How entrepreneurs-in-residence increase seed investment

rates

Prepared For:

Canadian Association of Business Incubation

Prepared By:

Andrew Maxwell MBA P.Eng.1774 Grosvenor Place, Mississauga,

Ontario, L5L 3V8

This article investigates the role of entrepreneurs-in-residence (EIRs) in closing the equity gap born by a lack of venture capital investment in early-stage businesses. We conducted interviews with ten Israeli-based venture capitalists and four EIRs to identify the mechanisms and actions used by EIRs when operating in venture-capital firms, and subsequently in funded ventures, that lead to a greater proportion of funds targeted to seed investments. The findings of our exploratory study suggest that EIRs facilitate investment decisions by acting as catalysts in the development of the relationship between the venture capitalist and the fund-seeking entrepreneur. EIRs can thus prevent some of the problems that preclude venture success through the nurturing of trusted relationships with both fund-seeking entrepreneurs and venture capitalists. Furthermore, ex-ante, during and ex-post investment, through building these trusted relationships, EIRs act as transaction-cost reducers, thus increasing expected return on investments from early-stage ventures. In an attempt to help reduce the equity gap by developing a better understanding of this key phenomenon, these findings provide guidance to rising entrepreneurs as they develop their early-stage businesses, to venture capitalists as they look for investment opportunities, and to governments eager to increase the rate of seed funding.

Keywords: Equity gap, seed funding, venture capital, entrepreneur-in-residence, transaction costs, trust

Introduction

Obtaining venture capital (VC) is critical for high growth potential companies, but is

increasingly problematic for seed ventures due to “the economics of the investment appraisal and

monitoring processes” (Mason and Harrison, 1992: 377). Mason and Harrison (1995) identify an

equity gap attributed to the “evaluation and monitoring costs which must precede and

accompany venture capital investments [and] are a significant fixed cost element, which makes it

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uneconomic for funds to make investments of less than about £250,000” (p. 155). These costs

arise from the practices of venture capitalists (VCs) who incur transaction expenses ex-ante,

during and ex-post investment, in order to reduce their perceived risk in the investment (Van

Osnabrugge, 2000). Given the fixed nature of these transaction expenses, they constitute a much

higher percentage of the investment amount in seed funding compared to investments made in

later stages of funding where investments are larger. In this article we explore how

entrepreneurs-in-residence (EIRs) can decrease these costs, reduce the equity gap and increase

VC funds that flow into early-stage ventures.

EIRs are particularly active in Israel, found in 31% of VC firms who invest in seed

ventures in the information and communication technology (ICT) sector (Schwarzkopf, 2007).

Since 1995, the Israeli economy has had an inflow of US$43 billion in ICT investments

including US$16 billion of direct VC investments (Myre, 2005) of which seed ventures represent

8% (Israel Venture Capital Association, 2008). Israeli VCs view the utilization of EIRs in an

internship program as a critical mechanism that allows for these high rates of seed funding

compared, for instance, to the US with only 4% of VC funds in seed ventures (PWC Moneytree,

2008). Previous research on the role of EIRs has been limited, with only one key study

(Rosenblatt and Thelen, 1997) that suggests that an EIR’s role is to both attract more fund-

seeking entrepreneurs and improve the likelihood of success of funded ventures. However, since

there are other mechanisms (such as the recruitment by VCs of experienced CEOs) that appear to

replicate these effects, these explanations alone are insufficient to explain the higher rates of seed

funding (and specifically how EIRs reduce the equity gap). This leads to our research questions:

What is the role of the EIR in reducing the transaction costs that cause the equity gap that

inhibits seed investments? Specifically, how does an EIR working with an Israeli VC and the

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fund-seeking entrepreneur build a relationship able to reduce each transaction cost component

normally encountered in VC investment?

We address this question by exploring theoretically and empirically how investors can

reduce their investment risks, especially those born from the relationship risk introduced by

allowing a fund-seeking entrepreneur to manage a funded venture. Understanding the nature of

the transaction costs introduced into the VC-entrepreneur relationship allows us to characterize

how, through the development of mutual trust, an EIR can enable the development of a relational

contract that complements the more formal agreement. We adopt a qualitative research method

for this exploratory study and draw conclusions on how the presence of an EIR influences the

perceptions and behaviors of both VC and fund-seeking entrepreneur. Our interviews with ten

Israeli-based VCs and four EIRs allow us to identify how EIRs act as catalysts for investment.

We also extract data from our interviews to explain how a VC chooses an EIR who can identify

opportunities, overcome VCs’ past investment problems, boost expected returns, and who can

nurture trusted relationships with VC partners and the fund-seeking entrepreneur. Our insights

can be used to explain how EIRs are able to reduce the equity gap and increase the rate of

funding in seed ventures.

Reducing investors’ perceived relationship risk

A VC making a seed-investment decision must consider the performance risk and the

relationship risk rooted in two different domains: the former in the competitive environment, the

latter in partners’ co-operation. Performance risk is the likelihood of achieving expected

outcomes, given full cooperation by both partners (Das and Teng, 1996). Relationship risk

occurs because the investor must engage an entrepreneur to manage the enterprise, whose

decisions may not always align with those of the investor (Das and Teng, 2001). Relationship

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risk, also known as agency risk, has two components (Fama and Jensen, 1983): moral hazard,

arising when the two parties have diverging interests; and adverse selection born from

information asymmetry between the two parties. Moral hazard can lead the fund-seeking

entrepreneur to take actions that are beneficial to her/him but detrimental to the VC. Adverse

selection can lead the fund-seeking entrepreneur to fail to recognize her/his lack of knowledge,

which can result in poor decisions.

To reduce the relationship risk perceived by the VC to an acceptable level, the VC must

achieve a level of confidence in the future behaviors of the entrepreneur. Typically, the VC

accomplish this by undertaking due diligence on the previous behaviors of the entrepreneur –

seen as an indication of future behaviors, and introducing control clauses into the shareholder

agreement (Barney et al., 1994; Fiet, 1995; Kaplan and Stromberg, 2003). However, due

diligence and the monitoring of control clauses introduce transaction costs, which reduce the

expected return of an investment because limited resources are then diverted away from business

development. This reduction in return often reaches the point where the VC’s expected returns

cannot be achieved especially in seed investing where these transaction costs are a relatively high

percentage of the investment amount. Consequently, the potentially good seed-investment

opportunity does not take place.

Barney and Hansen (1994) argue that relationship risk can also be reduced by the

development of interpersonal relationships to the point where they can substitute for costly

controls. These relationships require the development of interpersonal trust (Harrison et al.,

1997) that facilitates the development of investor-entrepreneur relational contracts (Casadesus-

Masanell, 2004). This suggests that an alternate model for the relationship between investor and

fund-seeking entrepreneur might rely more on stewardship theory than agency theory (Arthurs

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and Busenitz, 2003). Developing trust-based relational contracts requires time, which is usually

in short supply during the direct interactions between investor and fund-seeking entrepreneur.

Lewicki and Bunker (1996) note the staged nature of such interactions, suggesting that higher

levels of trust, known as identification-based trust, can only be reached when each party

understands, appreciates and anticipates the other’s wants. As Flores and Salomon (1998) note,

trust development is slow, starting from an anchored position created by each party’s initial trust

perception of the other based on their predisposition and initial impression, which, as argued in

Shepherd and Zacharakis (2001), is then modified over time by the reciprocal display of trusting

and trustworthy behaviors from both parties. In the case of the investment decision, time-

constrained VCs do not have the patience to develop such relationships, instead choosing to rely

on the introduction of controls and their associated costs.

We elaborate on the various cost components introduced by this traditional risk

mitigation strategy using transaction cost economics theory, as shown in Table 1. Williamson

(1975) identifies three types of transaction costs that reduce market efficiencies and prevent

otherwise worthwhile transactions from being completed: ex-ante, negotiation and ex-post. Ex-

ante costs are incurred before the transaction is completed, and include those associated with the

identification of high potential opportunities and the assessment and selection of opportunities

that meet the investment objectives of the VC. Negotiation costs are incurred during the investor-

entrepreneur interactions and include significant information gathering and verification, as well

as structuring contracts to reduce the likelihood of future risks associated with moral hazard or

adverse selection. Ex-post costs are incurred subsequent to the investment and include ongoing

monitoring of behaviors and performance against milestones as well as enforcement costs if

required. Ex-post costs are typically the largest transaction cost component because they

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continue for the life of the investment. When evaluating an investment opportunity, the VC

views all of these transaction costs as reducing perceived relationship risk, but also reducing

expected ROI. As argued by Shepherd et al. (2005), balancing these costs against the VC’s time

(ex-ante, during negotiations, and ex-post) is key, especially considering their resource

constraints and the fact that much of the effort allocated ex-ante is not with ventures that become

part of their portfolio.

-------------- Insert Table 1 about here --------------

Mason and Harrison (1992) identify an alternate approach to introducing costly control

clauses to manage relationship risk that involves a trusted third party, helping fund-seeking

entrepreneurs understand what VCs are looking for. The role of this third party can be even more

impactful if they have a good reputation and their incentives aligned with the venture’s long-term

success (Pollock et al., 2004). We suggest that this third party, in the form of an EIR, enables the

development of a relationship contract, can reduce each component of the transaction cost (due

to that EIR’s likely impact on each cost component, as highlighted in Table 1), and can increase

the rates of seed funding. Previous research on the role of EIRs has been limited and tended to

either record individual success stories or identify the value of the EIR as increasing the number

of opportunities presented to their host VC (Rosenblatt and Thelen, 1997). We propose that the

role of the EIR is much more fundamental to relationship development, and that EIRs make

possible seed investment decisions that otherwise might not happen due to the perceived high

relationship risk.

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The role of EIRs

EIRs are recruited by a VC and paid a salary during their internship, which typically

lasts between 12 and 18 months. They are “high status” individuals (Baron and Markman, 2000)

with an outstanding record of accomplishment as either an entrepreneur or technology innovator.

They are recruited to increase the quality of opportunities presented to the VC and to enhance the

long-term success of the ventures that are funded. During their internship, they develop strong

personal relationships with VC partners and are exposed to the VC’s networks, resources and

tools. This enables the EIRs to identify emerging market segments and specific business

opportunities and resources that may be useful to future funded ventures. In addition, EIRs often

utilize their expertise to provide direct assistance to VC portfolio firms facing specific

challenges. In developing investment opportunities, some EIRs develop their own ideas from

scratch, while others work with external entrepreneurs seeking startup finance. In both cases, the

EIR plays a role in the investment process before and after the venture is funded.

The specific role played by an EIR varies depending on their background or interest.

Also, before becoming directly involved with a specific opportunity, EIRs are likely to first work

inside the VC firm where they develop strong trusted relationships with VC partners while

attracting opportunities and mentoring fund-seeking entrepreneurs. The relationship the EIR

develops with the fund-seeking entrepreneur and their anticipated participation in the venture,

post-funding, facilitates a positive investment decision, given the existing relationship the EIR

has with the VC. The development of this trust based relationship is based on the development of

two types of trust (Das and Teng, 1996): goodwill trust – based on the alignment of intention

between two parties wishing to accomplish the same goals fostered when both parties share the

same values and norms; and competence trust – based on the ability to accomplish certain goals.

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Goodwill trust and competence trust develop by the trustor examining the previous performance

of the trustee, often based on the EIR’s reputation and past relationships with investors.

Further, when an EIR elects to join the fund-seeking entrepreneur and become part of the

venture’s management team, the VC’s confidence in the longer-term performance of the venture

is increased. Jacobius (2004) reports on evidence from the VC community that the presence of an

EIR in a funded venture is likely to have a direct positive impact on the value of the company at

the time of a liquidity event. EIRs’ long-term role in supporting the aligned interests of all three

parties is enhanced by their equity participation in the venture and their desire to maintain their

reputation. EIRs’ behaviors and roles are explored though our interview-based research method

described next.

Research method and analysis

Our exploratory research was designed to determine how specific mechanisms and

actions used by EIRs in VC firms and seed ventures can explain the relatively high proportion of

Israeli VC seed investments. Specifically, we wanted to understand how the presence of an EIR

in the investment decision process affects the behaviors and perceptions of the entrepreneur

seeking funding and, more importantly, the VC. We elected to use a qualitative approach,

interviewing key players in a semi-structured format because it permitted us to determine how

EIRs operate and what the effects are of their presence. Semi-structured interviews allowed us to

generate useful information to address questions such as how the roles of EIRs changed before,

during and subsequent to the VC’s investment decision. This approach also enabled us to probe

VCs’ perceptions of highly subjective factors, such as the relative importance of the EIR’s

reputation.1 1 Qualitative data analysis is common in the sociology literature, for instance, and can be done using two alternative approaches. In the first, interview data is transcribed and segments extracted to support specific view points. In the

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We selected 14 sample subjects through a criterion-based process, a strategy in which

particular settings, persons, or activities are selected to provide information that cannot be as

easily obtained from random sampling (Miles and Huberman, 1994). We selected the subjects

from 57 VC firms operating in the Dan Valley region of Israel, investing in ICT seed ventures,

and operating EIR internship programs. These firms were chosen to encompass a variety of VC

sizes (in capital) and we chose to interview the primary decision makers (CEOs) of the first 10

VC firms who were available. While the number of VCs interviewed was small, our sampled

VCs employed 36 EIRs, had 204 portfolio startup/seed ventures, and raised 41% of the Israeli

VC funds in the two years before our research. Their perspectives were based on a great deal of

experience with EIRs and we believe they are representative of the Israeli VC industry. Five

were satellite offices of Silicon Valley VCs in Israel and five were locally owned VC firms. Our

investors were predominantly male (90%) in their fifties with extensive managerial experience;

75% of those we interviewed were repeat entrepreneurs. They all lived in the central region of

Israel, had served in the Israel Defense Forces (IDF) and were technologically competent. Our

focus on VC’s view of EIRs was motivated by our desire to understand how the presence of an

EIR affected the VC’s perceptions of relationship risk and their investment decision-making

process. Table 2 summarizes our data on VCs.

------------- Insert Table 2 about here -------------

All selected EIRs were associated with firms where the VC had previously agreed to be

interviewed, ensuring that we would gather information on relationships between VCs and EIRs

second, there is a greater attempt to determine the frequency of specific words or expressions, their magnitude and time of occurrence. We chose the former and utilized a common research tool, Microsoft OneNote 2003, with notebook capability to record data. This software allows for continuous sorting and resorting of the data, which can then be re-categorized. The latter approach (used e.g. in a tool like nVivo) was not used because the level of refinement it offers provides unnecessary details for the purpose of our exploratory study.

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from both perspectives to better understand them. Our EIRs included two in the resident phase

and two who had “graduated” with ventures that had received funding during the previous year.

While all the EIRs interviewed were in their thirties, they all had similar backgrounds to the

investors and had strong ties within a relatively small and inter-connected community.

Our semi-structured interviews, in English, lasted about 90 minutes and took place during

July and August 2005 in the interviewees’ offices. The interviews were taped and transcribed for

analysis, increasing the quality of the data that could be extracted while ensuring participant

confidentiality. As highlighted in Table 3, the questions focused on the operating practices and

perceptions of EIR internship programs, the challenges of seed investing, and experiences with

overcoming seed-funding barriers with the need to consider transaction costs. Specific attention

was paid to gathering information about the constructs we had identified in our background

research, such as the display of goodwill and competence trust. We gathered information on the

importance of reputations of all parties and how the various relationships between them evolved

over time. The information we obtained also provided insights on how the presence of an EIR

affected the need for additional resources subsequent to funding.

------------- Insert Table 3 about here -------------

Once we had conducted the interviews and transcribed the data, we analyzed the content

through multiple iterations, on each occasion looking to explore in depth a different set of

factors. Our initial analysis was based on factors from previous research, for instance about the

role of the EIR and the nature of trust development. Subsequent analysis was based on

attempting a more detailed understanding of factors observed in an earlier stage of our analysis.

We used a simplified coding system on a spreadsheet to gather, sort and record the factors we

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were investigating. The initial analysis focused on extracting background information about the

VC’s prior experience with EIRs (persons and programs), their involvement in formal internship

programs, and how they funded such programs. We also determined if the VC planned to

continue with these programs and whether or not they would recommend them to others. In our

second iteration, we gathered specific data on how the relationships between EIRs and VCs

developed over time. Specifically, we assessed whether this was more of a function of the prior

reputation of each party and the common background factors or if it was more closely linked to

the actual experiences of each party during the interactions that occurred as the relationship

developed.

In the third iteration, we looked for evidence of increasing relationship complexity, that

is, how the complex and time-dependent relationships between all three parties developed. Our

focus was to understand how the EIR influenced the relationship between the VC and the fund-

seeking entrepreneur and how this affected the investment decision. Based on our understanding

of the transaction cost components typically introduced during the relationship to reduce

relationship risk, we specifically looked for evidence of specific types of costs and how the

presence of the EIR eliminated the need for these costs to be incurred. This led to our final

analysis, which focused on how the development of the trusted interpersonal relationships

between the three parties facilitated the actual VC investment decision, to provide sufficient

insights to answer our research question.

EIRs as catalysts for seed investments

The VCs noted the importance of EIRs in facilitating a positive investment decision by

acting as catalysts in the development of the relationship between the VC and the fund-seeking

entrepreneur and increasing the long-term performance of the venture. They noted that the

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presence of the EIR could prevent the occurrence of problems with invested companies and

increase the likelihood of positive investment outcomes for VCs, fund-seeking entrepreneurs and

the EIRs themselves. In addition, the EIRs ability to build trusted relationships with both fund-

seeking entrepreneur and VC reduce each component of the transaction cost, especially the need

for ongoing monitoring and enforcement costs. Practical insights can be derived from our

interviews to highlight the catalytic function of EIRs and consequently the characteristics VCs

looked for when recruiting an EIR.

EIRs could have prevented VCs’ past investment problems. VCs were keen to learn from

their previous mistakes and identified a number of problems in previous funded venture, as

shown in Table 4. VC’s believed the presence of an EIR inside these ventures would have

overcome many problems that prevented venture success. In most cases, these problems created

relationship risk that could have been prevented by building higher levels of trust, which

required building trust effectively through the involvement of an EIR. As one VC suggested,

“people need to have the experience of working together, know how they think, how they work…

[and] there is a very high value to that trust.”

------------- Insert Table 4 about here -------------

EIRs boost expected returns. VCs suggested that the primary benefit of including an EIR

in an investment decision was based on her/his ability to increase the expected value of the

funded venture, based on their knowledge and experience. Quoting one interviewee, “most

entrepreneurs do not have the experience… [that] EIRs are expected to have … to enter into the

market, build the right company [and] be successful outside of Israel.” While VCs were often

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recruited because of their specific experience and knowledge, softer characteristics like trust

were not as obvious recruitment criteria.

EIRs attract high-potential opportunities. VCs also noted that the EIRs were able to help

them attract high-potential opportunities, specifically ones that fit with the VC’s investment

preferences. This was primarily a function of the industry’s perception of the EIR as an

individual with a “high status” reputation, reinforced by their benevolent behaviors when

preparing the fund-seeking entrepreneur for their meetings with the VC.

EIRs nurture trusting relationships. VCs highlighted the development of a “referred-

trust” relationship whereby a trusted relationship between them and EIRs and between EIRs and

fund-seeking entrepreneurs created higher levels of trust between VCs and entrepreneurs. The

need to develop this three-way relationship strengthened the VCs’ position on the importance of

trust-building ability in recruiting EIRs. A VC noted that “you can talk to them [EIRs], you can

evaluate their personality, their vision, their ability to execute and take risk.” The EIR’s ability

to establish trusted relationships over time with partners was viewed as being key to the long-

term success of the venture. VCs acknowledged both aspects of a trust-based relationship:

goodwill trust and competence trust. They noted that competence trust was easier to assess, while

goodwill trust required time to develop. VCs understood that the EIR’s ability to develop a

trusted relationship with them before the investment gave the VC sufficient confidence to

overcome perceived relationship risk and hence invest. As one VC noted, “you trust … EIRs one

hundred percent, one thousand percent, day and night.”

VCs also identified how they determined goodwill and competence trust when selecting

and recruiting EIRs based on their prior record of performance. VCs acquired information from

third parties, either whom they knew or from the EIR’s reputation in a relatively small

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community. These third parties included VCs’ personal networks, investors in previous EIR

ventures or from ventures with whom the EIR had established relationships. VCs noted that

goodwill trust, seen as an alignment of intention between two parties (i.e., both parties had the

same goals) could only happen as the relationship evolved over time, although it was facilitated

by the shared incentive of equity participation. As articulated by a VC, “we are getting into this

process of working together, I like his [the EIR] ideas … his ideas fit my own way of doing

business and they are also good.” Given the difficulty associated with determining goodwill

trust, VCs were more inclined to start a relationship when there was a high level of competence

trust as opposed to goodwill trust. VCs also attempted to build trust with fund-seeking

entrepreneurs using similar trust-building practices. VCs viewed positively any evidence that

EIRs worked well within a controlled environment and required minimal monitoring to ensure

compliance, while the need to enforce monitoring policies was seen negatively. This initial

assessment then became the anchor point for the VC’s own perception of the EIR’s

trustworthiness, which was modified over time based on direct experience.

EIRs as transaction-cost reducers

Relationship risk is perceived to be very high in the early stage of ventures where

inexperienced entrepreneurs seeking funding have had limited time to build a reputation or

performance history. As catalysts for seed investments, EIRs were able to reduce the perceived

relationship risk and reduce the transaction costs associated with the introduction of risk-

reducing control mechanisms. The VC developed a trusted resource, the EIR, who could be

deployed when a seed-investment opportunity arose and the VC had insufficient time to build the

required level of trust with the fund-seeking entrepreneur. In further investigating the

mechanisms and actions that EIRs used when operating in Israeli VC firms, we found they

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reduced each of the transaction cost components identified as contributing to the equity gap. We

now discuss how the EIRs reduce each of the six components of the transaction cost.

EIRs reduce deal identification costs. Part of the EIR’s mandate was to engage with local

communities to identify potential investment opportunities and encourage fund-seeking

entrepreneurs to contact the VC with whom that EIR was associated. A combination of

entrepreneurs’ increased awareness of the VC and a more favorable view of the VC, brought

about by the EIR, increased the number of entrepreneurs applying for funding. The association of

an EIR with a VC thus encouraged more early-stage ventures to seek financing from that VC,

although we found that the actual number of ventures depended on the EIR’s reputation. The

presence of an EIR thus resulted in reducing the deal identification component of ex-ante costs.

EIRs reduce deal selection costs. EIRs engaged directly with fund-seeking entrepreneurs

to help raise their likelihood of receiving an investment by making them “investable”. This

action influenced the likelihood that the fund-seeking entrepreneur would be selected to move to

the next stage of interaction with the VC. During this process, the EIR (who had already

developed a strong relationship with the VC) started to build a personal relationship with the

fund-seeking entrepreneur. The development of this relationship was facilitated by the context of

their previous interactions, where they worked together to increase the likelihood of receiving

investment. This relationship facilitated the disclosure of “private” information, increasing the

efficiency of the interaction at an early stage when the greatest level of information asymmetry

existed. The presence of the EIR therefore increased the “investability” of the venture and the

efficiency of the interaction, which reduced the deal selection component of ex-ante costs.

EIRs reduce contracting costs. Contracting was characterized by discussions that

developed into a shareholder agreement as well as an agreement on the percentage of equity each

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party would receive from the new venture. The presence of the EIR allowed both parties to

rapidly conclude an agreement. As a VC noted, “the EIR helped us with domain expertise …

helped us in our deal flow. When we found a company he led the due diligence process .” When

the EIR proposed to join the funded venture and the fund-seeking entrepreneur agreed, the

negotiations were facilitated because the VC could expect the value of the funded venture to be

higher than without the EIR on board. The VC also would anticipate a reduced likelihood of

moral hazard from the now funded entrepreneur, thus reducing the need for as many monitoring

clauses to be incorporated in the shareholder agreement. In addition, the entrepreneur would

have more confidence that the VC would continue allocating sufficient resources to the venture.

The combination of these factors reduced the contracting component of negotiation costs.

EIRs reduce due diligence costs. Due diligence took place during the VC’s selection of

which fund-seeking entrepreneurs s/he would issue a term sheet. The existing relationship

between the EIR and fund-seeking entrepreneur diminished information asymmetry between the

parties. An additional benefit was the perceptions of the EIR providing a third party perspective

on the negotiation who would ostensibly not favor either party since the long-term incentives of

the EIR were also aligned with the fund-seeking entrepreneur. Further, the anticipated role of the

EIR in the venture and introduction of a compensation plan that aligned the objectives of each

party reduced the need for as thorough a due diligence as would be necessary if no EIR-

entrepreneur relationship existed. As an EIR noted, “the experience of being inside the VC firm

where they could more easily understand its mechanisms and goals was extremely helpful

in later due diligence and board dealings.” As a result, the due diligence component of

negotiation costs was reduced.

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EIRs reduce monitoring costs. The long-term engagement of the EIR in the venture

allowed for less complete shareholder contracts that could foresee every eventuality, which

reduced the overall level of monitoring required. The presence of the EIR in the venture further

reduced the effort required to implement the smaller number of monitoring clauses in the

contract. As a result, resources that might otherwise have been used for ex-post monitoring were

retained for business development. These factors combined to reduce the monitoring component

of ex-post costs.

EIRs reduce enforcement costs. VCs expected greater startup compliance due to the

relationships that the EIR had established with the fund-seeking entrepreneur and the VC. For

fund-seeking entrepreneurs, their established relationships with the EIR enabled them to better

understand and carry out the clauses of the shareholder agreement. Therefore, subsequent to the

decision to invest, the long-term involvement of the EIR in the funded venture led fewer

resources being diverted from business development to enforcement and, as a result, a reduction

in the enforcement component of ex-post costs.

Concluding remarks

Nearly 50% of the ventures using an EIR in our sample were successful in attracting

financing. One VC reported that in the four and a half years since his VC firm had started, they

had looked at close to 1,500 companies and invested in 24. For business ventures in which an

EIR was involved, this ratio improved to two out of five. Nevertheless, the impact of the EIR on

the rates of ICT seed investment in Israel should not be considered in isolation. Other factors can

account for Israel’s higher rates than other countries. The close-knit ICT community in Israel and

the Dan Valley creates a particularly high level of trust and an innovation culture that permeate

the community. This reduces the perception of relationship risk due to factors such as

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participants’ prior and (concern for) future reputations in the community, strong social networks,

and a homogenous cultural and religious background. Frequently mentioned was common

institutional background in the Israeli Defense Force. As noted by one VC, “where you were in

the army will influence my decision ... [I look for] ... someone who came from a certain

background … went through certain things and can do difficult things …” In addition, our

interviewees (VCs and EIRs) regarded governmental policies to support the commercialization

of research and early-stage venture financing that leverage equity investments as important

programs (because most are designed to reduce perceived risk and increase potential returns).

Syndication of investments was further regarded as a risk-reduction mechanism that was

common between VCs in the Dan Valley.

Furthermore, the special investment company created by the VC to fund the EIR is also

important in explaining the success of the EIR program. The investment company pays the EIR’s

salary out of the VC’s investment fund rather than the management expense ratio, with the

investment company folded into the funded seed venture once the deal is done. This funding

instrument allows VCs to overcome the constraint placed on them through the imposition of a

ceiling on the management expense ratio, which limits the amount of money a VC can spend on

management expenses as a percentage of the total investment portfolio.

Our research further highlights the importance of transaction costs in creating a barrier to

seed investing. We find evidence in the Israeli context that these costs can be reduced by the

development of trusted relationships. The introduction of an EIR facilitates the time-consuming

trust-building process over many months. In contrast, investment decisions typically occur far

more quickly, making trust development more challenging. The EIR builds a trust repository

with the VC and subsequently with the fund-seeking entrepreneur. These relationships built on

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trust facilitate the investment decision. Further, the manner in which EIRs reduce the various

components of the transaction cost provides specific insights that might allow some of the

mechanisms used by EIRs to be replicated in order to increase the overall rate of seed

investment.

Practitioners involved in investing in seed ventures will benefit from a better

understanding of the nature of the various transaction cost components they incur when they

introduce risk mitigation strategies (i.e., controls). This will encourage VCs to review the costs

and benefits of introducing such strategies and may cause them to modify their current risk

mitigation practices. Our research identifies how the development of relational contracts can

reduce the costs of controls. Investors might identify how they can engage trust catalysts to

enhance the number of opportunities in which they achieve the confidence to invest. Further, a

better understanding of why investors introduce controls to mitigate risk, and the associated costs

these incur, will encourage funders to relax pressure on management expense ratios, where high

levels are assumed to be due to VCs’ inefficiency rather than responsible risk mitigation.

Governments interested in increasing the number of seed ventures that can attract funding

will also benefit from a better understanding of the impacts of transaction costs. Based on our

insights, governments can now look at specific strategies to reduce these costs, in addition to the

traditional approach of subsidizing equity finance. While governments could encourage the

deployment of EIRs, they could reduce, for instance, identification costs by increasing

networking activities. Contracting costs could also be reduced by subsidizing qualified third

parties to facilitate investment decisions.

Our research should also be of interest to researchers attempting to explore relationship

development between organizations and encourage them to broaden their approach to consider

19

both stewardship theory (Arthurs and Busenitz, 2003) and the development of relational

contracts (Casadesus-Masanell, 2004) as an alternative to traditional agency theory (Eisenhardt,

1989). Researchers interested in exploring the behaviors of entrepreneurs, their ventures and

strategic relationships may benefit from examining the psychology literature on the development

of close personal relationships (Rempel et al., 1985) and specifically the characteristics of fund-

seeking entrepreneurs and VCs that enable them to build relational contracts.

We believe that the application of a transaction-cost model to the investment process

provides an opportunity for future research, especially when looking at optimizing transaction

costs across different stages of the investment process. Such an approach could build on

Shepherd et al.’s (2005) work that looks at the optimization of time utilization by VCs, who

spend a percentage of their time identifying new opportunities, negotiating investments and

managing current investments. As the costs incurred at each stage have a direct effect on

subsequent costs, considering the costs and benefits of incurring transaction costs at each stage

of the investment process (and the impact of those costs on the investment decision itself) could

be a fruitful research endeavor. Also, evaluating the true impact of EIRs on long-term venture

success, whether this was due to their ability to reduce transaction costs, ‘scout’ high potential

opportunities, or, as Baum and Silverman (2004) put it, ‘coach’ funded ventures to success,

could provide a promising line of research.

We therefore hope that our exploratory attempt stimulates much further research,

especially to address some of our limitations. We collected qualitative data on how EIR

internship programs function in Israel. As portrayed in Table 2, since 9 out of the 10 VCs

interviewed expressed their intent to continue funding EIR programs, exploring these programs

elsewhere may be valuable. The values and norms in Israel, especially the homogenous nature of

20

a small and well-connected community, might not be the same in other countries, thus practices

may be different and operate on culture-based factors that influence the role of EIRs.

Additionally, our conclusions have been limited by our small sample size. Enlarging the number

of participants to include fund-seeking entrepreneurs and angel investors could provide more

insights. We also undertook the research over a relatively short period, during which investments

had already been made. Expanding the time horizon might provide additional insights on the

investment decision process itself and on the longer-term impact of initial conditions on venture

success. We hope that others join us in the effort to comprehend the causes of the equity gap, to

understand how EIR programs help develop relational contracts that reduce transaction costs,

and, as a result, to increase the number of seed ventures that VCs can fund.

21

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24

Table 1. Transaction cost components and impact of an EIR

Investment Stage

Transaction cost component

Nature of activity Reference Likely impact of an EIR

Screening (before deal)

IdentificationAttract interesting opportunities (often through networks)

Fried and Hisrich (1994)

EIR’s reputation encourages entrepreneurs to approach VC

SelectionReview of business plan – decision to proceed

Harrison et al. (1997)

EIR’s knowledge/experience facilitates the selection process

Contracting (during deal)

Negotiation

Extensive information gathering and contract structuring

Rosman and O’Neill (1993)

EIR’s relationships reduces information asymmetry and likelihood of moral hazard

Diligence

Information verification and finalization of contract

Lawson et al. (1991)

Anticipated incentive alignment reduces the need to verify each piece of information

Controlling (after deal)

MonitoringOngoing investment of time as needed

Sapienza and Korsgaard (1995)

Relational contracts and alignment of incentives reduce the need for monitoring

EnforcementHands on control activities of entrepreneur

MacMillan et al. (1989)

EIR’s role in venture reduces the need for additional resources to control the entrepreneur

25

Table 2. Data on VCsIn

terv

iew

ee

Loc

al

Fun

d si

ze

Num

ber

of

seed

ven

ture

s (2

000/

4)

Num

ber

of

EIR

s

% o

f E

IRs

rece

ivin

g in

vest

men

t

Hig

h st

atus

ba

ckgr

ound

Pre

viou

sly

anen

trep

rene

ur

Thi

nks

EIR

s ar

e a

good

id

ea?

Wil

l sta

rt a

n E

IR p

rogr

am

in 2

006?

1 Yes Small 16 3 100 Technology management Yes Yes Yes2 No Small 13 1 100 Management Yes Yes Yes

3 No Medium 24 5 40 Technology management Yes Yes Yes

4 No Medium 20 0 0 Technology management Yes Yes Yes

5 Yes Small 9 0 0 Technology management Yes No No

6 Yes Small 9 0 0 Technology management Yes No Yes7 Yes Medium 18 8 50 Technology management Yes Yes Yes

8 No Large 32 2 50 Management No Yes Yes

9 No Large 40 10 80 Management Yes Yes Yes10 Yes Small 15 4 50 Management No Yes Yes

26

Table 3. Outline of structured survey questions

Factor discussed Details

VC firm characteristics

Structure, SizeHistory, IndustriesExitsSeed investments, Relationship with angel investors

Personal questions to interviewee

IDF experience: intelligence, computer, combatExperience: technological, managerial

EIR program

HistoryUnique featuresSuccessLessons learned

About EIRs

IDF experience, Other experienceKnowledge: technology, software, hardwareEducationMarket, IndustryManagement experience, Investor experience

EIR-based venture characteristics

Nature of relationship, Level of trust

27

Table 4. Reasons and explanations for venture failures

28

Reasons for failures Explanations by our interviewed VCs

Entrepreneurial team in-fighting and eventual inability to perform

VCs reported that this occurred because they did not make enough effort (during due diligence) to ensure the team was of similar backgrounds and/or had mutual interests. It is quite common for VCs today to change parts of the team as a condition for investment. Our VCs believed that common backgrounds helped to ensure more goodwill trust among team members.

Poor international marketing and sales

VCs noted that they look for repeat or experienced entrepreneurs with international marketing and sales experience, even if the first time around they were not successful. By including marketing/sales prowess as part of what constitutes competence trust, the risk of failure is reduced.

Entrepreneur’s inability to let go and start anew

VCs reported that the most important characteristic they look for in an entrepreneur is the ability to understand and trust product changes dictated by the board. VCs see goal congruence as fueling the goodwill trust that motivates EIRs to accept their decisions.