Venture capital and the principal agent relationship: Mitigating the occurring problems of hidden characteristics

Abstract

A newly founded company requires, besides an opportunity, good ideas and motivated entrepreneurs, capital. While existing companies can use the whole spectrum of different financing instruments, startups have always struggled to find an appropriate financing. 1 The high uncertainty of a newly founded company limits the willingness of potential investors to provide capital for the startup. The higher the uncertainty is, the lesser the willingness to invest is.2 Besides the uncertainty, the entrepreneur has very detailed visions, ideas and plans for the future development of his startup whereas the venture capital company doesn’t possess this information. This huge information asymmetry makes an investment even more difficult. To receive an investment, the asymmetric level of information has to be mitigated that the venture capital company can get a picture of the entrepreneur’s plans and estimations. Through past trial-and-error learning many venture capital companies developed a systematic approach to indentify startups that have a high potential.3 But why is the investment process as it is applied today? The agency theory describes the occurring problems of asymmetric distributed information and offers several solutions. This paper uses the agency theory to explain the underlying principles of venture capital investments and explains the central question why the investment process is as it is applied today. The underlying theory of the principal agent relationship is explained in chapter two. Chapter three applies the theoretic framework to venture capital investments and evaluates the common practices of venture capital companies to mitigate information asymmetries in order to make the right investment decisions.