Entrepreneur’s choice between Venture Capitalist and Business Angel for Start-Up Financing

Table of contents

1 Introduction
1.1 Purpose
1.2 Structure of the study

2 The venture capital market
2.1 The entrepreneurial perspective
2.2 Business angels
2.3 Venture capitalists
2.4 Corporate venture capitalists
2.5 High- and low-technology ventures
2.6 The principal-agent problem - Venture capital contracting

3 Literature review and Hypotheses development
3.1 Value creation of business angels
3.2 Value creation of venture capitalists
3.3 Complementarities

4 Data and Methodology
4.1 Data selection
4.2 Scientific approach
4.3 Determinants of success and failure

5 Empirical results
5.1 Sample summary
5.2 Odds ratios
5.3 Logit regression
5.3.1 Binary logit regression
5.3.2 Multinomial logit regression
5.4 Hypotheses testing

6 Discussion

7 Conclusion, limitations and implications
7.1 Conclusion
7.2 Limitations
7.3 Implications

References

Appendix

Abstract

The study extends the literature on venture capital by examining whether entrepreneur’s choice for an external investor and certain firm characteristics have an impact on venture success or not. The focus is set on the differences in value creation by venture capitalists and business angels for ventures of the high- and low-technology sector. The assessment of a data set including 252 Series A financing rounds by venture capitalist firms, business angels and collaborative investments of both investors conducted between 2005 and 2012 unveils value enhancing aspects for all three financing solutions. Overall, start-ups initially financed by venture capitalist firms perform best with regard to general venture success (exit and survival rates), whereas start-ups collaboratively supported by venture capitalists and business angels have the highest chances to exit successfully through a trade sale. It becomes further apparent that ventures located in one of the high-technology industries ‘internet’, ‘pharmaceuticals’ and ‘high-tech’, ventures that are longer established in the market and ventures whose Series A financing round was executed more recently indicate an enhanced likelihood of success.

1 Introduction

“If you’ve got a business - you didn’t build that. Somebody else made that happen.”

US-President Barack Obama, July 13th, 2012^[1]

The foundation of an innovative start-up company requires an outstanding idea, guts, a bit of luck and mostly financial support by externals. The process of developing a product or service that fills a gap in consumer needs or even creates new desires is undeniably the most sophisticated factor of the previously mentioned and financial support probably the most difficult to obtain. Most entrepreneurs face capital constraint and often the generosity of the three Fs (family, friends and fools) is not sufficient. The classical way of receiving a bank loan is also not feasible due to the lack of basic capital. Consequently, entrepreneurs start with their own savings and attempt to gain financial support from the venture capital market as soon as their idea turned into a business. In the venture capital market, the entrepreneur has the theoretical choice between several financing possibilities, whereas business angels (BAs), venture capital firms (VCs) and corporate venture capitalists (CVCs) represent the most common options. Each of the investors possesses unique knowledge, access to various networks and individual advising expertise, thereby providing more than merely capital (Chemmanur & Chen, 2006). Either way, the access to external capital is not easy and attached by certain obligations influencing the probability of venture success.

While a notable amount of scholarly activity focuses on institutional venture capital, research on informal investors is still limited (Mason, 2006). Much of the literature produced in the past was based on surveys and focused on the ‘ABC’ of business angels; attitudes, behavior and characteristics (Harrison & Mason, 2000). Given the fact that Sohl (2003) estimates that between 300.000 and 350.000 business angels are investing approximately US-$30 billion in close to 50.000 ventures every year, the paucity of quantitative literature is quite striking. This can partially be explained by the nature of the business angels, as they are private financiers investing their own money. They intend to keep their pecuniary circumstances confidential to not permanently receive offers by various entrepreneurs (Wetzel, 1987). This hampers the tracking of angel deals and the establishment of databases with solid information about transaction volume, personal data and target firms (Fenn, Liang, & Prowse, 1998, Prowse, 1998). Nevertheless, in recent years the angel market is evolving “from a largely invisible, atomistic market dominated by individual and small ad hoc groups of investors who strive to keep a low profile and rely on word-of-mouth for their investment opportunities, to a more organized market place in which angel syndicates are becoming increasingly significant” (Mason 2011, p.22), although solo investors still dominate the market. This enhancement, in terms of structure and transparency, facilitates data collection and enables the incorporation of venture capitalist firms and business angels to compare the impact of each investor on ventures from a quantitative perspective. Despite these new research opportunities, little is known about the economic differences in value creation between venture capital and angel-financing (Chemmanur & Chen, 2006). Existing literature on the VC-entrepreneur relationship is fragmented and almost solely focused on high-technology ventures (Sapienza, 2000). Hence, research on the impact of VCs on low-technology ventures as well as BAs as investors on both industry sectors is considered as very limited.

1.1 Purpose

In light of the research gap discussed above, this study attempts to discover the interrelationships between venture capitalist, business angel and entrepreneur with regard to value creation. This is conducted through a quantitative assessment of the probability for venture success in order to answer the following research question:

Does an entrepreneur’s choice of investor type affect venture success?

This study extends the literature of Goldfarb, Hoberg, Kirsch and Triantis (2009), who were the first conducting quantitative research on formal and informal investors, by incorporating the investor as well as further variables that might have an influence on venture success. These variables are determined by the demographics and basic firm characteristics of the ventures assessed. Of particular interest are the differences in value creation potential of each investor on ventures in the high- as well as the low-technology sector. Based on a quantitative analysis of the German venture capital market, drivers and preventers of venture success are identified in order to create a 360 degree view of the venture capital market.

1.2 Structure of the study

In the first part, the different participants of the venture capital market are introduced; the entrepreneur, business angels, venture capital firms and corporate venture capitalists. The introduction of the entrepreneur is very in-depth at this point as he is no part of the hypotheses development later on. Nevertheless, the entrepreneurial perspective is highly important for understanding the venture capital market as different types of entrepreneurs have different attitudes and thus prefer different approaches for venture financing. Further, the principal-agent problem itself and solutions to it are discussed, as it is a main problem for venture capital contracting and for the venture capital market in general. The subsequent section reviews relevant literature on venture capital and integrates it into the hypotheses development to be able to answer the research question formulated in the beginning. Afterwards, the methodology determines parameters for the data collection, measures for venture success and the stepwise scientific approach. Finally, the empirical results are presented before the last sections discuss the results, conclude the study and point out implications and limitations.

2 The venture capital market

The venture capital market is composed of various participants. Entrepreneurs seeking for capital turn to informal investors such as business angels (BA) or institutional investors such as venture capitalists (VC) and corporate venture capitalists (CVC). The following section presents key players of the venture capital market and explains their function and characteristics of the high- and low-technology sector and the principal-agent problem.

2.1 The entrepreneurial perspective

Every entrepreneur has a unique approach to build up his business and this also holds for the financing strategy. Schwienbacher (2007) discovers that the financing strategy for a venture primarily depends on the attitude and character of the entrepreneur. He identifies three basic types of entrepreneurs: life-style, serial and pure profit-maximizing. The focus of his study lies on the comparison of the life-style and the serial entrepreneur to the pure profit-maximizing entrepreneur, which is a proxy for an entrepreneur who is not interested in anything else than financial gains. A life-style entrepreneur starts a new venture and intends to run it on his own. He wants to stay in the company and to keep control of the operations, mostly in form of occupying the position of chief executive officer (CEO). In order to avoid loss of control, he attempts to reduce claims of external investors by giving away as few company shares as possible. In contrast, a serial entrepreneur finds a new venture with the intention to sell it as soon as it becomes successful. After that, he reinvests a fractional amount of the investment returns to start a new venture from scratch. Additionally to financial gains, the serial entrepreneur receives non-monetary, personal benefits such as “fame” every time he sets up a new successful venture. Every type of entrepreneur also pursues his own strategy to achieve the same goal, venture success. Life-style entrepreneurs prefer a ‘just-do-it strategy’, which means that they invest a specific amount in the venture although they know that this is not enough for completing it. To fill the equity gap^[2], seed financing is mostly provided by BAs. Thereby, the venture can reach a milestone and attract larger external investors such as VCs. In best case, the venture has reached a sufficient size by achieving the first milestone to attract the attention to have of several VCs competing for it. This puts the entrepreneur in a strong bargaining position and protects him or her from control dilution. Serial entrepreneurs cannot be assigned to a specific financing strategy. While some choose the ‘wait-and-see strategy’, implying to wait and to invest more money and effort into the venture as soon as a VC becomes interested, others take a more risky approach and initially refuse the utilization of external capital in order to obtain maximum gains without being at risk of losing control.

Ehrlich, de Noble, Moore and Weaver (1994) propose that “entrepreneurs with a strong technical or scientifical background and limited managerial experience may desire the more formalized approach of a venture capital firm” (p.80). This entrepreneur often has a detailed knowledge about his innovation but is lacking entrepreneurial experience. At this point, VCs can provide support for the implementation of a managerial system and operative controls. Entrepreneurs who gained first experience in venture foundation rather opt for a BA, as they have less control mechanisms in place and thereby provide more flexibility and decision autonomy. Furthermore, the results of Ehrlich et al. (1994) advocate for a deeper involvement of BAs in venture operations. The surveyed entrepreneurs requested more support by their financiers, particularly in managing crises and problems, serving as a sounding board, monitoring financial performance, soliciting distributors and customers, and developing professional support groups. Hence, entrepreneurs expect added value by incorporating BAs in certain areas.

With regard to the qualification of investors, Saetre (2003) underscores the findings of Ehrlich et al. (1994) by demonstrating that entrepreneurs call for more than merely financial capital. He emphasizes the importance of finding and gaining over investors who can provide ‘relevant capital’. In first instance, capital must be ‘competent’. ‘Competent capital’ stems from investors who can contribute “entrepreneurial experience (i.e. experience in founding and running his or her own enterprise), leadership and business experience (i.e. experience in general management and business experience), higher education, and investor experience (i.e. experience with investing in unlisted companies)” (Saetre, 2003, p. 83). However, these are just the minimum requirements for a potential investor. Sophisticated entrepreneurs demand investors who can provide ‘relevant capital’ which is perceived as more valuable than ‘competent capital’. As ‘competent capital’ consists of capital, competence and commitment, ‘relevant capital’ adds a fourth C, namely contacts. Thus, branch related expertise must be complemented by an extensive network. The access to a network is perceived as highly valuable by entrepreneurs, because it converts human capital into social capital. Coleman (1988) asserts that “as physical capital is wholly tangible and human capital in form of skills and knowledge acquired by an individual is less tangible, social capital is the least tangible as it describes the relations among persons” (as cited in Saetre, 2003). Hence, the most important factor about relevant capital for new ventures is the added value provided by these social structures which facilitate the access to resources and knowledge and promote the achievement of venture goals. This ‘relevant capital’ can only come from BAs who worked in the particular industry before and gained first-hand experience. By supporting a start-up in ‘their’ industry, they pass on the credibility they build up over years and create trust for the attraction of further financiers. Moreover, they possess a valuable network and may give the best possible advice due to their industry experience.

2.2 Business angels

BAs are usually cashed-out entrepreneurs or retired senior executives who own investable assets of more than US-$1m, so-called ‘high-net worth individuals’. Along with time and expertise, they invest their money in high-risk, high return ventures, almost exclusively in seed and early stage financing rounds (Freear, Sohl, & Wetzel, 1994). Since they invest their private money, they are called ‘informal’ investors. The investment amounts typically range from US-$50.000 to $100.000, but sums of US-$10.000 and more than US-$100.000 are also common. The exit type is normally unplanned and highly depends on a venture’s development. Mostly, BAs invest in start-ups in geographical proximity to their hometown. Due to their knowledge and experience in a special field, they invest in ventures in the same industry they worked in or founded companies before. The provision of mere capital and equity growth is often not the only reason why BAs support new ventures. Many of them are also interested in tapping into an exciting venture, to leverage their business contacts and also to protect their investment by active involvement (Mason & Lumme, 1998). As BAs provide equity for the new venture, they can demand a position as mentor or advisor and the entrepreneur is forced to coordinate decisions with them if he intends to retain the BA money (De Clerq, Fried, Lehtonen, & Sapienza, 2006). Sohl (2003) estimates that there are 300,000 to 350,000 business angels in the USA who invest approximately $30 billion per annum in close to 50,000 ventures.

Many angels are organized in syndicates. These associations can consist of only a few BAs up to 100 or more members who exchange information, conduct due diligences and collaboratively invest in start-ups. A prominent example is Silicon Valley’s ‘Band of Angels’, consisting of more than 100 members. In 2009, the Angel Capital Association (ACA), which represents angel syndicates based in North America, estimated that there are 330 angel syndicates in the USA and Canada. The average ACA member angel group had 42 members and invested a total of $1.94 million in 7.3 deals per year in 2007 (Angel Capital Association 2012, www.angelcapitalassociation.org). The advantages of angel syndicates are manifold. Since syndicates have a public profile, they make the informal venture capital market more transparent and also more efficient through the reduction of search costs for BAs as well as entrepreneurs (Mason, 2007). Furthermore, BAs in a syndicate combine marketing, finance and technology experience which is particularly beneficial for individual BAs, as they mostly have limited time and resources and cannot afford to employ staff for completing thorough due diligences for each deal they are offered (Shane, 2005). Similar to VCs, syndicates build up knowledge that enables efficient due diligence routines and procedures, thereby reducing transaction costs and leveraging their membership’s expertise and judgment skills (Stedler & Peters, (2003), Paul, Whittam, & Johnston, (2010)). After the investment, the entrepreneur benefits from the cumulative value provided by the pool of members (May & Simmons, 2001) as well as the monitoring by individual specialists who help the venture achieve required milestones for further financing (Shane, 2009).

2.3 Venture capitalists

Venture capital firms (VCs) manage private equity from outside investors (limited partners) in one or more venture capital funds; hence they are formal or institutional investors. Big venture capital firms manage a couple of funds with specializations in industry sectors or stages of financing (Norton & Tenenbaum, 1993). The capital available in one venture capital firm typically ranges from US-$100 million to $500 million, depending on the reputation and the strategy the firm pursues. The investors are mostly of institutional nature such as banks, insurance companies or pension funds. Venture capital funds have a fixed life of approximately 10 years within those the fund must invest and exit (Mason, 2011). Since equity of venture capital funds belongs to external investors, VCs are not only responsible but also have a legal duty of care for the investments they make with it. In order to spread the risk, they invest in a portfolio of entrepreneurial ventures, usually from the start-up financing stage until the end, the buy-out financing in form of a trade-sale, an initial public offering (IPO) or management-buy-out (Sahlman, 1990). Usually the investment sum in new ventures lies between US-$2 and US-$10 million, whereas they can also be higher or lower. Decisions about venture investments are collectively made by all partners of the venture capital firm. The primary target of a VC is not to overtake the venture but to keep the entrepreneur motivated and to grow and enhance the venture in order to conduct an IPO or a trade sale as soon as the venture has reached a sufficient size (De Clerq et al., 2006). Sohl (2003) estimates that approximately US-$30-35 billion in venture capital funds are currently invested in fewer than 3,000 entrepreneurial ventures.

2.4 Corporate venture capitalists

CVCs are large firms that acquire stakes in ventures of the same or an aligned industry. Mostly those start-ups are built upon a product or service closely linked to the acquiring company’s business line. More important than equity growth for CVCs is the anticipation of a strategic benefit for the parent company. The target is the co-operative development or acquisition of a new product or service that can be incorporated into the firm portfolio. CVCs invest at all financing stages but preferably in the later ones with amounts from US-$2 up to US-$20 million (De Clerq et al., 2006).

2.5 High- and low-technology ventures

Riche, Hecker and Burgen (1983) categorize firms by their research and development (R&D) expenditures, the use of scientific and technical personnel relative to total employment, and product sophistication. This allows a differentiation between ventures of the high- and low-technology sector that will be useful for the research conducted in this study. Sapienza (2000) describes the cooperation between VCs and high-technology ventures as “an extremely potent combination of cutting edge technology with savvy business start-up strategies and market presence” (p. 64). Especially the divergence in backgrounds, expertise and values promises tremendous benefits for both parties. Although high-tech ventures benefit more from the advice and the involvement of a VC compared to low-tech ventures, the potential for conflict is also extended as those forces can also be responsible for a failure of the cooperation when things do not go according to plan. A detailed framework for the optimal VC-investor relationships can be found in Perry (1988). He distinguishes between three investor and three entrepreneur types and proposes perfect matches with regard to the goals each party are pursuing.

Lockett, Murray and Wright (2002) in their study of investments in UK-based technology firms separate the funds managed by VCs into generalist funds (Low-Technology sector) and technology specialists (High-Technology sector). Except for seed financing stages, VCs impose higher ‘hurdle rates’ for high-technology than for low-technology ventures. In other words, high-technology ventures have to generate a higher return on investment (ROI) than low-technology ventures. The study further outlines that seed financing was the least favored activity for all VCs surveyed, as only 8% responded that this is their preferred financing stage. Particularly, generalist funds prefer mature investments in expansion and buy-out investment stages, although they have become more interested in seed stage financing. Technology specialists on the other hand, prefer early-stage investments, including seed financing. The study further discovers that VCs managing generalist funds have an increased interest in High-Technology ventures, as 74.5 % responded that they invested in technology-based companies in the year prior to the survey, i.e. 1999, compared to 46.2 % in 1991. The intention to invest in High-Tech firms in the next year (2000) even doubled (from 42.3 % in 1991 to 87.2 % in 1999), representing a complete reversal of the situation at the beginning of the 1990s and thereby blurring the boundaries between technology specialists and generalist funds.

2.6 The principal-agent problem - Venture capital contracting

A major concern on both sides of the investor/entrepreneur relationship during the investment process is the principal-agent problem. The principal-agent problem arises when two individuals operate in an uncertain environment in which both prefer risk-sharing. The benefit for both parties depends on the effort exerted by the agent (entrepreneur), but the principal (VC or BA) cannot constantly observe and control the agent’s efforts (Grossman & Hart, 1983). Kaplan and Stromberg (2001) identify three ways for solving the problem: Allocation of cash flow and control rights structured by financial contracts, a thorough due diligence ex ante the investment and screening and monitoring along all financing stages of the venture.

VCs attempt to exclude risk by setting up contracts in which specific control rights are determined, including the allocation of cash flow rights, board rights, voting rights and liquidation rights contingent on observable measures of financial and non-financial performance. In case of underperformance by the entrepreneur, venture control incrementally shifts over to the VC. As soon as the venture performance improves, the entrepreneur regains control rights, although cash flow rights retain with the VC (Kaplan & Stromberg, 2000). Those control mechanisms protect the VC from being held up by the entrepreneur. The entrepreneur has the advantage of information since he knows first how well the venture is performing. By implementing those rights of control shifts, the VC ensures indirect control over the venture performance. Hellmann (1998) points out that the probability of control shift increases the smaller entrepreneur’s equity stakes are in the venture and the more wealth constrained he is. Furthermore, the more control the VC possesses, the more likely is the recruitment of a professional management team determined by the VC which is supposed to enhance the venture performance. His model further recommends more investor control the less the entrepreneur is capable to function as a manager, former business experience of the entrepreneur serves as a proxy here.

Chemmanur and Chen (2006) reveal that information asymmetry diminishes over time as the VC interacts with the firm and the entrepreneur. They further characterize the evolution of convertible features such as convertible debt^[3] and convertible preferred equity^[4] in venture capital financing contracts. In the beginning, the fixed income component (“downside protection”) paid by the entrepreneur for receiving the loan is greater because of information asymmetry in favor of the entrepreneur. As further financing rounds take place, the financing contract changes. Since information asymmetry diminishes due to interaction between both parties and the VC incrementally increases its stakes in the venture, “the need to provide incentives to the venture capitalist dominates, so that the fixed income component of the contract will be less, while the upside (warrant) component of the contract will be more” (Chemmanur & Chen, 2006, p.38). In other words, initially the entrepreneur has to pay the VC for providing capital and the risk they bear due to information asymmetry. As the venture matures, the information asymmetry for the VC diminishes and the VC gains more knowledge about the venture. Thus, in order to retain the VC and to avoid potential information leakage, the VC must be incentivized. Financial leverage tools such as convertible debt function as a trade-off mechanism between the contrary developments of information asymmetry minimization and the provision of incentives for exerting effort with regard to the VC. Considering financing contracts of BAs with entrepreneurs, the model predicts less convertible features and only the downside protection of fixed income play a role. This is because BAs invest smaller amounts of money and they usually acquire common stocks (Fenn et al., 1998). Those contracts will consequently have a smaller upside component (i.e. warrant).

Van Osnabrugge (2000) compares BA and VC investment procedures by means of an agency-theory based model. While both investors attempt to minimize agency risks at all stages of the investment, BAs prefer the ex post investment approach. The ex post approach is based on the theory that contracts are never perfect and thus always incomplete. Hence, gaining control rights after the investment is of paramount importance in order to influence the venture development and preserve BA’s interests. The ex ante investment preferred by VCs bases on the principal agent approach. The objective hereby is to set up an “almost perfect” contract by intensive pre-investment screening and a thorough due diligence. There are two reasons for the preference of each investor. First, VCs are responsible for other people’s money and thus have to carefully evaluate every investment they make. Second, BAs do neither have the time nor the resources for conducting a thorough due diligence for each venture they get offered. Since they are investing their own capital, they prefer to quickly eliminate unpromising ventures. This theory of BA’s quick decision-making process is supported by a recent study of Maxwell, Jeffrey and Lévesque (2011) who assessed 150 interactions between entrepreneurs and potential investors. They reveal that BAs tend to use shortcut decision making heuristics to evaluate a potential investment. Specifically, they eliminate start-up firms by their aspects in order to rapidly exclude investments with low or no potential at all. Those aspects include adoption (by the customer), product status, protectability, customer engagement, route to market, market potential, relevant experience and financial model. BAs use a path of comparable pace, allowing them to conduct an initial screening (key criteria: fit with venture’s landing guidelines and long-term growth, profitability of the industry) within less than six minutes and the assessment of a complete proposal (key criteria: source of business proposal, availability of previous peer reviews) within less than 21 minutes (Hall & Hofer, 1993). In addition, Hall and Hofer (1993) present an aggregated overview of venture capitalists’ decision criteria literature and provide advising for the achievement of successful venture capital financing. An important outcome of this study is the fact that VCs, in contrast to BAs, do not put too much importance on the entrepreneur/-entrepreneurial team or the proposed strategy at this early stage. They rather focus on the idea of the product or service as they can eventually replace the entrepreneur with a manager they choose.

3 Literature review and Hypotheses development

The general difference in investment volume between BAs and VCs is more or less known, even though it may vary from venture to venture. The value creation by both investors beyond mere financial capital is complex and consists of different components. The following section assesses academic literature produced so far with regard to each investor’s unique approach of creating value for a new venture. Additionally, significant complementarities resulting from collaborative investment are outlined. For each tendency in the literature, two hypotheses focusing on the high- and the low-technology sector are developed.

3.1 Value creation of business angels

One very important factor of entrepreneur’s financing decision is the value provided by each type of financing since both supply more than solely financial capital (Kaplan & Stromberg ,2001; Prowse 1998; Gorman & Sahlman, 1989). BAs create value by mentoring, strategic advice, networking and sometimes a functional capacity in the start-up. Contributions to the venture such as serving as a sounding board (Harrison & Mason, 1992), interfacing with the investor group, monitoring financial performance and formulating business strategy (Ehrlich et al., 1994), use of BA’s personal network, coaching and provision of financial know-how (Brettel, 2003), enhancement of management skills and help with additional fund raising (Paul, Whittam, & Johnston, 2003), were perceived as the most valuable non-financial contributions by BAs. As BAs typically invest in markets and industries they formerly worked in, entrepreneurs can benefit from the expertise, knowledge and experience BAs gained over years. Many entrepreneurs even confirm that the hands-on involvement of BAs discussed before adds more value to the venture than the actual capital and enhances the prospects for venture success (Mason, 2011).

The participation of a BA can also serve as a steppingstone. Madill, Haines Jr. and Riding (2005) ascertain that 57% of the ventures in their sample which had received initial angel investment also obtained later VC financing, whereas only 10% of ventures without angel financing received later VC financing. Thus, it can be assumed that BA investment helps ventures to become “more ready”, thereby enhancing venture’s growth potential and the likelihood of a successful venture exit. It is reasonable that the hands-on involvement in form of network opportunities, assistance in legal advice, accountancy advice and the provision of resources as well as business and marketing intelligence creates substantial value. BAs are heterogeneous individuals who are actively involved in the venture and thereby provide individual combinations of contacts, guidance, and governance, as reported by all 33 companies in the sample. Although it needs to be stated that angel financing is not a necessary requirement for later stage VC financing, BAs have an accrediting role as they provide trust and credibility for recently founded and mostly unknown start-ups. The fact that BAs invest their own capital and are not obliged to manage an investment fund raised by other people’s money can work as an advantage for the entrepreneur. In many cases, BAs tend to overinvest with the result of earning zero profit but higher stakes in the firm. So on the one hand, they gain more control rights and the entrepreneur loses control to certain extent. But on the other, they are also forced to exert effort the more money they invest and consequently have a stronger incentive to contribute valuable input to the venture (Leshchinskii, 2002). The BA becomes more and more part of the venture and is consequently also interested in its success.

Goldfarb et al. (2009) also find a positive relationship between angel participation and the probability of a successful venture exit. Specifically, angel-only financed deals have a 33% to 36% higher chance to survive compared to other deals assessed in the sample. Concluding, there is extensive evidence for value creation beyond mere financial capital by BAs in new ventures, either in form of active hands-on involvement or due to the characteristics of the relationship between BA and entrepreneur itself. From the literature produced so far, it is impossible to determine on which technology sector BAs have a more significant impact on value creation. Nevertheless, it can be assumed that BAs are less beneficial for ventures in the high-technology sector, as those require structured advising and specialist knowledge skills (Lockett et al., 2002). It follows that

H1a: The financing by a BA has a positive impact on value creation and thus enhances the prospects of success for a venture in the High-Technology sector.

H1b: The financing by a BA has a positive impact on value creation and thus enhances the prospects of success for a venture in the Low-Technology sector.

Contrary to the findings discussed before, several studies attribute limited value creation potential to BAs. Chemmanur and Chen (2006) state that BAs fail to add significant economic value to the venture. BAs tend to invest in ventures in less technologically sophisticated and knowledge intensive areas, leaving less potential for value creation to them. Consequently, entrepreneurs who have broad technological knowledge themselves tend to have self-financing or angel-financing as financier’s incremental value added may be limited. Based on their model, the authors come to further highly interesting conclusions regarding the financing path of ventures. Ventures which can initially attract and maintain VC financing over several financing rounds have the highest chance of going public or being acquired, thus have the highest quality. Ventures that are financed by BAs in their early stages and later switch to VCs will less likely have a successful exit, hence are of lower quality. Finally, ventures which start with VC financing and later switch to BAs or obtain BA financing only through all financing stages have the least chances of going public or be successfully acquired and indicate the lowest quality.

Fairchild (2011) uses a behavioral game-theoretic approach and also underscores the lack of value creation potential of BAs. He emphasizes that besides economic factors, behavioral aspects also influence entrepreneur’s financing choice. Whereas VCs provide higher-value adding capabilities in economical terms, entrepreneurs often benefit from an empathetic and trusting relationship with a BA. This promotes mutual trust and thereby mitigates double-sided moral-hazard problems.^[5] The findings of Fairchild (2011) are supported by Freear et al. (1994), who also emphasize the more interpersonal relationships with BAs, providing the benefits of a productive and trustful atmosphere. Still, it is uncertain if the benefits of a trustful relationship lead to economic growth, thus

H2a: The financing by a BA has no impact on value creation and thus does not enhance the prospects of success for a venture in the High-Technology sector.

H2b: The financing by a VC has no impact on value creation and thus does not enhance the prospects of success for a venture in the Low-Technology sector.

[...]

^[1] President Barack Obama address, Roanoke Virginia, July 13, 2012. http://www.whitehouse.gov/the-pressoffice/

2012/07/13/remarks-president-campaign-event-roanoke-virginia.

^[2] As explained in Mason (2011): The transaction costs, e.g. time for evaluation, deal negotiation, post investment support, for a VC for each deal are substantial and largely fixed regardless the size of the investment. So for small investments < $1 million, the transaction costs are the same as for a large, making it uneconomic as transaction costs are a significant proportion of the overall investment. BAs in turn are better able to make small investments because they do not cost their time in the same way as venture capital fund managers and their requirement for professional support, for example from lawyers and accountants, is minimal.

^[3] Convertible debt: The holder has the option to convert this security into shares of common stock of the issuing company or into a specified amount.

^[4] Convertible preferred equity: Preferred stock including an option for the holder to convert the preferred shares into a fixed number of common shares, normally after a predetermined date.

^[5] Double-sided moral hazard problems arise from the fact that entrepreneur and financier have different incentives concerning the venture goal and may not work to the best of his or her ability.