New and young businesses often depend on equity finance from venture capitalists. This does not, however, mean that they’re indiscriminate in their choice of venture capitalist fund. Recent research suggests that, in certain circumstances at least, entrepreneurs will spurn offers from equity investors who have a poor reputation for ethical behaviour.
Entrepreneurs sometimes have several offers from venture capitalists ‘on the table’ and will often spend a significant amount of time evaluating potential financiers, but the factors that influence their ‘willingness to partner’ are under-researched. The majority of studies concentrate on the things that might make a new venture a ‘good bet’ for the investor; only a few consider the perspective of the entrepreneur.
New research, from Will Drover of the University of Oklahoma and Babson College, Matthew Wood of Baylor University and Vlerick Business School’s Yves Fassin, helps redress the balance. An empirical study, it contributes to a nascent stream of research on the selection process of entrepreneurs by looking at the influence of a specific criterion: ethical reputation.
Drover, Wood and Fassin argue that the dynamics of the investor-investee relationship make the ethical dimension particularly important to entrepreneurs. At a ‘power advantage’ in a partnership with a small business, the venture capitalist might proceed to act ‘opportunistically’ or in ways that further their own interests more than those of the entrepreneur.
The researchers ‘conceptualize’ VCs as agents who assume (to a greater or lesser extent) a degree of control over a business — and ethical reputation as a predictor of possible future ‘agency costs’.
Their model is tested in two studies of entrepreneurs and the factors that underlie their funding decisions. In the first, a conjoint experiment (where participants rate or rank options and make trade-offs), entrepreneurs were given explicit information about the previous behaviour of potential backers. In the second, a scenario experiment used partly as a control, they were left to make up their own minds about investors’ ‘ethical form’.
The results strongly support the researchers’ central hypotheses, providing “robust evidence that entrepreneurs greatly prefer to partner with VCs who are perceived to have behaved ethically in the past”.
More than this, they suggest a ‘pecking order’, in which ethical reputation comes first. Two factors shown to influence entrepreneurs’ willingness to partner in earlier research — ‘value-added services’ and investment track record — are found to be largely “contingent upon and often subjugated by investors’ ethical reputation”.
Prior behaviour, in other words, can be the decisive factor, capable of making an investor more or less attractive. The value of ‘extras’ such as strategic advice and access to the VC’s networks can decline where ethical reputation is poor; so, too, can the value of a proven VC track record.
So will an entrepreneur always run away from an unethical VC? It’s not as simple as that. The second study also suggests that:
The first finding is unsurprising: if the choice is between bankruptcy and rescue by a less-than-ethical VC, common sense suggests young businesses will opt for the latter. The second, on the other hand, seems counter-intuitive. This could possibly be explained as a reluctance to take the risk of partnering with an investor of questionable ethics — and of incurring greater ‘agency costs’.
The two studies demonstrate that entrepreneurs are sensitive to the ethical reputation of investors — and that the degree of this sensitivity varies with ‘individual-level’ and ‘contextual’ factors. They also help bridge the gap between two long-established research themes: the new-venture financing process; the role of ethics in organizations.
There are practical implications of this research for both investors and entrepreneurs.
The findings suggest that ‘sins of the past’ might come back to haunt VCs and weaken their ability to partner with high-quality entrepreneurs. (At a time when online communities such as TheFunded.com are naming and shaming ‘ethically challenged’ VCs and making the behaviour of investors more transparent, these are serious risks.)
VCs, therefore, need to try to protect their reputations by acting in ways entrepreneurs perceive as ethical and making it known that they follow the codes of ethics of their professional associations.
Entrepreneurs, meanwhile, should continue to do their research on potential investors and assess them carefully. They should also be aware of the factors that lower resistance to offers from unethical VCs — and try to ensure they weigh the short-term gains of cash injections against longer term ‘agency costs’.
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