The VC-Entrepreneur Relationship: 3 critical factors

The relation between the founders and the VC’s is essential. The founder-VC partnership is a long-term relationship, and the two parties have to build trust and to be upfront about their goals. CBInsights in its failure report has listed “Disharmony with Investors/Co-founders” as a key failure reason. This shows that maintaining a healthy relationship with investors can be crucial for the startup well being. This article presents three of the most well-research topics in the VC-Entrepreneur relationship academic studies, trust, social interaction and goal congruence advising both parties. Although all three topics we cover will benefit the startup, losing some of these topics will have a bigger impact but for the worst.

Trust

The presence of ‘trust’ has always been considered important in exchange relationships[1]. It involves expectations about others intentions and motives, and it is not always objective. Sweeting[2] noted that trust for Venture Capitalists is a major concern. This is always the case in every relationship where one party will give something now, and the other will return it with interest after some time. Venture Capitalists have developed mechanisms to safeguard against this, with most common the staging and board representation (for more see here), but for trust cannot be won by having to present results and to ask for more money. Sapienza[3] showed that successful VC’s emphasised building trusting relationships with the entrepreneur. When an entrepreneur feels entrusted to execute on the vision, he can perform better and even if there is a setback it is always better to know that the investor will have his back.

Without trust, it is almost impossible to accomplish anything, but one note that has to be made is that there is an upper limit on trust. Having too much faith, loosening the monitoring aspect and removing the professionalisation of the relationship could be potentially damaging[4]. One analogy people make is that of parents with teenagers where removing trust will have the opposite results but also trusting them with too much will be naive.

Social interaction

In venture capital and startups, the parties are involved with each other for long time and healthy interpersonal relationships, and personal contacts between exchange partners could prove to be beneficial for both[5]. The investor could get some better knowledge of the company, the entrepreneur and trends in the industry and the entrepreneur could get mentorship, access to other investors and his ideas[6]. Research suggests[7] that there is a positive correlation between the interaction of the two parties in social occasions and the startup performance.

Social interaction does not mean that the entrepreneur should be best friend with the VC but to try to give more time and understand each other. The startup game takes years, and no VC wants to be with a founder that doesn’t understand how he thinks and what motivates him and no entrepreneur will go far without understanding and sometimes easing the worries of the investors.

Goal congruence

According to Nahapiet and Ghoshal[8], goal congruence is the degree to which two exchange partners hold common beliefs regarding their relationship. Even if the goals are stated upfront, the execution and the interpretation of the goals might be different for each party. The confusion in Venture Capital backed companies comes when the individual goals are confused with that of the startup. If for example, a target of a startup is “to be the category leader of X,” the entrepreneur “to be the next Steve Musk” and the VC “to exit fast with 100x returns” then it is clear that there will be some confusion, resulting in trade-offs and some rearrangement of priorities.

Goal incongruences come from information asymmetries where one party doesn’t have the same information that the other might have. Information asymmetries may lead to agency problems of adverse selection or moral hazard[9] and it is important to safeguard against them. Most commonly in Venture Capital, we see goal setting, staging, monitoring and personal commitment/investment as a mechanism against them[10].

An interesting fact is that goals change with time and although all parties may share similar goals, they may fail to honour their commitment to these, later on, leading to disappointment and conflict[11]. It is important thus to review periodically the goals and assess how each party feels about them and whether the motivation to accomplish the goals is still there. There are many cases of the successful founder that decided to step down and let a professional CEO accomplish the goals, and they continued doing what made them happy.

Note: This article has been appeared first in www.whydotheyfail.com and is based on the research for the project and dissertation named “Venture Capital failures. Why VC backed start-ups fail and how can we improve the failure rate” that was submitted to Warwick Business School on 05/03/2018 by Kostakis Bouzoukas.

[1] Ring, P.S. and Van de Ven, A.H., 1992. Structuring cooperative relationships between organizations. Strategic management journal, 13(7), pp.483–498.

[2] Sweeting, R.C., 1991. UK venture capital funds and the funding of new technology‐based businesses: process and relationships. Journal of Management Studies, 28(6), pp.601–622.

[3] Sapienza, H.J., 1989. Variations in Venture Capitalist-entrepreneur Relations: Antecedents and Consequences. University Microfilms.

[4] Clercq, D.D. and Sapienza, H.J., 2005. When do venture capital firms learn from their portfolio companies?. Entrepreneurship Theory and Practice, 29(4), pp.517–535.

[5] Morgan, R.M. and Hunt, S.D., 1994. The commitment-trust theory of relationship marketing. The journal of marketing, pp.20–38.

[6] Nahata, R., 2008. Venture capital reputation and investment performance. Journal of Financial Economics, 90(2), pp.127–151.

[7] De Clercq, D. and Sapienza, H.J., 2006. Effects of relational capital and commitment on venture capitalists’ perception of portfolio company performance. Journal of Business Venturing, 21(3), pp.326–347.

[8] Nahapiet, J. and Ghoshal, S., 1998, Social capital, intellectual capital, and the organizational advantage. The Academy of Management Review, 23( 2), pp. 242–266.

[9] Sapienza, H.J. and De Clercq, D., 2000. Venture capitalist-entrepreneur relationships in technology-based ventures. Enterprise and Innovation Management Studies, 1(1), pp.57–71.

[10] Sapienza, H.J. and Gupta, A.K., 1994. Impact of agency risks and task uncertainty on venture capitalist–CEO interaction. Academy of Management journal, 37(6), pp.1618–1632.

[11] Parhankangas, A., Landström, H. and Smith, D.G., 2005. Experience, contractual covenants and venture capitalists’ responses to unmet expectations. Venture capital, 7(4), pp.297–318.

Originally published at www.whydotheyfail.com on April 17, 2018.

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