UNIT 8 : THE ROLES OF STAGING AND VC MONITORING IN

RESOLVING PRINCIPAL-AGENT CONFLICTS

Structure
8.0 Learning Objectives:
8.1 Introduction:
8.2 Negotiation between entrepreneur and a venture capitalists
8.2.1 Venture capital firms view point
8.2.1.1 Crucial tasks of venture capitalist:
8.2.2 Entrepreneurs Viewpoint
8.3 Differences of concern between the entrepreneurs and venture capital firms
8.4 Principal-agent conflicts between entrepreneurs and venture capital firms
8.5 The roles of staging and VC monitoring in resolving principal agent conflicts
8.6 The optimality of having both insider and outsider investors resolving the principal
agent conflicts
8.7 Venture capital stage preferences
8.8 Case study
8.9 NOTES
8.9 Summary
8.10 Key words
8.11 Self assessment questions
8.12 References

8.0 Learning Objectives:

1. To learn about the involvement and interest of venture capital firm in firms management
2. To describe about entrepreneurial interest in his venture
3. To discuss about principal agent conflict between entrepreneur and venture capital firms
4. To explain the roles of staging and VC monitoring in resolving principal agent conflict
5. To discuss about optimal monitoring and reduce agency cost.
8.1 Introduction:
The risk involved in the venture capital financing is too high, as they prefer high tech based,
innovative ventures, the chances of failure of such ventures are high . Venture capitalist are
aware that many of the ventures they support will fail. However, venture capital can earn a
good profit overall from the big payoffs from the small proportion of venture they support.
Managing venture investments requires continuous monitoring and staged financing to the
reduce the level of risk. Entrepreneurs are concerned about the ownership dilution and their
interest and incentive from the business.

8.2 Negotiation between entrepreneur and a venture capitalists

8.2.1 Venture capital firms view point
The circumstances of venture investment is critical with high risk. In this situation venture
management must give high prominence in the following activities:
i.
ii.

Screen out ventures which are having poor prospects

Continuously assess and work with the selected portfolio investment companies

iii.

management to maximize their probability of success

Secure a sufficient share of successful ventures profits for the venture capital to
offset losses on the failures.

8.2.1.1 Crucial tasks of venture capitalist:

Venture capitalists most crucial task is select only those ventures which has true for success.
This is not easy task, the success and failure of the entire business depends on the right
selection of high potential ventures. To select the right true potential ventures the
requirement for the venture capitalist are the extraordinary knowledge of the industry in
which a venture expects to do business and must have a visions future. This is empirical
evident from the profile of any venture capital firm, as they state their selected industry
preferences for their prospective investment venture. The venture capitalist must be able to
recognize that the venture has an idea that at least has the potential to flourish as a major firm
in the industry.
The selection criteria of prospective investment also includes entrepreneurs ability. The
venture capital firm must be able to judge the ventures entrepreneur to address the following
important aspects of entrepreneurial potential such as
i.
ii.
iii.
iv.

Entrepreneurs in depth knowledge, talent and perseverance

Entrepreneur has a Organized Presentation and Feasibility of a business plan
Entrepreneur has committed personal funds and motivated to succeed
Entrepreneur readiness to accept the venture capitalist advice on their business

v.

development
Entrepreneur fairness in terms of negotiation

A venture capital form of financing is a equity or equity linked financing. Venture capital
firms also prefer convertible preferred stock , to have priority claim on assets in case venture
failure, while the conversion option allows venture capital firm to participate as share holder
if the venture succeeds.
After the evaluation of the proposed investments and such investments being made, the
actual task begins,

it needs the efficient management of funds invested. This requires

critical eye, top know when to mitigate losses and fold the failing ventures, rather than
continuing investment in the failing venture.

8.2.2 Entrepreneurs Viewpoint

Entrepreneurs has to face essentially experience three major problems in negotiating with a
venture capital at various stages
i.

Dilution of the ownership: the most difficult problem for an entrepreneur is the
trade off between obtaining adequate finance and accepting the substantial
ownership dilution.

ii.

Protective clause of venture capital firm: A venture capital firm also tries to
protect its interest in the investment through the securities purchased like
convertible preferred stock, which gives venture capital firm to have prior calim
over the entrepreneur.

iii.

Monitoring by the venture capital firm: entrepreneurs are often frustrated by

the discipline that a venture capital firm impose on them, periodic demands for
information as a part of monitoring effort and influence that venture capital firm
wishes to exert on the development of the business. These factor could create in
many entrepreneurs about the loss of control over the venture

8.3 Differences of concern between the entrepreneurs and venture capital firms
Venture capital firm is anxious about getting a fair return for the risk borne. Entrepreneurs
are concerned about the ownership dilution.
Illustration of negotiation problem
Suppose a entrepreneur opts for venture capital form financing and approaches a venture
capital firm for the next stage of development. Two alternatives levels of financing are to be
considered for this stage : 5crores or 10 crores. The post financing value of the firm depends

not only in the amount of capital that the Venture capital firm provides, but also the on the
percentage of holding retained by the Venture capital firm in exchange of the capital
provided.
It is assumed that the for any given level of funding, value of the firm is a decreasing
function of the ownership percentage. That means the value of firm reduces along with
increase in the venture capital ownership percentage, this is because of the assumption
reflects the adverse effect of dilution of incentives.
Let us assume for given example at the Rs. 10 crores funding level , the firm value starts at
Rs. 30 crores if the venture capital ownership percentage is zero but decreases to Rs. 13.58
crores with the venture capital ownership percentage of 92 %.
So there will be rational negotiating range in holding a percentage stake in any potential
investment will protect the interest of the both the parties and increase the value of the firm.
8.4 Principal-agent conflicts between entrepreneurs and venture capital firms
There are many conflicting areas between entrepreneurs and venture capital firm, the interest
of both the parties differ. Principal agent conflict often loom large in venture financing. Here,
venture investors are principal and the entrepreneurs are agents.
If the entrepreneurs possess the complete control of development of ventures, they may take
decisions that are in their personal interest rather than in the interest of outside investors.
Example of entrepreneurs decision for their personal interest includes the following:
i.

The entrepreneur may be interested to invest even in unprofitable venture reasons

might be because of intrinsic passion towards the venture, or the venture will give
him personal gratification in the form of recognition from public, scientific
community or others.

ii.

Entrepreneur is likely to have invested a large fraction of his or her personal

wealth in the ventures, thus he might not be interested in taking high risk for the
rational development of the project. However, may choose the low risk, low value

path rather than high risk, high value path to development. Whereas outside
investors usually tend to be wealthy and have diversified portfolios, they are ready
to take high risk, high value path to development.
iii.

The entrepreneur may possess strong personal incentives even though they know
that the venture is in line of losing. They may have irrational psychological
fixation to make the project successful, or might be simply happy to continued to
be paid for the development of venture whose prospects have diminished.
However the outside investors obviously prefer to terminate a losing venture.

8.5 The roles of staging and VC monitoring in resolving principal agent conflicts
Gompers (1995) provided a theoretical model of the entrepreneurs financial
contracting problem from the perspective of principal- agent conflicts.
i.

The optimal balance between costs of monitoring and agency costs:

In his model, he felt that monitoring is costly. Monitoring also involves time and resources
on the both the investors and the entrepreneurs side to prepare and review the pertinent
information. The main mechanism would be the presence of an inside investor, representative
of the investment in the board of management of the investee firm to mitigate the agency
costs.
The optimal balance has to be struck between the costs of monitoring, which increases with
the frequency and intensity of monitoring and the agency cost which decrease with the
frequency and intensity of monitoring.
ii.

Monitoring opportunity at the end of each stage:

Gompers suggested that the end of each development stage of business provides the
monitoring opportunity. However, the optimal monitoring frequency, or equivalently the
number of stages in the venture development depends on various factors which are often
related to the agency costs.

Expected agency costs increases as

(a) When the venture has more of intangible assets
(b) There is a increase in the growth options
(c) There is a state where asset specificity arises. Asset specificity refers to the extent to
which the firms developed real assets are valuable only if the venture succeeds.
VCs typically have a monthly review a ventures management to assess whether the
management decision is in line with the business plan and investors interests. They also
provide strategic advice for the development of the venture.
iii.

Due Diligence Report at the end of each stage:

The investee companys Management has to carefully prepare and provide due diligence
report at the end of each stage of development as the additional finance relies on the outcome
of the report.
iv.

Quantum of amount required and effective staging:

To make the staging effective , the amount of finance provided at beginning of each stage
should be sufficient just to allow the firm to reach the next stage of development. Whereas,
the amount required and provided depends on the rate at which the venture consumes cash,
called as the burn rate.
v.

Fume date and development milestone(staging):

The date on which the firms cash resources are exhausted is known as fume date. Venture
capital firms planning the fume date to coincide with the development milestone ensures
that the next due diligence report will be generated at the appropriate timing. And also by
rightly sizing the allocation of capital carefully, venture capital firm can enforce the
entrepreneur to utilize the cash carefully.
8.6 The optimality of having both
principal agent conflicts

insider

and

outsider investors resolving the

Admati and Pfleiderer (1994) in his theoretical paper focuses on i. role of venture capital
firms and ii. the staging of a ventures development in resolving information asymmetry and
principle agent problems in venture financing.
i.

Venture capitalists as a insider and capital contributor to assess the private

information and monitor.

They explain the role of venture capital as both an insider and capital contributor. Venture
capitalists as a insider can be aware of private information that the entrepreneur possess
about the value of the firm and also works

with the firms management by having a

representative and frequently monitors management decisions.

ii.

Contributions only from an outsider: the over investment problem

When the entrepreneur attempts to contract for funding from only outsider, who does not
have access to know the private information about the value of firm, the associated problems
is explained by Admati and Pfleiderer. The problems arises because of outsiders provide only
finance for the development of the next stage, but the entrepreneur will be the decider for
continuation or termination of the business.
Entrepreneur will have clear incentive to continue the venture even the venture is worth to
terminate. This incentive is likely to be strong because of the following reasons
a)
b)

Entrepreneurial remuneration would be lost if the venture is terminated

Entrepreneur adds valuable option on the future value of the firm at no costs.
Though it is out of money but it may bring positive value if the venture continues

c)

which would be worthless if the venture is terminated.

Entrepreneur would have deep psychological attachment towards the venture as it
is his creation that would restrict his rational decision towards the development of
the business.

iii.

Contributions only from an insider : the under investment problem

Admati and Pfleiderer consider a arrangement in which the entrepreneur bonds with an
insider venture capital, who provides capital in the expectation of return as a fractional
claim on the ventures futures payoffs( a percentage of the firms equity share). However
this scenario would lead to underinvestment problem (Myers, 1977), rational venture
capital firm would be inclined to underinvest.
iv.

Resolution: Have both an insider and outsider

The authors considers the third scenario or arrangement which is typically in practice. In
this scenario, each stage funding is received from both insider and outsiders, each
receiving a fractional claim to the ventures future payoff .while entrepreneur will retain
the remaining fraction.
Having both insiders and outsiders funding, the overinvestment and underinvestment
problem could be balanced out. Thus , a rational decision for continuation or termination
decision would be made at each stage of development.

8.7 Venture capital stage preferences

Venture capital firms differ in terms funding preference at different stage of development of
the business. Venture capital firms has its own preference to enter into investing in particular
stage of business assist the business.
Some Venture capital firms prefer investing at the early stages, perhaps even at the seed or
startup stage. By doing so they can exert more control and influence over the venture
development. Whereas others prefer to invest in later stages like early development,
expansion stages. The rationale behind is that the number of ventures that a venture s
management can dedicate its attention to is limited, so they can focus on ventures that have
already been proven successful.
8.8 Case study

SVB India Finance Private Limited was started in 2008, SVB India Finance Private Limited
is a subsidiary of Silicon Valley Bank. It is positioned as India's first and only specialty
lending business, providing venture debt targeting high growth entrepreneurial companies in
India backed by top-tier venture capital and private equity investors. SVB have done over 60
transactions across sectors in India ranging from technology, ecommerce, healthcare to QSR,
education etc. they offer multiple sources of diverse debt capital including venture debt,
acquisition financing, growth capital and capex financing. Preferred Sectors: Sectoragnostic. Investment Range: Rs.3 Cr to Rs.25 Cr. Select Transactions: Applied Solar
Technologies, Capillary Technologies, Faasos Food

Services, Indiahomes, iYogi

Technologies, Manthan Software Systems, Myntra, Prizm Payments, Snapdeal, Yatra.com.

They look for early to growth stage high potential companies that have raised equity
investment from top tier institutional Venture Capital or Private Equity investors. Companies
that have strong management teams and robust investor support in addition to significant IP
or display of innovation form our target addressable market.
Questions:
1. Describe about the strategy of SVBs financing venture debt to the venture backed
firms.
2. Connect the case with insider and outsider financing of a project.
3. What are the benefits that the SVB would receive from financing the venture backed
companies?

8.9 NOTES

8.9 Summary
The risk involved in the venture capital financing is too high, as they prefer high tech based,
innovative ventures, the chances of failure of such ventures are high . venture capitalist are
aware that many of the ventures they support will fail. However, venture capital can earn a
good profit overall from the big payoffs from the small proportion of venture they support.
Managing venture investments requires continuous monitoring and staged financing to the

reduce the level of risk. . Entrepreneurs are concerned about the ownership dilution and their
interest and incentive from the business . there are arises difference in interests, areas of
conflict. Venture capitalists most crucial task is select only those ventures which has true for
success. This is not easy task, the success and failure of the entire business depends on the
right selection of high potential ventures. Venture capital firm is anxious about getting a fair
return for the risk borne. Entrepreneurs are concerned about the ownership dilution. The
entrepreneur may be interested to invest even in unprofitable venture, he might not be
interested in taking high risk for the rational development of the project, may possess strong
personal incentives. The staging and VC monitoring in resolving principal agent conflicts
plays a very crucial role through the optimal balance between costs of monitoring and agency
costs, creating monitoring opportunity at the end of each stage, Due Diligence Report at the
end of each stage, matching the Quantum of amount required

and effective staging,

coinciding the Fume date and development milestone, the optimality of having both insider
and outsider investors resolving the principal agent conflicts and bring benefits to both the
parties.

8.10 Key words

Principal agent conflict
Fume date
Burning rate
Staging
Monitoring
Interest
Dilution of ownership
Agency cost
Optimal balancing
Insider
Outsider in financing

8.11 Self assessment questions

1.
2.
3.
4.

Describe the role of venture capital firms in the development of the business.
Explain the problems associated in entrepreneur and venture capital negotiation.
What are major concerns of entrepreneur towards the venture capital?
Why does the principal agent conflict arises between entrepreneur and venture capital

firms.
5. Describe the roles of staging and venture capital monitoring in reducing principal
agent conflict.
6. How can venture capital firm attain optimal monitoring by reducing agency costs
associated?

8.12 References
Joseph P. Ogden, Frank C. Jen, Philip F. OConnor, Advance Corporate Finance, Policies and
Strategies, 2003 edition, published by Pearson Education Pte Ltd, Indian branch.
Handbook on venture capital, published by Venture Intelligence, retrieved from google.