Academic journal article Journal of Small Business Management

Managing Risk in a Transitional Environment: An Exploratory Study of Control and Incentive Mechanisms of Venture Capital Firms in China

Academic journal article Journal of Small Business Management

Managing Risk in a Transitional Environment: An Exploratory Study of Control and Incentive Mechanisms of Venture Capital Firms in China

Article excerpt

Although venture capital (VC) industry in China is in its infancy, it is now growing at a rapid rate. The development of VC industry provides an important source for Chinese entrepreneurs to solve problems associated with inadequate systems of corporate governance and the lack of long-term financing for restructuring and growth (White, Gao, and Zhang 2005; Zhang 2001). VC has played an increasingly important role, helping small and medium-sized start-up businesses in China (Fung, Liu, and Shen 2004). Given the potential existence of divergent interests between VC firms and their portfolio firms, VC investments are also characterized by high risks such as volatile returns, lack of information, and agency problems (Promise and Wright 2005; Sahlman 1990). Thus, VC involvement in entrepreneurial firms also includes monitoring while providing managerial, technical, and capital assistance to venture management (Kaplan and Stromberg 2004, 2003, 2001; Hellmann and Puri 2002; Gorman and Sahlman 1989; MacMillan, Kulow, and Khoylian 1989). However, due to the lack of knowledge and experience, the interfirm governance (control and incentive) mechanism of the Chinese venture capitalists is not always effective.

Many entrepreneurs believe that venture capitalists provide little more than money, yet studies of VC activity show that venture capitalists are actively involved in their portfolio companies (Engel 2004; Kaplan and Stromberg 2004; Bygrave and Timmons 1992). Though VC investments are associated with high risks (Promise and Wright 2005; Moore and Wustenhagen 2004), venture capitalists have provided both capital and management expertise that facilitate the development of entrepreneurial firms in China (Liu and Chen 2006; Zhang 2001). The discontinuity in the business environment during China's transition shifted the old equilibrium, in the course of what Schumpeter (1950) famously called "gales of creative destruction." An important force--private entrepreneurs--has emerged and shaken the foundations of the state monopoly. However, newly established small businesses face the liability of newness. The growth of entrepreneurial firms is severely constrained by their limited access to financial resources. Many entrepreneurs actively seek the support of venture capitalists.

Agency problems arise when venture capitalists invest their capital in entrepreneurial firms. Given that agency problems may arise as asymmetric information potentially exists, which makes it difficult for the venture capitalists to monitor the entrepreneur's actions, the codevelopment between venture capitalists and entrepreneurs depends on the venture capitalists' abilities of screening, monitoring, and involvement. Thus far, nonetheless, few studies have focused on how venture capitalists use control and incentive mechanisms to enhance the firm performance and achieve higher returns in the transitional context such as China. In the emerging VC market in China, venture capitalists offer a form and style of financing that has not been provided elsewhere in the spectrum of financial services available so far in terms of the combination of a certain length of commitment with greater involvement and a degree of influence over the companies in which equity stakes are taken (Zhang 2001). Therefore, studies on the emerging codevelopment phenomenon are important, which may have insightful implications to both theory and practice.

In this study, we conduct an exploratory study, drawing on agency theory, to examine the initial development of VC in entrepreneurial firms in terms of both control and incentive mechanisms. In particular, we identify critical factors that affect the periodic investments by venture capitalists. Our study contributes to the VC literature by providing pieces of evidence based on the first in-depth interviews and survey of major domestic and foreign venture capitalist firms in China.

Theory and Research Issues

Agency theory (Fama and Jensen 1983; Jensen and Meckling 1976) provides a useful theoretical lens for understanding the relationship between venture capitalists and VC-backed entrepreneurs. …

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