Financing With Venture Capital: Advances in Knowledge Over the Last Ten Years and Research Avenues

3.2 The functioning of the venture capital market: financing decisions, risk measurement, contractual aspects

According to our survey, the functioning of the market is the second-most-developed topic in academic literature. The venture capital market is an important component of financial markets which has shown strong growth in the last few years. On the other hand, its degree of maturity is very variable, depending on the country, and the United States is considered by many as the model to be copied. One finds several international comparisons of various countries that often include the American market.

Figure 6: Summary of Topic 2 Studies

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3.2.1 The criteria for investment and the investment decision-making process for VCC

The decision-making process has been amply studied, as shown by the literature. The less developed aspects concern the criteria used by investors to justify their financing decisions. The primary subjects dealt with are:

• types of investment: stage of development, sectors, gender of the entrepreneur, need for monitoring depending on the maturity of the business that is financed, segmentation of markets, influence on the type of VCC, VCC risk depending on the projects financed, etc.;
• selection criteria: experience of the entrepreneur and of the senior executive team, type of products, market potential, nature of the assets (tangible or not), adaptation of criteria depending on the stage of development of the financed project, variation of criteria depending on the country, etc.;
• the decision-making process of the VCC and their behaviour: influence of the VCC's mission, unionization, evaluation and modelling of the risk, variation depending on the country, etc.

Several factual studies looked at VC interventions in business start-ups whereas few studies can pinpoint the reasons justifying the lack of intervention of VCC at this critical stage in the development of new companies. It would be interesting to look more in depth at the risk factors of projects at this particular stage to identify the mitigating elements or efficient strategies to be implemented to ease this stage in the development of companies. There are few studies on the phenomenon of public/private partnerships to finance business start-ups, which could deal with sharing the risk.

Among the selection criteria, one finds little discussion on the models of evaluation, of measurement and risk management. In the same way, what are the relationships between the level of risk measured using evaluation criteria and components of the financing contract?

In summary, we find many studies on the industry, financing supply, types of VCC and their behaviour but few studies on the demand side. Investment criteria, for example, are frequently broached from the VCC point of view.

3.2.2   The evaluation of risk (identification, estimate and mitigation)

The estimate of risk is a crucial element in finance and allows one to explain the returns expected by the investors. This relationship cannot be contested in itself. However, measurement of the real risk of the projects to be financed, specifically in the case of SME or private companies, is a topic that is less well developed. This evaluation of risk is the basis for defining financing contracts and of the concept of VC itself. There is a field of basic research here to be developed to contribute to a supply of more efficient financing and which would allow the businesses that are financed to take on financing conditions that reflect more their real risk and not the risk perceived by the valuators.

Despite the interest that such a research subject offers in the literature on venture capital, one finds very few works. The primary subjects dealt with are:

• Identification and description of risks: alteration of the evaluation criteria depending on the stage of development, differences in behaviour between business angels and VCC, subjectivity in the valuation of businesses with rapid growth, specific intervention depending on whether the risk is internal or external to the business.

Obviously, the subject is not a simple one. But inasmuch as risk valuation is at the centre of the relation and conditions for financing, a more in-depth look at the valuation tools and of their relevance to the companies financed, as well as an examination of the "new risks" with which VCC are increasingly confronted, constitute a pertinent research direction.

3.2.3 Contractual aspects of VC and their repercussions on SME

Certain contracts that tie the moneylender to the business have few constraints and leave a lot of latitude to the business' senior executives. Others, on the other hand, limit the freedom of the executives and go as far as to apply the brakes on the growth of the businesses. What is the structure of these financing contracts and what repercussions do they have on the financial health and vulnerability of the beneficiaries? The topics that are developed are:

• financing tools: combination of securities, convertible securities, quality of information and choice of financing tools, moral hazard and the problem of asymmetric information, etc.;
• types of contract: opportunistic contracts and behaviour, exit strategy, agency problems, etc.
• content of contracts: control of the business financed, rights to cash flow, departure of the founders, management of the business, international comparisons, etc.

There is heavy borrowing from the agency theory to explain the drafting of financing contracts between VCC and business. Opportunistic behaviour of entrepreneurs, the need for monitoring, the problems of moral hazard or of asymmetric information have all been studied in different contexts to allow for the drafting of contracts that are judged to be "optimal" for the VCC. Are these contracts equally optimal from the entrepreneur's point of view? Very little is said about this. Also, there is little discussion, and the little there is often theoretical in nature, concerning the means of measuring agency problems, opportunistic behaviour, or moral hazard and asymmetric information; and yet, these elements are at the centre of contract definition and of the establishment of conditions for financing. That which is arbitrary, or elements of perception, seem to be more the rule in the preparation of financing contracts, especially for innovation projects. Better knowledge is needed of the ways in which the VC market really works. Are there "typical" contracts that are more often associated with successful investments? Can the flexibility of a contract be a factor in the success of the SME?

Convertible securities and combinations of securities seem to be the financing strategies with the most "payback". Their use depends on information conditions, on the climate of confidence and on the maturity and risk of the business that is financed. Along the same lines, these strategies protect the rights of VCC. There is much said about the rights of VCC but little about those of the business that is financed. This needs to be looked into, as it might explain why only a very small number of businesses are turning to VC to finance their projects.

Some texts deal with the dismissal of the founder by the VCC after numerous rounds of financing, but they do not discuss the consequences from the standpoint of the development of the business and its capacity for growth and for future innovation. Finally, the literature says nothing on the specific traits of entrepreneurs and the importance of their investment in the business to facilitate the financing of their projects and to bring the relationship between the business and the VCC closer to that of a collaboration and a partnership.

3.2.4 The deciding factors in the involvement of VCC in the SME

This subject is not well developed, but the following aspects are dealt with:

• the involvement by the VCC in, and commitment to, the business that is financed: reputation of the VCC, asymmetry of information and agency problems, confidence, uncertainty, business risk, board of directors, etc.

Overall, the elements that refer to confidence, to uncertainty and to risk are those that will determine the degree and the shape of the involvement of the VCC in the SME to protect its investment.

3.2.5 Control mechanisms (control of the investment from the VCC's perspective)

As moneylender, the VCC can use various mechanisms to protect its investment, which will take various forms depending on the specifics of the business that is financed. There were references to the following elements in the literature:

• the board of directors and management of the business: reputation of the VCC, type of company, etc.;
• the contracts: need for monitoring, replacement of the senior executive, agency problems, voting rights and rights to cash flow, confidence, etc.;
• type of financing: contracts with a combination of securities, convertible securities, financing rounds, financing term, etc.;
• syndication: protection of the reputation, risk sharing, access to more resources, etc.

The primary control mechanisms used by VCC are contracts and financing tools. Contractual clauses will be defined by the extent of agency problems, the moral hazard or the asymmetric information that are anticipated between the VCC and the business that is financed. Moreover, a climate of confidence will make the contract much less cumbersome (aspects studied by some authors but which should be confirmed in other contexts). There are no links made between the costs of financing and the satisfaction of the entrepreneur. The use of boards of directors has not been studied very much in the literature as a control and monitoring mechanism in the business that is financed. Inasmuch as this can contribute to the increase in the quality of the business' management by 'professionalizing' certain activities and by developing the network of contacts, it would be beneficial to study this phenomenon more.

Convertible securities or contracts that use a mixed approach (shares and bonds) have been studied at length and the tendency for mixed contracts to the detriment of shares (privileged or ordinary) seems to have had more success than an approach with only one type of financing (even if there are possibilities for conversion). This can be interesting insofar as these forms of tools allow the parties involved to establish mutual trust by learning to know each other better.

Some studies deal with financing in stages (rounds of financing) when the investments are large or the entrepreneur displays opportunistic behaviour. It is also considered as a solution where there is uncertainty or incomplete information.

Finally, the sharing of risk and access to more financial resources can be done by syndication. Few studies have been made on this type of organization with regard to the greater risk of technological investments or assets that are strongly immaterial.

3.2.6   Investment in an SME as a component of a securities portfolio

This area of research has raised little interest. However, it could allow for a better knowledge of the strategies used by VCC and can suggest tools for the overall management of risk of VCC, as is the case in the field of insurance.

• The portfolio strategy: consistency between investments and the portfolio strategy of VCC, optimum size, influence on the type of fund (specialized or not), etc.

There are factual studies on the strategies for reducing risk to the portfolio, but few conclusions on the mechanisms of protection as such. There are some texts on geographic diversification and diversification depending on the maturity of the projects, but this is still embryonic. There is an important dilemma that faces all VCC, namely that of financing risky projects and surviving.

Public/private partnerships, syndication, personalized management of investments: how to combine all these possibilities to make this market more efficient and to promote its development while reducing losses? The legal structure of a VCC has an influence on the size of its portfolio and, therefore, on its means of diversification. This avenue has not been explored much.