Academic journal article Entrepreneurship: Theory and Practice

The Boundaries and Limitations of Agency Theory and Stewardship Theory in the Venture Capitalist/entrepreneur Relationship *

Academic journal article Entrepreneurship: Theory and Practice

The Boundaries and Limitations of Agency Theory and Stewardship Theory in the Venture Capitalist/entrepreneur Relationship *

Article excerpt

The dynamic ownership arrangements surrounding the venture capitalist--entrepreneur (VC-E) relationship inherent in new ventures make the examination of principals' or venture capitalists' (VCs) and agents' (entrepreneurs) governance arrangements interesting to explore. This article examines the limitations of agency theory and then stewardship theory in explaining the behaviors of individuals in the VC-E relationship. Our analysis points out the potential problems inherent in each theory's explanatory ability as it relates to the VC-E relationship. Lastly, theoretical gaps in the VC-E relationship are discussed along with suggestions for new theory surrounding this important and intriguing relationship.

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Entrepreneurs typically start firms with an innovative idea with the anticipation that the venture will become a long-term success. Often the new venture obtains some business angel financing to aid its development (Mason & Harrison, 1996). If the venture achieves some early success, resource gaps often emerge and need to be filled if the venture is going to achieve its potential. As the venture progresses through the initial startup phase, venture capital investments are often sought. In addition to providing risk capital to high potential ventures in exchange for partial ownership of the firm, venture capitalists (VCs) are typically active investors who seek to add value through their interaction with and advice for the managers of the entrepreneurial venture (Macmillan, Kulow, & Khoylian, 1989; Bygrave & Timmons, 1992), as well as through their monitoring and reorganization of the companies in which they participate (Sapienza & Gupta, 1994). Given the substantial equity stake that VCs typically take in a firm, the relationship between VCs and the entrepreneurs that they fund has been compared to that of large block stockholders in leveraged-buyout firms (Jain & Kini, 1995).

Efforts to explain this intriguing VC-E relationship have relied on agency theory and its assumptions (e.g., Barney et al., 1989; Sahlman, 1990; Sapienza & Gupta, 1994). Agency theory prescribes actions that focus on the protection of the investment of the principal (VC) against the harmful behaviors of the agent (entrepreneur) (Jensen & Meckling, 1976). Whereas agency theory has been developed primarily in the context of publicly traded firms with diffuse ownership structures and managers with very limited equity stake, its logic has some appeal for explaining the VC-E relationship. When VCs buy into a venture, they are like outside stakeholders (or large blockholders) who carefully observe the firm to track its business potential and monitor agent behavior to protect against opportunism. Except for a few isolated articles (e.g., Cable & Shane, 1997; Sapienza & Korsgaard, 1996), agency theory has been the dominant theoretical perspective applied to the VC-E relationship. However, some cracks are beginning to appear in the agency logic as applied to VC-backed firms (Bruton et al., 1997; 2000; Busenitz et al., 2001). This article probes temporal issues in the VC-E relationship. It appears that the dominance of agency theory in explaining the VC-E relationship is partially misdirected because of its insensitivity to temporal boundaries. Researchers applying agency theory to explain certain phenomena in the VC-E relationship will likely generate theoretical misspecifications or draw indefensible conclusions unless the timing for the use of agency theory is appropriate. Interestingly, recent research fails to find much relevance of agency theory in explaining the business angel/entrepreneur relationship (e.g., Kelly & Hay, 2001; Landstrom, 1992; van Osnabrugge, 2000).

At issue is the idea of goal congruence between the VC and the entrepreneur. When there is goal congruence between the two, agency theory is silent. Only when there is goal incongruence between the two is agency theory applicable. …

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