Venture Capitalists and Psychological Contract Violations - CiteSeerX

Helsinki University of Technology Department of Industrial Engineering and Management Institute of Strategy and International Business

VENTURE CAPITALISTS AND PSYCHOLOGICAL CONTRACT VIOLATIONS: AN INSTITUTIONAL APPROACH Annaleena Parhankangas, Helsinki University of Technology Hans Landström, Lund University Working Paper Series 91-WP-2002-001 Espoo, Finland 2002

Helsinki University of Technology Department of Industrial Engineering and Management Institute of Strategy and International Business

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Venture Capitalists and Psychological Contract Violations: An Institutional Approach Annaleena Parhankangas, Helsinki University of Technology Hans Landström, Lund University ABSTRACT The expectation of reciprocal obligations lays a foundation for the venture capitalistentrepreneur relationship. These expectations, or perceived promises, constitute a psychological contract between the venture capitalist and the entrepreneur. In this paper, we are concerned with four forms of psychological contract violations in this relationship: i) disagreements over the strategy of the portfolio firm; ii) incompetence; iii) shirking; and iv) opportunism. We use the institutional theory as our frame of reference when explaining venture capitalists’ behavior in situations where psychological contract violations occur. Our study is based on a survey conducted among 78 venture capitalists in Finland and Sweden. Our results show that the choice of the behavioral response is dependent on the institutional pressures exerted by the venture capital and the business community. It seems that venture capitalists with strong ties to their colleagues and entrepreneurs use more active and constructive approaches than venture capitalists with a lesser exposure to venture capital and business communities. In addition, there exist country-level differences in responses to unmet expectations. This is one of the very first studies focusing on the behavior of venture capitalists facing disappointments in their relationship with the entrepreneur, and it contributes to the psychological contract literature by analyzing the impact on institutional forces on human behavior in troubled inter-organizational relationships. Keywords: Venture Capital, Psychological Contracts, Institutional Theory

2 INTRODUCTION Ever since the 1970s, a well-functioning venture capital industry has been regarded as highly important for business development, and a key driving force behind a dynamic economic sector. For many entrepreneurial ventures, the venture capitalists appear to be an important “external” resource. The prerequisite for the “value-added services” provided by the venture capitalists to their portfolio companies is the existence of an ongoing cooperative relationship between the venture capitalist and the entrepreneur – a relationship characterized by an open and frequent communication (Sapienza et al., 1995). The expectation of reciprocal obligations lays a foundation for this relationship. These expectations, or perceived promises, constitute a psychological contract between the venture capitalist and the entrepreneur. However, research indicates that cooperation between venture capitalists and entrepreneurs is far from ubiquitous (Sahlman, 1990), and that tensions and conflicts often arise in this relationship – conflicts that, if not solved in a proper manner, could be disastrous for the success of the venture. Most of the studies focusing on the “dark side” of the venture capitalist-entrepreneur interaction view contractual covenants as a key to preventing and resolving problems emanating from this relationship (see, for instance, Gompers, 1995; Sahlman, 1990; Suchman and Cahill 1996; Kaplan & Strömberg, 2001, 2000; Cummings, 2002; 2001). However, not all the problems between a venture capitalist and the entrepreneur are of legal nature. Neither are the legal contracts able tocapable of protecting from or helping deal with all kinds of disappointments caused by the entrepreneur. Therefore, our paper will take a more general concept of a psychological contract between a venture capitalist and an entrepreneur as the point of departure when analyzing problems in this relationship. In our paper, we are concerned with four forms of psychological contract violation (Rousseau, 1995) in the relationship between venture capitalists and entrepreneurs: (i)

3 inadvertent violation occurs when the parties are willing to keep their promises, but fail to honor their commitments because of divergent interpretations, for example, a disagreement over the goals or strategies of a portfolio company, (ii) disruptions refer to situations where the venture capitalists and entrepreneurs are willing to contribute their share, but are simply incapable of doing so, and (iii +iv) reneging occurs when one party refuses to fulfill the contract, albeit of being capable of doing so. Reneging may be divided into shirking and opportunism. Against this background, our paper focuses on the behavioral responses of the venture capitalists in the face of psychological contract violations based on differences of opinion, incompetence, or refusal to collaborate from the part of the entrepreneur. We suspect that the venture capitalists’ institutional involvement within the industry will influence their behavior in problematic situations. Thus, we rely on the institutional theory in our attempt to explain the responses of the venture capitalists to psychological contracts violations. Our knowledge about how problems get solved in the venture capitalist-entrepreneur relationship is rather limited. This is one of the very first studies focusing on the behavior of venture capitalists facing disappointments in their relationship with the entrepreneurs. The study is based on a survey conducted among 78 individual venture capitalists in Finland and Sweden. Our results show that the choice of a behavioral response is dependent on the institutional pressures exerted by the venture capital and the business community. It seems that the venture capitalists with strong ties to their colleagues and entrepreneurs use more frequently active and constructive approaches than the venture capitalists with a lesser exposure to the venture capital and the business community. In addition, there exist countrylevel differences in responses to unmet expectations. The study adds to the existing knowledge by helping us better understand the venture capitalist’s behavior in problematic situations. This study also contributes to the

4 psychological contract literature by applying this theory on the relationship between entrepreneurs and venture capitalists (earlier research has mainly applied the psychological contract theory to the relationship between the employer and the employee), but also by considering the impact on institutional forces on the behavioral responses to psychological contract violations. The remainder of the paper includes seven sections. In section two, we present earlier research on psychological contracts, and in section three we formulate hypotheses based on the institutional theory. Section four describes the context of the study (the Swedish and Finnish venture capital markets), the research method, including the sample and data collection as well as the measures used in the study. The empirical results are presented in section five, and finally, in sections six and seven, we draw some conclusions based on our study. PSYCHOLOGICAL CONTRACT BETWEEN THE VENTURE CAPITALIST AND THE ENTREPRENEUR The concept of a psychological contract has mainly been employed to describe the relationship between an organization and its employees. However, it has been recently argued that the concept generalizes to a wide variety of exchange relationships between individuals, individuals and organizations, as well as between organizations (for a review, see Roehling, 1997). A psychological contract has been defined as expectations about reciprocal obligations that compose an exchange relationship between the focal party and another party (Levinson et al., 1962; Schein, 1965). Psychological contracts are perceptual and idiosyncratic in nature in the sense that the expectations held by one party may or may not be shared by the other party. Also, psychological contracts are based on perceived promises defined as any communication of the future intent (Rousseau, 1989). This intent may be communicated

5 through several means, such as a written document, contract, oral discussion, or organizational practices (Rousseau & Greller, 1994; Morrison & Robinson, 1997). Our paper focuses on the psychological contract violations in a relationship between a venture capitalist and the entrepreneur, which may be understood - at least in the case of small ventures- as roughly synonymous for the relationship between the venture capitalist and the portfolio company. In this relationship, we may perceive the psychological contract as a set of expectations about what each party is entitled to receive, and obligated to give, in exchange for another party’s contributions. A common goal for both the venture capitalist and the entrepreneur is to work together to maximize the value of the portfolio company. This value creation is achieved through an ongoing relationship between the entrepreneur and the venture capitalist based on open and frequent communication. In an ideal entrepreneurventure capitalist relationship, both parties exert themselves fully and perform competently on behalf of the firm. In reality, either the venture capitalist or the entrepreneur may fail to live up to the expectations of the other party to the relationship, giving rise to a psychological contract violation so characteristic to all human relationships (Robinson & Rousseau, 1994). Psychological contract violation may take four forms. First, inadvertent violation occurs when the parties to the psychological contract are willing to keep their promises, but fail to honor their commitments because of divergent interpretations. An example of an inadvertent violation might be a disagreement over the goals or strategies of a portfolio company. In such situations, both the venture capitalist and entrepreneur work toward the maximization the value of the portfolio company, but their means for achieving this common goal differ. Second, disruption refers, broadly speaking, to situations where the venture capitalists and the entrepreneurs are willing to contribute their share, but are unable to do so. Reneging occurs when one party refuses to fulfill the contract, albeit of being capable of doing so (Rousseau, 1995). Venture capitalists or entrepreneurs involved in reneging might be either

6 shirking or acting opportunistically. Shirking refers to one party not exercising sufficient effort to carry out the task assigned to him. Shirking involves a wide array of behaviors ranging from the failure of the entrepreneur to actively pursue growth opportunities or recruit key personnel to missed deadlines or lower product quality. Acting opportunistically implies seeking one’s own self-interest at the expense of the other party and contrary to other party’s reasonable expectations (Smith & Parhankangas, 2000). Opportunistic behavior may be manifested in dishonesty or fraud in the entrepreneur’s dealings with the company, often fulfilling the criteria of the breach of a legal contract. In a less extreme case, we are speaking of an entrepreneur spending excessive time and money on various perquisites, such as using the company’s expense account more than is necessary. This typology of psychological contract violations has been developed in contexts other than venture capital financing. However, previous literature gives us a reason to believe that the potential incompetence of the entrepreneur resulting from the adverse selection mechanisms (Kaplan & Strömberg, 2002; Sapienza & Gupta, 1994; Rock, 1987; Ruhnka & Young, 1987), moral hazard taking the form of opportunism and shirking (Kaplan & Strömberg, 2002; Barney et al., 1994; Sapienza et al., 1995), as well as divergent objectives (Sapienza & Gupta, 1994) are common problems in the venture capitalist-entrepreneur interaction. Previous research distinguishes between four types of responses to a psychological contract violation: exit, voice, loyalty and neglect (Hirschman, 1970; Farrell, 1983). -

Exit is a voluntary termination of the relationship (Rousseau, 1995) between the

venture capitalist and the entrepreneur. Exit is impersonal and indirect, and avoids face-toface confrontation with the entrepreneur. In our study, exit may take the form of replacing the entrepreneur or exiting the investment altogether. -

Voice refers to the actions of the victim to remedy, rather than to escape from or live with

an objectionable state of affairs. Voice can be graduated, all the way from faint persuasion

7 attempts to violent protests (Hirschman, 1970). Hagedoorn et al. (1999) suggest that the voice option should be divided into two categories: Considerate voice consists of attempts to solve the problem in collaboration with the other party to a problematic situation, taking into account the concerns of both parties. Aggressive voice consists of efforts to win, without consideration for the concerns of the other party. It involves behaviors, such as announcing your view and expecting changes to be made accordingly, or using your power to resolve the problem your way. In the venture capital context, using aggressive voice may include behaviors, such as referring to legal contracts or working together with the board of directors to get your point through. -

Loyalty or silence is a form of non-response. It involves passivity combined with a

feeling of optimism – patiently believing that things will improve without intervention. -

Neglect involves the neglect of one’s duties to the detriment of the interests of the other

party. (Rousseau, 1995) According to the psychological contract literature, the exit, loyalty, voice and neglect options differ from one another along two dimensions. The first dimension may be referred to as constructiveness vs. destructiveness. Constructive responses, i.e. loyalty and considerate voice, are intended to revive or at least maintain the problematic relationship. Destructive responses, such as neglect, exit, and aggressive voice serve to end or destroy the relationship. With respect to the second dimension, activity is defined as dealing directly with the problematic situation, whereas passivity denotes ignoring the problem all together. Exit and voice are, therefore, considered active responses, whereas loyalty and neglect are passive responses (Rousseau, 1995; Rusbult, 1987; Hagedoorn et al., 1999), as shown in Figure 1. INSERT FIGURE 1 ABOUT HERE According to Rousseau (1989:129), “the intensity of reaction is directly attributable not only to unmet expectations, but also to more general beliefs about respect of persons, codes of

8 conduct, and other patterns of behavior associated with the relationships involving trust” (Robinson, 1996). Therefore, the type of the psychological contract breach as well as various actor-specific, context-specific, and relationship-specific factors may play a role in determining whether the venture capitalist decides to actively deal with the problem at hand instead of avoiding it, or whether he or she decides to destroy a problematic relationship rather than trying to improve it. In this paper, we will focus on the factors specific to the institutional environment to determine the nature of the venture capitalist’s response to disappointments caused by the entrepreneur.

INSTITUTIONAL THEORY AND A VENTURE CAPITALIST’S RESPONSE TO PSYCHOLOGICAL CONTRACT VIOLATIONS Institutional theory views organization as captives of the institutional environment, in which they exist (see for instance Meyer & Rowan, 1977; Scott, 1995). Organizations gain a “common understanding of what is appropriate and fundamentally meaningful behavior” as a result of pressures exerted by various types of institutions (Zucker, 1983: 105). Since organizations want to be viewed as competent and acceptable, they find value in compliance with institutional expectations. Through such compliance they receive the prestige, stability, access to resources, and social acceptance they require in order to survive (Oliver, 1991, 1997; Meyer & Rowan, 1977). Because of the quest for legitimacy, there is a tendency for organizations within a particular organizational field to become similar in structure and practices. This process leading to organizational homogeneity is called institutional isomorphism (DiMaggio & Powell, 1983). Institutional isomorphism is driven by three elements (Scott, 1995). Cognitive elements refer to shared frameworks of interpretation enabling a common definition of the situation (Davis & Greve, 1997). Normative elements emphasize “the stabilizing influence of social beliefs

9 and norms, which are both internalized and exposed by others” (Scott, 1995: 40). Although there are many forms of normative influence, professionalism is one of the key drivers toward a consistency in professional behavior and performance (DiMaggio, 1983; Scott, 1995; Fogarty & Dirsmith, 2001). Finally, regulative structures denote legislation and pressures for conformity to public expectations and demands. Stated differently, drivers for institutional isomorphism include regulatory structures, laws, professions, interest groups, and public opinion (Oliver, 1991), but also influences from other organizations within a firm’s industry or peer group (Haveman, 1993). Institutional pressures in a firm’s environment thus drive toward conformity in organizational structures and practices. However, some firms may be embedded in multiple institutional environments, or societal spheres, exerting ambiguous, sometimes conflicting pressures on organizations (Scott, 1987; Friedland & Alford, 1987). Because of the pluralism of institutional environments, there might be no necessary harmony or consensus of what constitutes legitimate behavior. For instance, institutional pressures emanating from the venture capital profession may urge the use of active approaches when dealing with the problems with the entrepreneur. However, the culture and the norms of the Nordic countries may work against this effect by emphasizing the long-term orientation and harmony in business relationships (Hofstede, 1984; Trompenaars, 1993). In our study, we examine the impact of institutional pressures on three levels, including nation, profession, and entrepreneurial community. Previous writings suggest that those closest in social distance provide the most vivid role model for us to learn from (Rogers, 1995; Burt, 1987). Therefore, we assume that venture capitalists will look to the venture capitalist community to determine what is acceptable behavior in their relationship with the entrepreneur. We anticipate that the venture capital community facilitates the occupational socialization process (Fisher, 1986; Van Maanen &

10 Schein, 1979) of its member by passing on the values, norms and the culture of the venture capital community. These norms and values aid individual venture capitalists in interpreting their work experiences and prepare them to confront challenges in work with meaningful and appropriate actions (Fogarty & Dirsmith, 2001). Contacts to other venture capitalists function may be seen as the channels through which norms spread and get reinforced. Syndication of investments among the venture capitalists serves as an excellent example of networks enabling efficient transmission of information and norms through collegial interaction (Bygrave, 1988). United by a common goal, it is important that syndicating venture capitalists identify and communicate effective means for dealing with problems that would potentially jeopardize the maximization of returns on investment in one of their portfolio companies. In such situations, it is highly unlikely that passively ignoring the problem at hand would serve the interests of any of the syndicating venture capitalists. Working as a group may also ease the identification and use of active approaches with problematic entrepreneurs. As a group, venture capitalists may also be better able to resist the temptation of resorting to aggressive and destructive approaches, which would tarnish their reputation in the market. Therefore, we hypothesize that Hypothesis 1a: Syndication is positively associated with the use of considerate voice. Hypothesis 1b: Syndication is negatively associated with the use of aggressive voice. Hypothesis 1c: Syndication is negatively associated with the use of exit option. Hypothesis 1d: Syndication is negatively associated with the neglect option. Hypothesis 1e: Syndication is negatively associated with the loyalty option. In addition to syndication relationships, we expect that interaction with venture capital associations (SVCA, FVCA, and EVCA) serve as a channel through which venture capitalists may learn the norms and values characteristic to the venture capital community. Institutional theory calls particular attention to the professional associations and their potentially profound

11 influence in shaping the organization’s behavior (Meyer & Rowan, 1977; Scott, 1987; Zucker, 1987; Austin, 1998). According to the home pages of the Finnish Venture Capital Association, its objective is to “to develop venture capital activities and practices in Finland, …to provide a forum for the exchange of views and experiences between the members, …to arrange courses and seminars and assist in improving professional practice, and to liaise and cooperate with international and national venture capital associations”.1 Therefore, we expect that the venture capitalist associations are instrumental in assisting and advising venture capitalists facing problems in their daily work, such psychological contract violations by the entrepreneurs. We believe that the reinforcement of positive and active approaches and the repression of destructive and passive behaviors with regard to the entrepreneurs will best serve the interests of the venture capital association in its quest of legitimacy within the surrounding business community. Thus, we hypothesize Hypothesis 2a: Interaction with the venture capital associations is positively associated with the use of considerate voice. Hypothesis 2b: Interaction with the venture capital associations is negatively associated with the use of aggressive voice. Hypothesis 2c: Interaction with the venture capital associations is negatively associated with the use of exit option. Hypothesis 2d: Interaction with the venture capital associations is negatively associated with the use of neglect option. Hypothesis 2e: Interaction with the venture capital associations is negatively associated with the use of loyalty option. While contacts to other venture capitalists and venture capital associations play a significant role in shaping the behavior of individual venture capitalists, we believe that we cannot fully understand the dynamics of the venture capitalist-entrepreneur relationship without a broader

12 conceptualization of the institutional environment. Nations may also be understood as institutions with distinct regulative, cognitive and normative elements. In prior work, significant differences have been found in terms of how venture capitalists operate in different parts of the world (Bruton & Ahstrom, 2002; Bruton et al., 2002; Sapienza et al., 1994). National business environment regulates economic exchange in a variety of ways. First, nations have their own regulatory institutions representing standards provided by laws and other sanctions. Second, nations may have their distinct cognitive institutions referring to the most informal, taken-for granted rules and beliefs on proper and appropriate behavior, which may or may not be in line with the norms of the international venture capital community. Third, national business environments may differ in terms of the market structure, potentially translating into differences in the extent to which venture capitalists and entrepreneurs have high-quality alternatives to their present investment relationship (Rusbult et al., 1988; Rusbult, 1987). As neighboring countries in Northern Europe, Finland and Sweden share many common characteristics. However, these two countries also vary in many subtle and more visible ways. For example, there exist differences in the value structure and culture in general, and in communication style and power structure in particular (see, for instance Verkasalo, 1996; Tixier, 1996; Auer-Rizzi & Berry, 2000). In addition, the venture capital industry of Sweden is more established than its Finnish counterparts in terms of age, number of venture capital firms, and total capital under management 2. We suspect that the maturity of the capital industry will strengthen the values and norms of the venture capital community, possibly promoting active problem-solving behaviors deemed so characteristic to this profession. In a similar vein, we assume that venture capitalists in less established venture capital markets, such as Finland, would be more susceptible to the norms and values of their local business

13 communities, potentially promoting a more relationship-oriented approach to conducting business. In addition, it seems that the Swedish venture capitalists have more experience of and better opportunities for exiting through initial public offerings, because of a longer history and higher quality of financial services available for young firms in Sweden as compared to Finland. We believe that these differences will translate into differences in behavioral responses to psychological contract violations in the venture capitalistentrepreneur relationship. Hypothesis 3: The behavioral responses of the Swedish venture capitalists to psychological contract violations will differ from the behavioral responses of the Finnish venture capitalists. Finally, we expect that the level of business experience will have an impact on how a venture capitalist responds to disappointments caused by the entrepreneurs. Business experience may be understood as the strength of the venture capitalist's ties to the entrepreneurial community and the degree to which he has internalized its values and norms. We believe that the level of business experience will influence the degree to which the venture capitalist is able to identify himself with the situation of the entrepreneur. Thus, we assume that the venture capitalists with entrepreneurial and managerial experience would be more sympathetic with the situation of the entrepreneur than the venture capitalists without such experience. As a result, business experience of the venture capitalist would encourage the use of constructive, rather than destructive approaches. Also, we expect that business experience will make the venture capitalist more knowledgeable about the antecedents and the potential cures of the problem and thus, more capable and active in solving the problem with the entrepreneur. Therefore, the business experience of the venture capitalist will encourage the use of active and constructive approaches, i.e. considerate voice, and discourage the use of destructive or passive approaches, such as exit, aggressive voice, loyalty and neglect. Thus,

14 Hypothesis 4a Business experience of the venture capitalist is positively associated with the use of considerate voice. Hypothesis 4b: Business experience of the venture capitalist is negatively associated with the use of exit. Hypothesis 4c: Business experience of the venture capitalist is negatively associated with the use of aggressive voice. Hypothesis 4d: Business experience of the venture capitalist is negatively associated with the use of neglect. Hypothesis 4e: Business experience of the venture capitalist is negatively associated with the use of loyalty. METHOD Context: Swedish and Finnish venture capital markets The Swedish venture capital industry essentially was founded in the 1970s, when the Swedish Government, together with the most prominent Swedish banks established the first venture capital firm. Since then, the industry has experienced several cycles of growth and contractions. The first venture capital boom occurred in the early 1980s, but after a shake out period of the late 1980s, most of the venture capitalists exited the industry. In 1992, the Swedish Government intervened in the venture capital market by creating two large investment companies with a venture capital focus. Through the remainder of the 1990s, new investors began to find the market attractive, due to a dramatic development in high growth sectors in the economy, such as the information and biotechnology industries. The heightened interest was also due to an increase in capital supply in Sweden in general, spilling over into venture capital investments, and to an introduction of new stock markets for new and growing firms. However, since the failure of the dot.com industry in 2000, the venture capital

15 market in Sweden has stagnated, with many venture capitalists having left the market, resulting in very few new investments in seed and start-up phases. The Finnish venture capital industry is somewhat younger than its Swedish counterpart, but its evolution follows a rather similar pattern. The first Finnish venture capital firm, Sponsor Oy Ltd., was established in 1967 by the Finnish government. Sponsor was not primarily established to pursue phenomenal financial returns, but rather to develop Finland’s financial system. By 1990, a total of 30 venture capital companies were established, of which as many as 17 were governmental venture capital companies. Instead of investing in technologically ambitious early stage prospects, the venture capital firms had chosen solid cash-generating businesses, such as real estate targets. It was not until the late 1990’s before the industry expanded and assumed a role of more established international venture capital industries (Seppä, 2000). Like its Swedish counterpart, the emergent Finnish venture capital industry was hit hard by the economic downturn of the last years. Data Collection and Sample Before the actual data collection, we contacted and interviewed several venture capitalists, entrepreneurs, and lawyers to ensure that venture capitalists truly perceive the psychological contract violations in the terms of the prior literature reviewed earlier in this paper. Consultation with experts in Finland, Sweden and the US gave us reason to believe that the disagreements over the goal of the portfolio companies, as well as perceived incompetence, shirking and opportunism of the entrepreneur are common causes of the disappointments in the venture capitalist-entrepreneur relationship. In a similar vein, we asked the venture capitalists to assess our selection of responses to psychological contract violations. Our interviewees advised us to pay to closer attention to the role of legal covenants and the board of directors when solving problems with the entrepreneurs. These suggestions were integrated to the final version of the questionnaire.

16 Due to the relatively small size of the Swedish and Finnish venture capital markets, it was possible to include all the existing venture capital firms in our study. The questionnaire was sent to the investment managers of the Swedish and Finnish venture capital firms, since the investment managers were assumed to have a closer contact to the entrepreneur than the CEOs and thus a better knowledge of the venture capitalist-entrepreneur relationship. We used several strategies for identifying existing venture capitalist firms in Sweden and Finland. First, we used the listing of the venture capitalists published on the homepages of Swedish Venture Capital Association (SVCA) and Finnish Venture Capital Association (FVCA). We complemented and modified these listings by using an existing database of Swedish Venture Capitalists (see Karaömerlioðlu & Jacobsson, 2000). In addition, we interviewed industry experts in Sweden and Finland to make our listing as comprehensive as possible. The venture capitalist firms without an office in Finland or Sweden at the time of the study were excluded from our analysis. The process of data gathering in Sweden and Finland took place in Spring 2001. A total of 294 investment managers were included in the study. After three waves of mailings, we received responses from 78 investment managers in 50 venture capital firms, adding up to a response rate of 27 per cent. A comparison of VC firms in the study and those who did not participate reveal no significant difference in year established, number of employees, total capital, and the number of portfolio companies (comparison data obtained from the websites of individual venture capital firms). In addition, we found no differences between the early and late respondents. Given the similarity between participating and nonparticipating firms, there is unlikely to be a non-response bias. In our questionnaire, we asked the venture capitalist to describe their most likely behavior in four hypothetical situations. The first scenario involves a situation where the venture capitalist disagrees with the entrepreneur in one of the portfolio companies. In the second

17 scenario, the venture capitalist finds out after the investment that the entrepreneur is simply not able to perform up to the expectations. The third scenario has to do with a situation where the entrepreneur is fully capable of meeting the expectations of the venture capitalist, but fails to exert sufficient effort. In the fourth scenario, we assume that the entrepreneur is fully capable of meeting with the expectations of the investor, but falls short because he acts opportunistically. A more detailed description of the scenarios can be found in the Table 1. Insert Table 1 about here

In our questionnaire, we asked the venture capitalists to indicate how often they had encountered disagreements, incompetence, shirking and opportunism from the part of the entrepreneur 3. Our results show that disagreements and incompetence occur as often as 60 percent of the cases, as shown in Table 2. Shirking and opportunism was present in approximately 40 and 30 percent of the investments, respectively. It seems that the Swedish venture capitalists have more experience of disagreements and incompetence than their Finnish colleagues. These results seem to confirm that our four types of psychological contract violations are, indeed, an integral part of the venture capitalist-entrepreneur relationship. In each of these four scenarios, we asked the respondents how likely they would be use the neglect, exit, loyalty, considerate voice and aggressive voice options. The respondents were allowed to choose more than one of these options as their response to disappointments caused by the entrepreneur. Not restricting their choice to one behavioral response is consistent with prior literature (Van de Vliert et al., 1995: 272; Van de Vliert, 1997; Munduate et al., 1999). These studies suggest that rather than using a single conflict management strategy independently, people tend to adopt configurations of conflict management strategies. In addition, psychological contract literature suggests that the Exit-Voice-Loyalty–Neglect

18 options are in fact continuous and overlapping to some degree. Weak forms of exit verge on neglect whereas strong forms of loyalty verge on voice (Rusbult, 1987). Thus, an individual’s response to problematic situations may be seen as a blend of two or more categories. Sample Characteristics. The key characteristics of our sample are summarized in Table 2. A typical respondent works in a venture capitalist firm founded in the early 1990’s. He has been working as venture capitalist for approximately six years and managed a total of 14 portfolio companies during his or her career. These results give reason to believe that we are dealing with relatively experienced venture capitalists capable for assessing their behavior in the face of psychological contract violations committed by entrepreneurs. Insert Table 2 about here

The average size of the investment for the total sample was 1.86 million euros; with no statistically significant difference between the Finnish and the Swedish samples. We found out that the rejection rate of business plans is higher (92,57%) in Sweden than in Finland (87,95%), p= 0.04. In a similar vein, we found out that debt funding is much more common in Finland (54,33%) than in Sweden (14,20%), p=0.000. It seems that both Finnish and Swedish venture capitalists make investment in various industry sectors, such as biotechnology and pharmaceuticals, electronics and computer hardware, medical devices and equipment, software and information services, healthcare services as well as retailing and consumer products. Measures Independent Variables. The interaction with the domestic and international venture capital community was measured using the frequency of syndication and contacts to the venture capital associations as a proxy. We define syndication as two or more venture capitalists investing in the same venture in the same financing round. We asked the venture capitalists to

19 indicate the number of syndicated investments with other domestic or foreign venture capitalists during their career. Then we calculated the ratio of syndicated investments by dividing the total number of syndicated investments by the total number of investments made by the venture capitalist. 4 The frequency of interaction with national (Finnish and Swedish) and European venture capital associations was captured by using the approach adapted from Sapienza & Gupta (1994). Using a six-point Likert-type scale ranging from 1 “less than once a quarter” to 6 “everyday”, we asked the venture capitalists to indicate his or her interaction with the venture capital associations mentioned above. The business experience of the venture capitalist was operationalized as managerial and operational experience. Managerial experience refers to the number of years in a general managerial position in a company. Operational experience is measured as a number of years in research and development, production, or marketing and sales functions prior to the career as venture capitalist. Operational experience may also include managerial experience within these functions. The operationalization of these measures follows the example of previous empirical literature (Sapienza et al., 1994; Sapienza & Gupta, 1994). Dependent Variables. The use of neglect, exit, loyalty, considerate voice and aggressive voice options was operationalized using a set of statements modified from the psychological contract literature (Hagedoorn et al., 1999; Rusbult et al., 1988). The statements were assessed using 7-step Likert scales, as shown in Table 7. In order to investigate whether the five responses to psychological contract violations were not only theoretically, but also empirically separable, we carried out factor analyses using a principal component method. Based on the theoretical assumptions and a scree test, we settled for a five -factor solution using Quartimax with Kaiser Normalization as a rotation method. Following the theoretical assumptions, the five factors could be labeled neglect, exit, loyalty, considerate voice and aggressive voice.

20 Factor analyses were conducted in each of our four scenarios. The five factor solutions explain 55.55 – 69.12 per cent of the variance. Items defining a factor were those with structure coefficients greater than 0.65 (Hair et al., 1995:385). With incompetence and shirking, we were able to form a factor analysis using all the items listed in our questionnaire. However, with the disagreement and opportunism scenarios, some factors had factor loadings smaller than 0.65 or cross-loaded on more than one factor. These factors were excluded from the factor analysis. To improve face validity, some items were dropped, because they did not load on the factor they were supposed to. For more information on the exclusion of certain items and the final factor solutions, please refer to Table 7. The Cronbach alphas of the scales were satisfactory, ranging from 0.67 to 0.90. Control Variables. Prior literature on psychological contracts and venture capital investments gives us reason to believe that it is necessary to control for several investment-specific factors when testing the afore-mentioned hypotheses. First, we control for the average size of the investment made by venture capital firms. The average investment size may be interpreted as the perceived size of the loss for a venture capitalist unable to cash on his or her investment in the portfolio company. Prior psychological literature suggests that the greater the perceived size of the loss, the more frequent the use of active and constructive approaches, and the less frequent the use of passive and destructive behaviors (Rusbult, 1987; Rusbult et al., 1988). Second, prior literature highlights the importance of the satisfaction level, or the quality of the relationship, as a key determinant of an individual’s response to psychological contract violations (Rusbult, 1987; Rusbult et al., 1988). Third, we controlled for the frequency of psychological contracts violations in the venture capitalists’ past relationships with the entrepreneur, assuming that even a one-time violation of the psychological contract early in the relationship may tinge future perceptions. Fourth, we felt that it was important to control for the cross-border investments made by the venture capitalist. In here, we make an

21 assumption that domestic investments are associated with more intense venture capitalist – entrepreneur interaction than foreign investments, thus encouraging the use of active and constructive approaches (Hirschman, 1970). In a similar vein, we expect that venture capitalists managing foreign portfolio companies would be more inclined to resort to passive approaches (Maula & Mäkelä, 2002), when encountering problems with foreign entrepreneurs. Fifth, we controlled for some special characteristics of the Nordic venture capital markets by including the level of debt funding in the regression analyses. Sixth, we decided to control for the respondent’s experience as a venture capitalist. In here, we make an assumption that the behavior of a newcomer may differ from the reactions from an old-timer in the industry. Finally, prior psychological contract literature gives us reason to believe that the venture capitalist’s reaction may be dependent on whether he or she is dealing with disagreements, incompetence, shirking or opportunism. These four types of psychological contract violations differ from one another at least in terms of voluntariness

5

of the psychological contract

breach and the extent to which it is possible to impair the unsatisfactory state of affairs. Prior writings suggest that high voluntariness of the psychological contract breach present in shirking and opportunism would lead to the use of destructive approaches, whereas the low voluntariness characteristic to incompetence and disagreement scenarios should prompt more constructive responses (Greenberg, 1990; Turnley & Feldman, 1999). Good prospects of restoring the impaired relationship with the entrepreneur associated with shirking and disagreement scenarios, in turn, should encourage the use of active approaches. Following the same logic, the entrepreneur’s incompetence and opportunism may be seen as rather permanent personal characteristics, thus making venture capitalists more likely to resort to passive approaches (Whithey & Cooper, 1989).

22 The frequency of foreign investments was measured using the percentage of foreign portfolio companies as a proxy. We measured the experience of the respondent as venture capitalist as the number of years as venture capitalist. The amount of debt financing is operationalized as a percentage of cases where the venture capitalist invests also as a creditor. Following Zaheer et al. (1998), relationship quality was measured using the following three statements: 1. During the past years, there have often been disagreements between us and the portfolio companies regarding how to manage the firm. 2. During the past years, we have had serious conflicts with the entrepreneurs. 3. Our relationships to our portfolio companies have been harmonious (reversed). The Cronbach alpha for the three items was 0.70, indicating a sufficient level of internal consistency (Nunnally, 1967). The frequency of psychological contract violations in past investment relationships was operationalized by asking the venture capitalist to indicate how often they had experienced disagreements, incompetence, shirking or opportunism from the part of the entrepreneur during their career. Our measures of relationship quality and psychological contract violations were constructed on the portfolio level because of our theoretical focus on institutional forces and our approach to data collection relying on a scenario survey detailing hypothetical situations of psychological contract breach. It should be noted, however, that violations of psychological contract may vary a lot depending on specific portfolio company characteristics, and therefore, venture capitalists’ behavior may vary depending on the type of the venture they are dealing with. Our measures are thus reflections of the “average” relationship characteristics between the venture capitalist and the entrepreneur. RESULTS Table 3 presents the Pearson correlations among the dependent, independent and control variables. Due to the limitations for the length of this paper, only the correlation table for the

23 disagreement scenario is presented in the appendices. The correlation tables for other scenarios will be made available upon a request from the authors. The independent variables were reasonably independent, with the highest correlation existing between contacts to national venture capitalist associations (SVCA and FVCA) and European Venture Capitalist Association (EVCA), r = .563, p