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Chapter 3, Literature review and Hypotheses development:
The general difference in investment volume between BAs and VCs is more or less known, even though it may vary from venture to venture. The value creation by both investors beyond mere financial capital is complex and consists of different components. The following section assesses academic literature produced so far with regard to each investor’s unique approach of creating value for a new venture. Additionally, significant complementarities resulting from collaborative investment are outlined. For each tendency in the literature, two hypotheses focusing on the high- and the low-technology sector are developed.
3.1, Value creation of business angels:
One very important factor of entrepreneur’s financing decision is the value provided by each type of financing since both supply more than solely financial capital (Kaplan & Stromberg, 2001; Prowse 1998; Gorman & Sahlman, 1989). BAs create value by mentoring, strategic advice, networking and sometimes a functional capacity in the start-up. Contributions to the venture such as serving as a sounding board (Harrison & Mason, 1992), interfacing with the investor group, monitoring financial performance and formulating business strategy (Ehrlich et al., 1994), use of BA’s personal network, coaching and provision of financial know-how (Brettel, 2003), enhancement of management skills and help with additional fund raising (Paul, Whittam & Johnston, 2003), were perceived as the most valuable non-financial contributions by BAs. As BAs typically invest in markets and industries they formerly worked in, entrepreneurs can benefit from the expertise, knowledge and experience BAs gained over years. Many entrepreneurs even confirm that the hands-on involvement of BAs discussed before adds more value to the venture than the actual capital and enhances the prospects for venture success (Mason, 2011).
The participation of a BA can also serve as a steppingstone. Madill, Haines Jr. and Riding (2005) ascertain that 57% of the ventures in their sample which had received initial angel investment also obtained later VC financing, whereas only 10% of ventures without angel financing received later VC financing. Thus, it can be assumed that BA investment helps ventures to become ‘more ready’, thereby enhancing venture’s growth potential and the likelihood of a successful venture exit. It is reasonable that the hands-on involvement in form of network opportunities, assistance in legal advice, accountancy advice and the provision of resources as well as business and marketing intelligence creates substantial value. BAs are heterogeneous individuals who are actively involved in the venture and thereby provide individual combinations of contacts, guidance, and governance, as reported by all 33 companies in the sample. Although it needs to be stated that angel financing is not a necessary requirement for later stage VC financing, BAs have an accrediting role as they provide trust and credibility for recently founded and mostly unknown start-ups. The fact that BAs invest their own capital and are not obliged to manage an investment fund raised by other people’s money can work as an advantage for the entrepreneur. In many cases, BAs tend to overinvest with the result of earning zero profit but higher stakes in the firm. So on the one hand, they gain more control rights and the entrepreneur loses control to certain extent. But on the other, they are also forced to exert effort the more money they invest and consequently have a stronger incentive to contribute valuable input to the venture (Leshchinskii, 2002). The BA becomes more and more part of the venture and is consequently also interested in its success.
Goldfarb et al. (2009) also find a positive relationship between angel participation and the probability of a successful venture exit. Specifically, angel-only financed deals have a 33% to 36% higher chance to survive compared to other deals assessed in the sample. Concluding, there is extensive evidence for value creation beyond mere financial capital by BAs in new ventures, either in form of active hands-on involvement or due to the characteristics of the relationship between BA and entrepreneur itself. From the literature produced so far, it is impossible to determine on which technology sector BAs have a more significant impact on value creation. Nevertheless, it can be assumed that BAs are less beneficial for ventures in the high-technology sector, as those require structured advising and specialist knowledge skills (Lockett et al., 2002). It follows that.
H1a: The financing by a BA has a positive impact on value creation and thus enhances the prospects of success for a venture in the High-Technology sector.
H1b: The financing by a BA has a positive impact on value creation and thus enhances the prospects of success for a venture in the Low-Technology sector.
Contrary to the findings discussed before, several studies attribute limited value creation potential to BAs. Chemmanur and Chen (2006) state that BAs fail to add significant economic value to the venture. BAs tend to invest in ventures in less technologically sophisticated and knowledge intensive areas, leaving less potential for value creation to them. Consequently, entrepreneurs who have broad technological knowledge themselves tend to have self-financing or angel-financing as financier’s incremental value added may be limited. Based on their model, the authors come to further highly interesting conclusions regarding the financing path of ventures. Ventures which can initially attract and maintain VC financing over several financing rounds have the highest chance of going public or being acquired, thus have the highest quality. Ventures that are financed by BAs in their early stages and later switch to VCs will less likely have a successful exit, hence are of lower quality. Finally, ventures which start with VC financing and later switch to BAs or obtain BA financing only through all financing stages have the least chances of going public or be successfully acquired and indicate the lowest quality.
Fairchild (2011) uses a behavioral game-theoretic approach and also underscores the lack of value creation potential of BAs. He emphasizes that besides economic factors, behavioral aspects also influence entrepreneur’s financing choice. Whereas VCs provide higher-value adding capabilities in economical terms, entrepreneurs often benefit from an empathetic and trusting relationship with a BA. This promotes mutual trust and thereby mitigates double-sided moral-hazard problems. The findings of Fairchild (2011) are supported by Freear et al. (1994), who also emphasize the more interpersonal relationships with BAs, providing the benefits of a productive and trustful atmosphere. Still, it is uncertain if the benefits of a trustful relationship lead to economic growth, thus.
H2a: The financing by a BA has no impact on value creation and thus does not enhance the prospects of success for a venture in the High-Technology sector.
H2b: The financing by a VC has no impact on value creation and thus does not enhance the prospects of success for a venture in the Low-Technology sector.