partner co-operation has been of recent interest to scholars such as those utilizing an agency perspective (Amit et al.

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1990a), and a prisoner’s dilemma perspective (Cable and Shane 1997). These research approaches have concentrated on the relationship between control and confidence in the co-operative behaviour of the partner and in doing so have made a significant contribution to the literature. It is argued, however, that there is more to establishing a functional relationship between an entrepreneur and a VC than obtaining control through various mechanisms. Based on research from a number of literatures, it is proposed that the construct of trust is also an important consideration in attempting to gain a greater insight into the VC– entrepreneur relationship. This raises a number of questions not sufficiently addressed by previous theoretical models. For example, is it the case that control acts as a substitute for trust in order to increase confidence in partner co-operation? (As implied by Cable and Shane 1997 and following works such as Smitka 1994, Williamson 1975.) Can the relationship between control and trust be complementary? (See for example, Rousseau 1995.) In order to gain a deeper understanding of confidence in partner cooperation it is argued that both control and trust need to be considered simultaneously. What is the nature of such a relationship? To address these questions an integrated model of co-operative behaviour is offered taking into consideration both mechanisms to gain control and to generate trust. The paper proceeds as follows. First a review of the two most dominant approaches to the VC–entrepreneur relationship (agency theory and prisoner’s dilemma) with reference to the broader control literature are offered. Second, the social judgment perspective, which acknowledges the importance of trust is reviewed. The paper investigates the relationship between trust and confidence in partner co-operation. Third, a model of building trust is offered including: (a) signalling commitment and consistency; (b) being fair and just; (c) obtaining a good fit with the partner; and (d) maintaining frequent and open communication. It is proposed that ‘frequent and open communication’ also moderates the relationship between the other trust building variables and confidence in partner co-operation. Fourth, it is proposed that trust moderates the relationship between control and confidence in partner co-operation and control moderates the relationship between trust and confidence in partner co-operation— research that investigates control (or trust) without considering the role of trust (or control) likely offers an over-simplistic explanation of confidence in partner co-operation. Therefore a model that explains confidence in partner co-operation in a more complete and parsimonious manner than previously is offered. The model of confidence in partner cooperation is presented in figure 1. Finally, the limitations of the model and future research opportunities that arise from this model are explored. The literatures are now reviewed and the model developed. Control and confidence in partner co-operation The majority of studies that have investigated the development of cooperation in the VC–entrepreneur relationship have proposed mechanisms for the VC to increase their control over the entrepreneur and in doing so

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Figure 1. A model of confidence in partner co-operation.

encourage (coerce) co-operative behaviour. Control is a regulatory process by which the elements of a system are made more predictable through the establishment of standards in the pursuit of some desired objective or state (Leifer and Mills 1996: 117). Studies to date have proposed contexts in which the risk of entrepreneurs acting opportunistically are high (see Fiet 1995) and actions that can be taken by the VC to encourage co-operation. For example, the introduction of penalties for defection in order to increase the likelihood that the other party will co-operate include a dilution of the entrepreneur’s equity in the venture (Sahlman 1990), replacement of the entrepreneur with professional management (Barney et al. 1996, Hoffman and Blakey 1987), and compensation structures (Sahlman 1990). These control mechanisms increase the confidence in partner co-operation. Such an approach underlies the agency and prisoners’ dilemma perspectives, which are now reviewed. Agency theory perspective of the VC–entrepreneur relationship Agency risk is the degree of uncertainty that either the entrepreneur or the VC will pursue his or her own self interests rather than comply with the requirements of the contract for venture capital (Fiet 1995). This definition places the emphasis on the mechanism used to gain confidence in partner co-operation through the use of a contract. Studies utilizing agency theory

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have primarily focused on the issues of moral hazard and adverse selection (Amit et al. 1990a).2 Moral hazard refers to circumstances in which parties in a contractual relationship can take actions that cannot be verified and thus cannot be contracted upon and adverse selection refers to any circumstance in which one party has private information about any intrinsic characteristics that might be relevant to performance in a contracting situation (Besanko et al. 1996). Agency theorists have provided valuable advice to VCs and implement control mechanisms to ensure that the entrepreneur does not act opportunistically to the VCs detriment. In sum, this perspective offers a description of the risks associated with the principal (the VC) and the agent (the entrepreneur) and actions that the VC can take to ‘force’ the entrepreneur to co-operate. Cable and Shane (1997) question the appropriateness of agency theory suggesting that it is not always the case that the parties have unequal power where a principle seeks control of an agent’s behaviour. As discussed above, both parties may act opportunistically (Williamson 1985). Theories of economic exchange, like agency theory, place little emphasis on trust, but they do offer explanations for managerial behaviour, such as monitoring and control (Whitener et al. 1998). Further, as stated above, VCs can also choose defection strategies (Sahlman 1990). In this case, agency theory is less useful in developing the agent’s confidence that the principal (VC) will engage in co-operative behaviour. In other words, the agency perspective describes the relationship in only one direction; it focuses on VC control over entrepreneur’s opportunistic behavior while ignoring the entrepreneur’s concern that the VC may act opportunistically. Prisoners dilemma perspective of the VC–entrepreneur relationship Underlying the prisoners’ dilemma perspective is an assumption that each individual actor has an incentive to act according to competitive, narrow self-interest even though all actors are collectively better off (i.e. receive higher rewards) if they co-operate. The payoffs for each actor are dictated by the strategy adapted by the other actor and follow the payoff structure of: (1) temptation of extra payoff from defection; (2) reward for mutual cooperation; (3) mutual defection; and (4) suckers pay off where the sucker cooperated and the other party defected (Axelrod and Dion 1988). It appears that for the party that does not know the other party’s strategy, their own optimal strategy is to defect even though co-operation is collectively optimal for both parties (Komorita et al. 1991). In this way the prisoners’ dilemma framework incorporates much of what agency theory has to offer (issues of uncertainty and goal conflict). The above discussion from the agency and prisoner’s dilemma perspective leads to proposition one: Proposition 1: The greater control the VC has over the entrepreneur the greater confidence the VC has that the entrepreneur will be co-operative. The same holds for the control an entrepreneur has over a VC.

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Cable and Shane (1997) draw on prisoners’ dilemma research to develop a conceptual model that examines the antecedents of co-operation between the two parties, namely, time pressure, the payoff from co-operation, information, power, transaction periods, generosity, and penalties for defection. Cable and Shane’s (1997) approach makes a contribution over and above agency theory (also the static prisoner’s dilemma framework) by including in the model the development of social relationships between the partners over time (i.e. increasing the probability of co-operation and mutual gain). This appears to be an important addition to our understanding, as VCs do recognize the dynamic nature of their relationship with entrepreneurs (Sapienza 1989). It is not clear, however, how theory ties Cable and Shane’s (1997) antecedents of co-operation together or even to the Prisoners’ dilemma framework other than to say that they effect co-operation. While they have made a good first step expanding the prisoners’ dilemma framework, there is a need for theory to further explore the social relationship aspect of developing co-operative behaviour. For example, Sweeting (1991: 619) wrote, ‘VCs . . . were seeking to establish whether or not they could simply ‘‘get along with’’ team members and trust them. The benefits of this mutual understanding and trust were evident even before the deal was made.’ Sapienza and Korsgard (1996) represent an important next step in this direction utilizing theory from the social justice literature. Their perspective is now reviewed. Social justice perspective of the VC–entrepreneur relationship Sapienza and Korsgaard (1996) are the first, to the authors’ knowledge, to emphasize the importance of the entrepreneur engendering investor trust. They use Social Justice theory to investigate means of building trust, namely, to encourage investors to believe that the procedures used by the entrepreneur are fair and include consideration of the investor’s interests. In particular, they investigated the investors’ responses to the timeliness with which entrepreneurs shared information, and the level of influence the investors had over the strategic direction of the venture. The contribution here is the emphasis on trust in the relationship. Trust is a concept that agency theorists ignore and some economists explicitly rule out (e.g. Williamson 1975). In sum, is control sufficient to explain confidence in partner cooperation? Are there other constructs that affect the nature of the VC– entrepreneur relationship? Cable and Shane (1997) propose that control mechanisms (penalties for defection) are required to increase the likelihood of co-operation when trust is absent. While this is a rare reference to the term ‘trust’ in research utilizing an agency and/or prisoner’s dilemma perspective, both VCs and entrepreneurs appear to place importance on trust in their relationship. While Sapienza and Korsgard (1996) acknowledge the importance of trust it was not their intention (it is assumed) to explore the relationship between trust and co-operative behaviour but explore the relationship between the timeliness of information provided and the level of influence over strategic direction.

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Therefore, while control has taken a pre-eminent position in the literature and made a significant contribution, it is argued that the literature on trust offers an opportunity to further explore the VC– entrepreneur relationship by creating a model that can incorporate and extend previous models in a more parsimonious and complete manner. The concept of trust is more explored. Trust and confidence in partner co-operation A possible explanation for the conspicuous absence of an explicit recognition of the trust construct is the inconsistency with which it has been treated across disciplines (see Fichman 1997). A special issue on trust in Academy of Management Review is evidence of the importance and conceptual opportunities that abound for research into this construct. Rousseau et al. (1998) propose, based on the definitions offered in the AMR special issue, that trust is a psychological state comprising the intention to accept vulnerability upon positive expectations of the intention or behaviour of another. From this definition it is important to note that trust is not a behaviour or a choice but a psychological state that can be interpreted in terms of perceived probabilities (Bhattacharya et al. 1998), positive expectations (e.g. Hagen and Choe 1998; Jones and George 1998), and confidence (e.g. Das and Teng 1998). Implicit in the emergence of trust using this definition, is the necessary inclusion of some form of risk (perceived probability of loss) and interdependence (the attainment of one party’s interests cannot be achieved without reliance on another party) (Rousseau et al. 1998). An important distinction between trust and control is that trust (a perception) does not directly influence others’ behaviour whereas control (control mechanisms) does (Das and Teng 1998, Leifer and Mills 1996). The above discussion leads to proposition two: Proposition 2: As a VC’s trust in the entrepreneur increases his/her confidence that the entrepreneur will co-operate also increases. The same holds for an entrepreneur’s trust in the VC. If the above proposition is accepted, then the question becomes how do both parties build the level of trust in order to gain the mutual benefits from cooperation. The study proposes that trust can be built by both parties in the relationship by: (1) signaling commitment and consistency; (2) being fair and just; (3) obtaining a good ‘fit’ with the partner; and (4) frequent and open communications. Each is explored and propositions developed. Signalling commitment and consistency The concept of trust, as discussed above, requires that the parties face a risk (e.g. opportunistic behaviour by the other party). Therefore trust requires the party to be vulnerable (Rousseau 1998)—to take a risk. When one party

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‘trusts’ the other (makes themselves vulnerable to the partner’s opportunistic behaviour) then this seems to encourage the partner to be trustworthy and co-operate. For example, scholars suggest that this form of reciprocity is an important element to building trust (Johnson et al. 1997, Larson 1992, McAllister 1995, Creed and Miles 1996). It appears this initial act of vulnerability signals the parties’ commitment to the relationship—it represents a symbolic exchange (see Haas and Deseran 1981). This gradual and incremental process of signalling commitment and building greater levels of trust may at the same time represent a staging of risk (see options theorists such as Bowman and Hurry (1993) and McGrath (1999)). Therefore the investment of commitment in the relationship through a series of incremental steps represents a trial and error approach (in an environment of uncertainty) to relationship building. This accumulation of experiences can contribute to increasing trust between the parties (Luhmann 1988, Larson 1992, Gulati 1995). The accumulation of experience initiated by a signal of commitment to the relationship assumes that the behaviour (acts of commitment) is consistent (i.e. reliable and predictable) (Graen and Uhl-Bien 1995). Behavioural consistency has been found to be an important aspect of trust (Jennings 1971, Gabarro 1978, Johnson-George and Swap 1982, Butler 1991, Robinson and Rousseau 1994). Thus: Proposition 3: An initial signal of commitment by the entrepreneur sent to the VC will initially increase the VC’s confidence that the entrepreneur will co-operate so long as the VC perceives behavioral consistency. The same holds for signals of commitment by the VC.

Perceived as fair and just One party showing concern for the other party may connote genuine interest in the other party and generate trust (Whitener et al. 1998). Sheppard and Sherman (1998) argue that trust can be developed by evoking (and fulfilling) a sense of obligation.3 This obligation is a central theme of the procedural justice literature. This approach proposes that how procedures are conducted shape the attributes and actions of those engaged in the process (Kumar 1996, Johnson 1997). Procedural justice scholars argue that the more one party perceives the procedure (process) to be ‘fair’, the greater they will trust the other party. Part of developing and building the perception of fairness and justice (and therefore trust) is behavioural integrity (Ring and Van de Ven 1992, Mayer et al. 1995, Whitener et al. 1998). The antecedents to behavioural integrity include telling the truth and keeping promises (Dasgupta 1988)—they can be confident that what the other party says they will do will be done. A firm with a reputation of being honest, fair and trustworthy gives one the needed first piece of evidence to take some initial risk (Barney and Hansen 1994).

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Another important part of a fair and just behaviour in a relationship is in the allocation of rewards, i.e. the party contributing the most resources to the relationship (building the most value) should receive more of the rewards generated by the partnership (Korsgaard et al. 1995, Sheppard and Tuchinsky 1996). Sometimes the need for equity (fairness in the distribution of outcomes) becomes more important than the efficiency of obtaining that outcome (Ring and Van de Ven 1994). These concepts of fairness and justice have been and will continue to be, extensively investigated. A full discussion of these concepts is beyond the scope of this paper. However, the above discussion leads to proposition four: Proposition 4: By the entrepreneur instituting a procedure that is ‘fair’ will initially increase the VC’s confidence that the entrepreneur will co-operate (so long as the VC perceives ‘fairness’). The same holds for the VC instituting ‘fair’ procedures.

Obtain a ‘fit’ with the other party Making adjustments to accommodate the needs of the partner increases the fit between the two parties and thereby increases trust in the relationship (Heide and John 1992, Madhok 1995). Of course those parties that are similar (or at least perceive that they are similar) to each other are likely to need less adjustments to obtain a fit. Therefore trust is often developed quicker by parties that are attracted to each other and perceive that they have similar characteristics (Zucker 1986, McAllister 1995, Creed and Miles 1996). Sheppard and Sherman (1998) propose that over time parties can develop highly similar internalized views, beliefs and values. Thus: Proposition 5: By the entrepreneur selecting a VC with whom they have a good fit and by making adjustments to obtain a better fit will initially increase the VC’s confidence that the entrepreneur will co-operate. The same holds for the VC selecting an entrepreneur.

Frequent and open communication Trust in a relationship can increase when adequate explanations and timely feedback are offered (Folger and Konovsky 1989, Konovosky and Cropanzano 1991, Larson 1992, Thomas and Trevion 1993, Das and Teng 1998, Whitener et al. 1998). It appears that communication speeds up the process by which the parties can assess the other’s ‘trustworthiness’ (Creed and Miles 1996). For example, collocation and electronic communication linkages have been found to increase communication and trust (Womack et al. 1990). Thus:

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Proposition 6: Open and frequent communications from the entrepreneur to the VC will initially increase the VC’s confidence that the entrepreneur will co-operate. The same holds for open and frequent communications from the VC.

The moderating relationship of ‘frequent and open communication’ Communication is also a catalyst for the other means of trust building proposed above. For example, the unsolicited communication of information (especially if that information is sensitive) can provide a clear and strong signal of commitment to the relationship (Das and Teng 1998) encouraging reciprocity. Communication may also act as the vehicle to exchange information about adjustments/accommodations made as well as feedback—thus increasing trust in the relationship (MacNeil 1980, Thomas and Trevion 1993). Communication also helps bring the parties closer together, without explicitly comprising adjustments of one party, by helping the partners further develop common values and togetherness (Madhok 1995, Leifer and Mills 1996). Sheppard and Sherman (1998) refer to it as active discovery through communication and research. Communication through the use of timely feedback, is perceived by the other party as behaviour that is fair and just (there is procedural justice) and therefore influences another trust building dimension (see Sapienza and Korsgard 1998). Thus: Proposition 7: The level of open and frequent communication moderates the relationship between the generation of trust and: (a) signalling commitment and consistency; (b) enhancing perceived fairness and justice; and (c) obtaining a better fit. In the presence of open and frequent communication the other mechanisms of trust generation are more effective. It is proposed that in order to understand the relationship between the mechanisms of building trust and the level of trust, the moderating role of communication must also be considered. Similarly, a contingency approach to understanding the relationship between control, trust and confidence in partner co-operation is proposed. This contingency approach is now explored. Control, trust and confidence in co-operation There is inconsistency in the literatures over the relationship between trust and control. There are some scholars who suggest trust is a type of control mechanism (similar to the argument made by agency theorists). Others

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suggest that trust and control are substitutes (i.e. control is required when trust is absent (Sitkin and Roth 1993, Aulukh et al. 1997, Cable and Shane 1997). It seems that there is some optimal level of control that will allow trust in the relationship to develop and thereby generate the maximum level of confidence in partner co-operation and the level of trust influences the choice of control. Such an explanation may reconcile what currently appears to be conflicting perspectives in the literature, i.e. reconcile those who argue that the introduction of control mechanisms implies one party does not trust the other and therefore inhibits trust generation (Argyris 1952) with those who argue control mechanisms allow trust to develop (Goold and Campbell 1987, Sitkin 1995). The authors suggest that both are right but are not always applicable. It depends on the amount of control. There is a curvilinear relationship such that at low levels of control there will be low levels of trust. The paper argues that the perceived risk from being vulnerable is ‘too high’ to encourage trust by one or both parties. Such an argument is consistent with previous research (c.f. Argyis 1952). At the other extreme, where control is high there is less need for trust as the partner is already coerced into the desired behaviour. In fact, the act of one partner implementing (or requiring) such high levels of control might send a signal that they see the other party as untrustworthy. Such a perception might erode any trust that exists and might even build distrust.4 Such an argument is consistent with previous research (see Haas and Deseran 1981). Somewhere between these two extreme levels of control (minimal control and maximal control) is an optimal level that allows and encourages trust in the relationship to be developed. It is proposed that an assessment of one’s current level of trust is likely to directly influence the choice and magnitude of the control mechanisms implemented. In this way the assessment of trust can act as a feedback mechanism informing the control decision in order to fine tune the combination of trust and control towards an optimal level of confidence in partner co-operation. Thus: Proposition 8: The relationship between a VC’s control mechanisms and the generation of trust in the entrepreneur is curvilinear in nature—an inverted U shape. The same holds for an entrepreneur’s control mechanisms. Proposition 9: A VC’s assessment of his/her level of trust in the entrepreneur influences the choice of control. The same holds for an entrepreneur’s assessment of his/her level of trust. The above implies that there is an optimal level of both control and trust that maximizes partner co-operation. A parabola in three-dimensional space with control, trust, and confidence in partner co-operation as the axis, indicates the optimal combination of control and trust that maximizes

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partner co-operation. The actual optimal combination becomes an empirical question, of course, and while it is likely to vary from relationship to relationship it is likely that this concept of an optimal combination of trust and control is useful in appreciating how different classes of parties may interact. This issue is explored further in the section below. Optimal levels of control and trust The optimal level of trust likely differs from one entrepreneur/VC relationship to the other. Greater variance, however, probably exists between different classes of equity investors/entrepreneur dyads. The entrepreneurial financing process can be roughly thought of as a progression from one source of equity capital to another based upon venture type, stage, etc. After self-investing, most entrepreneurs progress through family, friends, business contacts, and maybe business angels (high net worth individuals). Only those ventures that have high potential, are relatively established, and need large cash infusions ever capture the VC’s attention. It is suggested that the typical combination of trust and control differs based upon the type of investor and that these points can be plotted on a three dimensional graph with confidence in partner co-operation, control and trust as the axis (see figure 2). The three dimensional figure suggests that each type of investor can achieve high confidence in partner co-operation but they can do so only through a unique combination of trust and control. Family and friends appear to achieve high confidence in entrepreneur co-operation through low control and high trust, business angels through a moderate level of both control and trust, and venture capitalists through a high level of control and low trust. Examining investor type along the proposed dimensions of trust indicates why the tradeoff with control varies (see table 1). For instance, signaling commitment and consistency is very high with family and friends and diminishes to low with VCs. Both parties in the family/friends— entrepreneur dyad are highly vulnerable to each other. Informal repayment schedules and terms increase family/friends’ exposure. On the other side, the threat to friendships or family relationships of a failed venture increases the entrepreneur’s vulnerability. Within the VC–entrepreneur dyad, on the other hand, vulnerability is limited due to the VCs extensive conditions detailed on their boilerplate term sheets. Similarly the details on the term sheet give the entrepreneur more certainty in how the relationship will unfold. Perceived fairness and justice is a function of perceived fair processes and allocation of rewards. From the entrepreneur’s perspective, the allocation of rewards is best with friends/family and decreases through to VCs. The less formal the investment process, assuming that the entrepreneur does secure the investment, the greater the perception of fairness because the added flexibility of the process means that the investor paid individual attention to the entrepreneur versus just following a formula. Fit tends to be highest with family and friends and then decreases across investor types. The entrepreneur has the

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Figure 2. Typical level of trust by investor.

Table 1.

Types of investors and typical levels of trust antecedents. Friends and Angels family

Signalling commitment and consistency Perceived fairness and justice Fit Open communication Control

Very high Very high Very high Moderate Very low

High High High Very high Moderate

VCs Low Low Moderate Moderate Very high

longest history with family and friends. The family shaped who the entrepreneur became and the entrepreneur chooses his/her friends. Thus, the fit between these groups is likely to be the highest. Fit with traditional angels is also relatively high as angels typically invest in industries where they have operational experience. Therefore, the angel is the mentor who has been there and done that. As the investor becomes more formalized (and institutionalized), the fit likely decreases because the investor is less apt to have the same life experiences. Communication also follows a decreasing trend across investors with one notable exception. Whereas traditional angels are likely to have a ‘hands-on’ approach to working with the entrepreneur (i.e. offer expertise on operational aspects), family and friends may have considerably less involvement in the operations of the business. Communication between the entrepreneur and family/friends investors may often take place during social settings (e.g. family dinners, etc.) and not at the same level of depth as with traditional angels. Whilst progressing towards VCs, the day-to-day involvement decreases as the portfolio of companies these groups manage

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increases. Thus, VCs have relatively less time to invest in each portfolio company than do traditional angels. Given the proposed interaction that communication has with the other trust dimensions suggests that business angels are quite capable of building considerable confidence in partner cooperation. Applications and extensions, and testing of the model Signalling commitment and consistency Entrepreneurs and VCs signal commitment and consistency in many ways, but perhaps the most important is by their past record of achievement. The VC mantra of preferring an ‘A’ team with a ‘B’ idea to a ‘B’ team with an ‘A’ idea implies that VCs trust those entrepreneurs who have higher qualifications, especially if those qualifications include past entrepreneurial experiences and/or evidence of trustworthiness in their relationships with investors. Thus, entrepreneurs espouse their commitment by showing what they have accomplished and what they are willing to give up in order to pursue the new venture (e.g. high paying, prestigious job, etc.). Sophisticated entrepreneurs also screen VCs to gauge whether the VC can add value beyond merely the funds. Thus, VCs signal their commitment and consistency via web pages that show their portfolio of companies, press releases, testimonials from entrepreneurs of portfolio companies, qualifications and reputations of individual venture capitalists, etc. There are likely other actions and factors that signal vulnerability and trust, the question is how effective are these actions? Understanding which signals are more clearly perceived might allow the maximum amount of trust building for the least amount of actual exposure (vulnerability). Future research should explore a number of issues in more detail. How much vulnerability is appropriate? What is the relationship between the amount of vulnerability and the effectiveness of this action as a risk staging (options) process? Which signals are going to lead to the most productive trial and error process—most efficiently build accumulated experiences between the VC and the entrepreneur? Along with signalling vulnerability, what is the best way to signal your behavioural consistency? For example, instead of one action that shows considerable vulnerability, is an entrepreneur (or VC) better served by consistently offering a series of actions that show lower levels of vulnerability? Fair and just Perceived fairness most often focuses on valuation and equity dilution to secure funding. Valuation is often highly contentious primarily because of a lack of information. While each party clearly has a vested interest in the valuation, it is critically important for both the VC and entrepreneur to

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detail the procedure they used to value the business as this likely increases the perception of fairness by both parties. For the VC this might mean showing valuations of comparable companies, validating pro forma projections, etc. ‘There has been little research on evoking a sense of obligation in the VC context. While some findings from other contexts likely apply to the VC–entrepreneur context others likely do not. Which actions do apply and which do not? This represents an empirical question that requires scholarly attention. Sapienza and Korsgaard (1996) investigated VCs’ responses to the timeliness with which entrepreneurs shared information, and the level of influence the VC had over the strategic direction of the venture. More research needs to follow Sapienza and Korsgaard’s lead. Fit Oftentimes, the only way for an entrepreneur to gain access to VCs is through an introduction. The very fact that someone the VC trusts is an advocate for an entrepreneur may transfer that trust to the entrepreneur and they can be more confident that the entrepreneur will not act in a detrimental way. Likewise, the fact that someone the entrepreneur trusts is recommending a particular VC may transfer some trust to that VC. In essence, the entrepreneur’s and VC’s network signal commitment and consistency. The common network that brings an entrepreneur and VC together also suggests higher degrees of fit. The fact that both the entrepreneur and VC have common associations implies that they have some similarities. At the very least, they share the intermediary (e.g. accountant, friend, professor, third party entrepreneur, etc.) in common. Fit over time often increases as VCs tap their network to help fill out the entrepreneurial team. While general prescriptions to choose a partner that has similar internalized views, beliefs, and values as yourself is beneficial, it may be difficult to achieve. Which views, beliefs and values are most important in selecting a VC (or entrepreneur)? Is an initial assessment of fit accurate or are we overconfident in our ability to make such assessments? There is evidence to suggest VCs (as most people) are overconfident in their assessments of new venture success (Zacharakis and Shepherd 2000). Maybe more emphasis should be placed on making adjustments to accommodate the needs of the entrepreneur (or VC) and/or encourage them to also make adjustments towards your needs. What type of adjustments are typically required/desired? How can the VC (or entrepreneur) be encouraged to accommodate your needs? This represents a fruitful line of inquiry. Frequent and open communication Once a venture has been funded, the level and quality of interaction between VCs and entrepreneurs varies. Many factors influence the level and quality of interaction. For example, smaller VCs are likely to spend

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more time with each venture. Those VCs who constrain their investments to close geographic proximity also may spend more time with their portfolio companies. Stage of development also likely impacts time and energy spent on a portfolio company. On the other hand, large VC firms have more portfolio companies, typically have broader geographic scopes, and often invest in later stage ventures. As such, they may only interact with entrepreneurs at board meetings or if the venture faces difficulty. Ginger More, a partner with Oak Ventures, noted that VCs, in general, are becoming more like money managers rather than active partners (More 1999). As the size and style of VC firms has changed, the frequency and quality of communication has also changed. This changing nature raises a number of interesting research questions. How important is it to choose a VC (or entrepreneur) within close geographical proximity? Are there more effective ways to communicate that are not geographically dependent? Do entrepreneurs and VCs communicate via e-mail? Do those VC–entrepreneur relationships that meet more frequently have greater confidence in partner co-operation? Does the context of such meetings (such as where the meeting is held, e.g. in an attorney’s office or in a bar over a drink) affect the openness of the communication? Are there other factors that affect the openness of a series of communications? Does communication act as a catalyst between the other trust building mechanisms and confidence in partner co-operation as proposed in this article? Trust, control and confidence in partner co-operation While there has been some excellent work in this area (e.g. Sahlman 1990, Fiet 1995, Barney et al. 1996) more scholarly attention needs to focus on the joint effect these control mechanisms have on both trust and confidence in partner co-operation. Are there some control mechanisms that in isolation increase confidence in partner co-operation (direct affect) and also foster the building of trust, which also increases confidence in partner cooperation (indirect affect)? By better understanding both the direct and indirect affect of control mechanisms the entrepreneur and VC might be able to better structure the relationship for mutual benefit. Which control mechanisms are merely a substitute for trust and which complement or even foster the building of trust? What is the optimal combination of control and trust in a specific VC–entrepreneur dyad? Cross national research Much of the research used to develop the present model of trust, control and partner co-operation in the VC–entrepreneur relationship draws on US based studies. Whilst believing that our model is still generalizable to other countries there are a number of important and interesting opportunities for cross national comparisons. Do VCs and entrepreneurs have the same relationship in other countries as they do in the US? While preliminary

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studies highlight some of the similarities and differences between the entrepreneur–VC dyad across countries, few have investigated the nature of the VC–entrepreneur relationship. Culture, is likely to be a useful means of classification and thus increase our understanding of the VC–entrepreneur dyad. How do cultures differ in generating the elements of trust? Control? For example, maybe collectivistic cultures differ substantially from individualistic cultures along many of the proposed dimensions of trust and those differences help explain heterogeneity in the productiveness of VC–entrepreneur relationships globally. Research has been done into culture and control and while there has been some research into culture and trust, it is believed that further work that builds upon and/or empirically tests our model across cultures will be highly valuable. Maybe difference between cultures can help explain the dominance of certain forms of equity investors, e.g. why some countries do not have active formal venture capital markets. It is possible that culture influences perception such that the optimal combination of trust and control for a VC produces lower confidence in partner co-operation than all other sources of equity—it is sub-optimal and fails to survive. Another example, is a relative lack of debt for new ventures in the US—banks require very high control and have very low trust producing a sub-optimal source of funding for new ventures. There is evidence that debt may be optimal in some countries (e.g. the micro loan program of Bangladesh). Therefore research that extends this possible boundary condition and/or extends the model will likely make a substantial contribution to the literature. Research method Empirical testing of these relationships is likely to make a contribution and be of practical importance—allow equity investors and entrepreneurs to better set up and manage the relationship to achieve the optimal level of confidence in partner co-operation. Research methods appropriate for testing this paper’s propositions are limited. The challenge is that variables such as confidence in partner co-operation and trust cannot be measured independent of the persons involved. It is the perception that is important not objective measures of the other party’s actions. While there are a number of different methods that could be used, it is proposed that conjoint analysis (including policy capturing) are well suited to the investigation of a person’s perception. It is an excellent technique for investigating VC’s decision policies (Shepherd and Zacharakis 1999) and has been used in hundreds of studies from many different disciplines (Green and Sirivasan 1990). Conjoint analysis is a general term referring to a technique that requires respondents to make a series of judgements, assessments, or preference choices, based on profiles from which their ‘captured’ decision processes can be ‘broken down’ (decomposed) into its underlying structure, i.e. the attributes significance in the judgement, how these attributes affect the judgement and the relative importance of each attribute in the decision process.

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Conclusion This article acts as a counterweight to the majority of studies on the VC– entrepreneur relationship that focus on control mechanisms. It builds on the work of Cable and Shane (1997) and Sapienza and Korsgaard (1996) that implicitly suggest the importance of building trust in the VC– entrepreneur relationship. This article acknowledges the complexity of the relationship and achieving confidence in partner co-operation. First, we proposed that the entrepreneur can build trust with the VC (and vice versa) through: (a) signaling commitment and consistency; (b) being fair and just; (c) obtaining a good fit with one’s partner; and (d) frequent and open communication. Second, it proposes that open and frequent communications can act as a catalyst for the other trust building mechanisms. Third, is proposed that the relationship between control, trust and confidence in partner cooperation is curvilinear in nature—low levels of control foster trust and therefore confidence in partner co-operation while high levels of control does the opposite. The entrepreneur and the VC need to balance the level of control to build trust so that the optimal level of confidence in partner co-operation can be achieved. Notes 1. This is not to say that there is not an incentive to cooperate (as described above) but merely to say that in many cases cooperation is not always the selected strategy by entrepreneurs (Amit et al. 1990b). 2. Fiet (1995) compared risk avoidance strategies (in terms of agency risk and market risk) employed by business angels and VCs. 3. The authors of this paper have added words in parentheses. 4. Some scholars view distrust as a concept distinct from trust (cf. Lewicki et al. 1998).

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