Splitting the firm between the entrepreneur and the venture capitalist with the help of stock options

The Net Present Value (NPV) Rule provides the basic principle underlying the sharing of ownership in a new venture. The principle often fails because the entrepreneur and the venture capitalist cannot agree on the potential profitability value of the venture.First, the venture capitalist may simply have a less optimistic interpretation of the data related to the venture's profit potential. We refer to this discrepancy between the expectation of the entrepreneur and that of the venture capitalist as the expectation gap.Second, the venture capitalist knows that for the venture's potential to be realized, the entrepreneur/manager must devote his full effort to the success of the organization. This is not a problem if the entrepreneur owns the entire project. Once the ownership is shared, however, especially when the venture capitalists own the majority of the shares, the entrepreneur has a financial incentive to apply less than the diligence required to control costs and protect the interests of the outside equity holders. This financial incentive arises because any perk, including leisure or shirking, consumed by the entrepreneur does not have to be shared with the venture capitalist, while every dollar saved does. This is not solved by the venture capitalist acquiring a larger percentage of the company. That will only exacerbate the problem as it decreases the cost to the entrepreneur of each dollar of the company's funds spent for the perk. We refer to this as the motivation problem.In the article, we show how stock options can be used to deal effectively with both problems. First, stock options are always worth more to the optimist than to the pessimist. Thus, there will be a reverse valuation gap with respect to the stock options. We show that by issuing stock options to the entrepreneur, it is possible to close the expectation gap.To solve the motivation problem, the entrepreneur's stake must be increased to the extent where the cost to him of excessive consumption of perks will be as high as the benefit he derives. This can be accomplished by taking advantage of two valuation characteristics of stock options. First, stock options are worth only a fraction of the value of the underlying equity shares. Thus, it is easier for the venture capitalist to give up these, rather than the underlying equity shares. Second, the stock options will fluctuate with the venturing firm's value at a higher rate than the entrepreneur's percentage ownership. Thus, by issuing the entrepreneur a combination of equity shares and stock options, it is possible to increase significantly the entrepreneur's cost of “shirking” or “excessive consumption of perks.” Under idealized conditions, it is possible to design a financing arrangement that eliminates the motivation problem.The principles discussed here provide benchmarks that both the entrepreneur and the venture capitalist may wish to bring to the negotiating table. In the end, there is no substitute for the building of trust between the two to give the venture the maximum chance of success.     

The determinants of foreign partner's equity ownership in Southeast Asian joint ventures

Using a sample of 375 equity joint venture agreements between 2 partners in 6 Southeast Asian countries, we document the active role of Asian companies in driving the flow of joint venture activity in this region and provide a comparative analysis of joint ventures in transitional and non-transitional Southeast Asian countries. Specifically, we analyze the relationship between the foreign partner's equity ownership and partner uncertainty, the types of joint venture activities, and the frequency of transactions between the joint venture partners. In addition, we show that the relationship between the foreign partner's equity ownership and partner uncertainty, as proxied by cultural dissimilarity, depends on the types of joint venture activities. In the case of Vietnam, a transitional economy, the evidence suggests that, in the presence of a weak legal and regulatory system, foreign firms are entering the country on a smaller scale and are more prone to informal, relational contracting as a substitute for legal enforcement.     

Do women-owned businesses have equal access to angel capital?

Women-owned businesses are the fastest growing sector of new venture ownership in the United States. Although women's access to, and use of, debt and venture capital financing have been explored, comparatively little is known about women's access to capital from private equity investors. In this paper, we examine the equality of women's access to angel capital. The research suggests that women seek angel financing at rates substantially lower than that of men, but have an equal probability of receiving investment. We also document that women are more likely to seek, and to a lesser extent receive, financing from women angels.     

Board composition,family ownership,institutional distance and the foreign equity ownership strategies of Turkish MNEs

In much of the developing world, families represent the dominant form of firm ownership. This study investigates how this influences equity ownership strategies when firms venture abroad. Drawing on agency theory and institutional theory, we investigate the direct effect of board composition and family ownership on the equity-based ownership strategies of multinational enterprises (MNEs) in their affiliates, and how institutional distance may moderate this. Examining foreign affiliates of listed Turkish MNEs, we find that a high ratio of independent directors is negatively linked to levels of equity ownership of MNE affiliates. We also find that a high ratio of inside directors on the board is positively associated with the equity stake of MNEs in their affiliates. The significant interaction effect between board composition, family ownership and institutional distance helps explain the unexpectedly weak effects of institutional distance.     

Compensating corporate venture managers

This article reports the results of a questionnaire survey addressed to CEOs of Fortune 500 companies concerning incentive practices for venture managers. Data was also collected for venture performance history in these companies.Highlights of the results are:Most companies are not providing different incentives for venture managers than for other managers.Companies that do and companies that do not provide special incentives seem to agree on the types of incentives which would promote improved venture performance, which include milestone bonuses, equity, and/or options in the new venture, variable bonuses based on venture ROI.The primary obstacle to installing such incentives is reported by firms without special incentives in place to be concern about internal equity.Firms with special incentives already in place have less concern with this problem. A moderate problem to such firms is difficulty in defining venture objectives.There is no evidence, from this study, that special incentives for venture managers affected the outcome in venture performance, when such performance was measured by the percentage of “successes” and “failures.” About 50% success rate was reported by each group.The article deals with these questions:Are performance incentives essential?Certainly not, from the data in this sample, but this was a “head count” of successes and failures—a study of overall economic performance might yield a different result. One expensive failure can wipe out the gains from many small successes.Are the incentives reported effective?Obviously not enough to show a difference between those who use them and those who don't. Analysis of the incentive elements used and the earnings limits imposed suggest that the special incentives are not particularly special, nor very much of an incentive. Further, the most common incentive reported, based on venture ROI, fails to consider the time period usually required to achieve a positive ROI, and the many changes of management which occur during that period.What criteria should be used for designing an incentive program for venture managers?Recognition of the probability of management change, incentives which promote early identification of need for change of direction or to abort, focus on event completion milestones rather than the calendar, the relationship of reward potential to risk potential including job security and actual financial risk by the venture manager, achievability, and simplicity are factors to be considered.What kind of financial incentives might be included in incentive design?Depending on the life cycle stage of the venture, fixed and variable bonuses, options for equity or shadow equity in the venture itself, actual equity in the new venture, and to a lesser extent, salary increases and equity or equity options in the parent are suggested. How can the obstacles to installation of performance incentives for venture managers be reduced?To reduce perception of internal inequity, relating potential risk to potential reward and extending performance incentives to other managers is suggested. The problem of defining venture objectives as an obstacle is instantly solved as an incentive issue by making ownership possibility a reality for venture management, especially with financial investment required by venture management.     

Environmental Risk and Foreign Equity Ownership in Joint Ventures in China

ABSTRACT

Environmental risk in a host country is a key issue that foreign firms must deal with when deciding how much equity ownership to acquire and how much control to have in an equity joint venture (EJV) in that country. This study examines the relationship between changes in the risk situations in China and the level of foreign equity ownership in the EJV. It hypothesizes that Japanese partners would be more likely than U.S. or Hong Kong partners to acquire a 50% or higher level of equity ownership. This tendency would become more pronounced when the risk conditions in China deteriorate. The empirical results, based on 3,838 EJVs in China that had foreign partners from U.S., Japan, Hong Kong and Europe during the 1979–1992 period, are largely consistent with the hypotheses.     

Brand alliance and customer‐based brand‐equity effects

This research examines brand alliances, a specific marketing strategy designed to transfer the positive brand equity of two or more partner brands to the newly created joint brand. The study explores how customer‐based brand equity (that is, brand equity as seen from the customer's perspective) of partner brands affects consumer evaluations of an alliance brand; how the brand equity of one partner brand affects the other; how customer‐based brand equity of the partner brands affects consumers' evaluations of the search, experience, and credence attribute performance of the alliance brand; and how product trial influences such evaluations. Results suggest that merely the act of pairing with another brand elevates consumers' evaluations of the partner brands' customer‐based brand equity, and high‐equity partners enhance pretrial evaluation of experience and credence attributes that are relevant to the high‐equity partner. As hypothesized, product trial moderates the equity value of the alliance partner for experience attributes, and brand equity of the partner brands influences consumer perceptions of the alliance brand's equity. © 2004 Wiley Periodicals, Inc.     

Institutional and transaction cost influences on MNEs’ ownership strategies of their affiliates: Evidence from an emerging market

This paper examines the impact of institutional, and transaction cost specific variables on MNEs’ choice of equity ownership in their foreign affiliates. We consider the determinants of the choice of foreign investors between full ownership (setting up a wholly owned greenfield subsidiary or engaging in a full acquisition) and sharing ownership with a local firm (establishing a greenfield joint venture or making a partial acquisition). Drawing on both transaction cost and institutional theories, a number of hypotheses are developed. Based on a dataset of 6838 foreign affiliates in Turkey, the empirical analysis reveals that institutional variables are important in explaining the equity composition of foreign affiliates. Particularly important in determining equity ownership were found to be political risk, cultural distance, linguistic distance, agglomeration, location and the size of the affiliate. A distinguishing feature of the paper is that we examine the marginal effects of the independent variables in explaining ownership patterns of MNEs.     

Venture capital in Western Europe

Western Europe is in the process of an entrepreneurial renaissance. An integral part of this renaissance is the emergence of a venture capital industry in Europe. Although the venture capital institution in Europe is very much modeled along the lines of its American counterpart, it is significantly smaller in size both in absolute terms as well as in relation to the size of the economy. Substantial differences in venture capital activity are also found to exist within Europe,it is most prevaient in the United Kingdom, France, and Netherlands. Surprisingly, it is less developed in West Germany, particularly given the size of this country's economy.Venture capital in Western Europe shares some characteristics with that in the United States. Its investment focus is in high technology, and syndication between funds is common. Unlike the United States, however, banks are a major source of venture capital funds. Surprisingly, in spite of the economic integration to which the European Community aspires, the mobility of venture capital across national boundaries is low.The authors try to explain differences in venture capital activity in several countries of the European Community by examining four aspects of each country's environment. In particular, the size of the technology sector, the cultural influence on entrepreneurial risk-taking, the government's policy to stimulate risk capital and entrepreneurship. and finally, the ability of venture-backed firms to turn to publicly traded markets as a source of future financing. One common factor shared by the three countries with the highest level of venture capital activity is the presence of a secondary stock market geared to the needs of a small, relatively new venture contemplating an initial public offering. The Unlisted Securities Market in the United Kingdom, the Seconde Marché in France, and the Parallel Market in the Netherlands serve these needs and provide the mechanism by which venture capitalists can liquidate their equity position after the venture is quoted on these financial markets. To the venture it provides access to public financing for funding continued growth.In the United Kingdom and Netherlands, the business enterprise has historically been regarded as a tradeable entity and hence the concept of ownership by passive investors is well accepted. In France, where this is a relatively recent phenomenon, the government has played a strong role in stimulating an interest in stock market investing in general. It has also created some extremely attractive fiscal incentives for investors in venture capital funds.     

Assessing credit quality from the equity market: can a structural approach forecast credit ratings?

We investigate the empirical performance of default probability prediction based on Merton's (1974) structural credit risk model. More specifically, we study if distance‐to‐default is a sufficient statistic for the equity market information concerning the credit quality of the debt‐issuing firm. We show that a simple reduced form model outperforms the Merton (1974) model for both in‐sample fitting and out‐of‐sample predictability for credit ratings, and that both can be greatly improved by including the firm's equity value as an additional variable. Moreover, the empirical performance of this hybrid model is very similar to that of the simple reduced form model. As a result, we conclude that distant‐to‐default alone does not adequately capture the firm's credit quality information from the equity market. Copyright © 2007 ASAC. Published by John Wiley & Sons, Ltd.     

Geographic Distance as a Moderator of Curvilinear Relationship Between Cultural Distance and Shared Ownership

This study tests geographic distance as a moderator of the curvilinear relationship between cultural distance and a firm's preference for shared ownership entry mode. The sample consisted of US foreign direct investments in 60 countries spread over 18 years. Results showed that an inverted U‐shaped relationship between cultural distance and preference for shared ownership is stronger for firms separated by high geographic distance. While full equity ownership is most likely when both cultural and geographic distances are either low or high, shared ownership is most likely when the cultural distance is high (low) but the geographic distance is low (high). Copyright © 2012 ASAC. Published by John Wiley & Sons, Ltd.     

Risk management in Indian venture capital and private equity firms: A comparative study

Venture capitalists and private equity funds are often considered experts at investing in high‐risk projects and firms. To be successful investors, venture capitalists and private equity funds must therefore manage the many aspects of risk associated with investing in unlisted small and medium‐sized enterprises. This study examines how Indian venture capital and private equity firms manage several dimensions of risk. We analyze risk management preferences in Indian venture capital and private equity firms. A comparison between Indian and U.K. funds is presented. The results are discussed in detail. © 2005 Wiley Periodicals, Inc.     

Exploring the innovation strategies of young firms: Corporate venture capital and venture capital impact on alliance innovation strategy

We investigate how governance structure and power influence alliance exploration strategy. Adopting a real options perspective and the agency view, we suggest that innovation strategies differ based on the firm's governance authority. We find that the motivations of corporate venture capitalist firms, venture capitalists, and firm founders may have an impact on the formation of exploratory alliances among adolescent firms. Using a sample of 122 adolescent firms, we examine the influence that governance structure has on the firm's alliance portfolio and innovation potential. While the influence of corporate venture capitalist firms alone do affect alliance formation strategy, corporate venture-backed firms with founders having high influence (knowledge or ownership in the firm) are more likely to form innovation-focused alliances. In contrast, venture capitalist-backed firms tend to avoid innovation-focused alliances, preferring more exploitive ones, even when founders have high influence within the firm.     

Strategic Interactions,Bargaining Power and Stability of Joint Venture in an Emerging Nation

We model strategic interaction between a domestic firm and a foreign firm involved in a joint venture, incorporating negotiations over equity shares and its implications for stability in the context of an emerging country. The foreign firm has superior technology, whereas the domestic firm has better local market knowledge. Modelling simultaneous innovation effort and bargaining power over equity share, we provide a rationale for the stability of the joint venture. We find that a certain level of technological knowledge can empower the bargaining power under certain parameter configurations and assumptions, such that the firms will negotiate to agree over their equity shares and maintain the joint venture. In this context, the stability of the joint venture is always an expected outcome. We have also shown that the domestic firm’s bargaining power and knowledge acquisition directly affect the domestic firm’s R&D effort and threaten the stability of the JV. We try to justify a probable situation where the firms may negotiate hard over equity shares but still maintain the joint venture.

     

Speed to Legal Registration and Nascent Venture Performance: A Temporal Dilemma for Nascent Entrepreneurs in an Emerging Economy

In this paper, we examine the effect of a nascent venture's speed to legal registration during its formation on the initial venture performance in an emerging economy. Quickly obtaining legitimacy via legal registration in the early stages of a new venture's formation accelerates its resources acquisition and transition to other start‐up activities, facilitating the venture to seize dynamic entrepreneurial opportunities; however, in an emerging economy, quick legal registration also incurs substantial costs and compliance activities that may inhibit the venture's engagement in other start‐up activities. A nascent venture in an emerging economy suffers from being either too fast (early) or too slow (late) in registering its business during the formation process, and the relationship between the speed to registration and nascent venture performance is best reflected by an inverse U‐shape. Moreover, the inverse U‐relationship becomes more pronounced when the entrepreneurial opportunity is more innovative. Based on analyzing 145 nascent entrepreneurs from the event history data set of the China Panel Study of Entrepreneurial Dynamics (CPSED), we found strong support for our arguments.     

The Effects of Ownership and Governance on SMEs’ International Knowledge-based Resources

Small- and medium-sized enterprises (SMEs) play an important role in today’s global economy. However, there are significant differences in how they respond to the opportunities and threats in international markets. This study␣suggests SMEs’ ownership and governance systems significantly influence the development of knowledge-based resources necessary for internationalization. Using a sample of 384 US SMEs, we find a positive relationship between both the equity held by top management team members and venture capitalists and the development of these important resources. This positive association is further accentuated by the presence of independent outside directors on SMEs’ boards, supporting their monitoring and enterprising roles.      

Partnering strategies and performance of SMEs' international joint ventures

The international joint venture (IJV) is an important mode in the internationalization of small- and medium-sized enterprises (SMEs). Internationalization in turn is an entrepreneurial behavior in the pursuit of growth. Partnering strategies in the formation of IJVs can have significant effects on the outcome of SMEs' international expansion. In this study, we examine the performance implications of two types of resources contributed by SMEs' IJV partners, host country knowledge and size-based resources. We develop and test three sets of hypotheses about the longevity and financial performance of a sample of 1117 international joint ventures established in 43 countries by 614 Japanese SMEs that have fewer than 500 employees. Our findings indicate that SMEs' IJVs with local partner(s) may be associated with decreases in longevity, especially when SMEs acquire host country knowledge. The host country experience of Japanese partner(s) does not have any direct effects on IJV profitability but reduces the longevity of IJVs. Finally, the size of Japanese partner(s) increases the longevity of IJVs but may have negative effects on IJV profitability when large Japanese partners have low equity ownership in IJVs. Our findings highlight the differential effects that IJV partners' experience-based and size-based resources have on IJV performance. Our findings also demonstrate that the same strategy could have different effects on different dimensions of performance.     

“It's MY Service,it's MY Music”: The role of psychological ownership in music streaming consumption

Music streaming services have become today's most popular way of consuming music. These services give their users access to a comprehensive music library without providing legal ownership of that music. However, recent research suggests that music streaming users still continue to experience feelings of ownership. To advance our understanding, this study investigates the role of psychological ownership in music streaming consumption. In particular, based on the theory of psychological ownership, it is analyzed how service‐ and music‐based psychological ownership emerge. The study further investigates the relationship between these two targets of ownership and whether music‐based psychological ownership is positively related to users' intention to switch from a music streaming service's free version to its paid premium version. Using structural equation modeling, the results indicate that service‐based psychological ownership, stemming from users' investment of self into the service, is positively related to music‐based psychological ownership, which is positively influenced by the sense of control over the music accessed. The results also show that music‐based psychological ownership is strongly related to users' intention to switch from free to premium, which highlights the importance of psychological ownership for providers of music streaming services, particularly those operating a feature‐limited freemium model.     

The institutional determinants of private equity involvement in business groups—The case of Africa

This study examines the governance attributes of post-IPO (initial public offering) retained ownership of private equity in business group constituent firms in contrast to their unaffiliated counterparts, in 202 newly listed firms in 22 emerging African economies. We adopt an actor centered institutional-theoretic perspective in rationalizing institutional voids and the advantages of maintained governance by both business angels (BA) and venture capital (VC) private equity. Our findings reveal private equity retain higher post-IPO ownership in business group constituents compared to unaffiliated firms and that this is inversely moderated in the context of improving institutional quality – where this is particularly strong in case of foreign VC as opposed to domestic VC or BA. Our result adds to the literature on multifocal corporate governance mechanisms and the institutional determinants of private equity investment.     

British privatization: Evaluating the results

The 24 studies reviewed here reveal that nine of the 13 primary objectives of the U.K.'s privatization program have substantially been achieved. Privatization has reduced the size and scope of government, reduced political interference in management decisions, freed government funds so they can be used in sectors of the economy other than state-owned businesses, created a free market economy, promoted domestic investment, benefited the economy through higher returns on capital invested in privatized businesses, generated new sources of tax revenue, broadened domestic equity ownership and promoted equity ownership among employees of privatized businesses. Most of the research reviewed concludes that privatization has reduced the government's budget deficit; provided consumers with improved service, better quality, more choices, new products and lower prices; and improved the efficiency and performance of privatized firms. Finally, most of the studies reviewed report mixed results regarding the privatization program's success at reducing government control of business.