Contracts Between Entrepreneurs and Investors: Terms and Negotiation Processes

Hans Landström, Halmstad University
Sophie Manigart, University of Ghent
Colin M. Mason, University of Southampton
Harry J. Sapienza, London Business School and University of South Carolina


Theory of Contracts
Development of Propositions
Table 1


The written contract and the negotiation process in the venture capitalist-entrepreneur relation are discussed using two theoretical perspectives: agency and social exchange theories. This exploratory study is based on 16 semi-structured interviews with venture capitalists and entrepreneurs in four countries (Belgium, Sweden, UK, USA). We propose that both formal and informal investor-entrepreneur investment agreements are important in shaping investment relationships. The nature and elaborateness of written contracts and the willingness of both parties to negotiate on key points is influenced by prior experience of contractors, number of investors involved, involvement preferences of both VCs and entrepreneurs and venture stage.


The role of venture capital as an important factor for business development has since the 1970s attracted a great deal of attention, not only in the USA but also worldwide. A well developed venture capital market has been seen as an important driving force behind a dynamic business sector. In different studies (e.g., Ooghe et al., 1991; Sapienza et al., 1992) the growing venture capital market in different countries has been described and analyzed. The results show inter alia that, for many entrepreneurial ventures, venture capitalists appear to be an important “external” resource, and an ongoing cooperative relationship between the venture capitalist and the entrepreneur is important for the performance of the ventures (Sapienza & Korsgaard, 1996).

The prerequisite for venture capital companies to provide “value added” to the businesses in which they invest is however dependent on having a good working relationship between the parties characterized by open and frequent communication, i.e. some degree of mutual cooperation between the venture capitalist and entrepreneur appears a necessary condition for the successful post-investment performance of the entrepreneurial venture. In this respect, the initial contract and the negotiation process may be of central importance as a basis for a successful cooperation, and anecdotal evidence also indicates that much time is spent on the negotiation and contract writing.

Research indicates, however, that cooperation between entrepreneur and venture capitalist is far from ubiquitous (Sahlman, 1990). Despite extensive negotiations and elaborate contracts, relationships often encounter destructive problems. Studies (e.g., Fredriksen et al., 1997) have shown that tensions and conflicts often arise in the relationship between the entrepreneur and venture capitalist. For example, entrepreneurs may regard information manipulation as an attractive strategy, entrepreneurs and venture capitalists may have different views about the best use of resources, and venture capitalists may be tempted to underinvest in their ventures and to defect in terms of the time that they invest in specific ventures (Gorman & Sahlman, 1989; Sahlman, 1990; Admati & Pfleiderer, 1994). Furthermore, earlier research (see e.g., Macaulay, 1963; Macneil, 1980) indicates that actors do not use the contract in situations of contract violations or for problem solving. Instead, they rely on the other party’s word or a “handshake,” i.e. they rely more on the relationship than on the terms in the formal contract.

Against this background, the main question in this research project is: “What is the use of the contract and contract negotiation process in the venture capital context? We explore this question here in terms of two issues: (i) What is the nature of the contract and how willing are the parties to negotiate on key points?, and (ii) How is the contract used in the subsequent relationship between investors and entrepreneurs?

Contracts may take many forms, encompassing both formal written arrangements as well as undocumented exchanges. Not all conditions in the relationship are negotiated and explained in a formal amendment. In many cases the contracts between parties are less formal, based on both parties’ understanding of the relationship. In this paper we explore the potential of both formal and informal contracts for regulating exchanges.

Existing knowledge regarding the contract and negotiation process in the venture capital context is rather limited. Therefore, this research is aimed at contributing to our understanding of how the cooperation between venture capitalists and entrepreneurs emerges. Using agency theory and social exchange theory as our framework, our objective is to build theory by developing propositions concerning the formation of the venture capitalist – entrepreneur contract.

Theory of Contracts

The venture capital investment process can be divided into five stages (Tyebjee & Bruno, 1984): (i) deal origination, (ii) screening, (iii) evaluation, (iv) structuring, and (v) post-investment activities. While much is known about how investors select investments and the nature of the post-investment relationship (e.g., Sapienza, 1989; Fiet, 1996; Fredriksen, 1997), little is known about how the investment contract is negotiated (Steiner & Greenwood, 1995).

The literature regarding these contractual arrangements is mainly limited to the question of what characterizes the contract between venture capitalists and entrepreneurs. A great deal of normative literature describing standard operating procedures in industry is available (e.g., Bartlett, 1988; Gladstone, 1988; Lorenz, 1989), and the research on the subject has mainly been rather descriptive (e.g., Sahlman, 1990). In addition, Jog et al. (1991) conducted a study in which venture capitalists estimated the importance of different terms in the contract. The results show that the venture capitalists assessed almost all contractual terms as equally important. One conclusion from the study is that there seems to exist a high degree of standardization in the contractual terms, and that the contract may be regarded as a conflict solver in situations where there exist information and risk asymmetries. A study in Sweden (Landström, 1990b) showed that similar contracts were used across venture capital-entrepreneur relationships, i.e., some terms were used in most of the contracts (e.g., terms regarding board of directors, principles for changes in the ownership structure) whereas other terms were seldom used. A factor analysis identified a number of dimensions in the contracts: (i) terms focusing on the management of the venture, (ii) terms directed towards “exit,” (iii) terms regarding changes in ownership and management, and (iv) terms focusing on the monitoring of the venture.

Earlier research has also focused on why venture capitalists and entrepreneurs cooperate, i.e. factors influencing the intention to cooperate. Cable and Shane (1997) argued persuasively that entrepreneurs and investors have significant incentives to cooperate with one another rather than “defecting” or behaving opportunistically during their partnership. Through knowledge specificity of venture capitalist and entrepreneur, i.e. they specialize in the development and contribution of different types of knowledge, each party can exploit its comparative advantage. Also, entrepreneur and venture capitalist communities are small in many countries and lack an efficient replacement market for either party; this reinforces the dependence between the parties.

Using a “prisoner’s dilemma paradigm,” Cable and Shane (1997) discuss factors that promote venture capitalist-entrepreneur cooperation, such as (i) time pressure: the greater the time pressure to reach an agreement, the more likely parties are to reach a cooperative solution; (ii) payoff from cooperation: increased payoffs from cooperation enhance the probability of cooperation; (iii) information: easily gathered information about the other party’s cooperative strategy enhances cooperation; (iv) personal similarity: individuals are attracted to others who are seen as similar to themselves, and (v) transaction procedures: procedures such as generous behavior, penalty for defection, etc., can be implemented to increase the probability of a cooperative solution. These views suggest that the quality of relationships and information transfer may be enhanced if relational and transactional components are part of the exchange.

Earlier research thus indicates that investors and entrepreneurs have incentives to cooperate and identifies some factors influencing the interest in cooperating. However, very little is known about the formation of contracts between venture capitalists and entrepreneurs, i.e. how the cooperation emerges. The pre-partnering, or adversarial phase, includes for example what the key points of negotiation are and what the negotiation process is like. It can be expected that the negotiation process, leading to a contract between the venture capitalist and entrepreneur, has the intention to create a mutual understanding between the actors. In this respect the negotiation may bring to the surface values and principles required for the relationship in the future. As we see it, the negotiation process serves as a “friction process” including two fundamental problems: (i) for the venture capitalist to identify and solve potential agency problems in the relationship, and (ii) for both parties to build a long-term relationship. We believe that agency theory and social exchange theory provide complementary insights to aid in the understanding of the process.

An agency relationship is “a contract under which one or more persons (the principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent” (Jensen & Meckling, 1976, p 308). In the venture capitalist-entrepreneur relationship, the venture capitalist is usually considered as the principal, who delegates decision-making authority to the entrepreneur (agent), even if it sometimes is difficult to determine who acts as agent and who act as principal (e.g., Admati & Pfleiderer, 1994; Barry, 1994). Due to the fact that the agents act on behalf of the principal, two risk factors arise: (i) goal incongruence, i.e. the agent pursues a different goal than the principal, and (ii) information asymmetry, i.e. it is impossible for one party to know what the other party is doing. Goal conflicts as well as information asymmetries are substantially present in the venture capitalist-entrepreneur relationship (Amit et al., 1990; Chan et al., 1990; Barry, 1994). For example, the venture capitalist and the entrepreneur may have different cash flow objectives, different self-interest intentions, etc., and it is also difficult for the venture capitalist to control or verify the behavior of the entrepreneur.

Goal incongruence and information asymmetry cause two main agency problems, namely (i) moral hazard, i.e the agent might purposely not perform as agreed, and (ii) adverse selection, i.e. the agent might not possess the necessary skills. According to Chan et al. (1990) moral hazard in the venture capitalist-entrepreneurship relationship can be considered as if the entrepreneur has control over his own ability but performs below this ability. If perfect goal congruence occurs, the danger of moral hazard will vanish because there will be no incentive for the agent to purposely take actions not in line with the preferences of the venture capitalist. On the other hand, when the performance of the agent is not verifiable and there is goal incongruence, the moral hazard problem is more severe (Chi, 1996).

Barney et al. (1994) identify the moral hazard problem in venture capitalist-entrepreneur relationships as a problem of opportunism. They assume that the contract between the two can be seen as a governance device used to manage conflicts of interest between the parties and that the need to write and enforce contractual covenants is partly a function of the probability of opportunistic behavior occurring. The higher the probability of opportunistic behavior the more covenants are included in the contract. In the entrepreneur-venture capital relationship it is mainly two kinds of opportunistic behavior that may arise: managerial opportunism, i.e. managers may engage in actions that reduce the wealth of venture capitalists by spending too much money on research and development, taking out too high a salary, etc., and competitive opportunism, i.e. managers reduce the wealth of venture capitalists by leaving the firm and starting a new competing firm or acting as advisors to competing firms. The results of the study indicate that the contract can vary across different investments, and that the use of different contractual covenants depends upon the probability of managerial and competitive opportunism.

According to agency theory, contract covenants may mitigate the occurrence of moral hazard and/or adverse selection in venture capitalist-entrepreneur exchanges. A purpose of the contract is to align the goals of the parties and to reduce the information asymmetry between the principal and the agent. As the goal incongruence and information asymmetry are reduced, the probability of the occurrence of moral hazard and adverse selection problem diminishes.

In addition to addressing agency issues, contract negotiation helps establish the relationship in the long run. In contrast to standard exchange contracts which are designed to complete an exchange as efficiently as possible, the venture capital contract is designed to make it possible to maintain and terminate the relationship without disputes. Macneil (1980; 1985) distinguishes between discrete and relational contracts. Discrete contracts are based on the assumption that only well-specified rights and duties exist between the parties. Typical discrete contracts include commitments limited to well-specified conditions (mainly economical), limited personal involvement, close-ended time frame, and little flexibility (changes acquires negotiation of contract). However, in a long-term and complex relationship, such as that between the venture capitalist and the entrepreneur, it is not possible to define all the future contingencies, problems or opportunities; thus, discrete contracts are inadequate. Under these conditions, the contract must involve relational terms which emphasize flexibility and rules that can handle the changing needs of the parties. Relational contracts are characterized by emotional involvement as well as economic exchange, whole person relations, open-ended time frame, and dynamic and subject to changes during the life of the contract. As a conclusion venture capital contracts must involve both discrete as well as relational components. Whereas discrete aspects of the contract strive for an orderly and mutually satisfactory managing of the contractual relations, relational aspects strive for the continuation of the relationship.

The venture capitalist and entrepreneur enter thus into a relationship characterized by discrete as well as relational aspects. One important criterion for evaluating the results of the outcomes is the justice or fairness in the relationship. Organizational justice research can be divided into three basic areas; (i) distributive justice, (ii) procedural justice, and (iii) interactional justice (Cobb et al., 1995). First, the study of distributive justice has focused largely on how individuals view the fairness of the outcomes they receive. Few studies have explicitly examined distributive fairness in entrepreneur-venture capitalist relations. Clearly, the “fairness” of the price paid and the distribution of ownership in the venture is a critical issue for both parties and highly speculative given the inherent uncertainties involved. We assume that when one side or the other accepts a much lower price or share than they believe they deserve, the subsequent relationship and the informal conditions governing it will be affected. Second, procedural justice theory concerns the perceived fairness of the formal rules and procedures set up to govern decision-making. Given the significant stakes both parties have in their partnership and given the extreme uncertainty of future contingencies, the formal and informal development of rules and procedures to govern future contingencies is likely to play an important part in the success of the relationship. Finally, interactional justice refers to the perceived fairness of the interaction of agents during the decision-making process. The behavior of the parties is likely to be important because of the sometimes intense nature of the interaction between the entrepreneur and venture capitalist. For example, Sapienza & Korsgaard (1996) found that venture capitalists had greater trust in and commitment to CEOs who provided them with more timely. Sapienza (1989) also observed that both entrepreneurs and investors placed great importance on the establishment of mutual respect and trust in the relationship. In short, the informal ties established appear to have an important impact on the ultimate “success” of these relationships.


Design and Data Collection

This study represents an exploratory research, in which the emphasis is on developing propositions concerning the formation of initial investor – entrepreneur investment agreement.

The study is based on 16 semi-structured interviews with investors and entrepreneurs of investee companies in four countries: Belgium, Sweden, the UK and the USA. Interviews lasted from one to two hours. Data collection activities also included site visits and an examination of archival material. The interview schedule was influenced by agency and social exchange theories as it was anticipated that these theories would provide insights into contract terms and processes. Our objective in this study was to use field interview data to build theory concerning the formation of initial investor–entrepreneur investment agreements. Consequently, there was no attempt to match entrepreneurs or investors or to achieve comprehensive coverage of the entire spectrum of investments based on venture stage or investment type. Rather, convenience sampling was used to obtain in-depth interviews. Our sample includes formal venture capital investors as well as informal ones. We have cases that deal with successful and unsuccessful ventures, with high-technological and non high tech ones, with early stage and with later stage or MBOs, with deals that were closed only recently or that are close to their exit. This provides with a rich spectrum of experiences and contingencies.

Contractual Terms

Table 1 gives a condensed description of the contractual terms, used by the venture capitalists in the four countries of our study. The same dimensions as in Landström (1990b) were identified: all contracts include parts that deal with (i) changes in ownership of the venture, as well at entry as during the post-investment relationship, (ii) post-investment managerial agreements, (iii) post-investment monitoring and (iv) exit agreements. These are supplemented with pre-investment agreements between investor and entrepreneur. It has to be noted that not all clauses are included in every contract, nor that the table is exhaustive, but we have listed the most common clauses.

Most contractual clauses are included in order to avoid agency problems, by enhancing goal congruence between entrepreneurs and investors, by reducing information asymmetry between entrepreneurs and investors, and by reducing the opportunity for moral hazard problems. The main purpose of the written contract is thus to reduce possible agency problems at the outset, rather than to build trust between both parties. It is striking that most clauses protect investors against adverse actions of entrepreneurs, rather than vice versa. Although the former are possibly more important than the latter, investors may also take detrimental actions towards the venture or the entrepreneur, e.g., by not giving further financing when needed, or by not giving as much assistance as needed by the venture. Clauses regulating these possible problems are seldom included in the contracts.

Development of Propositions

We used existing theory and past results to select questions and to interpret the interview data. The propositions we develop represent a culmination of our own extensive discussions of these issues and the shared understandings we reached. However, it became clear to us as we proceeded that several important assumptions underlie our propositions.


One assumption we make is that venture capitalists have a greater influence on contract provisions and negotiations than do entrepreneurs. One reason we make this assumption is that the contract is largely written to protect the investor from mismanagement of the funds provided; they receive nothing tangible in exchange. Thus, it is likely that most terms will be put in by investors for protection, and an examination of Table 1 indicates that the vast majority of the provisions place restraints on management. An investor noted: “We feel that we need some protection... as a minority shareholder in a private company we really have very few rights except the ones we insist on. And therefore we have to make sure that we have enough class rights to allow us to have a say that we wouldn’t otherwise have.” As an example, one venture capitalist pointed out how certain provisions come to be in a deal: “If it’s an early stage company and they have some debt from some prior investors, we put a term in there that says, ‘Convert all the debt to equity and let’s move on.’ ” A further reason that venture capitalists are likely to “run” the negotiations is their greater experience in negotiating contracts. Deal negotiation is a process that venture capitalists go through as part of their business (Tyebjee & Bruno, 1984). As one financial consultant said, “The entrepreneur will seldom initiate the writing of the agreement. The VC has the know-how and in most cases the power to do this.”

We assume that the written contract is used for 1) setting major transactional parameters (e.g., “The most important clauses were those that determined the board of directors and those that settled the transfer of shares in case of a dispute” —quote from entrepreneur); 2) providing a basis for the formation of important informal agreements (e.g., “The written agreement is something to start the relationship with, but the general spirit is more important than the words. For instance, we have rights of first refusal when one of the shareholders wants to sell shares bona fide. What is bona fide?”—quote from venture capitalist) and, 3) functioning as the document of last resort when everything else has failed (e.g., “It’s sitting in the background, structured, ready to go, but I would hate for it to get to that situation . . . the last thing you want to do is get something like this into litigation because then all of your money goes to attorneys and your business goes down the tubes—that’s the last possible scenario that you want and we all understand that”—quote from entrepreneur; “Once you start hauling out the documents . . . you have lost”—quote from investor).  In short, the contract appears to function as “ . . . a kind of security . . . a security against the possibility that you estimated each other wrongly” (quote from an entrepreneur), and “the contract is not really of use if everything goes well, but it is only important if something goes wrong” (quote from venture capitalist).

If the terms are often unimportant, why is so much time and effort used to structure and negotiate contracts? We assume that written contracts are necessarily incomplete (Macneil, 1980). It is impossible to anticipate all future contingencies, and attempting to do so may send the wrong signal to future partners: “If you formalize everything, then you give the impression that you are scared” (an entrepreneur), and “Trying to get the most for one’s own advantage is just not the way I do business” (a different entrepreneur). Yet it is critical for both sides to know what kind of partner they are dealing with. We assume that a key purpose of negotiating terms is to dig deeper into the true motivations of partners: “ . . . you put it down on paper and say, now this is what I think we agreed to, that’s when you really begin to get to know each other . . . the things that they think are important to them tell you a lot about them . . . it’s of a way to figure out what the other person’s all about, not just what they say they’re all about” (a venture capitalist); “The spirit is more important than the letter of the agreement” (an entrepreneur). In short, the relationship between the two “completes” the contract by creating expectations about behavior and obligations; the negotiation process is a key starting point for the shaping of the relationship.

Finally, we assume that those experienced with negotiating investment terms understand the importance and limitations of the written contract. Especially, they realize the importance of letting each other know what is expected of them in ways that cannot be fully articulated in the written contract. For example, experienced venture capitalists realize that a key concern of entrepreneurs is maintaining decision control, so they attempt to communicate this during negotiations: “We spell out pretty clearly that we want them to run the company, and that we don’t want to run the company. We’re investing in them, and they’re going to run the company and we’re not smart enough to know how to play in 15 different markets.” Similarly, experienced entrepreneurs understand that accuracy and openness of information are critical to the establishment of a successful relationship: “What I’ve learned is don’t overpromise because it becomes a treadmill you’re in . . . you learn from your past errors—so in all of our planning and so forth we’ve been trying to be very realistic” (an entrepreneur). In short, experienced negotiators focus their efforts in negotiation on setting the groundwork for a successful relationship by establishing positive relational expectations for one another.

Propositions Regarding Written Terms

Although written contracts are mostly adapted to the specific situation at hand, we speculate that the characteristics of the participants, the involvement preferences of entrepreneurs and investors and the riskiness of the venture will influence the elaborateness and the type of clauses in the contracts. In a first proposition, we speculate that the characteristics of the participants in the negotiations will influence the elaborateness of written contracts.

As we assume that the primary purpose of the written contract is to reduce agency problems, we propose that experienced investors and/or entrepreneurs who have done prior deals with outside investors will include more clauses. An investor noted, “As we are only 1,5 year active as venture capitalists, we use relatively few clauses in our contracts.” Indeed, it is likely that experienced parties will have found themselves in situations not foreseen by their contract, due to the fact that no contract is complete. Every following contract by that party will then include a new clause, in order to deal with that new situation. In this way, the “standard” contract used by investors will become more elaborate and complex over time, due to their learning experience. This consideration may further partly explain why most contractual clauses protect investors, rather than entrepreneurs: investors, especially formal venture capital managers, are more experienced with investments and deal making than entrepreneurs, and thus are able to foresee more possible problems than entrepreneurs. However, entrepreneurs who have gone through the investment process will also be able to learn how to structure their following deal, as an entrepreneur noted: “If I were to start a new company, with the same or a different investor, then I would add a few clauses.”

Proposition 1a: The greater the prior experience of the lead venture capitalist or the entrepreneurial management team, the more elaborate will the written contract be.

In the same line of reasoning, the greater the number of investors are involved in the deal, the more experience is at hand and the more elaborate the final contract is likely to be. An investor noted that “every partner in the deal has his own specific vision. . . . Although the broad principles for all parties in the investment market are comparable, the approach of practical issues is different. . . . Each party in a syndicated deal should take the customs of the other parties into account.” Another investor noted: “If you do an investment on your own it is more straightforward. Once you start syndicating it becomes complicated.”

Proposition 1b: The greater the number of investors involved in the written contract, the more elaborate will the written contract be.

We expect that there will be large differences when informal investors are involved, compared to the situation where formal venture capital investors are involved. The latter are agents of the investors in their fund, whilst the former act for their own interest. Formal venture capital managers thus have to reduce possible agency problems with their investors. An investor noted: “If you invest other peoples money they have to see that you have gone through this process.” One way of doing this is to write contracts that are as complete as possible, even if every party knows that contracts will always be incomplete.

Proposition 1c: In comparison to informal or angel venture capital, when funds are provided by formal venture capital, written contracts will be more elaborate (i.e. contain a greater number of provisions).

Finally, more passive investors will face larger post-investment information asymmetries than active investors, everything else equal. Therefore, the need to cover possible agency problems in the contracts will be larger for passive investors than for active ones. This will be done through the writing of more elaborate contracts by passive investors.

Proposition 1d: The more passive the implied involvement of the investor, the more elaborate will the written contract be.

Economic (e.g., Ravid and Spiegel, 1997) and managerial agency literature (e.g., Eisenhardt, 1989) suggest that agency problems may be reduced by using monitoring devices, reward systems and financing techniques best adapted to the specific (investment) situation. If information asymmetry is high and the effort of the entrepreneur is difficult to verify, i.e. a situation with possible moral hazard problems, Eisenhardt (1989) proposed to discipline management or, here, entrepreneurs with behavior-based measured. Financial economists (e.g., Innis, 1990 and Nachman and Noe, 1995) come to the same conclusion: they showed that risky debt (a strong financial monitoring device) is more appropriate, as well in a situation with information asymmetry as in one with costly verification of realized cash flows (Townsend, 1979). Financial instruments and contractual clauses thus seem to supplement each other.

When investing in a (risky) early stage venture, its outcome is not solely a consequence of the actions and effort of the entrepreneur, but also from environmental developments outside the control of the entrepreneur. Agency problems may, in this situation, only be reduced by monitoring and rewarding the behavior of the entrepreneur, rather than the outcome of his or her actions (Eisenhardt, 1989; Ravid and Spiegel, 1997).

Proposition 2a: The earlier in the stage of the venture at the time of negotiation, the greater will be the relative reliance in the written contract on behavioral measures of venture activity (i.e. relative to the sum of outcome and behavioral measures).

Everything else equal, we expect that a lower level of involvement of investors in the venture will lead to a relatively higher emphasis on regular information requirements, in order to reduce the inevitable information asymmetry. They will require a higher and more in-depth reporting frequency: “If [the entrepreneurs] demand a more passive approach from us, we will do this, as long as we get enough information with respect to the more important decisions.”

Proposition 2b: The more passive the implied involvement of the venture capitalist, the greater will be the reliance in the written contract on information requirements.

Propositions Regarding the Focus of the Negotiation Process

We assumed that the written contract establishes transactional parameters but cannot specify all of the important relational components. The extent to which governance will be transactional versus relational (Macneil, 1980) is likely to depend on the opportunity that the investor has to shape the relationship through interaction (Ring & Van de Ven, 1994). Different investors have different styles or preferences for post-investment involvement (MacMillan, Kulow & Khoylian, 1986; Sapienza, 1992). Those who wish to take a ‘hands-off’ approach have to specify in the contract what is expected; those who anticipate high involvement can begin to shape the relationship by focusing negotiation around setting in relational expectations:

Proposition 3: The more active the venture capitalist anticipates being, the greater will be the focus during negotiations on relational versus transactional components.

Investors indicated to us during interviews that the negotiations are often used to express exactly what they anticipate their roles and the entrepreneurs’ should be. For example, one investor who expected high involvement said, “We actually feel like they’re obligated to use us. We want them to use us for things that they can’t do, not for things they can do.” Of course, it stands to reason that those who will not be involved must spend time making certain that the negotiation focuses on specifying content in a clear and well-defined manner.

A second reason to expect anticipated involvement to influence negotiation focus is that relational governance involves personal, non-economic satisfaction, trust, and identification (Dwyer, et al. 1987). Thus, an investor seeking involvement for intrinsic satisfaction as well as for protection will be more likely to focus discussions on relational elements. As an entrepreneur said, “They’re in this one as an investment, to have some fun, and to feel part of something…and to communicate that to their friends.” Investors who have been entrepreneurs appear most likely to hold these additional motives. Thus, we predict:

Proposition 4a: Venture capitalists who have been entrepreneurs are more likely to place greater focus during negotiations on relational versus transactional components.

We observed earlier that experienced entrepreneurs and investors are likely to understand that not all issues of importance can be specified in the written contract. They will realize that the spirit is more important than the letter in dealing with most issues. An investor, who was previously an entrepreneur, noted: “I try to find a deal which we both consider to be fair. That’s my key concern because you need to get the goodwill of the entrepreneur. The worst thing is to have an entrepreneur who is accepting the deal...even though they are secretly resenting it.” Another investor told: “You have to end up with what the entrepreneur considers to be a fair deal. If you don’t have this you are on very thin ice and if you do have it then there is a lot of room for give and take on both sides.” Therefore, we expect that more experienced individuals will de-emphasize transactional elements in favor of settling relational issues regarding future processes, joint efforts, and non-economic obligations:

Proposition 4b: The greater the experience of both venture capitalists and entrepreneurs with prior term negotiations, the greater will be the focus during negotiations on relational versus transactional components.

Propositions Regarding the Openness of the Negotiation Process

Relational components of the contract will be formed not only by the focus of the negotiations but also by the openness and candor with which they are conducted. As above, we expect that intended involvement and past experience will influence openness. High involvement serves the dual purpose of providing access to information and opportunity to exert influence. However, to achieve these aims, investors who intend to be highly involved must establish a norm of openness and cooperation. One investor discussed his view of being a ‘lead investor’: “Where I’ve been the lead partner, I spend a lot of time personally to get to know the entrepreneur and his family . . . then once the deal is closed you are on the same side of the fence, and that’s a difficult transition, and it sometimes gets bitter under negotiation.” Thus, we expect:

Proposition 5: The more active the venture capitalist anticipates being, the greater will be the venture capitalist’s openness during negotiations.

Our assumption that venture capitalists and entrepreneurs experienced with investment negotiations realize the limitations of written contracts is based upon the fact that such individuals are likely to have ‘been burned’ by prior situations in which stipulations have been misconstrued or neglected. Further, investors with prior entrepreneurial experience are especially likely to have a visceral sense of the fears and preconceptions of entrepreneurs. In short, prior entrepreneurial experience is likely to sensitize investors to the need for openness and complete disclosure, and experience with prior investment processes is likely to have revealed the pitfalls of obfuscating during negotiations. These expectations may be stated formally:

Proposition 6a: Venture capitalists who have been entrepreneurs are likely to exhibit greater openness during negotiations than those who have not.

Proposition 6b: The greater the experience of both venture capitalists and entrepreneurs with prior negotiations, the greater will be the openness of the negotiations.

 Finally, the sheer number of participants in the negotiations is likely to affect the openness of the negotiations. All else equal, the greater the number of people involved, the less time for each individual. Further, with a greater number of people the chances that conflict of interest in terms of timing and exit increase. Indeed, research has shown that the larger the group involved in decision processes the greater the conflict (Amason & Sapienza, 1997). We expect, then, that as the number of investors involved in contract negotiation increases, the openness and condor of the discussions is apt to decrease:

Proposition 7: The greater the number of venture capitalists participating in the negotiations, the lower will be the openness of the negotiations.


For Entrepreneurs

It is important for entrepreneurs, especially those without prior start-up experience, to formulate beforehand exactly what they want for protection in worst case scenarios and get protection against these events in the written contract. They should have a lawyer handle these issues. Entrepreneurs should also formulate what they want and don’t want in the day-to-day relationship and be clear about this in the negotiation process. They should keep in mind that many things cannot be specified in or enforced by a contract. They should relate their preferences openly and frankly. They should not try to hide misgivings or pretend to be able to live with agreements they know they cannot fulfill.

In short, entrepreneurs should get legal counsel and let the lawyers worry about the details of the written contract. They should focus negotiations on relational expectations. If the investor is relatively inexperienced, it is especially important for the entrepreneur to pull these things out since such an investor may be less forthcoming than one with great experience. Openness during the negotiation process will benefit both parties, as getting to know each other is one of the main purposes of the negotiation itself.

For Less Experienced Venture Capitalists

Less experienced VCs should keep in mind not to try to ‘win’ everything in the negotiations: leaving something on the table gives the entrepreneur faith in the investor and will lead to more trust and confidence between both parties. The term sheet should be handled as a valuable instrument to examine the true motives of the entrepreneur. Moreover, the negotiation process has to be used as a means to get the entrepreneur to fully understand the entire investment, involvement, and exit process as well as the nature of the partnership the VC wants. A thorough explanation of the likely level of involvement and roles to be played by the investor is necessary, in order not to disappoint the entrepreneur in case he had higher aspirations on this point. It is important that the entrepreneur understands the VCs’ duty to his/her backers and the demands of other entrepreneurs on the VCs’ time.

For Policy Makers

The focus of policy efforts should be on reducing the information gap of entrepreneurs. Sponsoring training sessions in negotiations for both sides might be an interesting avenue to help shape better deals.

For Future Research

Possible routes for future research could include the extent to which contract terms and negotiation process affect the subsequent progress of a venture. Are entrepreneurs and investors satisfied with the agreement reached and how does this influence the post-investment relationship? Is likelihood of subsequent funding influenced by the content of the written contract and the outlook of the negotiation process? Finally, research might focus on which theories are most applicable and on factors or contingencies have the greatest impact.


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