Economists have recognised for a long time that relationships between entrepreneurs and venture capitalists (VCs) may be subject to extreme conflicts of interest. These “moral hazard” problems can seriously impair performance and destroy value creation. Hence, contracts have been viewed as very important in attempting to mitigate these problems.
This view of the world is based on the traditional homo economicus model, in which it is assumed that people are fully rational, self-interested, unbiased maximisers of expected utility. The recent explosion of research in behavioural economics incorporates human psychology into the traditional model by recognising that people are not always fully rational, and are subject to psychological biases and heuristics in their decision-making – the homo sapiens view. A particularly interesting and informative area of behavioural research analyses social preferences, in which individuals are not narrowly self-interested, but instead care about others’ welfare. This area of research considers fairness, trust, empathy and co-operation.
We have incorporated the social preference approach into economic models of VC-entrepreneur contracting and performance in order to examine whether fairness, trust and empathy can enhance cooperation and value-creation.
In our Journal of Business Venturing article (2011), we consider an entrepreneur’s choice between approaching a VC or angel for finance for an innovative start-up. Following the literature, we employ a double-sided moral hazard approach, in which both the entrepreneur and the chosen financier contribute to the success of the enterprise by supplying value-creating efforts. The problem is that neither party can observe the other’s efforts, and therefore there is an incentive for each player to shirk – exert an inefficiently low level of effort. This seriously impairs value-creation.
A further problem we consider is “double-sided project stealing”. This is the idea that, after creating value, the entrepreneur or the VC can cannabilise the project, which destroys the other players’ pay-offs. We demonstrate that, in the fully self-interested case, a type of prisoner’s dilemma exists, where both players shirk on effort, both players end up stealing the project, and both are worse off.
The contribution of our analysis is to demonstrate that the behavioural factor of empathy between the entrepreneur and the financier enhances both players’ effort levels, and reduces project stealing. We thus argue that increased empathy leads to higher mutual trust, which enhances the performance of the venture.
Furthermore, the entrepreneur makes his choice of VC or angel by considering two dimensions of each finan-cier’s characteristics – value-creating abilities and empathy for the entrepreneur. Our analysis of social preferences provides the following implications.
Entrepreneurs need to be careful in their choice of financier – one financier may have higher valuer-creating abilities.
However, the other financier may be higher on empathy, trust and co-operation. So in addition to considering economic ability, the entrepreneur needs to ask himself a simple question: “Can I work with this guy?”
Financiers such as VCs and angels need to understand that reputation for economic ability and value-creation may not be sufficient to attract entrepreneurs. They must recognise that savvy entrepreneurs will also be considering the financier’s softer people skills, such as empathy, trust, fairness and general willingness to co-operate with the entrepreneur.
In our 2010 article, we focus on the effects of fairness in the entrepreneur-VC relationship and performance. Particularly, we consider the notion that different societies and cultures may have different fairness norms. In our analysis, the VC and the entrepreneur initially negotiate over their equity stakes in the financial contract – we assume the VC has the bargaining power and makes an equity offer to the entrepreneur.
They then both exert value-creating efforts, so that double-sided moral hazard problems exist in the form of effortshirking.
We demonstrate that increased norms of fairness in a society will lead to a higher offer of equity from the VC to the entrepreneur, and better venture performance and value-creation (see first graph).
In our 2013 paper, we consider the interaction between sociocultural closeness – empathy and trust – the strength of the legal system, and the optimality of tough or soft contracts.
Again, we employ the double-sided moral hazard framework, in which both the entrepreneur and the VC may shirk on value-creating efforts.
Co-operation may occur through two channels – higher feelings of empathy and closeness may encourage higher effort levels, regardless of the strength of the legal system; and stronger contracts, together with an effective legal system, may force higher efforts through the courts. Furthermore, in our model, tough contracts destroy feelings of closeness and empathy.
These ingredients provide the following interesting results.
In societies characterised by high cultural closeness or weak legal systems, the parties draw up soft contracts, so as not to destroy the high empathy levels. In societies with low empathy or strong legal systems, the parties draw up tough contracts to force co-operative efforts.
The second graph provides a useful classification system in which we can place different societies to assess whether strong or weak VC contracts are optimal. We surmised that China, for example, may be a society characterised by weak legal systems, but strong cultural closeness, in which case soft contracts would be optimal. In the UK or the US, the legal system is stronger, and cultural closeness may be relatively lower, in which case tougher contracts may be optimal.
We supplemented this analysis with a small-scale survey of Chinese VCs. This revealed they consider the importance of trust, fairness and empathy in their relationships with entrepreneurs, and they prefer soft contracts. It would be interesting to extend this analysis to UK and US VCs and entrepreneurs.