The Role of Relationships and Informal Norms in Entrepreneurial Finance

Contracting parties in an on-going relationship often rely on informal norms to resolve disputes and reduce transaction costs.  Known as “relational contracting,” this concept is typically studied in the context of procurement contracts between manufacturers and suppliers,[1] but it also applies in finance.[2]  A pre-existing relationship between an external investor and an entrepreneur can reduce monitoring costs, limit opportunistic behavior, and lower the initial cost of capital.

Despite the benefits of a relational contract, investors seeking to fund startups may need to look beyond their existing networks to find an entrepreneur with an innovative business plan.  Consistent with this, only 7 percent of founders of startups backed by venture capital (VC) go on to found multiple VC-backed firms.[3]  And those who do rarely engage the same group of investors.  In other words, VCs often provide financing to founders with whom they have no prior relationship.

Given these facts, one might expect to see more arm’s length contracting that would protect VCs from opportunistic conduct by requiring, for example, higher levels of control or more blocking rights.  I find no evidence, however, suggesting that VC financing agreements are tailored in this way.  The core problem is that, in today’s VC market, there is little variation in many governance terms.  And where variation does occur, it appears to be driven by considerations like geography (east vs. west coast),[4] identity of the startup’s law firm, and the year in which the financing occurs.  Indeed, a recent study finds no significant difference between the governance terms included in VC financing agreements with a serial founder and terms in agreements with a first time founder.[5]

By contrast, in a new project, I argue that the tension between the search for innovation and reliance on existing relationships is resolved not through arms-length contracting, but rather by bolstering the network position of the unconnected entrepreneur through third-party intermediaries like lawyers , board members, managers, scientists, and other entrepreneurs—to bring the entrepreneur into the VC’s network and by financing the startup in stages.  Put differently, the extent to which an entrepreneur is embedded into a VC’s network can be manipulated, making the entrepreneur’s position in a VC’s network a product of the bargaining between the parties. This insight represents the theory of “relational bolstering” and predicts that the various strategies used to accomplish relational bolstering will be used more often when bargaining with a previously unconnected entrepreneur.

Third-party intermediaries can transform the relationship between an entrepreneur and investor in various way.  First, even if an entrepreneur does not know any angel or VC investors, she may know (or be able to easily meet) a lawyer or another entrepreneur who does.  That person could play the role of matchmaker.  Second, beyond the introduction, an entrepreneur and VC investor could add a shared contact to their firm’s management team.  I refer to such individuals as chaperones, because they are in a position to monitor the primary parties.  A chaperone’s relational ties are effectively borrowed by the primary parties to a contract.  Third, a startup’s board of directors can be structured so that neither the entrepreneur nor the VCs control the board.  Instead, a third-party—ideally a mutual connection known to both the entrepreneur and investor—holds the tie-breaking vote and can serve as an informal arbitrator when the primary parties disagree.[6]

VC investments are typically staged over multiple rounds of financing.  Under the conventional interpretation, staged financing protects VCs against asymmetric information.  Relational bolstering suggests an alternative reason for staged financing.  Even absent asymmetric information, staging may still be desirable, as it transforms the previously unconnected entrepreneur into a repeat player.  The entrepreneur expects to have to raise future rounds of financing from the same group of VCs, making reputation and relational modes of governance more relevant.  A party that behaves opportunistically between rounds can be punished in following rounds.

The mechanisms of relational bolstering potentially allow entrepreneurs and investors to commit to informal business norms, even though the parties lack a prior relationship.  My project extends the literature in relational contracting and in entrepreneurial finance.

ENDNOTES

[1] Stewart Macaulay, Non-Contractual Relations in Business: A Preliminary Study, 28 Am. Soc. Rev. 55 (1963); Lisa Bernstein, Beyond Relational Contracts: Social Capital and Network Governance in Procurement Contracts. 7 Journal of Legal Analysis 561 (2015).

[2] Mitchell Petersen & Raghuram Rajan, The Benefits of Lending Relationships: Evidence from Small Business Data. 49 Journal of Finance 3 (1994).

[3] Ola Bengtsson, Relational Venture Capital Financing of Serial Founders, 22 Journal of Financial Intermediation 308 (2013).

[4] John Coates, Explaining Variation in Takeover Defenses: Blame the Lawyers, 89 Cal. L. Rev. 1301 (2001); Ola Bengtsson and S. Abraham Ravid, Location Specific Styles and US Venture Capital Contracting, 5 Quarterly Journal of Finance 1550012 (2015).

[5] Ola Bengtsson, Covenants in Venture Capital Contracts, 57 Management Science 1926 (2011).

[6] Brian Broughman, Independent Directors and Board Control in Venture Finance, 9 Review of Law & Economics 41 (2013).

This post comes to use from Professor Brian J. Broughman at Indiana University, Maurer School of Law. It is based on his recent paper, “Relational Contracting and Business Norms in Entrepreneurial Finance,” available here.

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