The Effects of Venture Capitalists on the Governance of Firms

• Author: Stefano Bonini,Senem Alkan,Antonio Salvi
• Published date: 01 January 2012
• DOI: http://doi.org/10.1111/j.1467-8683.2011.00888.x
• Date: 01 January 2012

The Effects of Venture Capitalists on the

Governance of Firms

Stefano Bonini,* Senem Alkan, and Antonio Salvi

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: What determines venture capitalists inf‌luence on the governance of f‌irms? How do venture

capitalists shape the governanceof their investees? Are venture capitalists governance practices consistent across countries?

These important questions are under-investigated in the extant literature. In this study, we shed light on the effects of

venture capital investors on a large set of governance decisions and we discover the existence of striking cross-country

differences.

Research Findings/Insights: We test our conjectures on a unique hand-collected questionnaire-based dataset of 164

companies in f‌ive countries and two regions (Europe and the US). Our empirical results show that there is a strong and

positive relationship between VCs’ funding and their inf‌luence on some factors like decisions on CEO hiring, executive

compensation, board decisions and appointments. Employee incentives are also positively related to the proportion of VC

funding. On the other hand, results show that the proportion of VC funding is only marginally signif‌icant in explaining VC

inf‌luence on strategy direction and investment planning. Our analysis though, offers a remarkably different view after

splitting data into European and American subsamples.

Theoretical/Academic Implications: Our results provide a novel view of the functioning of the Venture Capital industry

and its degree of pervasivenessin the management of portfolio companies. Adopting a unique dataset, we add new evidence

on detailed governance decisions, thus supporting the idea that the incremental contribution of a professional investor to a

new venture is largely exceeding the capital infusion only. Finally, we show that governance decisions exhibit signif‌icant

country effects. This evidence supports the view that a global theory of corporate governance cannot rely on a single

interpretation framework such as agency theory, but needs to be integrated with predictions from alternative views such

institutional theory.

Practitioner/Policy Implications: Corporate governance is the essential mechanism allowing proper management of f‌inan-

cial and corporate resources by aligning incentives of employees and investors, thus enabling oversight and control on

companies. Yet, corporate governance rules and mechanisms are costly and have different effectiveness across countries.

Our results provide guidance to investors in selecting the appropriate set of governance provisions conditional on a set of

investment-specif‌ic factors.

Keywords: Corporate Governance, Venture Capital

INTRODUCTION

Recent growth in the Venture Capital (VC) industry has

stimulated new academic research exploring the struc-

ture of Venture Capital deals. Gompers (1995), Hellmann

and Puri (2002), and Kaplan and Stromberg (2003, 2004)

show that VCs not only support f‌irms with essential f‌inanc-

ing, but also provide value-added services to their portfolio

companies1aimed at monitoring the progress and the strat-

egy of f‌irms. While we know much more than earlier

studies, several research questions are still awaiting

answers, including the role and effects of VCs on the inner

governance of f‌irms, conditional and unconditional on the

size of the investment injected and on the geographical area

of the portfolio company.

In this paperwe contribute to this recent stream of research

providing evidence on the effects of VC funding on the

corporate governance mechanisms in VC-backed f‌irms. In

this effort we differentiate from previous studies in several

ways. First, we construct an original questionnaire-based

*Address for correspondence: Stefano Bonini, Department of Finance, Bocconi

University, Via Roentgen 1, 20136, Milan, Italy. Tel: +39 0258363612; E-mail:

stefano.bonini@unibocconi.it

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Corporate Governance: An International Review, 2012, 20(1): 21–45

© 2011 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2011.00888.x

dataset by surveying 164 VC-backed companies in six coun-

tries, to analyze the previously unexplored relationship

between VC funding and the governanceof portfolio compa-

nies. In particular, we introducea more informative explana-

tory variablesuch as the proportion of VC funding instead of

a simple dummy characterization as, for instance, in Hell-

mann and Puri (2000, 2002). The rationale for this choice is

based on the theoretical and empirical contributions of Kan-

niainen and Keuschnigg (2003, 2004); Bernile, Cumming, and

Lyandres (2007), and Cumming (2006) that show that VC

investors carefully select the size of the economic interest

they acquire in a company in order to eff‌iciently use their

limited monitoring and advisory skills. Secondly, the survey-

based natureof our study allows us to investigate the effect of

VCs on a broader range of governance variable, unavailable

through standard data sources, namely: CEO hiring, human

resource practices, executive compensation, employee

incentives, board decisions, board appointments, strategy

direction, and investment planning. Finally, we provide

previously unavailable evidence on the regional differences

in VCs inf‌luence on portfolio companies corporate gover-

nance decisions. In the light of the ongoing debate on the

development of a global corporate governance theory, the

limited focus of the extant literature on either single country

analyses or coarse governance metrics, is likely failing to

properly capture a signif‌icant fraction of information. Our

contribution f‌ills this gap, providing new evidence on the

existence of persistent regional differences. In this paper we

do not provide an explicit test on the causes of these differ-

ences. Yet, we argue that differential cross-country results

may be related with three different factors. First is the exist-

ence of different regulation and standardsin the two areas as

recently highlighted by Cumming (2008). Secondly, the dif-

ferent levels of institutionalization of VCs in the two areas –

the VC market in the US has developed much earlier than in

Europe due to several factors, among which the existence of

an effective regulation on closed-end funds is of paramount

importance; on the other hand, most European countries

have developed similar rules only in the late 90s (EVCA,

2006). Third,development capital in Europe has traditionally

been offered to companies by banks and,in some cases, large

corporations. Theseinstitutions have traditionally been com-

paratively less involved in the governance of investees

than independent US venture capital f‌irms, given the differ-

ent characteristics and lower risk of bank and corporate

f‌inancing.

In our full sample regressions, we f‌ind a strong positive

relationship between VCs’ funding and their inf‌luence on

CEO hiring, executive compensation, employee incentives,

board decisions, and board member appointments. On the

other hand, results show that the proportion of VC funding

is only limitedly signif‌icant in explaining VC inf‌luence on

strategy direction and investment planning. Differently

from results in Hellmann and Puri (2002) on the effects of

VCs on human resources (HR) policies, our evidence sug-

gests a weaker relationship between the amount of VC

funding and VC inf‌luence on HR practices.

Splitting data into European and American VC-backed

companies, we aimed at assessing similarities and differ-

ences in the two regions which may be motivated by legal,

structural, and cultural issues. Surprisingly, the two regions

show strikingly different regularities with regards to corpo-

rate governance decisions – the proportion of VC funding is

strongly signif‌icant in explaining the VC inf‌luence on execu-

tive compensation, board decisions, and board appoint-

ments in US VC-backed companies while in European

VC-backed companies, the amount of VC funding is positive

and signif‌icantly related only to VC inf‌luence on investment

planning. CEO hiring is similarly inf‌luenced by VCs both in

Europe and the US but considerably different HR practices

are observed cross-country.

THEORETICAL BACKGROUND

AND HYPOTHESES

Theoretical literature argues that when ownership and

control are separated, principals develop governance struc-

tures to reduce agency costs and align agents’ incentives

[Jensen and Meckling, (1976), Grossman and Hart (1986),

Zingales (1995)]. Likewise, optimal f‌inancial structure design

by f‌inancial intermediaries can effectively help in mitigating

agency problems by identifying self-enforcing equilibria

[Diamond, (1984), Fama (1985), Stiglitz (1985), Bhattacharya

and Thakor (1993), Barry (1994)]. A particularly fruitful

testing ground for agency theories is the VC industry – since

venture capital deals are primarily characterized by asym-

metric information between entrepreneurs and f‌inanciers

and almost exclusive capital infusion by outsiders, it is

extremely likely to observe agency problems. In this spirit,

Gorman and Sahlman (1989) and Sahlman (1990) f‌irst sug-

gested that the value of VC lies not only in providing capital

but also in superior selectivity by consistently picking high-

growth f‌irms, and in the provisionof supplementary services

such as ,entrepreneurial advice, executive hiring, and strat-

egy shaping, resulting in a valuable “professionalization” of

portfolio companies. Following these seminal contributions,

a large number of studies have investigatedthe mechanisms

adopted by VCs to mitigate principal-agent conf‌licts identi-

fying three broad classes of control mechanisms: intense

pre-investment screening, the development of accurate

f‌inancing contracts, and continuous post-investment moni-

toring and advisory. Admati and Pf‌leiderer (1994), Lerner

(1994), Hochberg, Ljungqvist, and Lu (2007) shed light on

pre-investment screening and syndication. Sahlman (1990),

Berglöf (1994), Gompers (1995), Bergmann and Hege (1998)

provide extensive evidence on the increasing level of com-

plexity in the design of VC f‌inancing contracts through the

introduction of staging, monitoring, government and exit

rules. This evidence is supported by Cumming (2005) who

shows that agency problems are explicitly addressed by

appropriatesecurity design and that the degree of contractual

sophistication changes over time due to learning effects.

Finally, recent research has given increasing attention to the

valuable activities performed by VC beyond their f‌inancing

function. Particularly, value-added tasks of VC include

helping f‌irms to shape strategies, providing technical and

commercial advice [Bygrave & Timmons, (1992), Hellmann

(1998), Hellmann and Puri (2002), Baker and Gompers (2003),

Cornelli and Yosha (2003)].

Several questions though, remain unanswered in particu-

lar with regards to the extent of the inf‌luence of VCs on the

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Volume 20 Number 1 January 2012 © 2011 Blackwell Publishing Ltd