The Gatekeeper-Model of Innovations – An Integrative Framework for Entrepreneurs and Venture...

Universität Bremen

Fachbereich Wirtschaftswissenschaft Nachhaltiges Management

Prof. Dr. Georg Müller-Christ

DIPLOMARBEIT

The Gatekeeper-Model of Innovation

An Integrative Framework for Entrepreneurs and Venture Capitalists

By ROBERT HINSCH

Matrikelnummer: 1975707

December 18, 2009

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Copyright 2009

Robert Hinsch

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Contents LIST OF FIGURES ............................................................................................................. iv

LIST OF TABLES ............................................................................................................... v

LIST OF ABBREVOATIONS .......................................................................................... vi

PART I

CHAPTER 1: INTRODUCTION ..................................................................................... 2

1.1 Context and Relevance ................................................................................ 2

1.2 Objective of the Study .................................................................................. 5

PART II

CHAPTER 2: THE INNOVATION PROCESS ............................................................. 8

2.1 Entrepreneurship and the Diffusion of Innovation ................................. 8

2.2 Systems Model of Innovation by Csikszentmihalyi ................................ 13

2.3 Investors in Innovation and Risk‐Taking .................................................. 16

2.4 The Venture Capital Business ..................................................................... 19

2.5 Critical Summary and Conclusions ........................................................... 26

CHAPTER 3: STRATEGY DIMENSION ...................................................................... 27

3.1 Strategic Considerations of Venture Capitalists ....................................... 27

3.2 Strategic Resources Approaches ................................................................. 27

3.2.1 Sustainable Competitive Advantage ............................................... 27

3.2.2 Resource Dependence Approach ..................................................... 30

3.3 Sustainable Resource Management .......................................................... 31

3.4 Paradox Management ................................................................................. 34

3.5 Critical Summary and Conclusions .......................................................... 36

CHAPTER 4: THE TRUST PERSPECTIVE ................................................................... 38

4.1 Trust as a Concept ....................................................................................... 38

4.2 Models of Trust‐Building ........................................................................... 44

4.3 Trust‐Control Duality ................................................................................. 45

4.4 Levels of Trust .............................................................................................. 47

4.5 Critical Summary and Conclusions .......................................................... 48

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PART III

CHAPTER 5: DEVELOPMENT OF A FRAMEWORK ............................................... 50

5.1 Venture Capitalists as Gatekeepers .......................................................... 50

5.1.1 The Innovative Entrepreneur ............................................................ 50

5.1.2 The Leapfrog Concept of Innovations .............................................. 52

5.1.3 Gatekeeper Mechanism ...................................................................... 56

5.1.4 Value Creation of Innovation ............................................................ 59

5.1.5 Critical Summary and Conclusions .................................................. 61

5.2 The Sustainability Dimension .................................................................... 63

5.2.1 Relationship between Shareholders and Entrepreneurs ............... 65

5.2.2 Direct Survival Resources .................................................................. 67

5.2.3 Stakeholder Management .................................................................. 69

5.2.4 Indirect Survival Resources ............................................................... 70

5.2.5 Sustainability Circuit .......................................................................... 72


5.3 Trust‐Control Balance ................................................................................. 76

5.3.1 The Trust‐Building Process ................................................................ 77

5.3.2 Active Trust .......................................................................................... 81

5.3.3 Shared Visions ..................................................................................... 84


CHAPTER 6: THE GATEKEEPER‐MODEL AS AN INTEGRATIVE FRAME‐

WORK FOR ENTREPRENEURS AND VENTURE CAPITALISTS ........ 85

6.1 An Integrative Framework ......................................................................... 85

6.2 Summary of the Implications of the Integrative Framework

for Entrepreneurs and Venture Capitalists .............................................. 88

6.2.1 Entrepreneurs ...................................................................................... 89

6.2.2 Venture Capitalists .............................................................................. 90

6.3 Concluding Remarks .................................................................................. 91

BIBLIOGRAPHY ................................................................................................................ 92

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LIST OF FIGURES

Figure 1.1: Overview of the study ……………………………………………………………....5

Figure 2.1: Systems Model of Innovation ……………………………………………………..14

Figure 2.2: Financing Sequence…………………………………………………………………18

Figure 5.1: Circularity……………………………………………………………………………54

Figure 5.2: Leapfrog Concept of Innovations ……………………………………………....…55

Figure 5.3: Gatekeeper Mechanism .…………………………………………………………...58

Figure 5.4: Resource Allocation Opportunities ………………………………………………66

Figure 5.5: Sustainability Circuit ……………………………………………………………….74

Figure 6.1: Venture Capitalist‐Entrepreneur Relationship ………………………………….86

Figure 6.2: Shareholder‐Entrepreneur Relationship …………………………………………86

Figure 6.3: Integrative Gatekeeper‐Model …………………………………………………….88

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LIST OF TABLES

Table 2.1: Risks of Venture Capital Funding ………………………………………………….20

Table 2.2: Venture Capital Investment Process ……………………………………………….21

Table 5.1: Contrary Interests ……………………………………………………………………79

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LIST OF ABBREVIATIONS

ARD American Research and Development

e.g. Exempli gratia (for example)

Et al. Et alii (and the following)

Etc. Et cetera

i.e. Id est (that is)

IPO Initial public offering

LP(s) Limited partner(s)

MIT Massachusetts Institute of Technology

NVCA National Venture Capital Association

p. Page

RBV Resource‐based view

R&D Research and development

SPRU Science Policy Research Unit

VC(s) Venture capitalist(s)

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PART I

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1. INTRODUCTION

1.1 Context and Relevance

“You can run fast alone, or run far together.” ‐‐ African Proverb

“The tourists have left. […] Young entrepreneurs who thought they could get rich quickly

with just a good idea are now gone and those now left standing recognize the challenges

and tenacity needed to establish and build a sustainable business” (Heesen, 2009, p. 4).

Venture capital is a dynamic industry which has been constantly subject to changing

developments and conditions. Over the last decade, entrepreneurs viewed venture capital

as an easy source of funding, but a changing economic landscape and a couple of down

cycles led to a consolidation of this industry. Florida and Kenney (1988) argue that

venture capitalists act as catalysts or “technological gatekeepers” who facilitate and

accelerate innovations. They propose a new model which presents a third path to Joseph

Schumpeterʹs dichotomy of entrepreneurial versus corporate innovations: “Venture

capital‐financed innovation overcomes financial, technological and organizational

barriers which characterize both entrepreneurial and corporate‐based innovation”

(Florida and Kenney, 1988, p. 120).

Over the last decades, venture capital has evolved as a special group of financial

intermediaries to actively invest in new, unproven business concepts which are

disregarded by traditional financial institutions. This group of financial intermediaries

occurs within the context of what Schumpeter calls ʺradical innovationsʺ. They are

“agents of innovation, performing a technological gatekeeping function” (Florida and

Kenney, 1988, p. 135) and “intervening to help create new companies and actualize

important breakthroughs” (p. 128). Despite their immense economical impact1 on

innovations and funding of well‐known high‐technology companies such as Apple

Computer, Intel, Facebook, Google, and Microsoft over the last decades, viewing the

1 The capital inflows in the United States rose from $3 billion in 1990 to $103 billion in 2000 (Woodward and Hall, 2004). In 2003, companies that were backed by venture capital accounted for 9.4 percent of the private sector labor force in the United States, and generated $1.8 trillion in sales, or 9.6 percent of all business sales (Shane, 2008).

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venture capitalist as a gatekeeper has not been pursued or further developed by Florida

and Kenney or other scholars.

Radical innovations and technological revolutions substantially change the marketplace,

set new standards and create novel ways of how people and businesses interact. These

changes are commonly initiated by high‐tech entrepreneurs with a novel business idea or

concept. If venture capitalists are considered as gatekeepers, their criteria and screening

processes become relatively significant to the emergence of breakthrough technologies

within an economy. Muzyka et al. (1996) identified up to 35 different criteria that venture

capitalists use to select the right candidates. They are categorized into decision criteria

such as entrepreneur and management team, product and services, market and industry,

and financial criteria. Manigart and Sapienza (2000) found that the most important

criterion is the entrepreneur and the management team: “[…] the most important

criterion is human capital, especially the judged ability and character of the entrepreneur

and the entrepreneurial team. This criterion is typically followed in rankings by market

and product characteristics and expected financial outcomes” (p. 245).

Nevertheless, it is important to point out that because venture capitalists operate in

highly complex environments, they do not always make the most rational decisions. They

are also partly restricted by bounded rationality. The intertwined process of decision‐

making create trade‐offs between the different criteria that sometimes lead to

opportunistic investment behavior (Muzyka et al., 1996). Shepherd and Zacharakis (1999)

challenge the concept that venture capitalists have thoroughly understood their decision‐

making process: “VCs have a tendency to overstate the least important criteria and

understate the most important criteria compared to their ‘in use’ decision policy”

(Shepherd, 1999, p. 76; emphasis in original). Overconfidence in the venture capitalists’

judgment may have a negative influence on their decision‐making (Zacharakis and

Shepherd, 2001, p. 328): “[…] VC overconfidence will likely lead to a reduced information

search, decreased motivation to self‐improvement, and the funding of inappropriate

venture”. Hisrich and Jankowicz (1990) observe that experienced venture capitalists make

their decisions based on their gut feelings.

The lack of understanding of their own decision and selection process may be partly due

to a missing conceptual framework of scholars and practitioners. With the “systems

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model” by Csikszentmihalyi (1996) – a result of his in‐depth study on creativity – a

progress of closing that gap can be made and is undertaken in this study. Understanding

the key role of certain experts or “gatekeepers” in any system (called “domain”;

Csikszentmihalyi, 1996, p. 27) facilitates greater transparency in the process of how a new

idea becomes a relevant innovation. Thus, picking up on the idea of Florida and Kenney

(1988) that view the venture capitalist as a gatekeeper makes it possible to re‐frame

venture capital concepts within the innovation process.

Reviewing the current literature and considering a changing industry that is subject to

cyclicality of available capital and investment opportunities, it is necessary to update the

perspective on current approaches and frameworks of venture capital within the

innovation process. Strategic considerations and long‐term planning have barely been

observed by venture capital scholars and are in need of further research. In a changing

industry making the short‐ and long‐term tensions of the investment process and the

relationship with entrepreneurs more transparent may not only benefit the venture

capitalist in addressing current and future challenges, but also helps the entrepreneur to

gain a better understanding of the decision process of the venture capitalist.

In the venture capital literature, the relationship of venture capitalists and entrepreneurs

is considered from a principal‐agent perspective where the relationship is solely reduced

to single‐sided control mechanisms ensuring that the entrepreneur behaves desirably. In

practice, however, elements beyond pure control instruments of venture capital firms can

be detected. As a New Yorker venture capitalist put it on his blog: “Like a marriage, a

venture investment is a long term relationship.[…] Tolerance is critical to a successful

long term relationship [and it is] absolutely critical to get those relationships right and

sustain them for the long haul” (Wilson, 2009; accessed 11.11.2009). Evidently, scholars

need to integrate a perspective that complements the control bias of venture capital

research which is conceptualized in this study as trust.

However, based on the complexity of factors influencing the emergence of innovations,

an integrative framework is needed to show how entrepreneurs win venture capitalists

and how both parties create fruitful relationships in the long‐run.

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1.2 Objective of the Study

The objective of this thesis is to create a better understanding of the factors orientated

along a self‐developed gatekeeper‐model that influence the decision criteria and the

relationship between entrepreneurs and venture capitalists within the innovation process.

Therefore the thesis at hand is divided into three parts in which Part I (Chapter 1)

introduces the context and relevance and the objective of this study, Part II (Chapters 2, 3,

and 4) presents the main concepts and builds a theoretical fundament for understanding

the complexity of this issue, and Part III (Chapters 5 and 6) applies and integrates the

preceding theoretical findings and develops an integrative framework based on the

objective of this thesis (for an overview of the structure see Fig. 1.1).

Fig. 1.1 Overview of the study Source: compiled by the author

The current theoretical fundaments in combination with concepts applied in this study

are necessary to build a theoretical framework for the venture capital‐entrepreneur

relationship (Part II). Chapter 2, “The Innovation Process”, deals with the aspects of

entrepreneurs as a pivot for the diffusion of innovations. Subsequently, the “Systems

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Model” by Mihalyi Csikszentmihalyi is presented which builds the theoretical fundament

for the gatekeeper‐model. As a special intermediary the venture capitalist fills this

gatekeeper position. The innovation process is not isolated from the socio‐economic

context; rather it is a process which takes place in the interaction of actors embedded in

an environment. Thus, in Chapter 3 “Strategy Dimension”, strategic decision‐making and

a sustainability dimension are connected to venture capital research. Conceptualizing

trust as an economic function adds to the dominating control perspective in venture

capital research which is presented in Chapter 4 “The Trust Perspective”.

Part III develops an integrative framework for venture capitalists as gatekeepers for

innovations. Chapter 5 is subdivided into three sections that build up on the findings of

Part II. Section 5.1 analyzes the particular modules of the “systems model” and applies it

to the innovation process. Venture capitalists depend on numerous variables that need to

be considered in the decision‐process of funding entrepreneurs which is depicted in

Section 5.2. In Section 5.3, it is illustrated that in the relationship of entrepreneurs and

venture capitalists, they need to develop “shared visions” as a trusting element that binds

both parties in the long‐term. Chapter 6 summarizes the previous chapter and develops

an integrative framework of entrepreneurs and venture capitalists. While Section 6.1

describes the different layers of the integrative framework, Section 6.2 offers

recommendations for each party based on the findings of this study.

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PART II

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2. THE INNOVATION PROCESS

2.1 Entrepreneurship and the Diffusion of Innovation

Entrepreneurship can be characterized as a process which is performed by someone who

discovers, creates, and exploits opportunities to introduce future goods and services

(Venkataraman, 1997). Research of entrepreneurship can be characterized by its

multidisciplinary approach. Low and MacMillan (1988) refer to the multifaceted topic and

state that “[the] phenomenon of entrepreneurship is intertwined with a complex set of

contiguous and overlapping constructs such as management of change, innovation,

technological and environmental turbulence, new product development, small business

management, individualism, and industry evolution” (p. 141; added by the author). This

diversity of thoughts makes it difficult to form a uniform definition of entrepreneurship

and attribute what makes the entrepreneur so unique.

As Schumpeter (1939) suggests, being an entrepreneur is neither a profession, nor a

lasting condition. Thus, it makes sense to approach the entrepreneur and

entrepreneurship from the historical development of the term. Over the last three

centuries, the term entrepreneur has fluctuated between being irrelevant (for neoclassic

economics) and playing an essential role in economic development.

Hébert and Link (1989) contributed to the analysis of entrepreneurship in history by

marking out the different periods that evolved over time. Richard Cantillon (1680‐1734)

was the first person to coin the term “entrepreneur” in an economical context. In the

course of time different notions of entrepreneurship have emerged ranging from an

uncertainty‐bearer (Cantillon2, Knight2) who has to sell his goods at uncertain prices, a

coordinator (Say2, Marshall2) who coordinates the production process, an arbitrageur

(Kirzner2, von Hayek2) who perceives profit opportunities and tries to act upon them, to

the innovator (Schumpeter ; see also Faltin, 2001) who takes an invention or an idea to

exploit it commercially (see Hébert and Link, 1989). Over the course of the neoclassical

period the term entrepreneur almost faded away from economic theory. The assumptions

of the homo economicus and complete market led to a sole optimization problem which can

2All sources see Hébert and Link (1989)

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be solved mathematically. In a complete market, an entrepreneur becomes redundant in

regards to the predictability of the future and economic growth.

In the long‐run, economic growth is driven by technological changes and innovation.

Paul Romer has developed a theory that states that the accumulation of technological

knowledge creates economic growth. Higher investments made in knowledge and

human capital generate more productive outputs, but also indirectly creates spillovers of

knowledge. The accumulation and spillovers of knowledge are the factors that

endogenously lead to economic growth and prosperity. This endogenous growth model

(Romer, 1990) assumes more realistically the basis for economic progress, where

neoclassical theory proposes an equilibrium – a complete market.

Kenneth Arrow (1962) points out that knowledge differs from traditional factors of

production (such as physical capital and unskilled labor) that result in a gap between

general knowledge and what he termed economic knowledge. In his view, knowledge is

a public good that is non‐rival and non‐excludable. The endogenous growth model

(Romer, 1990) assumes these characteristics implying that technological knowledge

automatically spills over. In practice, agents value available knowledge differently and

decide differently. Romer’s (1990) theory fails to answer the question of how to

differentiate useless from valuable knowledge and what is the driving force behind the

separation (Acs, 2006). Acs and Varga (2005) argue that this gap opens up for the role of

entrepreneurs within an economy and identify them as “knowledge filter”. Thus, the

entrepreneur embodies this filter system by his or her thinking, decision‐making and

acting.

The Knowledge Spillover Theory of Entrepreneurship (Acs et al., 2004) provides a

valuable understanding of the filter mechanisms and how entrepreneurs close the gap

between spillovers and economic growth. The theory consists of two filters stressing on

the importance of the first, the entrepreneur as the knowledge filter, and the institutional

environment as the second filter.

Research labs and Research and Development (R&D) by incumbent firms create a wide

and diverse range of general knowledge. It is suggested that general knowledge is not the

same as economic knowledge and that new knowledge does not automatically result in

spillovers as the endogenous growth model assumes. The knowledge filter is a

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mechanism that prevents knowledge spillovers from transforming into economically

useful knowledge (Acs et al., 2009). This gap between general knowledge and economic

knowledge imposes a lower rate of knowledge spillovers.

The production of new knowledge creates entrepreneurial opportunities. Recently,

scholars have shifted their research focus in entrepreneurship from cultural and

psychological traits (i.e. identifying those people in society who prefer to become

entrepreneurs) towards the individual‐opportunity nexus (Shane and Venkataraman,

2000). It is problematic to simply base entrepreneurship on the characteristics of agents.

Thus, Eckhardt and Shane (2003) emphasize that the nexus of valuable opportunity and

enterprising individuals is crucial in understanding economic growth. It is important to

point out, however, that new knowledge is neither equally distributed within and

between societies nor does it evolve in “neat packages”, rather it has to be discovered and

then packaged (Acs, 2006). The process of knowledge spillover is a process of discovery

where knowledge is a non‐rival good (Acs and Varga, 2005). The two main sources of

opportunity discovery are academic (carried out in universities and research institutes)

and industrial (carried out in R&D departments in industrial firms or governmental

laboratories) (Acs et al., 2004). While entrepreneurship is a mechanism that exploits

knowledge spillover, it is irrelevant whether the entrepreneur is also the individual who

discovers this opportunity (i.e. the entrepreneur does not have to be the inventor as well).

The Knowledge Spillover Theory of Entrepreneurship helps to understand the emergence

and function of entrepreneurs by explaining the incentives for the discovery and

exploitation of opportunities. Incumbents that are not exploiting technological

opportunities efficiently leave space for the prospective entrepreneur to exploit it in the

context of a new venture.

For the discovery of opportunities, Michael Polanyi (1958, 1967) made an important

distinction between codified and tacit knowledge. Codified knowledge is defined as

knowledge that is possible to record or transmit in symbols or manifested in some type of

form. In comparison, tacit knowledge is that which cannot easily be captured in a

transferable form, but is acquired through observation or interaction, what Arrow (1962)

calls “learning‐by‐doing”. This has implications for the exploitation of technological

opportunities where the transmission of tacit knowledge is bounded to spatial proximity.

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The second filter mechanism is conceptualized in the entrepreneurship literature

primarily as the institutional environment, i.e. regulations, financing and bureaucratic

constraints (Acs et al., 2004; Acs et al., 2009). Knowledge spillover and entrepreneurship

are crucial for economic growth. However, the Knowledge Spillover Theory of

Entrepreneurship still leaves a gap of understanding between technological change and

the emergence of innovation.

Acs (2006) views the role of entrepreneurs as individuals who identify opportunities and

then go on to exploit them. They are constantly searching for opportunities, characterized

by alertness, prior knowledge, and have a wide social network. Schumpeter distinguishes

between the economic player, the initiator, and the imitator. In his view, imitators are

relevant for the diffusion of technological knowledge and the innovation itself. An

imitator is defined as someone who copies the innovation in the same market as a

competitor and spreads it across the economy. The entrepreneur is the initiator of the

innovation while the imitator accounts for the macroeconomic ascertainable impact

within an economy. Thus, growth processes and a changing economic structure depend

on both, the initiator who introduces the innovation to the market and the imitator who

pushes the diffusion of the innovation. Other theorists such as Kirzner view the imitator

as the key element in instigating change in the marketplace. Baumol (1993) argues in the

line of Schumpeter and ascribes the innovating entrepreneur the pivotal element of

economic growth and progress in productivity. A faster changing economy with shorter

product cycles ought to devote more attention to the entrepreneur who holds an

important function within a highly information and knowledge‐orientated economy and

is responsible for transforming existing knowledge into innovative goods and services.

Joseph Schumpeter (1939, 1942) argues that innovations are the cornerstone of economic

development leading to an inseparable combination of short‐term instability and long‐

term growth. For economic reasons, there has to be a distinction made between an

invention and an innovation. Invention is the first occurrence of an idea of a new product

or process, while innovation is the first successful step to carry it out into practice. This

transformation requires combining several different types of knowledge, skills, and

resources. The impact of the innovation varies widely. Schumpeter characterizes the

continuous improvement of an existing technology as “incremental” or “marginal”

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innovation, as opposed to the “radical” innovation (i.e. an introduction of a totally new

form) or “technological revolution” (i.e. clustering of several innovations that combined

have profound impact on the economy). In his view, radical innovations constitute what

he calls creative destruction and ascribes them more importance to economic progress. For

him it is one of the basic functions of capitalism. The emergence of innovations in an

economy oscillates between radical changes followed by incremental innovations.

However, marginal improvements build the foundation for the next technological

revolution and one might argue that the cumulative impact of incremental innovation is

as great, if not greater than disruptive innovations.

Radical innovations and technological revolutions are mostly pursed by entrepreneurs

with the vision and perseverance for their venture. In his earlier work, Schumpeter states

that entrepreneurship is a mechanism through which changes in the system create radical

innovation and entrepreneurs are the agents of “creative destruction” (Schumpeter, 1939;

Mark I). Later he shifted his position and argued that large firms, rather than small firms

are more proportionally innovative (Schumpeter, 1942; Mark II). However, empirical

research over the last 30 years suggests that young and entrepreneurial firms have a

greater advantage in innovation (see Acs and Audretsch, 1990).

“[The entrepreneur is] someone who specializes in taking responsibility for and making

judgmental decisions that affect the location, the form, and the use of goods, resources, or

institutions” (Hébert and Link, 1989, p. 155; added by the author). The emergence of

novelty is often facilitated in niches where opportunities and lack of institutional

constraints enable a more preferable result that might lead to an architectural change that

will enable full realization of potential (Nooteboom, 2000). New ventures that are created

by entrepreneurs who exploit opportunities in a fertile environment increase the

“[c]hances for both short‐term survival and long‐term success” (Chea, 2009, p. 37;

adapted by the author). Acs and Audretsch (1990) note that small firms are more

conducive to create this kind of environment, because decisions to innovate are made by

relatively few people and innovative activity may flourish the most in environments with

less constraints. It seems that entrepreneurial entrant firms have greater flexibility and are

able to identify protected market niches that are too small for larger corporations (see

Chen and Hambrick, 1995). Moreover, incumbents often fail to spot market opportunities

13

and lack innovativeness, not only in entering new markets but also when creating

innovative products and services (Berchicci and Tucci, 2006). Timmons (1999, p. 29)

shows that since World War II 95 percent of all radical innovations came out of the

formations of new businesses. Wyatt (1985; quoted in Nooteboom, 2000) conducted a

study based on the data of the Science Policy Research Unit (SPRU) in Brighton and

found that the relative innovative efficiency (innovative output divided by innovative

input) of small firms is much higher than in larger firms. Small firms seem to have an

advantage when it comes to a higher average rate of innovation (see Acs and Audretsch,

1990).

2.2 Systems Model of Innovation by Csikszentmihalyi

Innovation requires human creativity that is essential for economic progress in particular

and welfare in general. In “The Rise of the Creative Class”, Richard Florida (2002) talks

about the Creative Age and elaborates on the notion of creativity as extracting or

discovering novel and useful forms of knowledge. Yet, individual ingenuity is not

sufficient enough to specify the characteristics of innovation; it also requires a complex

process of exchange relations. A novel concept does not automatically translate into an

innovation. Only if others recognize and adopt the novel idea can creativity retain a

useful meaning, and thus become a product of a social system.

In his systems model Mihaly Csikszentmihalyi argues that creative ideas would

disappear without an audience that assesses and acknowledges them. Csikszentmihalyi

(1996) defines creativity (and innovation) “[as] any act, idea, or product that changes an

existing domain, or that transforms an existing domain into a new one… [and] that

domain cannot be changed without the explicit or implicit consent of a field responsible

for it” (p. 28; added by the author). This framework integrates the complex interactions of

different actors. According to Csikszentmihalyi (1996) creativity evolves from the

interaction of three core elements that define a system: A “domain” containing symbolic

rules and a certain structure, an “individual” who brings a novelty into a certain domain,

and a “field of experts” that recognize or reject the novelty. The field of experts includes

all actors that act as filters to help avoid information overload, which would otherwise

dissolve, by choosing relevant inputs that may lead to an innovation in the domain.

14

Attention is scarce and creativity requires places where there is abundance of societal and

individual attention; where it allows individuals to learn and to experiment beyond their

immediate needs. The existing structure imposes constraints on the potential of novel

elements in order to preserve the functioning of the existing system (see Nooteboom,

2000). Commonly, most novel ideas or concepts do not survive and will be quickly

forgotten. The group entitled to make decisions on what should and should not be

included in the domain inherits a gatekeeper‐function that results out of their position in

the system. For instance, in the case of Albert Einstein only a few leading university

professors were enough to certify that his ideas were truly creative. The judgments of this

small group of experts convinced people around the world that Einstein made a

breakthrough with his theory. In another example, Csikszentmihalyi (1996) uses the

domain of modern art to demonstrate that the gallery owner and not the painting itself,

sets the standard for what constitutes creativity in society.

Figure 2.1 illustrates the process an individual has to go through in order to bring a novel

idea into the domain. This mechanism varies widely from quite formal gate‐keeping (e.g.

official review process in scientific journals) to highly informal gate‐keeping (e.g. early

adopters).

Fig. 2.1 Systems Model of Innovation Source: compiled by the author based on Csikszentmihalyi (1996)

15

Most of the actors try to preserve the status quo in the domain and only a few others

actually work on innovative advancement in order to keep the domain competitive in

comparison to others. Experts have a deeply rooted interest in an attractive domain

because of all the tangible and intangible benefits that evolve from their position within

the field. The riskier the invention is, the more cautious the experts are as they do not

want to be associated with failure.

Centers of different cultures and lifestyles seem to nurture creativity where the space for

new combinations of ideas and alternative ways of thinking exists. Florida (2002)

describes the social environment where creativity flourishes as “one that is stable enough

to allow continuity of effort, yet diverse and broad‐minded enough to nourish creativity

in all its subversive forms” (p. 35).

Over time more specialized domains, so‐called sub‐domains, have evolved through the

accumulation of new information and knowledge. Domains are embedded in the socio‐

cultural context which help or hinder innovation based on the clarity of structure, the

centrality within the culture, and accessibility (Csikszentmihalyi, 1996). Most cultures

prove to be conservative and reject the majority of the produced novelties thus

guaranteeing only a small percentage of the innovations will ever arrive in the market.

The field of experts can actively affect the rate of innovations (created by creativity) in

three different ways.

• Experts are either reactive or proactive towards the novelty or invention. These

experts can stimulate creative actors in their ideas to increase the rate of

innovations.

• The field applies either a narrow or a broad filter in selecting attractive novelties.

The field decides how many ideas they allow to enter the domain at any given

time, which at the extreme determines if the domain will face overload or is

underserved by innovations.

• The field of experts can also support the novelty by leveraging their network

through connecting the creative individual with crucial players (other experts) in

the social system.

16

The gatekeepers who are embedded in a socio‐cultural and economic environment decide

if an invention becomes an innovation or not. Once the field of experts has accepted the

innovation, the new “cultural meme” (Csikszentmihalyi, 1993; Dawkins, 2006) replaces

the old ones and will be maintained from now on and preserved by the gatekeepers.

Innovations can take place at the macroeconomic level as well as on the organizational

level of society. Although both levels are an important part of economical change the

work at hand focuses only on the economical level. The organizational level is about the

process within large firms which have complex internal structures – that imply their own

ecosystem. This would be rather an interesting research field for intrapreneurship

(entrepreneurs within a corporation).

2.3 Investors in Innovation and Risk‐Taking

All novelty involves some degree of risk which means that innovation is a form of risk‐

taking. Entrepreneurs mostly lack sufficient capital to bring their idea to fruition and

must rely on outside financiers. However, those financial entities that control the bulk of

money are unlikely to have the time or expertise to invest in high‐tech start‐ups.

Audretsch (2002) found that, on the one hand, birth rates and growth rates of small firms

exceed large firms, especially for those which are technology‐orientated. On the other

hand, the death rates for small firms are higher than for large firms, in particular the ones

with a technology orientation. Innovative entrepreneurs usually have high capital needs,

characterized by the fact that they need long‐term investment financing for the growth of

the company. The next rounds of funding of the company are crucial and constitute

growth barriers for most of the start‐ups which often result in the omission of the

entrepreneurial opportunity. Therefore, external financiers represent an important

interface of the implementation of innovations in an economy. While some entrepreneurs

can use debt, such as bank loans as a traditional form of financing, others are limited to

access equity capital because of four critical factors (Gompers and Lerner, 2004, p. 157):

17

• uncertainty,

• the nature of firm assets,

• asymmetric information,

• the conditions in the relevant market.

Especially, the early‐stage of an innovative start‐up company is marked with uncertainty.

The product or service offered may or may not succeed because of an unproven business

model, an unexplored niche market, or a novel technology. Young companies usually

find it difficult to obtain debt financing because of the nature of their firm assets. Firms

with tangible assets – for instance, machines, buildings, or other physical assets – may

find it easier to finance their projects than start‐ups which must rely mostly on intangible

assets. Asymmetric information creates an advantage to an entrepreneur over an investor.

While the entrepreneur manages the day‐to‐day business, an investor knows less about

the entrepreneurs’ intention to exploit or act favorably on agreed terms. If these

information asymmetries could be eliminated, debt or equity financing would be neutral.

Providers of capital are aware of these agency problems and, as a result, outside investors

demand a higher rate of return for their share.

The last critical factor of raising high‐risk capital is varying market conditions. Especially,

high‐tech start‐ups face a range of quickly changing conditions – for example, increasing

intensity of competition or undiscovered consumer behavior.

These critical factors make it difficult for high‐tech entrepreneurs to finance their business

ideas through bank loans, so that they have to rely mostly on bootstrapping or equity

investments. Private equity as an alternative asset class includes growth capital,

leveraged buyouts, mezzanine, and angel investment as well as venture capital. The

group of business angels and venture capitalists focus on early‐stage ventures, while the

others finance transformational or restructuring events of non‐publicly traded companies.

Most entrepreneurs start their venture by bootstrapping, i.e., self‐financing out of savings,

but the combination of fast growth and high risk leads them to raise additional money.

Even if the bulk of entrepreneurs may prefer to self‐finance their businesses or rely on

debt financing in order to retain control of the company, this is not always possible or in

some cases not advisable. Bootstrapping is more cost intensive and it takes longer to raise

18

the needed amount. Nonetheless, Bhidé (2000) that only 5 percent of Inc. 500 companies

in 1989 in the United States began with venture capital funding, while 80 percent

bootstrapped from other sources. It is assumed that entrepreneurs have no own wealth

and must rely on an outside investor to fund their project. Moreover, because they often

lack experience in commercial matters, they do not only seek capital but also strategic

business advice.

Start‐up companies require significant up‐front expenditures for their ventures (i.e.

prototype development, business infrastructure etc.). From an investor’s point of view,

the financing sequences is illustrated in Figure 2.2, which is an adaption of the

“developmental funnel” commonly used in new product innovation management

(Wheelwright and Clark, 1992, pp. 111‐132).

Fig. 2.2 Financing Sequence Source: adapted and extended from Wheelwright and Clark (1992, pp. 111‐132) and Callahan and Muegge (2004)

Many business opportunities enter the funnel and over time the amount of actual funded

ideas shrink down to only a few. Venture opportunities arrive at the “fuzzy front end”

pursued by the entrepreneur and the entrepreneurial team. The progress of the ventures

depends on the attainment of required milestones that are also requested by outside

financiers. These milestones may include having a business plan, developing a prototype,

19

making a first sale, and becoming a positive cash flow. At each stage, portions of these

opportunities fail. Gupta and Sapienza (1992, p. 349) see an advantage in venture capital

compared to big institutional investors (e.g. pension funds) and outline how it creates

value. First, it is an interface bringing investors and entrepreneurs efficiently together.

Second, venture capitalists can make a more subtle investment decision in comparison to

ordinary investors. Third, they add value to the start‐up.

2.4 The Venture Capital Business

The investment of venture capital provides funds to entrepreneurs. Even if today’s

venture capital industry is fairly new, early observations of financing entrepreneurs by

individuals and organizations can be dated back in history to Babylon (Coopey, 2005).

The first modern venture capital firm, American Research and Development (ARD), was

established in 1946 by local business leaders in order to commercialize technologies

developed at MIT. During the late 1970s and early 1980s, the funds inflow into the

venture capital market increased dramatically because of regulatory and policy changes

(Gompers and Lerner, 2004) that paved the way for the development towards an

important financial intermediary for innovative and high‐risk firms. Venture capital

became an important part of capital market in the United States and in the early 1990s in

Europe as well. The capital inflows in the United States rose from $3 billion in 1990 to

$103 billion in 2000 (Woodward and Hall, 2004). In 2003, companies that were backed by

venture capital accounted for 9.4 percent of the private sector labor force in the United

States, and generated $1.8 trillion in sales, or 9.6 percent of all business sales (Shane,

2008). Even if the venture capital industry has a huge impact on the economy, the number

of firms is only around a few thousand. The distribution of venture capital investment in

the United States is highly concentrated; around 80 percent of all these investments are

made within 15 metropolitan areas (Zook, 2005, p. 57). Well‐known high‐technology

companies like Apple Computer, Intel, Facebook, Google, and Microsoft have been

backed by venture capitalists over the last decades.

The formal venture capital market can be categorized into incubators, corporate venture

capital, government supported venture capital, and independent venture capitalists,

which this study focuses on. Usually venture capitalists possess entrepreneurial

experience, managerial expertise, and detailed industry knowledge. Venture capital can

20

be defined as a company, which is independently managed with dedicated pools of

capital that focus on equity or equity‐linked investments in young privately held, high‐

growth companies for the primary purpose of capital gain (see Gompers and Lerner,

2004). The size of a venture capital firm varies from a few employees to larger ones with

50 to 100 employees.

Venture capitalists concentrate their activities on entrepreneurs in businesses with high

growth potential in hopes of achieving a high rate of return on invested funds (Timmons,

1999). Venture capital literature argues that venture capitalists rarely invest outside the

two main sectors of information technology (such as computers, telecommunication or

semiconductors) and life sciences (mainly biotechnology, medical instruments and

medical services), but in practice venture capital firms diversify their investments. For

many entrepreneurs venture capital financing is an attractive source of funding (informed

capital: financial as well as knowledge and network input), but not every start‐up should

request venture capital because of the business model does not the meet the venture

capitalists’ requirements.

The venture capitalists’ investments in businesses with a high risk‐reward ratio bear

uncertainty towards the entrepreneur as well as the industry. Firms that usually receive

venture funding have substantial intangible assets which are difficult to value, the

markets on which they operate are highly variable, and the relationship between investor

and investee is characterized by information asymmetries. Table 2.1 shows a compilation

of the various risks venture capitalists are faced with.

Tab. 2.1 Risks of Venture Capital Funding

Types of risks early‐stage (seed, start‐up)

later‐stage(expansion, bridge, MBO/MBI)

market‐related

• market development• competitive situation

• market potential • innovators and early adopters

• new competitor entry

business‐related • development and production costs • access to human capital

• research & development costs • flexibility

• revenue/market share • organizational structure

financial‐related • bankruptcy• high burning rate • disinvestment opportunities by

large corporations • poor‐performing stock market

Source: compiled by the author

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Scholars have conducted in‐depth studies on the different tools employed by venture

capitalists to mitigate the problems. These include screening methods; due diligence;

active monitoring (Hellmann, 1998) of internal (e.g. management team quality), external

(e.g. market size) and complexity risk (e.g. technology innovation); staging financing

(Bergemann and Hege, 1998); investment syndication (Admati and Pfleiderer, 1994); and

compensation contracts (Kaplan and Strömberg, 2003) to reduce the possibility of failure

in an uncertain environment.

The venture capitalist faces the trade‐off of spreading the risk by diversifying or the

specialization of the investments in the portfolio. Some firms channel their investments

into only one sector; others have more resources and capabilities and are able to diversify

their investments. The diversity of investment opportunities and changing economic

structures has created a broad heterogeneity of venture capital firms over time. However,

within the venture capital industry a certain type of investment process has evolved that

can be generalized. The venture capital process involves the raising of the venture capital

funds, making investments, proceeding with monitoring and adding value to the firms,

and finally, the venture capitalist exits successful deals and returns capital to the end‐

investor. Each venture capitalist has its own individual recipe of successes. However, Table

2.2 outlines the main seven stages of the venture capital investment process (Bygrave and

Timmons, 1992, p. 14; Sweeting, 1991, p. 603; Tyebjee and Bruno, 1984).

Tab. 2.2 Venture Capital Investment Process

Stage Features

1) fund‐raising • seeking for (institutional) investors 2) deal origination/

deal flow • access to investment opportunities (directly by theentrepreneur, active deal seeking, or third party referrals)

3) deal screening • criteria: technology and/or market size; stage of financing;and rating

4) deal evaluation • due diligence and decision‐making based on marketattractiveness, management team, and quality of theproduct or service

5) deal structuring • contracting and pricing

6) post‐investment activities/ monitoring

• value added (management guidance through the boards ofdirectors)

7) cashing out • sale of investment

Source: adopted from Sweeting (1991, p. 603)

22

Fund‐raising from big institutional investors is essential for the rest of the investment

process and constitutes one of its main elements. Fund providers can include big financial

institutions such as banks, pension funds or insurance companies, the government or

universities – all of which put a small percentage of their total funds into these high‐risk

investments. They expect a return of between 25 to 35 percent per year over the lifetime of

the investment. The limited partnership (LP) became the dominant organizational form in

venture capital investments.

While the venture capitalist serves as a general partner and manages the fund, the

investor only monitors the fund’s progress as a limited partner and as a result does not

get involved into the operational management activities (Gompers and Lerner, 2004),

otherwise the LP would risk its limited liability. Such partnerships involve aspects of both

limited liability (for the investors or fund providers) and of unlimited liability (for the

venture capitalist). While the venture capitalist should be specialized, LPs are diversified

in investing in a wide range of asset classes.

Zider (1998) argues that institutional investors place only a small percentage of their

portfolio on venture capital, so that the venture capitalist has the latitude to raise

additional capital. That lead the investor to invest in a fund is not the specific investment

but the venture capital firm’s track record, the fund’s “story”, and their confidence in the

partners themselves.

LPs expect a certain investment profile (i.e. sectors and stages that the venture capitalist

invests in). In the beginning, the limited partner and the general partner agree on the

funds’ terms, including the fund’s life cycle that is between ten to thirteen years and the

compensation that contains a fixed annual share of 1.5 to 3 percent of the committed

capital and around 20 percent of the fund profits. Venture capitalists frequently disburse

funds in stages to show their investors that their money is not invested in unprofitable

ventures. “Higher returns lead to greater capital commitments to new funds” (Gompers

and Lerner, 2004, p. 28). The initial partnership agreement governs the relationship over

the funds’ life and is rarely renegotiated. Government policy and a healthy stock market

may have a great impact on the commitment of venture capital funding (Gompers and

Lerner, 2004; Jeng and Wells, 2000).

23

“Deal flow” refers to the influx of business plans which is also an essential part of the

investment process determining the quality of the investment opportunities that the

venture capitalist can make. Usually, a venture capitalist receives around 1,000 business

plans per year (NVCA, 2009). Only a few of these proposals get a second look, most of

them ending up in the drawer. In fact, for every 100 business plans that request venture

funding, usually ten receive a serious look, and only one might be funded by a venture

capital firm (NVCA, 2009).

Relevant candidates get 10‐15 minutes for the first screening in regard to the investment

volume, geography, the industry and the financing stage (Sweeting, 1991, p. 610). The

first screening also reviews if the proposal fits the firm’s investment profile. Business

plans from trusted sources or personal network have a higher chance for closer screening.

The deal evaluation starts with the letter of intent to protect the venture capitalist that sets

the path for due diligence. It allows the venture capitalist to scrutinize serious candidates

extensively through a wide range of instruments. During that time, the entrepreneur is

not allowed to look for other sources of funding. Due diligence includes meetings with

the entrepreneur, entrepreneurial team, and consultation with external sources (such as

potential customers, market surveys, experts etc.). Due diligence investigations are

usually extremely time‐consuming and costly.

When the venture capitalist is positively convinced about investing in the venture, both

parties move on to deal structuring. The contract negotiations about the deal price

include the number of shares that venture capitalists invest, the venture capitalists’ rights,

reporting standards, board‐meetings, entrepreneur’s salary, and capital structure or

change of business model (defined in term sheet). If both parties agree, the venture

capitalist makes an investment proposal and closes the deal. The venture capitalist then

adds the new investment to the portfolio of the fund.

One of the major functions of venture capital is value adding to the portfolio company.

The dynamic development of young companies requires frequent support as well as

constant controlling of the high risk venture. “Venture capitalists play a catalytic role in

the entrepreneurial process [offering] fundamental value creation that triggers and

sustains economic growth and renewal” (Bygrave and Timmons, 1992, p. 1; added by the

author). Their strategic advice is generally regarded as one of the major contributions to

24

the portfolio companies (Gorman and Sahlman, 1989; MacMillan et al., 1988). Post‐

investment activities include a wide range of value adding services such as attending

board meetings, consulting management team in strategic decisions (e.g. introduction to

potential customers, suppliers, or experts etc.) as well as monitoring the portfolio

companies. The venture capitalist is in control of the value added through her or his seat

at the board of directors.

There are different types of involvement between the exchanging parties. The information

flow from the entrepreneur to the venture capitalist refers to the term monitoring and vice

versa to advising. If both parties have a bilateral information flow it is called assisting or

value adding which are executed through the board seat (Manigart and Sapienza, 2000, p.

248). The function of value adding is, on one hand, risk mitigation via controlling, on the

other hand, increasing the value of the investment via consulting. While these processes

are very labor intensive and time consuming, the involvement intensity varies among the

venture capitalists and each portfolio company appreciates this support differently

(Barney et al., 1996).

Ideally, venture capitalists should serve as a “sounding board” (MacMillan et al., 1988, p.

31) by providing information and exchange of idea for the entrepreneur and its team.

Time is a scarce resource and the venture capitalist has to decide on what portfolio

companies to spend his or her available time. The venture capitalist has around two to

four hours per week to support and advise one of the portfolio companies (see Gorman

and Sahlman, 1989). The time spent on value adding activities (such as directing,

monitoring and recruiting new management members) is estimated at about 70 percent of

available hours of the venture capitalist (Zider, 1998). The directors that represent the

venture capital firm possess in many cases special expertise and useful networking

connections, contributing to strategic decision‐making by offering social capital‐based

and knowledge‐based forms of value adding (Rosenstein et al., 1993). They use their

expertise in corporate governance to reduce agency and business risk. In exchange, they

demand a preferred equity share of the new venture, along with favorable upside and

downside investment protections. The degree of involvement (MacMillan et al., 1988)

depends on the different preference of venture capitalists, conceived differences in

business‐ and agency‐risk (Barney, 1986), regional and national differences in venture

25

capitalists’ approach (Sapienza et al., 1996), and other factors (such as degree of

innovation, distance to venture capitalist, experience of the people involved etc.).

The process by which value adding activities contribute to portfolio companiesʹ

performance is yet to be understood completely. Previous studies on venture capitalists’

post‐investment activities tend to be descriptive and somewhat a‐theoretical (Sapienza et

al., 1996) and have overlooked the fact that venture capitalists differ in their level of

involvement in policy making at their at their portfolio companies (see MacMillan et al.,

1988). In contrast to traditional financial‐contracting theories venture capitalists

implement different regulations depending on the practical use that allow them to

independently allocate cash flow right, board rights, voting rights, and liquidation rights

among others. Bhidé (2000, p. 144) argues that this asymmetry leads venture capitalists to

take excessive risk in their investments so that the efficient pricing of investment is also

very labor intensive.

Another instrument to mitigate risk is staging. Venture capitalists do not invest the entire

amount all at once, they rather set milestones and provide additional capital based of the

entrepreneur’s accomplishments. Venture capitalists sometimes need to partner with

other venture capital firms because they cannot back up full amount of capital needed for

the start‐up or they do not want to bear the whole risk alone. Venture syndication also

signals other venture capitalists that it might be worth investing in.

The final part in the cycle is the exit. It involves cashing out or a divestment of the shares

of the portfolio companies. Venture capitalists need successful exits to generate attractive

returns for the investor which are realized after 3 to 7 years of initial investment. Potential

outcomes of investments include an IPO (initial public offering at the stock exchange),

which is the most profitable exit opportunity, an acquisition by a large cooperation, or the

company remains private or goes bankrupt. The latter ones are unfavorable for the

venture capitalist and need to be compensated by the successful portfolio companies.

Interestingly, a study of venture capital portfolios by Bhidé (2000, p. 145) reports that

about 7 percent of investments accounted for more than 60 percent of the profits, while

one‐third resulted in a partial or total loss.

There has been some criticism about venture capital and its ability to add value to a start‐

up (Manweller, 1997). This might be a misconception, but not all entrepreneurs match the

26

venture capitalists’ criteria and as a result will not receive funding. Vice versa not every

venture capitalist is a supportive partner when working with entrepreneurs. Some

entrepreneurs may perceive venture capitalists as passive investors or even ʺvulture

capitalistsʺ that, in reality, only provide an expensive source of capital (Sorenson, 2004).

Zider (1998) criticizes venture capital by claiming: “The myth is that venture capitalists

invest in good people and good ideas. The reality is that they invest in good industries

[…] regardless of the talent or charisma of individual entrepreneurs, they rarely receive

backing from a VC if their businesses are in low‐growth market segments” (p.133; added

by the author).

2.5 Critical Summary and Conclusions

For an economy and its agents, the creation of new knowledge ‐ in the form of products,

processes, or organizations ‐ is essential because it enables them to exploit the arising

opportunities commercially (Acs, 2006). The ability to transform the new knowledge into

commercial useful knowledge requires a set of skills, aptitudes, and circumstances.

The Knowledge Spillover Theory of Entrepreneurship is a valuable model to build the

foundation for explaining technological change and economic growth but it misses the

most crucial factor of economic prosperity – innovations.

The systems model by Csikszentmihalyi (1996) points out that there is a field of experts

who judge if an invention turns into innovation or not. These experts are described as

“gatekeepers” that determine the inflow of innovations to a domain (or market). Their

function is either preserve the status quo or being a promoter for change.

Gatekeepers are ascribed here as venture capitalist who can be labeled as facilitators for

innovations. Venture capitalists, as active investors, have two main roles: “They identify

and locate more valuable investments and direct capital to them, and they monitor and

manage their investments to increase their return” (Sorenson, 2004, p. 2). They are the

“vehicles of innovations” and their influence and the role as a crucial player has

advanced over the last decades by supporting entrepreneurs to succeed in the market.

27

3. STRATEGY DIMENSION

3.1 Strategic Considerations of Venture Capitalists

Gaining insights into strategic considerations of the parties involved is important in order

to understand the decision‐making process of venture capitalists as “experts” (see

“systems model” by Csikszentmihalyi; Sect. 2.2). Strategic thinking implies two main

approaches. On the one hand, it develops concepts for the realization of goals that a

company wants to achieve in the future. On the other hand it focuses on the survival of

the company in the long‐term.

Companies are entities embedded in a complex and dynamic socio‐economic

environment in which they are continually interacting and exchanging resources with

other entities. They are open‐systems with more or less permeable boundaries (Beer, 1980)

depending on the input of resources from their environment which enable them to

survive in the long‐run (Luhmann, 1984). Defining resources as all latent and/or abstract

means which are critical in the production of goods and services, but are not unlimited

and cannot be acquired on factor markets (Müller‐Christ, 2004).

3.2 Strategic Resources Approaches

3.2.1 Sustainable Competitive Advantage

The Resource‐Based View

The dominant paradigm in strategic management literature is the “resource‐based view”

(RBV) which has gained a central position in explaining how firms achieve a sustainable

competitive advantage, and hence, why firms succeed over their competitors in certain

markets.

The RBV (Barney, 1991; Penrose, 1959) focuses primarily on the competitive advantage of

a firm that is based on internal resources and capabilities, i.e. bundles of firm‐specific,

tangible and intangible, resources. The origin of the RBV lies in Penrose’s (1959) work, in

which she views firms as a broad set of productive resources, considering every firm to

be unique due to heterogeneous bundles of resources that are accumulated and

developed over time (Penrose, 1959, p. 25).

28

As one of the predecessors of the RBV, Coase (1937) argues that certain types of business

processes can be deployed more efficiently within firms than on markets. Barney (1991)

considers firm resources to include “all assets, capabilities, competencies, organizational

processes, firm attributes, information, knowledge, and so forth that are controlled by a

firm and that enable the firm to conceive of and implement strategies designed to

improve its efficiency and effectiveness” (p. 155). Tangible and intangible assets are the

source of advantage if the accumulation, generation and deployment of these resources

are unique and valuable (Dierickx and Cool, 1989). Of course not all resources have the

potential to achieve a sustainable competitive advantage in the market, but in order to

create “barriers of imitation” resources need to be valuable, rare, inimitable and not

substitutable (Barney, 1991).

Intangible resources are critical for the generation and deployment of tangible resources,

but some of these resources can neither be purchased in secondary markets nor built up

quickly in the market. These important assets might be part of the strategy, but they are

non‐appropriable. Reputation, for example, “must be cultivated”(Dierickx and Cool,

1989, p. 1505) and is “not [a commodity] for which trade on the open market is technically

possible or even meaningful” (Arrow, 1974, p. 23; added by the author).

Factor markets are incomplete and some of the assets are not traded on open markets;

hence the RBV assumes these non‐tradable firm‐specific assets have to be accumulated

internally. It also argues that differential firm performance is fundamentally due to firm

heterogeneity.

In venture capital literature, the RBV has recently gained more attention (see Manigart et

al., 2002) but is still extremely understudied. Wuebker (2009) argues that the RBV can act

as a complement for the currently dominating venture capital literature on institutional

and agency approaches. One might refer to the venture capital as the “future trends

industry” because of their investments in cutting‐edge technologies and high‐potential

entrepreneurs. These investments in ventures of uncertainty make this industry very

unpredictable and vulnerable. Venture capital firms are constantly threatened by

changing regulations and the radical uncertainty of their environments and newly arising

market conditions. Some regulatory and market disruptions cause changes to which

venture capital firms cannot easily adapt their practices to in the short‐run because of

29

their resource dependencies (e.g. fund‐raising). In practice, venture capital firms

constantly adjust themselves to new trends and a changing business environment but the

literature lacks a consistent framework for strategic decision‐making that goes beyond a

sole position as a financial intermediary. Long‐term planning based on scarce resources

(e.g. high‐tech entrepreneurs) has yet to be discussed.

The Dynamic Capability Approach

While the RBV puts an emphasis on firm‐specific capabilities and the existence of

isolating mechanisms as the fundamental determinants of firm performance (Barney,

1991), the “dynamic capability approach” (Teece et al., 1997) can be viewed as an

extension that addresses rapidly changing environments through the firm’s ability to

integrate, build, and reconfigure internal as well as external competences.

The Relational View

The environment is the resource pool for a firm, but not all relevant resources are freely

accessible. Some resources are in the possession and under control of other organizations

or can only be achieved from a mutually interactive exchange. The “relational view”

(Dyer and Singh, 1998) considers the lack of outside focus of the RBV and draws its

competitive advantage from four potential sources: (1) relation‐specific assets; (2)

knowledge‐sharing routines; (3) complementary resources and capabilities; and (4)

effective governance.

The concept of social embeddedness of economic relations (Granovetter, 1985)

emphasizes that the continuity of the relationship depends on the long‐term orientation,

the willingness of the parties to continue doing business together in the future. Network

partners combine, exchange, and invest in resources and capabilities, and/or employ

effective governance mechanisms that lower transaction costs or release a new range of

opportunities (Dyer and Singh, 1998).

In a partnership, neither of the firms can purchase the relevant resources on the

secondary market. These resources are invisible and hence incentivize both firms to

cooperate to access complementary resources. A well‐positioned firm in the network is

able to access more reliable information about potential partners through trusted partners

who may have already had experience with this candidate (Granovetter, 1985). The

30

internal transformation of external resources of network partners depends on the firm’s

“absorptive capacity”, but goes beyond the sole possession of internal assets (see

Duschek, 2004). Resource indivisibility describes that certain intangible resources cannot

be separated into different parts, but are rather created through the “mutual coevolution

of capabilities” (Dyer and Singh, 1998, p. 673) and are therefore hard to imitate.

Networks are an organizational form distinct from both market exchange and firms

(Granovetter, 1985). In the entrepreneurship context, networks may serve a variety of

social purposes for facilitating the founding of new ventures. Networks can be viewed as

social networks that are structural responses to the social environment of governance

institutions. In the context of venture capital, networks may serve a variety of social

purposes for facilitating and sustaining to bring an innovation to market. They can be

seen as social networks that are a structural response to the social environment of

institutions. A network evolves out of the common will of social actors, who are goal

oriented and cooperate temporarily with each other to tackle common challenges.

Network experts are important latent resources. They are informal subsystems of

resources supply.

3.2.2 The Resource Dependence Approach

The “resource dependence approach” (Pfeffer and Salancik, 1978) emphasizes the

importance of the supply of valuable resources from the environment to maintain and

advance the company’s function and explains it under aspects of resource dependency.

The survival of an organization depends on the quality of the resource supply from its

environment (Beer, 1980). These systems are in exchange with others systems in order to

secure the constant influx of resources and to fulfill their purposes and goals. A special

dependency emerges when intangible resources such as reputation and trust gain

importance (as it is the case in venture capital). These resources are not only relatively

limited and not easily reproducible, but are rather absolutely scarce and only accessible

through complex processes (Müller‐Christ, 2001).

There has been no systematic attempt to amalgamate the RBV which views resources as

strategic competitive advantages (Barney et al., 2001) with the resource‐dependence

approach which is about sustaining the long‐term supply of critical resources. The

“resource dependence approach” is important in order to understand sustainability and

31

its exchange relation with the environment. Georg Müller‐Christ’s (2001) approach

acknowledges the resource dependency defining sustainability as the balance of resource

consumption and resource reproduction. He criticizes the RBV and resource dependence

approach as short‐sighted and focused only on the competitive advantage and the

exploitation of the source of resources, respectively. Therefore, Müller‐Christ (2001)

developed a concept that integrates the understanding of sustainability in the long‐run.

His concept reveals the tensions between short‐term resource exploitation and long‐term

resource supply (see Sect. 3.3). Subsequently, his approach is extended by Ina Ehnert’s

(2009) view on how to cope with paradoxes that are created by short‐ and long‐term

tension.

3.3 Sustainable Resource Management

Resources can be an indicator of firm’s progress as well as its survival. Management faces

the problem of decision‐making within the constraints of scarce resources (Ansoff, 1965).

Limited resources are an underlying notion of sustainability. Historically, it can be linked

to early ideas of household sustainability which already date back to Aristotle (Müller‐

Christ and Remer, 1999). Aristotle’s concept of the “household” (Greek: oikos) can be

summarized as the ability to produce what is needed for survival (Müller‐Christ, 2001).

Müller‐Christ (2001) picks up on this idea by defining sustainability as the balance of

resource consumption and resource reproduction or in other words, the ratio of

consumption to reproduction of resources equals one.

Sustainability is the balance of resource consumption and resource supply from the

community. A company as a resource‐dependent system has to manage its business in a

sustainable way (Müller‐Christ and Gandenberger, 2006). The sustainable resource

management approach (Müller‐Christ, 2001) is based on three theoretical assumptions

(see Ehnert, 2009, p. 56). First, organizations survive because they manage the balance

between mutually opening and closing their boundaries (Luhmann, 1984). Second, the co‐

evolution theory (see Bateson, 1972) assumes that organizations cooperate with each

other to create mutual exchange relationships and thus reproduce the resource base.

Third, economic ecology (Remer, 1993) states that organizations survive when “they

manage to sustain and reproduce their resource base in their environments” (Ehnert,

2009, p. 56).

32

Organizations depend on the constant influx of resources from their environments to

sustain their purpose in the long‐run, thus it seems rational for them to invest in their

survival (Müller‐Christ, 2001). “If companies want to consume critical resources on a

long‐term basis, the “origin” of these resources has to be sustained” (Ehnert, 2009, p. 56;

emphasis in original). Thus, companies need to identify the “specific conditions” of the

development and the conditions that define the reproduction of these critical resources

(Ehnert, 2009; Müller‐Christ and Remer, 1999). The “sources of resources” provide the

company with these critical resources (Müller‐Christ, 2001) and need to be sustained in

order to leverage the influx of these important assets in the long‐run (Müller‐Christ and

Remer, 1999). If a company perceives a resource as absolutely scarce, which means that

resources is or will become rare in the future, it engages in efforts to sustain it (see

Müller‐Christ, 2001).

From a system theory perspective, organizations are confronted with the circularity of

causes and effects and the time lag between the investment and the ultimate achievement of

the goal (Beer, 1980). “On a very long‐term basis an organization’s survival is dependent

on how well it has been exchanging with its environment”(Beer, 1980, p. 23).

Resource exchange with its environment is a complex and circular process of interactions.

If companies do not build up and maintain their “bottleneck resources” (Müller‐Christ

and Gandenberger, 2006, p. 11), they would fail to achieve their purpose in the long‐run.

Müller‐Christ (2001) argues that only a thorough knowledge about how the way

resources are reproduced can protect the reproduction circle from disruptions (laws of

reproduction). The company has to define its critical resources which threaten its

existence directly or indirectly if these resources are withdrawn from the supply. Müller‐

Christ (2004) argues that a detailed knowledge about the processes of reproduction and

the investment in the functionality of the system can stabilize the long‐term supply.

A firm manages its business in a sustainable way if the firm’s ability to produce and

invest remains intact and allow (re‐)building the economic substance (Müller‐Christ,

2001). As described previously, immaterial resources are all “latent and/or abstract

means” which are crucial factors in the process of creation of value for a company. These

intangible resources do not advect into the value creation but have a “moderator

function” (Müller‐Christ, 2004, p. 32) that secures the constant influx of important

33

tangible resources. Certain resources such as reputation are path‐dependent and

accumulated over time which makes it difficult for competitors to imitate.

The RBV assumes that a company creates a sustainable competitive advantage by

accumulating and developing resources and capabilities which enable it to create

economic rents. This approach does not address the problems of short and long‐term

conflicts. Müller‐Christ (2001) links sustainability to organizational theories. He argues,

on the one hand, a company needs to be efficient in the market through maximizing its

profits to survive in the short‐run. On the other hand, in order to survive in the long‐run

the company has to invest into its “resources base” and maintain a constant influx of

critical tangible and intangible resources. These investments may reduce the profits in the

short‐run, but are necessary to be able to attain and maintain crucial resources in the

long‐run. Both constitute contradictory logics or rationalities which cause a dilemma

between efficiency and sustainability (Müller‐Christ, 2001). The former, exploiting

resources, follows the economic logic, while the latter, reproduction of resources follows

the sustainability logic. The underlying concept assumes that both logics, economic and

sustainability, cannot be maximized simultaneously (Müller‐Christ, 2001).

Hülsmann and Grapp (2005) suggest a different classification of rationalities and instead

propose an efficiency‐orientated and a substance‐orientated model that is less absolute in

regards to opposing logics. As Ehnert (2009) points out, on the one hand, the efficiency‐

orientation seeks “to [maximize] the output‐input ratio of corporate resources” (p. 72)

which consists of all activities that deploy resources more efficiently. This also leads to an

“increased financial performance and sustainability […] perceived as a means to reach

this objective” (p. 72). On the other hand, “[s]ubstance‐orientated actions are those with

the objective of balancing corporate resource consumption and reproduction on a long‐

term basis” (p. 72) by, firstly, investing in the reproduction of the resources base, and

secondly, balancing between the consumption and the supply of new resources. As with

the Müller‐Christ’s (2001) classification, “[t]hese opposing demands are the identified

systemʹs goals of sustainability and efficiency. They have to be realized simultaneously.

Yet, this will only be possible by balancing between them and not by strictly following

only one of them” (Hülsmann and Grapp, 2005, p. 11).

34

In the context of this study, intangible resources such as reputation and trust are of

special interest. Reputation is a resource that appears in an interactive process of

exchange relations over time and it is difficult to acquire. The company‐environment

relationship becomes a mutual resource exchange relation.

3.4 Paradox‐Management

Ehnert (2009) recommends that “both short‐ and long‐term developments should be

anticipated and considered in corporate decision‐making processes” (p. 40). Since a

venture capital firm is embedded in a network of complex exchange relations one has to

consider the different interests of various stakeholders. Dyllick and Hockerts (2002)

suggest that “corporate sustainability can accordingly be defined as meeting the needs of

a firm’s direct and indirect stakeholders (such as shareholders, employees, clients,

pressure groups, communities etc), without compromising its ability to meet the needs of

future stakeholders as well” (p. 131).

The efficiency‐orientation and the substance‐orientation cannot be maximized

simultaneously. The allocation of a resource to a certain task means inversely a non‐

allocation that cannot be applied to a non‐chosen alternative. Resources cannot be

deployed at different places at the same time. This results in a management dilemma or

an either‐or problem of the allocation. Companies have to reflect on the consequences as a

byproduct of their actions; therefore they need the ability to understand the environments

that they are embedded in (Müller‐Christ, 2001).

How can a company manage to achieve its goals in a complex process of interactions?

Peters and Waterman (1982) assume that “excellent companies […] know how to manage

paradox” (p. 91). Or as Cameron (1986) put it: “most effective organizations are also those

characterized by paradoxes, i.e. contradictions, simultaneous oppositions, and

incompatibilities” (p. 539). Companies have to deal with wide range of challenges that are

sometimes contradictory and need to be addressed not only by practitioners, but also by

scholars through theoretical concepts.

Paradox, duality, and dilemma are examples from literature on paradoxical phenomena

(for a detailed review and subtle differences see Ehnert, 2009). Paradox is the broadest of

these three terms. Ehnert (2009) suggests:

35

“Paradox theory suggests that contradictory opposites or dualities exist in any organizational setting and that the tensions arising from them cannot be avoided or escaped from. Instead, the oppositions and tensions have to be faced and dealt with in order that a company is successful on a long‐term basis” (p. 29).

Ehnert (2009) compiles a comprehensive overview of the research on paradox theory

which was introduced a few decades ago to organizational research as an analytical tool

to tackle the increasing challenges in society and in the business world. The concepts of

paradoxes should to question the linear cause‐and‐effect thinking in strategic management

(see Ehnert, 2009).

As Ehnert (2009) points out “[p]aradoxes have been [characterized] by oppositions or

contradictions, mutually exclusive elements which operate simultaneously and create

tensions” (p. 135). She compares a paradox as an analytical tool that could be similar to

“Janusian thinking” (after Rothenberg, 1979), “holding two or more opposites together in

mind accepting their coexistence” (Ehnert, 2009, p. 135). While the notion of paradox can

include more than one contradiction, the term duality stands for only two opposing

forces that are complementary. The third term, dilemma, involves a situation in which a

choice must be made; what is a paradox today can become a dilemma in any instant if

action has to be taken. Ehnert (2009) summarizes a dilemma: “A situation in which a

difficult choice has to be made between two alternatives, especially when a decision

either way will bring undesirable consequences” (p. 132). Hülsmann (2003) distinguishes

a constructive dilemma as reflecting a problem in decision making in which the goal can

be achieved by two alternatives. While there is opportunity in a constructive dilemma, a

destructive dilemma is characterized by the impossibility of choosing between two

options that can result in a rational choice. In this case, neither of the two options can be

fulfilled simultaneously.

Remer (2001) criticizes that the scientific community has not yet discussed the issue of

contradictory phenomena extensively. Ehnert (2009) picked up on Remer’s request and

integrated it into her perspective by claiming that “dilemma management is a matter of

finding adequate configurations of a management system with particular focus on the

relationship between different elements of this system” (p. 146) (see also Remer, 2001).

Ehnert (2009, p. 147) highlights three elements of the paradox theory: (1) paradoxical

36

tensions, ambivalence and ambiguities; (2) reinforcing cycles; and (3) strategies to cope

with these phenomena.


In this chapter, the strategic considerations of venture capitalists are condensed to the

aspects of resources and sustainability. Management scholars inherently assume

sustainability when they speak about “sustained competitive advantage” (Barney, 1991).

The term sustainability has been on the rise in general management literature over the

last several years. Lately, various streams of sustainability research have been mostly

focused on large corporations with less emphasis on the differences in smaller

organizations. In fact, venture capital firms are similar to small firms, but with an

immense impact on the economy (see Sect. 2.4). Achieving a sustainable competitive

advantage is part of the strategy process, but it falls short of explaining how to survive in

a constantly changing environment where (intangible) resources are idiosyncratic and are

incapable of being generalized.

This chapter introduces further approaches in strategic management literature such as the

dynamic capability approach, relational view, and resource dependence approach.

RBV in management literature has contributed to the appreciation of the importance of

tangible and intangible resources. The RBV suggests the need to identify resources gaps

and to invest in a company’s resources base, as Grant (Grant, 1996) proposes, for

“harmonizing the exploitation of existing resources with the development of the

resources and capabilities for competitive advantage in the future is a subtle task” (p.

132). However, it dismisses the “specific conditions of development” of the “sources of

resources” (Ehnert, 2009, p. 120) and future resources that need to be deployed. Thus, a

concept is needed that deals with the “origin” of resources and how they can be

developed (Müller‐Christ, 2001).

The (re‐)production of these crucial resources requires certain inputs and is time

consuming. Thus, RBV and the resource dependence approach are linked to build an

understanding for sustainability in the venture capital context. Short‐term efficiency and

long‐term sustainability are analyzed and it is recognized that both poles cannot be

maximized simultaneously. It is then proposed that the sum of decisions define if a firm

37

has balanced out the efficiency‐orientated and substance‐orientated effort. Subsequently,

paradox management is introduced to get a better understanding of the embeddedness of

venture capital firms in complex environments which they are dependent on and thus

need to be managed.

Up till now, the term sustainability in venture capital literature could only be detected in

regards to investment profiles of “green projects” (investments in clean tech, i.e.

ecological and energy ventures). Introducing a sustainability dimension to venture capital

research seems like a valuable concept when trying to understand an industry which is

faced with struggles such as ʺcyclicalityʺ or ʺherdingʺ, making strategic decision‐making

and anticipating future trends even more important.

The venture capitalist is a financial intermediary who bridges between the entrepreneur

and an investor. For accomplishing this task, the venture capitalist needs other supporters

who provide access to resources and/or facilitates complex processes. The network

contains accountants, lawyers, and market researchers etc. who possess certain resources,

capabilities and network connections. A strong personal and/or professional network

seems to be an important asset of venture capitalists. Network resources can be leveraged

for recruiting personnel for the start‐up, through personal references, technical

evaluations, management advice, and financing sources etc. In particular, informed

networks of experts can evaluate technologies and the market potentials of proposed

business plans.

Another crucial resource is trust; its absence would damage a vital part of the

entrepreneur‐venture capitalist relationship and in the worst case the relationship would

dissolve. This resource deserves more attention in venture capital and entrepreneurship

research. Thus, Chapter 4 discusses the characteristics and the development of trust.

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4. THE TRUST PERSPECTIVE

4.1 Trust as a concept

Trust is an essential part of a functioning economy. It is the cohesion element which enables

economic exchange to proceed smoothly. As Arrow (1972) suggests that “virtually every

commercial transaction has within itself an element of trust” (p. 357), but trust as a

concept still lacks in‐depth research, especially in the field of venture capital research.

Scholars found a positive correlation between trust and economic growth (Knack and

Keefer, 1997; Zak and Knack, 2001). However, as a subjective concept, trust is often

distrusted by economists, but this distrust is also of the same subjective reasoning

(Bottazzi et al., 2009). Trust as a concept has recently gained more attention because of the

limits of control mechanisms (Adler, 2001) and trust as a multifaceted phenomenon turns

out to be ambiguous and difficult to conceptualize. These issues make trust concepts

controversial in the scientific community, but also fascinating to study.

The rediscovery of trust in organizational theory owes a considerable amount of credit to

Guido Möllering’s (2006) work about the conceptualization of required pillars for trust:

reason, routine and reflexivity. Hence, this chapter introduces different perspectives on

trust and then builds up a foundation which enables the conceptualization of the

relationship between entrepreneurs and venture capitalists beyond the dominating

control mechanisms. The different levels of trust are then introduced and discussed

which enables an understanding of embeddedness within the system and exchange of

interactions.

Luhmann (1979) argues that “trusts constitutes a more effective form of complexity

reduction” (p. 8). It also increases the “tolerance of uncertainty” (p. 15) for the actors. The

concept of trust goes beyond the information it receives and risks defining the future, and

thus reduces the complexity of the future by narrowing it down to only certain allowable

possibilities (Luhmann, 1979). It is strongly paradoxical because it solves a problem of

interactions in a relationship without eliminating the problem (Möllering, 2006).

As mentioned in Chapter 3 some of the intangible resources such as trust cannot easily be

acquired on the spot market. Such resources take time to develop and they only develop

in mutual exchange relationships. Long‐lasting relationships, for instance, are

39

characterized by trust rather than opportunism. Ring and Van de Ven (1992) define trust

broadly as confidence in the goodwill of others not to cause harm to you even when you

are vulnerable to them.

Venture capital firms invest in high‐risk ventures and inexperienced entrepreneurs and

management teams. They facilitate innovations, but they cannot rely on any previous

experience for developing the new product or service.

It is important to note that the notions of risk and uncertainty need to be distinguished. In

the concept of Frank Knight (1971 [1921]), risk as the probability of a loss or threat has to be

distinguished from uncertainty, which cannot be reduced significantly by attempting to

gain more information. Risk assessment, on the other hand, combines the probability of

an event occurring with the impact that the event would have and with its different

circumstances – so‐called knowledge of the future. Risk means to proceed based on limited

knowledge, whereas, Knightian uncertainty is the unknown or only partly known element

of the alternatives as well as probabilities of the future.

The discovery and exploitation of a novelty goes beyond rational choice from a known set

of alternatives, and thus entails radical uncertainty. Financing of new companies is

limited to little information, and is thus associated with radical ‐ Knightian ‐ uncertainty.

Investors may therefore be more prone to rely on trust.

Someone who trusts (trustor) lacks the certainty that the person who is trusted (trustee)

will behave in a way that is expected which leaves room for autonomous behavior. In

relations where there is a low level of certainty about future behavior, both parties are

forced to deal with the matter of trust. The blurred image of the future facilitates the trustor

to form positive expectations towards the trustee’s competence or goodwill because

complete knowledge or complete ignorance would eliminate the need for or possibilities

of trust. Giddens (1990) asserts that trust is always required when there is a lack of

knowledge and information.

Reason

Trust researchers agree that there needs to be a reason for trustors to trust, but note, that

if trust is diminished only to the mechanism of calculativeness it runs the danger of

dissolution. The rational choice theory is based on the assumption that a person is

40

weighing the costs against the benefits before taking any action and therefore has a

rational reason for the decision. Rational choice scholars seem to fundamentally agree on

calculativeness as the main mechanism of decision‐making, but appear to be helpless

when they are confronted with trust. Trust seems likely that it does not appear anywhere

or at any time in rational choice theory.

Hardin (2001) describes the three characteristics of trust as, firstly, being selective,

meaning not everybody can be trusted, secondly, that trust is reasonable and people look

for good reasons to trust, and thirdly, that trust is decisive and involves making a

decision to pursue a certain path.

Van de Ven and Ring (2006) assert that the role of risk is central to the model of trust and

“parties who are contracting with each other face ex ante in assessing how to deal with

foreseeable risk ex post” (p. 148). Venture capitalists and entrepreneurs are in an

unbalanced relationship with each other: the entrepreneur possesses more detailed

information about the venture than the venture capitalist, and in turn, the venture

capitalist applies a range of mechanisms to overcome these information asymmetries.

There are two popular approaches in how to deal with information asymmetries and

uncertainty in rational choice theory, “principal‐agent” and “game theory”. Venture

capital research mostly focuses on the principal‐agent theory for describing the

governance tools that are needed to align the interest with entrepreneurs. Principal‐agent

problems arise under the conditions of asymmetric information where the principal hires

an agent to perform a certain task. Thus, principal can be seen as the trustor and agent as

the trustee. The principal evaluates the agent in regard to the invisible intentions and

actions, and faces the following principal‐agent problems (Eisenhardt, 1989): hidden

information (adverse selection), hidden action (moral hazard), and hidden intent (hold

up). While the principal incurs the agency costs of the difference between the agent’s

expected and actual effort, the agent incurs the costs of convincing the principal in regard

to the agent’s capabilities and trustworthiness (see Eisenhardt, 1989).

The theory tries to anticipate the agent’s intentions and actions. In other words, the

principal tries to calculate the agent’s rational behavior and trustworthiness, but here, the

theory lacks its explanation by its own assumptions of bounded rationality. It implies that

the invisible cannot easily become visible to the principal so that the situation remains

41

uncertain. If the principal could know with certainty about the agent’s trustworthiness,

the concept of trust would be obsolete because uncertainty would disappear. The concept

of trust also fails to answer the question of how actors recognize trustworthiness and how

they deal with the remaining uncertainty and vulnerability that neither trust nor

governance mechanisms can fully remove.

The other rational choice theory, “game theory” or “prisoner’s dilemma” in particular,

assumes that actors will trust and cooperate if the perceived pay‐offs are positive. These

forms of calculative cooperation (Williamson, 1993) are based on economic an explanation

which gives incentives for someone to be trustworthy, but this would also remove the

meaning behind trust. Game theory goes a step further than the principal‐agent approach

by considering the strategic situation, in which it tries to measure the likelihood of an

event and the logical choice of the actors involved. It seeks to find a solution for the

prisoners’ dilemma based only on economic calculus and without the introduction of

trust or an equivalent construct.

Relationships with trust enable actors to exclude others from taking advantage of their

relationship or pursuing certain paths. However, an over‐reliance on trust may invite

opportunistic behavior which, in turn, might lead to a tit‐for‐tat game that forces the

actors to install formal safeguards, and eventually ends in the termination of the

relationship (Ring and Van de Ven, 1994).

Nooteboom (2006) notes on the tradeoff of the relationship that the “relation typically

ends when one of the partners encounters a more attractive alternative, while the other

partner wants to continue the relation” (p. 256) so the latter one is confronted with a

potential loss that “may cause the second partner to engage in more aggressive, risky

behavior, to maintain the relation, than the first partner, who may be more willing to

forego his profit and run less risk of a harmful separation procedure” (p. 256). It appears

that there is a need for a practical reason in a partnership, but it cannot solely rely on

calcultiveness. The problem of cooperation is the uncertainty of future profits or

performance, especially in long‐term relationships. The future development of common

projects is invisible in regards to the partner’s behavior or exogenous changes and this

makes it difficult to choose the right option.

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It has been shown that there needs to be a reason for trusting someone as well as there

have to be control mechanisms, but it cannot solely rely on calculativeness in order to

create a trustful relationship. Trust needs to be “as strong as, or stronger than, rational

proof or personal observation” (Simmel, 1990, p. 179) for a social relationship to endure in

the long‐run.

Routine

“[T]rustor (and trustee) need to be seen as embedded in systems and structures consisting

of social relationships, rules and resources that can have strong constraining and/or

empowering influences” (Möllering, 2006, p. 50; adapted by the author). As the world

becomes more complex and inscrutable it becomes more difficult to make rational

choices, and instead, relying on trust becomes an option for actors because it draws more

from reliable and relatively stable relationships. Routines help to overcome these

challenges of trusting another partner without questioning their trustworthiness or

assessing alternative options all the time. However, actors can only start trusting those

with whom they share a set of expectations towards the future of the relationship. Thus,

actors “learn to trust each other through mutual experience, knowledge and rules that

develop over time” (Möllering, 2006, p. 78) and “play a crucial role in initiating, shaping,

sustaining and changing trust in the process of interacting and associating with others”

(p. 79). This process will never be complete, that is, the trustor will never have full control

over the trustee but self‐reinforcing mechanisms may create some sort of path

dependency which may result in a trusting relationship.

Trust‐building can be seen as process of familiarization (Möllering, 2006) and it needs a

foundation to build on. Luhmann (1979) puts it, “trust is only possible within a familiar

world” (p. 20), because a person cannot confer trust without previous experiences. The

process of familiarization enables the actors to develop trust, gradually departing from a

low familiarity base or as Möllering (2006) states “familiarization shifts the boundaries of

familiarity from within. Unfamiliarity only renders trust impossible when the actor fails

to engage in familiarization” (p. 96; emphasis in original). Familiarity is a precondition for

trust as well as for distrust, the fundament for every sort of commitment towards the

future (Luhmann, 1979).

43

Trust enables the actors to exclude certain possibilities of development from

consideration and neutralizes some of the dangers. Past experiences are pooled and the

continuity of the relationship is presented, so that future‐orientated trust becomes

possible. Möllering (2006) summarizes “[f]amiliarity is required in forming trusting

expectations; familiarization creates familiarity; trust represents a kind of familiarization

with the future; but the future, in the sense of the other’s eventual actions and intentions,

remains unknowable” (p.98; adapted by the author).

Reflexivity

Trust can be viewed as a reflexive process of ongoing interactions between actors which

may have started relatively blindly or accidently, but then gradually grows and becomes

self‐reinforcing due to positive experiences of both parties involved. Luhmann (1979)

notes that in order for blind trust to be rational it has to be functional for the system. Co‐

operation requires trust and to start it is functional for both parties of not being

completely rational. Trust evolves dynamically and processual over time with an

orientation towards the future. Hardin (2002) refers to learned trust when it comes to the

process of making decisions on trust that have been made in an embedded context, not so

much based on rational choices but rather on overall experience. The “principle of

gradualness” (Luhmann, 1979, p. 41) is about the reduction of complexity over time and

that trusting relationships must be created gradually, in a step‐by‐step manner. Barnes

(1986) agrees on the dimension of time and that trust is generated and extended step by

step and the relationship is rather tentative. All this implies a slow process with small

mutual exchanges that involve little risk where the actors can prove their trustworthiness,

which results in a strong relationship with engaged partners.

Trust, as a gradual process of interaction beginning with small steps, displays some kind

of self‐reinforcement and always requires a certain level of initiative from the actors

involved. The central question is “how can actors induce positive expectations of others?”

based on the two main assumptions of uncertainty and vulnerability. Different

approaches of the trust‐building process are presented below to cover the various

perspectives on trust and its depending variables.

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4.2 Models of Trust‐Building

There is a variety of concepts about the trust‐building process that helps explain how

trust can be established and advanced in the long‐run. Two models are presented below,

the first focuses on the establishment of trust and the second on the development of trust

over time.3 Both have implications for trusting relationships.

Lynne Zucker (1986) discusses three central modes of trust production and how actors

may start establishing trust. First, “process‐based trust” is tied to past or expected

exchanges between specific actors, for example, by reputation. This enables the actors to

form a mutual exchange relationship, but the downside is that these interactions can

neither be replicated outside their relationship nor institutionalized. Second,

“characteristic‐based trust” is tied to a person based on social characteristics. This kind of

trust is produced by individuals sharing similar characteristics (e.g. education and career

background), but (this however) is already generalized to some degree, because

externally ascribed characteristics activate expectations about common understandings.

Third, “institutional‐based trust” is tied to formal societal structures based on individual

or firm‐specific attributes or other shared expectations of a group (e.g. membership of

associations).

Since trust‐building is a gradual process, Lewicki and Bunker (1996) developed a three

stage model of trust development based on the work of Boon and Holms (1991). This

model describes the process of developing and maintaining trust in business relationships

over time. In the beginning of a new relationship, “calculus‐based trust” is essential in

order to get to know each other. Rational judgments about the other’s interests and

intentions are made to prevent the other one from abusing the relationship. When the

partner’s preferences are more predictable, the relationship moves on to “knowledge‐

based trust”, which is about anticipating the other’s behavior. Once the parties start to

“efficiently understand and appreciate the other’s wants” (Lewicki and Bunker, 1996, p.

122) and “effectively act for the other” (p.122), the relationship builds on “identification‐

3 de Saint‐Exupéry (1995, p. 79): ” ‘[…] If you want a friend, tame me!’ ‘What should I do?’ asked the little prince. “You must be very patient,’ replied the Fox. ‘First you will sit down at a little distance from me, like that, in the grass. I shall watch you out of the corner of my eye and you will say nothing. Words are a source of misunderstandings. But every day, you can sit a little closer to me …’”

45

based trust”. The goal for both parties ought to be to engage in the process in such a way

that they empathize with each other to build a strong and trusting relationship. However,

not all relationships are able to do this, yet are still effective for their purpose.

Möllering (2006) argues in favor of Luhmann that “trust building is a processes of

selection which actors engage in continuously in order to determine whom they trust and

whom they distrust. Only exceptional experiences are valuable to the actor in selecting

who can be trusted or not” (p. 88; emphasis in original). To establish trust step‐by‐step,

Luhmann points out the need for displaying trust deliberately in a relationship. The

fundamental condition is that the trustor has to make a “risky investment” (1979, p. 42)

which means that it is possible for the trustee to abuse the trust or that the trustee has a

great interest in betraying her or him. Hence, the trustor increases his vulnerability, but

the trustee must abandon the opportunity against his or her own interest of betraying the

risky investment. This is a fixed sequential process requiring the mutual commitment of

both parties, forcing first the trustor to trust in the trustee and in return the trustee to

honor it. Constantly building up trust demands that the actors mutually understand their

investment at stake by deliberately displaying trust. In the long‐run this may lead to an

actively displaying relation of trust which Luhmann calls “supererogatory performance”

(p. 43), in which actors behave beyond their duty or obligation. The learning process

becomes effective when the trustee has had opportunities to betray that trust but did not

perform this action. The relationship can lead to cycles of trust or cycles of distrust which

are reinforcing depending on the context.

4.3 Trust‐Control Duality

Since nobody can promptly trust someone else right from the beginning of a relationship

and no relationship will reach a point of complete trust, the trustor also relies on control

instruments to evaluate if the trustee seems trustworthy. Loose and Sydow (1994) reason

that trust contributes to a decrease in bureaucratic coordination and control activities, and

reduces negotiation time. It also opens up the information exchange and may ease

contractual restrictions. Due to the incompletion of trust there are several control

mechanisms such as the creation of additional dependencies (transaction‐specific

investments) and switch costs, sunk costs, detailed contracts, risk of jeopardizing

reputation, formal planning and control systems, implementing redundancies, and

46

incentives (see Loose and Sydow, 1994). Control mechanisms are essential for explaining

trust and trust cannot be defined without it.

In the trust‐building process, control can be defined more broadly as “any instrument or

condition that may mitigate relational risk” (Nooteboom, 2006, p. 249) or more narrowly

as “deterrence” (p. 249). Nooteboom (2002, 2006) proposes three ways to mitigate

opportunism: (1) opportunity control through the limitation of opportunities (e.g. by

contracts); (2) incentive control through the limitation of material incentives to utilize

opportunism due to the dependence on the relationship or reputation effects; and (3)

benevolence or goodwill through the limitation of inclinations towards opportunism on

the basis of social norms and personal relations. The first two ways employ deterrence,

while the latter one goes beyond the limits of deterrence.

Nooteboom (2006) categorizes trust in people and organizations as behavioral trust which

expresses itself in various aspects such as trust in competences (competence trust),

intentions (intentional trust), honesty or trustfulness, resource availability and robustness.

Intentional trust implies the absence of opportunism which is called benevolence or

goodwill. It expresses itself in two dimensions, as trust in dedication and trust in

benevolence. Nooteboom (2006) suggests that the different facets and levels of control

and trust and assumes with his concept that one can think of it as two separate or dual

elements.

Luhmann (1979) makes the point that a trustor should refrain from installing all kinds of

control mechanisms against the unpredictability of the trustee in its full complexity, and

instead she or he “can seek to reduce the complexity by concentrating on the creation and

maintenance of mutual trust, and engage in more meaningful action in respect of a

problem now more narrowly defined” (p. 64). Möllering (2005) proposes a

conceptualization of trust and control as a duality instead of a dualism. He argues that

instead of following the common assumptions of the trust‐control framework as a

dualism (i.e. two distinct concepts), scholars should shift the perception towards a duality

perspective. He points out that “…[t]rust and control each assume the existence of the

other, refer to each other and create each other, but remain irreducible to each other”

(Möllering, 2006, p. 194; adapted by the author). If researchers continue separating trust

form control, they run the risk of failing to answer the question of how actors form

47

positive expectations in a relationship and start building trust. Especially where there is a

lot of uncertainty in markets and entrepreneurs with little track record, it is important to

uncover the forces that create a strong relationship.

4.4 Levels of Trust

Trust develops from complex interactions between the different levels of a society. If a

person, an organization, or an institution seems trustworthy it is easier for them to enter

into a trusting relationship than it would be in a situation where suspicion dominates.

Relational capital based on mutual trust and interaction at the individual level between

partners creates a basis for learning and know‐how transfer across the exchange interface

(Kale et al., 2000). Aggregated interpersonal trust of the exchange interface constitutes

inter‐organizational trust that creates an overlap or redundancies which provides a buffer

from exogenous damages. Actors are embedded in an institutional environment which

shapes their behavior within environment and with other actors. Möllering (2006) adds

“when institutions serve as a source of trust between actors those institutions become

objects of trust, too” (p. 54). However, there are multiple ways to structure the different

levels of trust. An appropriate framework of interactions can be considered between three

levels of trust: interpersonal, inter‐organizational, and institutional trust.

In the inter‐organizational context, Dyer and Chu (2003) found that information sharing

decreases transaction costs and further demonstrates the perceived trustworthiness of the

partner. Moreover, Ba and Pavlou (2002) demonstrated that trust can mitigate

information asymmetries by reducing transaction–specific risks. Van de Ven and Ring

(2006) suggest that the direct effects of trust create greater flexibility for organizations.

Young et al. (2003) show in their findings on entrepreneurial software companies that

trust promotes flexibility in inter‐organizational relationships, which becomes an

important inter‐firm resource that increases productivity. Zaheer et al. (1998) found that

inter‐organizational trust was strongly related to lowered transaction costs and increased

performance, while interpersonal trust was only indirectly linked to these outcomes

through inter‐organizational.

Janowicz and Noorderhaven (2006) analyze that an organization itself cannot trust, but

rather the individuals who represent it. At the inter‐organizational level trust is held

collectively by the trustorʹs firm towards the trustee firm (Dyer and Singh, 1998).

48

Conceptualizing organizational‐level trust is difficult: On the one hand, trust is an

inherently individual‐level phenomenon and so it can only be attributed to an

organization because it consists of individuals. On the other hand, however, the

aggregation of the individual‐level attitudes allows trust to be assigned to the

organization as a whole. This bridges the individual‐level and the organization‐level of

trust and embeds it in inter‐organizational context (Janowicz and Noorderhaven, 2006).


Even if the concept of trust is multifaceted and hard to grasp, it permits a better

understanding of economical actors, especially for the relationship between entrepreneur

and venture capitalists which is characterized by high uncertainty and vulnerability.

Trust seems to be a powerful concept when the control instruments and tools of rational

choice are exhausted and cannot solve all difficulties that arise during economic

interactions. This chapter bases its assumptions of trust on Möllering’s (2006) three pillars

to explain the concept of trust – reason, routine and reflexivity. The goal for trust is to

form positive expectations towards somebody else, thus it needs to have a reason for

trusting that person that over time establishes routines, and a reflexive process that

evolves gradually step‐by‐step. Control mechanisms help to evaluate each groupʹs

expectations, and thus, trust and control are complementary to each other. Trust and

control are not separated from each other, and therefore constitute themselves as a

duality (Möllering, 2005). These interactions are embedded in a social context and if

actors maintain their agency others will base their expectations on the inseparable

aspects, trust and control. Actors can form positive expectations based on the two sides of

the coin: This social structure enables the actor to form positive expectations which would

be attributed to the control mode. Whereas, the actor bases positive expectations on the

goodwill of the other, which implies a leap of faith and is regarded to trust. Both of these

together can lead to the development of positive expectations from the respective parties

(Möllering, 2006). He sums up that “[c]ontrol … needs to be combined with trust and the

leap of faith that it entails if truly positive expectations of others are to be reached” (p.

195; adapted by the author). Trust may not dispel uncertainty, but it enables the actors to

progress their relationship through the leap of faith to establish common goals and a

shared understanding.

49

PART III

50

5. DEVELOPMENT OF A FRAMEWORK

5.1 Venture Capitalists as Gatekeepers

The venture capital literature has for the most part focused on the function of venture

capitalists as resources for financing new ventures focusing on matters such as securing

their investments, high ROI markets and industries, and first‐mover advantage etc.

Although informative, this point of view has failed to acknowledge one of the core

functions of venture capitalist. This core function goes beyond providing financial

resources but rather it includes a gatekeeper position that rejects or enables an invention

to become an innovation through its entry into the market place. By analyzing the

gatekeeper function through the “systems model” by Csikszentmihalyi (1996; see Sect.

2.2), one is able to have a better understanding and insight into the decision‐making

process of venture capitalists. Another important issue in understanding the innovation

process is by distinguishing between radical and incremental innovations which result in

different applications for the gatekeeper mechanism. These processes are described in the

following chapter.

5.1.1 The Innovative Entrepreneur

Joseph Schumpeter acknowledges that the innovative entrepreneur occupies a central

position within the economy. Following his earlier work (“Mark I”; see Sect. 2.1)

entrepreneurs within modern society are drivers of economic growth and facilitators for

change.

“This is the entrepreneurial age. Entrepreneurs are driving a revolution that is transforming and renewing economies worldwide. Entrepreneurship (...) gives a market economy its vitality. New and emerging businesses create a very large proportion of innovative products that transform the way we work and live(...) They generate most of the new jobs” (Bygrave, 1994, p. 1).

Innovative entrepreneurs are characterized as individuals who are able to explore

business and technological opportunities and cope with yet undefined future challenges

based on their attitudes. Nowadays, being creative and innovative is a key resource for

meeting future challenges. Csikszentmihalyi (1996) argues that in order to be creative an

individual or an organization needs a surplus of scarce resource, called “attention” (p. 8).

He does not further specify the term attention, but states that it is a resource which allows

51

“individuals [and organizations] to learn and to experiment above and beyond what [is]

necessary for survival” (p. 8; added by the author).

The concept in organizational theory that approximates the notion of attention is “slack

resources”. In the organizational context, slack resources can be described as the

“difference between total and necessary payments” (Cyert and March, 1992 [1963], p. 42)

which is required to maintain the functioning of the organization. In conventional

economic theory, slack is zero (at equilibrium) implying that the processes in an

organization work efficiently. The existence of slack resources in organizations is a

necessary condition for creative experimentations, enables the adaptation to

environmental changes, organizational risk‐taking, strategic decision‐making, and

innovative behavior of the organization.

Bourgeois (1981) defines organizational slack as a “cushion of actual or potential

resources that allows an organization to adapt successfully to internal pressures for

adjustment or external pressure for change in policy as well as to initiate changes in

strategy with respect to the external environment” (p. 30). It refers not only to resources

within the firm, but also outside resources such as financial resources (e.g. bank loans).

Higher levels of slack resources enable a company to experiment more safely with new

products or services within changing environments. The presence of organizational slack

enables a relaxation of control mechanism and therefore leads to undertaking actions

associated with greater risk and uncertainty. Entrepreneurs that act in a context where

there is an abundance of slack resources have a greater chance of being innovative as well

as risk‐taking in uncertain environments.

In an economic system, information is unevenly distributed across people. Some people

possess idiosyncratic information about certain industries or technologies which lead to

the existence and identification of technological opportunities (see Sect. 2.1). The

Knowledge Spillover Theory of Entrepreneurship (Acs et al., 2004) does not explicitly

mention the existence of slack resources, but it is assumed that along with knowledge

spillover they create entrepreneurial (technological) opportunity. The innovative

entrepreneur constitutes the knowledge filter (see Sec. 2.1) in the economy determining

how many novelties are being discovered and exploited. The aggregated activity

represents the vitality of the entrepreneurial ecosystem within a region or a country.

52

5.1.2 The Leapfrog Concept of Innovations

In Schumpeter’s (1939, 1942) view, innovations are the cornerstone of economic

development that create short‐term instability through creative destruction and lead to

long‐term growth. The trigger for creative destruction is the change of existing

knowledge followed by the accumulation of new knowledge. The accumulation of

technological knowledge can be compared with the diffusion of innovation within a

system and can be considered from two perspectives. On the one hand, the micro level

describes the process of a particular innovation (i.e. rate of adoption etc.). On the other

hand, it is assumed that economic change on the macro level proceeds in leaps or waves

(see also business cycles or Kondratieff waves) in which technological knowledge

accumulates gradually (a form of clustering) changing between radical and incremental

change. Large amplitudes express fundamental changes and it seems that economic

progress is basically driven by radical innovations. In “The Structure of Scientific

Revolutions” by Thomas Kuhn (1970), scientific progress is marked more by radical

changes than by of marginal findings. Observing the diffusion of innovation appears to

be the growth in technological knowledge proceeding in leaps to new knowledge

thresholds (introduced below as the “Leapfrog Concept of Innovations”).

However, before explaining the Leapfrog Concept on the macro level, it is important to

pay some attention to processes that take place when an innovation is leaving the micro

level expanding to macro level. The rate of adoption indicates the “relative speed with

which an innovation is adopted by members of a social system” (Rogers, 2003, p. 23).

Within the diffusion, the crucial point is the “critical mass” (p. 343), i.e. enough

individuals have adopted the innovation so that it is self‐sustaining. Malcom Gladwell

(2000) calls it the “tipping point”, the level where a social epidemic becomes self‐

spreading. Once the innovation is self‐spreading, it makes the “leapfrog” to a new

knowledge threshold. The pace of diffusion thereby depends on the “intrinsic

characteristics of innovations” (Rogers, 2003, p. 15): (1) “relative advantage”, the degree

to which an innovation is perceived better than the previous innovation; (2)

“compatability”, the degree to which an innovation is consistent with the existing values

and needs of potential adopters; (3) “complexity”, the degree of how difficult it is to

understand and to use the innovation; (4) “triability” the degree of how experimental the

53

innovation is; and (5) “observability”, the degree to which extent the innovation is visible

to others. These five characteristics determine how readily an innovation diffuses in an

existing market.

An idea, practice, or object needs to be adopted by individuals or groups in order to

achieve the status of an innovation that is evaluated in the “innovation‐decision process”

(Rogers, 2003, p. 11). In this process, an individual aims to reduce uncertainties about the

advantages and disadvantages of that innovation. Rogers (2003) defines the diffusion of

innovation as the process by which (1) an innovation (2) is communicated through certain

channels (3) over time (4) among the members of a social system. The communication of

an innovation is embedded in a social system that impacts the diffusion of innovation

differently. Adopters of innovation can be classified into five different categories (Rogers,

2003): (1) innovators, (2) early adopters, (3) early majority, (4) late majority, and (5)

laggards. While the first former categories are crucial for an innovation to start diffusing

and gain attention in the market, the latter categories complete the diffusion of the

innovation.

On the macro level, the diffusion of innovations follows a common pattern. Based on

Schumpeter’s (1939) distinction between radical and incremental innovations (see Sect.

2.1), economic systems are disturbed by both types of changes which result in a

technologically altered environment. It is assumed that an economic system oscillates

between conditions of stability and instability. Another assumption is that all systems in

the long‐term follow their inherent logic of internal stability (see “Synergetics”, Haken,

2004; “Chaos Theory”, Kellert, 1993; “Fractal Geometrics”, Mandelbrot, 1983).

If a system gets disturbed by a radical change, it creates the condition of instability within

a system enabling realignment. Instability is characterized by confusion of the existing

conditions and inefficient procedures helping to render old practices and facilitating the

emergence of something radically new. Subsequently, the system aims to stabilize itself

by (marginal) improvements in order to function efficiently again and be reliable until the

next radical change happens. This sequence can be ascribed to the circularity (see Fig. 5.1)

of causes (i.e. radical and incremental changes) and its ensuing conditions (i.e. stability

and instability).

54

Fig.5.1 Circularity Source: compiled by the author

Technological discontinuities are followed by periods of incremental technological

changes and, subsequently, by new discontinuities. Thus, the “Leapfrog Concept of

Innovations” is introduced to illustrate the impact of the circularity to the diffusion of

new technological knowledge within a certain market (see Fig. 5.2). The growth of

technological knowledge on the vertical axis equates the accumulated knowledge of the

innovations and time on the horizontal axis displays how long these innovations (i.e.

radical and incremental) need to diffuse. While a radical innovation creates instability,

many following incremental innovations generate stability in the system until the

accumulated knowledge build a foundation for the next radical innovation. Incremental

innovations develop slowly in a step‐by‐step manner building up on and exploiting on

existing knowledge. However, after a certain time the growth of technological knowledge

by incremental innovations stagnates or even declines making the system unstable. This

facilitates the introduction of a radical innovation that grows exponentially (i.e. self‐

sustaining) once it has reached its tipping point (Gladwell, 2000). Technology evolves

through periods of incremental changes punctuated by technological opportunities (see

Sect. 5.1.1) opening up for radical breakthroughs (so‐called leapfrogs).

55

Fig. 5.2 Leapfrog Concept of Innovations Source: compiled by the author

Technological opportunity refers to the point where an individual or company perceives

a market being rich of new knowledge and opportunities for innovative and

breakthrough technologies. Leapfrogs make previous knowledge obsolete, thus possibly

changing or transforming existing markets into something completely new. Tushman and

Anderson (1986) particularize radical innovations by stating that “[major] technological

innovations represent technical advance so significant that no increase in scale, efficiency,

or design can make older technologies competitive with the new technology” (p. 441;

added by the author). The cyclicality of radical and incremental innovations is what leads

to breakthrough or a technical revolution in the existing system.

Schumpeter made the distinction between initiators and imitators that can be associated

with both types of innovations. The former are accounts for the leapfrogs through the

exploration by radical innovations, while the latter for the exploitation of existing

knowledge by incremental innovations. The exploitation of existing knowledge by

imitators has the advantage to take place in relatively stable environments and thus easily

harvest profits. However, a diminishing growth of technological knowledge implies that

even small improvements are related to high efforts (efficiency‐problem). On the

56

contrary, explorations by initiators within unstable environments are associated with

high uncertainty in regards to actual outcomes and gains, but with the prospect of an

exponential increase of technological knowledge. It requires a confrontation with new

knowledge that reduces or eliminates the efficiency of old routines that were used to

solve common economic problems.

The expectations of individuals are more uncertain because the discontinuity made old

routines inefficient and leaves room for new solutions that will be adopted by the others

(effectiveness‐problem). It is suggested that companies operating in uncertain

environment, which are rich in opportunities, have a greater innovative activity than firm

in more stable environment.

In summary, an incremental innovation involves modest technological changes of

companies in order to remain competitive in the market. Whereas, leapfrogs or radical

innovations result in an exponential knowledge increase which make the existing product

or service obsolete. This illustrates that incumbents have a better position when it comes

to incremental innovations by leveraging their existing knowledge and resources. New

entrants, on the contrary, are not tied to any formal structure or routines, and therefore

do not have to adapt their processes. They are more open‐minded to uncertainty.

Describing the macro changes of innovations without a specification of the adoption

process on the micro level is not sufficient and would lead to a misunderstanding of the

diffusion of innovation. The leapfrog only happens when a considerable amount of actors

within a market decide to adopt an innovation. Obviously an invention can also happen

too early with the consequence that the notation of Max Planck (1949) gains a bitter

meaning: ”A new scientific truth does not triumph by convincing its opponents and

making them see the light […] but rather because its opponents eventually die, and a new

generation grows up that is familiar with it” (pp. 33‐34).

Hence, the next section explains the gatekeeper mechanism based on Csikszentmihalyi’s

(1996, p. 27) framework (see Sect. 2.2).

5.1.3 Gatekeeper Mechanism

The “systems model” by Csikszentmihalyi (1996; see Sect. 2.2) has been introduced to

illustrate that the market does not automatically absorb all novelties or inventions

57

(general knowledge, more precise knowledge spillover; see Sect. 2.1) which were

discovered and/or exploited by individuals or companies. The creative individual, in his

concept, is considered in this study as the innovative entrepreneur (see 5.1.1) who is

responsible for the discovery and/or for the exploitation of knowledge spillover.

However, placing the innovative entrepreneur as the pivot point of economic

development dismisses the importance of a filter mechanism that sorts out individuals

with savvy business concepts. At the micro level, gatekeepers are the decision makers

who determine what technology gets accepted becoming innovation or what gets rejected

and remains irrelevant to the market.

The gate‐keeping mechanism requires an understanding of domains. The domain

represents the epistemological level of a place where people use, apply, or buy certain

artifacts in that they pinpoint personal value. While Csikszentmihalyi develops no formal

criteria to define domains, these repositories and collections of artifacts evolve over a

period of time are here characterized as markets. Domains or markets are embedded

within social systems and maintain themselves by the people who follow the rules that

have evolved over time. If the people obey the rules of a social system they preserve the

domain by recursive inputs of iterational rules that lead to self‐reinforcing stable cultural

patterns (Kruse, 2004). “The open and concealed rules of a culture stabilize […] the

reality, and hence narrow the contingency of change as long as these rules are not

questioned” (Kruse, 2004, p. 106; translated by the author).

The actors within a domain who are responsible for the stabilization and keeping a

domain attractive are called gatekeepers who have a deeply rooted interest to maintain

their position. Their main function is keeping the domain alive by preventing

information‐overload and selecting meaningful content from useless input.

There is wide range of gatekeepers that need to be considered to understand the filter

mechanism of innovations. They include venture capital firms, business angels,

incubators, investment banks, institutional investors, lawyers, patent examiners,

technology journalists, early‐adopters, incumbent firms, governmental organizations and

so forth. However, not all gatekeepers within the field of experts are equal, they have

different perspective of how to keep a domain attractive. As Csikszentmihalyi

(Csikszentmihalyi, 1996, p. 43) outlines gatekeepers can actively affect the rate of

58

innovations in a domain. First, gatekeepers are either being reactive or proactive towards

the novelty. For instance, venture capital firms and business angels might be considered

as facilitators for innovations, while incumbent firms try to preserve the domain because

they are threatened by radical innovation that would make their products or services

obsolete. Second, the amount of ideas that gatekeepers allow to enter the domain by

applying narrower or broader filters varies at any given time. Venture capital firms, for

example, increase their investment at a certain time (broader filter) because they spot a

promising future market, but another time they cannot detect viable markets (narrower

filter). Finally, gatekeepers help to connect entrepreneurs with other gatekeepers to make

others aware of the novelty and thus help to start the diffusion of a potential innovation.

The sum of gatekeeper decisions determines if an innovation evolves in a certain market

(i.e. reaches its tipping point).

Figure 5.3 aggregates the interplay of the different variables involved in the gate‐keeping

mechanism. The innovative entrepreneur cannot directly enter the domain, because the

gatekeepers decide if the novelty is worth passing. Gatekeepers are bipolar and can be

distinguished into facilitators for the innovation or preservers of the status quo in the

domain.

Fig. 5.3 Gatekeeper Mechanism Source: compiled by the author

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In general, for radical innovations, it is more difficult to pass the gatekeepers. As a radical

innovation may bear the risk to harm or even destroy the system. Convincing gatekeepers

of incremental innovations is easier, because they build on existing knowledge that they

are already familiar to. The five intrinsic characteristics of innovations (Rogers, 2003; see

5.1.2) apply to the acceptance of incremental innovations, while the intrinsic

characteristics of radical innovations are more difficult to measure and to analyze.

Radical innovation triggers instability and changes the current domain. If a domain, on

the one hand, becomes too complex (increasingly difficult to master all the knowledge

within), it separates itself into sub‐domains. Csikszentmihalyi (1996) concludes that

“specialized knowledge will be favored over generalized knowledge” (p. 9). On the other

hand, if the existing knowledge becomes redundant it opens up for the transformation of

the domain. Transformation means a complete change towards a new set of rules and

routines. The new sub‐domains or transformed domains are in a state of instability and

the responsible actors within these domains work on implementing new structure and lay

down new rules aiming to stabilize the system. New cultural meme replaces the old ones

and create novel meaning for the new sub‐domain.

Gatekeepers are either facilitators for innovations or preservers of the status quo (to avoid

any misconception: the same gatekeeper can be more or less open to innovation

depending on all the internal decision factors that are here discussed). However, given

the investment profile of venture capital firms (e.g. early‐stage or more risky investments)

within the market, they can be accounted to being facilitators of radical innovations. In

order to make high returns on investments (ROI), the venture capitalist mostly invests in

disruptive innovations that promise new huge markets with high volumes of sales.

Exploiting huge markets is only possible if incumbents have not discovered the market

yet. The leapfrog enables the exploration of huge potential markets. However, this raises

the question of how entrepreneurs explore radical innovations along with venture

capitalists. This is part of the following section.

5.1.4 Value Creation of Innovation

The new growth theory (or endogenous growth model; see Section 2.1) by Paul Romer

recognizes that the accumulation of knowledge contributing to economic growth.

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However, where this theory fails separate general knowledge from economical useful

knowledge the Knowledge Spillover Theory of Entrepreneurship (Acs et al., 2004) offers

valuable insights into the knowledge creation and its filter mechanisms. The entrepreneur

constitutes the knowledge filter that is responsible for the discovery and the exploitation

of knowledge spillover (created in universities institutes and R&D laboratories). “The

knowledge filter is the sum of the barriers to converting research into commercialized

knowledge” (Acs et al., 2009, p. 6). The Knowledge Spillover Theory assumes that the

entrepreneur is able to convert a technological opportunity directly in commercial

knowledge (i.e. an innovation); however, scholars have acknowledged the difference

between an invention and an innovation (see 2.1).4

An abundance of slack resources enable the entrepreneur to be more innovative and to

take more risk in uncertain environments which eases the discovery and exploitation of

technological opportunities. Any novelty, practice, or technology is incomplete or fully

developed when it arises. It might be discovered partly by chance or trial and error, and

partly by a novel combination of elements from experience. During the diffusion path, the

idea and implementation often require further improvements or changes that make the

product or service attractive for end‐users. Entrepreneurs are the creator and designer of

the invention (e.g. new technology). Nonetheless, the gate‐keeping mechanism described

above fills this gap of how venture capital firms contribute to the value creation of

innovations as a facilitator.

“No matter how we look at the numbers, VC clearly serves as an important source for economic development, wealth and job creation, and innovation. This unique form of investing brightens entrepreneurial companies’ prospects by relieving all‐too‐common capital constraints. Venture‐backed firms grow more quickly and create far more value than non‐venture‐backed firms. Similarly, VC generates a tremendous number of jobs and boosts corporate profits, earnings, and workforce quality. Finally, VC exerts a powerful effect on innovation.” Gompers and Lerner (2004, p. 83)

Venture capitalists’ most important instrument as a facilitator for innovation is the seat on

the “board of directors” (see Sect. 2.4). Through the seat, the venture capitalist assumes

4 The Knowledge Spillover Theory of Entrepreneurship (Acs et al., 2004) intuitively incorporates the institutional environment as the second filter mechanism, but leave it only as a marginal note on economic growth and innovation. The theory does not identify this important difference and assumes that every products or service automatically converts into an innovation. The knowledge filter only applies to the exploitation of knowledge spillover.

61

the rights of value‐adding and actively monitoring the new ventures activities. These

activities of venture capital firms improve “the “crystallisation” of knowledge into new

products and processes” (Romain and Pottelsberghe, 2004, p. 14; emphasize in original).

They may add value through both strategy formulation and implementation activities to

the portfolio company’s performance. Venture capitalists change the path of their

investments by altering the commercialization strategy and making the venture more

sensitive to the business environment. In the process of value creation the entrepreneurs

gain the opportunity to learn from the venture capitalist’s contribution (Bygrave and

Timmons, 1992; Sapienza, 1992). They also might possess valuable problem‐solving

expertise, which they can apply to a variety of contexts, or contribute to performance by

using their expertise to enhance the comprehension of a firm’s decisions. Their

engagement and their means might have a strong impact on the future direction of the

firm. In sum, venture capitalists’ value‐adding activities strengthen the market position of

the new venture and help to develop resources and capabilities (venture capital firms can

be view from the RBV as bundle of resource available to the entrepreneur).

All these activities lead to the conclusion that the conversion from new technology

towards an innovation is not just a one‐shot process, like a cause‐effect relation, but rather

an iterational process (see iteration as the fundamental principle of fractal geometric;

Mandelbrot, 1983). The gate‐keeping mechanism is rather a reflexive process marked by

iterational loops than an automatic conversion of a novelty into an innovation. The

venture capitalist acts as a facilitator for the innovation that includes proactive behavior

in supporting the entrepreneur as well as connecting the entrepreneur with other

facilitators (within the field of experts) and convincing domain preserves. Venture

capitalists could overall support the innovative entrepreneurs in the exploration of

radical innovations by disturbing the rules and routines of the existing system. The

chance to leverage the circular process and enable a radical change is by making

concealed rules visible, deliberately disrupt them and replace them by a new set of rules

(Kruse, 2004, p. 108).

5.1.5 Critical Summary and Conclusions

Entrepreneurs are innovative when there is a surplus of “attention”, i.e. they can access

resources that are above what is necessary for survival (Csikszentmihalyi, 1996). Within

62

organizational context, the difference between total and necessary payments is described

as “slack resources”. This chapter deals with the complex selection process in which

business opportunities, especially technological, are identified by entrepreneurs and

realized as innovations. Entrepreneurs act as the first filter by discovering and exploiting

technological knowledge. When an idea passes the first filter, it has to pass the second

filter as well (called the gatekeeper mechanism) in which the venture capitalist evaluates

the novelty. Finally, an invention or novelty only becomes an innovation after it is

accepted in the marketplace by enough customers. The quality of the impact depends on

incremental and radical innovations which are illustrated in the Leapfrog Concept.

Any existing system (called “domain”; Csikszentmihalyi, 1996) is interested in its own

survival which depends on the oscillation between stability (e.g. obeying the rules and

following routines) and enough flexibility (i.e. innovations). The domain is protected and

developed by a “field of experts” (called gatekeepers) who decide what is accepted

within a domain or not. Entrepreneurs have to find a gatekeeper with influence and

power that accepts their novelty (e.g. technology) and helps them in the diffusion process

of innovations. The understanding of the role and the decision‐making process of the

gatekeepers – here the venture capitalist – is key in establishing a framework. It helps to

understand the interactions between the venture capitalist and the entrepreneur and

solidifies the success factors for both sides.

On the one hand, the gatekeeper model helps the entrepreneur have a better

understanding about the dependencies and intentions of the venture capitalist and is thus

able to improve his or her business model. The venture capitalist, on the other hand, can

optimize the selection process by unfolding insights that up until now have been labeled

as “gut feeling”. This will be the key to balance short and long‐term interests. While

short‐term interests such as ROI has been clearly defined, long‐term orientation appears

to be more complex and understudied. Long‐term orientation needs to take into

consideration strategic aspects of sustainability of resources and the establishment of trust

as previously shown in Chapters 3 and 4. In addition, in this chapter the value creation of

innovation has been described which opens up for the notion of embeddedness and the

importance of iteration in the process of innovations.

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5.2 Sustainability Dimension

Over the last four decades of the existence of venture capital, the industry has been

subject to up‐ and down cycles. The venture capital industry has been slow in adjusting to

“shifts in the supply of capital or the demand for financing” (Gompers and Lerner, 2004,

p. 4). Neoclassical theory assumes that financial markets instantaneously respond to the

arrival of new information. However, Gompers and Lerner (2004) argue that the venture

capital industry has difficulty adjusting to short‐run disruptions created by regulatory

and policy changes. On the one hand, venture capital firms make long‐term illiquid

investments in new ventures and cannot adjust quickly to changing demands of

financing. On the other hand, it is also difficult to expeditiously increase the supply of

capital because raising capital from investors is time consuming. These challenges

demand the incorporation of a strategic orientation in the management of venture capital

firms.

Strategy in the “future trends industry” (see Sect. 3.1) has not been a broad issue in

venture capital literature, yet. In fact, there is little research on strategic orientation and

long‐term challenges facing venture capital firms. Sustainability as a concept relating to

strategic management seems to be helpful in addressing complex challenges (see Chap.

3). Müller‐Christ’s (2001) approach involves optimizing short‐term interests and

sustaining long‐term resource supply. However, according to Müller‐Christ (2001), short‐

term efficiency and long‐term sustainability constitute contradictory logics that both

require a considerable amount of attention to strategic and operational management, but

cannot be maximized simultaneously.

On the one hand, the short‐term interest of a venture capital firm is optimizing its ROI

(i.e. profits) in order to survive. On the other hand, investments in crucial resources

ensure long‐term survival and create sustainable competitive advantages. Specifying

long‐term resources raise the question of how venture capital firms differentiate

themselves from other firms in uncertain environments. Sahlman (1990) found that

venture capital firms create economic value for themselves when they develop

reputation. These firms are “specialized financial intermediaries operating in a highly

fragmented industry where most VCs specialize in industry niches. Thus, reputation

should be particularly valuable to these financial intermediaries” (Ivanov et al., 2008, p.

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1). The RBV helps to identify reputation as an important intangible resource that creates a

sustainable competitive advantage for a venture capital firm within a highly competitive

environment. Reputation is defined as a social evaluation through the knowledge and

perception of actors in a network (stakeholders) towards a person or an organization

(Bromley, 2002). Venture capitalists’ reputation can be achieved, for instance, through

expertise in a certain field (in regards to end‐investors and entrepreneurs), public

relations, personal networks, and its own scientific advisory board. As an intangible and

more or less indirect concept, reputation only has some aspects that can be subject of

quantitative measurements (for reputation measurement see Ivanov et al., 2008).

However, it can be discussed which aspects are conducive to creating a positive

reputation and which aspects may be harmful to that goal. As described in Section 3.2

reputation is a resource that can only be developed over a longer period of time. The RBV

does not offer a deeper understanding of dependencies of the long‐term supply with

these crucial resources. Thus, considering the “specific conditions” of the “sources of

resources” opens up the analysis of the characteristics of long‐term “survival resources”.

It makes sense to include the resource dependency into a broader perspective and to

follow Müller‐Christ’s (2001) approach, in which profit can be ascribed to short‐term

efficiency, while long‐term sustainability can be accomplished by reputation.

In the world of venture capital, strategic management encompasses different dimensions

(shareholders and stakeholders) that are influencing the short‐ and long‐term survival of

venture capital firms. From a shareholder perspective, venture capital firms have to

manage the influx of two “direct survival resources” (i.e. being able to fund‐raise from

LPs and sourcing deal flow from entrepreneurs). In addition, they also have to invest in

“indirect survival resources” to maintain relationships with their stakeholders (i.e.

scientific experts, service providers, and other venture capital firms) and their current

portfolio companies. Therefore, this section sheds light, firstly, on the shareholders and

entrepreneurs influencing the “direct survival resources”, and secondly, on the

relationships towards other stakeholder (i.e. syndication partners, experts, and portfolio

companies) affecting the “indirect survival resources”. In conclusion, the “sustainability

circuit” integrates both dimensions into a holistic approach of a sustainability dimension

of venture capital firms. The emerging framework has to involve all these aspects of

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sustainability, but also has to include the indirect relation between shareholders and

entrepreneurs, which is discussed in the following section.

5.2.1 Relationship between Shareholders and Entrepreneurs

Venture capital involves LPs who invest in shares of a venture fund and then the venture

capitalist allocates the fund to various start‐up companies (entrepreneurs). The LP holds

equity shares in a venture capital fund and thus can be described as shareholder.

Entrepreneurs receive financial resources from the venture capitalist in exchange for less

ownership (i.e. power and control are partially passed over to the venture capitalist).

Shareholders and entrepreneurs constitute the two main “sources of resources” and have

different interests when dealing with the venture capitalist. Their expectations have to be

satisfied in order to sustain the future influx of these “direct survival resources”. When

considering the sources of resources, it is important to keep the renewing cycle of

potential shareholders and potential entrepreneurs in mind.

The first main source of resources is the potential shareholder (i.e. end‐investor or LP).

The primary goal of fund managers of institutional capital (see Sect. 2.4) is to search for

the optimal returns by deciding what investment categories (referred to as “asset classes”)

should receive which percentage of the overall capital allocation (Gurley, 2009; accessed

11.11.2009). Their strategy of asset allocation is to choose among the different asset classes

such as stocks, bonds, LBOs, and venture capital (see Sect. 2.3). Stocks and bonds, for

instance, are called “liquid assets” because these assets trade on a daily basis on

exchanges around the world and their prices are publicly known (thus, they can be

bought or sold at these public prices). In contrast, alternative asset classes (such as

venture capital), known as “illiquid assets”, are associated with higher risk due to their

illiquidity and other factors, but are expected to earn a higher return (e.g. 25 to 35 percent

per year for venture capital). Fund managers usually allocate a small percentage to

alternative asset classes and only when they expect high returns. Therefore, fund‐raising

of a venture capital firm depends on the allocation strategy of the institutional fund and

the current market situation. When available capital is scarce, the venture capitalist has to

compete for “potential shareholders” with other illiquid asset classes (e.g. other venture

capital firms) and liquid asset classes (e.g. stocks, bonds etc.).

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The second main source of resources is the potential entrepreneur. Entrepreneurs have

different options for receiving funding for their business idea. Debt financing (e.g. bank

loans, lines of credit etc.) of start‐up companies is one instrument used to obtain receive

capital, but this is difficult to acquire (see Sect. 2.3). Venture capital firms provide equity

financing for start‐up companies and are competing between each other for the most

attractive investment opportunities.

On both ends of the capital inflow and outflow, a venture capital firm has to compete

between the two main sources of resources (i.e. potential shareholders and potential

entrepreneurs). Both are direct sources of survival and thus need to be maintained. Figure

5.4 below illustrates the resource allocation opportunities of the two main “sources of

resources”.

Fig. 5.4 Resource Allocation Opportunities Source: compiled by the author

Potential entrepreneurs create the deal flow with their business concepts. The venture

capitalists screen business plans and select candidates with the highest potential ROI.

Start‐up companies that focus on markets that are too small are unattractive because their

growth potential is limited. If the market is sizable for the venture capitalist, both parties

move on to structuring the contract to determine the amount of shares allocated between

them. The venture capitalist receives a substantial share of the start‐up company, which

in turn, reduces the control and financial rewards of the entrepreneur. The assumption is

that the more shares the venture capitalist receives in the start‐up company, the less the

entrepreneur is pleased about the decrease of control rights and potential rewards.

Finally, the exit through an IPO or an acquisition by a corporation generates the ROI for

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the venture capitalist. In the short‐run, venture capitalists focus on maximizing their

profits in order to return a high ROI for the shareholder and to secure their own survival.

The conditions of the contract between the venture capitalist and the LP determine the

lifetime of the fund and the percentage that the venture capitalists receive annually as

well as when an investment is exited. The higher the profit‐sharing is for the venture

capitalist, the less attractive an investment is for the venture capital fund and this will

make the LP more reluctant in providing capital for the next rounds of fund‐raising.

These short‐term profit decisions create tensions for both sides of the relationship. Both

“sources of resources” are required in order to maintain the venture capital cycle. The

quality of the incoming deal flow and amount of fund‐raising depends in large part on

the venture capitalists’ reputation. Investments in reputation depend on these sources

and imply that the venture capitalist has to focus on short‐term profits, but also must be a

valuable partner for both sources of resources in the long‐term. Contemplating the

contrary expectations of LPs and entrepreneurs require balancing them in order to build

up and maintain their reputation for future activities. The cycle can be sustained by

investing in these long‐term resources such as reputation. However, investments in

reputation‐enhancing relationships are cost intensive and time consuming. When

considering reputation as a long‐term resource, one has to keep in mind that these

sources of resources are subject to their specific conditions of development which are

described in Section 5.2.2 below.

5.2.2 Direct Survival Resources

Callahan and Charbonneau (2004) call the deal flow the “lifeblood” of a venture capital

firm. Thus, a constant deal flow of high‐quality venture opportunities is vital for the

venture capital firm. The deal flow depends largely on the history of previous

investments made within a region (2005). Successful investment in start‐up companies

establishes a track record for the venture capital firm, but also a reputation for being a fair

and knowledgeable partner within the entrepreneurial community. Timmons and

Bygrave (1986) found in a survey of 464 venture capital‐funded entrepreneurs from 1967

to 1982 that capital was consistently the least important variable in the entrepreneur’s

decisions (p. 161). If entrepreneurs seek funding, they do not approach the investor solely

because of capital shortage. They also look value added and personal fit with the venture

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capitalist. The emergence of the Internet has created greater transparency for

entrepreneurs to judge the venture capitalist as a potential investor in their company.

Platforms such as “The Funded.com”5 empower the entrepreneur to compare different

venture capitalists by reviewing comments about their behavior from other entrepreneurs

who have previously dealt with them.

When venture capitalists seek new deals, they rely heavily on their connections and

relationships within the larger entrepreneurial community. Venture capitalists receive a

high volume of business plans and use their knowledge about the source of the deal to

judge whether a business plan is worth examining (Shane and Stuart, 2002) . This volume

can be quite large, particularly for venture capital firms who have established their

reputation. Business plans brought to them by personal contacts and individuals that they

know and trust are treated with higher regard. “Generally, the source of the request for

funding was a condition factor in the manner in which it was subsequently processed by

venture funds” (Sweeting, 1991, p. 610). The origin of the deals can be grouped into two‐

thirds that comes from “referrals” by former investment partners or personal contacts

and one third that come from “cold contacts”, which have less chance of a closer look

(Tyebjee and Bruno, 1984, p. 1055). The majority of venture capitalists view local

connections as more capable of generating deal flow because these ties were stronger and

more trustworthy (Zook, 2005, p. 82). Decisions rely heavily upon local tacit knowledge to

research the background of an entrepreneur and company, but also involve observing the

investments made by other venture capitalists.

Deal flow not only depends on the quantity of the incoming business plans, but more on

the quality of the investment opportunities. If the presented quality of the investment

opportunities are too poor, it may result in long‐term disadvantages for the venture

capitalist and may lead to a shift towards “proactive deal seeking” (Wright and Robbie,

1998, p. 536).

The other critical source of resources is fund‐raising on the basis of the reputation of

being a savvy investor who has made successful deals and is capable of generating high

5 http://www.thefunded.com

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returns for the LPs. They have the capacity and networks to evaluate attractive venture

capital funds. Better reputations may enable the venture capitalist to maintain their

higher prices (for their investment in start‐up companies) as a result of the high cost of

investments in reputation (Megginson and Weiss, 1991). In consequence that capital per

se is not a differentiated good, rather the reputation of a venture capitalist providing

these financial resources can be a source of differentiation against competitors.

Besides the two main sources of resources, there are other sources of resources that are

crucial for long‐term survival of a venture capital firm which are described in Section

5.2.4 below.

5.2.3 Stakeholder‐Management

In a knowledge‐driven economy, the information explosion caused increasing complexity

and fragmentation in markets. Many projects cannot be merely evaluated or monitored ex

ante, so that the venture capitalists’ network reputation is pivotal to gaining access to

complementary resources of networks of potential collaborators. Venture capital firms are

embedded in dynamic environments where network agents fulfill various functions and

exchange information and resources. They acquire knowledge and resources that they

lack from outside sources and provide these sources with their resources and capabilities

so that they build a diverse network of interactions. It is assumed that all network

connections influence the decision‐making process of the gatekeepers (see Sect. 5.1.3).

The relational view opens up acknowledging that mutually developed resources within

the inter‐firm relation are always outside the firm. It argues that relation‐specific assets

and knowledge‐sharing routines create a sustainable competitive advantage for the

venture capitalist, but they also help to build a network with other gatekeepers that are

conducive for the diffusion of an innovation. Inter‐firm knowledge‐sharing routines

permit the transfer, recombination, or creation of specialized knowledge (Grant, 1996).

Over time venture capital firms build up networks of contacts and other information

sources that they can relate to for each investment (economies of scope). Economically,

venture capital firms benefit the most from having a wide range of relationships,

especially if these involve other well‐networked venture capital firms. They gain better

access to better deal flows from venture firms or they can invite other venture partners

into syndicates, which may lead to reciprocal co‐investment opportunities over time.

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Studies show that venture capital firms who occupy influential network positions show

significantly better performance (Hochberg et al., 2007). In addition, “VC assemble

informal networks of people for various purposes” (Smart et al., 2000, p. 13). For instance,

“networks enable VCs to source deals and to manage their portfolio companies by

connecting them with entrepreneurs. Networks may couple VCs with lenders who can

help finance growth, as well as provide access to other VCs to syndicate deals and spread

risk” (p. 13).

The venture capital firm needs resource influx from other gatekeepers. Entrepreneurs

from portfolio companies are another „source of resources“ which provide valuable

resources for the venture capitalist. Therefore, external stakeholders can be distinguished

into three categories, network experts (i.e. scientific advisors, market researcher, patent

lawyers, journalists etc.), syndication partners (i.e. other venture capital firms), and

portfolio companies. Building up reputation in the network in the long‐term requires

investing in these stakeholders by spending time interacting with them. As one venture

capitalist argues, “What weʹre really selling is time. When you have a startup, time is

your most precious commodity so you want to do anything that saves it” (cited in Zook,

2005, p. 21). These sources of resources also depend on the specific conditions of

development which are analyzed in Section 5.2.4 below. Being concerned with the

necessary time investment is another important aspect the venture capitalist has to keep

in mind when considering their gatekeeper position.

5.2.4 Indirect Survival Resources

Network Experts

Network experts provide the venture capitalist with information and resources that are

valuable for a wide range of activities. Experts such as scientific advisors, market

researchers, and patent lawyers are also a part of the group of gatekeepers (see Sect. 5.1)

helping in the evaluation process of the entrepreneur’s invention. These experts might

supplement the venture capitalist’s judgment as specialists with specific expertise about

feasibility or legal issues.

Increasing the venture capitlists‘ reputation seems conducive for a more central position

within a network (centrality). A central position within a network will positively impact a

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firm’s performance and opportunities to form further linkages based on at least three

mechanisms (Gulati, 1995). First, central venture capital firms can obtain information

about linkage formation opportunities from their partners and their partners’ partners.

They possess more accurate information on the quality of the potential exchange partners

(i.e. other gatekeepers). Second, a central position is in itself a signal of the status and

reliability of a venture capital firm. An extensive number of existing partnerships with

other high‐status actors creates trust among potential new partners through accumulated

reputation and references from the existing partners. Third, the centrality in the network

acts as a signal that the venture capital firm has access to other highly central actors.

Potential exchange partners thus have the opportunity to connect to other high‐status

actors in addition to the venture capital firm. As a result, central firms attract more

exchange partners than peripheral firms.

Buying information from anonymous markets is not the same as receiving information

from close partners. Information from partners “can be expected to be of higher relevance

as the partners serve as information filters and communicate only the information which

they judge as relevant for their partners” (Gemünden and Heydebreck, 1994, p. 196). In

addition, this information is of “higher reliability as the partner does not want to set the

relationship at stake” (p. 196). The reliance on personal connections makes this screening

technique both highly effective.

Syndication Partners

Venture capital firms syndicate in order to share financial risk and mitigate uncertainty

through sharing information. Bygrave (1987) found that the sharing of knowledge and

information seems to be more important than the sharing of financial resources as a

reason for syndication. By syndicating venture capital firms have the chance to

complement skills, but they also may learn new skills for future investing and help to add

value to their portfolio companies. Strong relationships with other venture capital firms

likely improve the chances of securing follow‐on venture capital funding for portfolio

companies. In addition, venture capital firms screen each other’s willingness to invest in

potentially promising deals.

In general, venture capital firms syndicate with each other because of financial

constraints, and the desire to reduce the risk and the competition (Berchicci and Tucci,

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2006). In addition, they leverage economies of scale and help each other to overcome

agency conflicts (see information asymmetries). However, there are also some reasons

against syndicate because of difficulties in partner co‐ordination and the potential

reduction in venture capitalists’ profits (Berchicci and Tucci, 2006). Bygrave (1987) found

that the odds of syndication were higher for early‐stage investments, for more than

innovative companies and for high‐tech industries.

Portfolio Companies

The venture capital firm and its portfolio companies can be considered as being in a

“symbiotic‐relationship” (Hülsmann, 2003, p. 386) implying that the venture capitalist

coevolutionaryly depends on the survival of their portfolio companies. They have to

sacrifice parts of their individual autonomy in order to survive in the long‐run. The

venture capitalist gains new knowledge and experience out of every investment that they

can apply for future investments. This effect gets stronger through specialization in

different industries and financing stages.

Venture capital firms develop alongside economic development characterized by

feedback loops that emerge over time (Zook, 2005). Even if a new venture does not

succeed, valuable information, experience, and contacts develop during the process

which increase the learning‐curve. “[W]ith respect to learning‐curve effects, VC firms

become repositories of useful institutional knowledge. VC and their support staff benefit

from learning‐curve effects as they become more adept in dealing with each other and

with other resource suppliers, such as law and accounting firms, investment bankers, and

management recruitment firms. [..] The ultimate effect is to make the firm more efficient

as time passes and experiences accumulate” (Sahlman, 1990, p. 500; adapted by the

author). The learning‐curve of venture capitalists depends on the interaction with their

portfolio companies that may allow them to renew, develop and transfer expertise in new

and emerging domains.

5.2.5 Sustainability Circuit

The venture capitalist is challenged as a gatekeeper of innovations who has to balance the

various expectation of the different dimensions, namely the demands of shareholders and

stakeholders. Balanced investments in the different dimensions of a venture capital firm

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are critical for its survival. The venture capitalists’ time is limited and the embeddedness

in its socio‐economic system requires that they have a strategy beyond their financing

profile. Peters and Waterman (1982) suggest that excellent companies are capable of

managing paradoxes. The different dimensions and the interests of the various

stakeholders create tensions that cannot be easily solved by focusing on, for instance, only

fund‐raising in a certain period because portfolio companies still need to be managed and

new deal flow needs to be screened and evaluated. The time constraints lead to a

dilemma because venture capital firms are usually small firms with little manpower so

that it constitutes an either‐or problem of allocating resources to the stakeholders. This is

not only about time management, but rather a strategy issue of balancing short‐ and long‐

term challenges. Allocating certain tasks to network experts and syndication partners

seems to be helpful, but require a long‐term investment in these relationships.

Venture capital firms need to implement a strategy to cope with these challenges. Amit

and Schoemaker (1993) argue that “strategic assets by their very nature are specialized”

(p. 39) and need commitment to renew and sustain them, so that they do not disappear

during times of operational pressure. Path dependency has to be considered and it

implies that “strategy involves choosing among and committing to long‐term paths or

trajectories of competence development” (Teece et al., 1997, p. 529). In a venture capital

firm’s strategy, choices have to be made about how much to spend or invest in certain

activities as well as which competences and decisions paths will be pursued or neglected.

From a strategic resource‐based perspective, venture capital firms are an additional

bundle of resources to their portfolio companies. They play a key role (within the

gatekeeper mechanism) as a value enhancer of the venture capital‐baked firm (Manigart

et al., 2002). “Strategy and sustainability can be linked concerning the choice of corporate

goals (‘ends’) and the “means” to achieve them (i.e. resources deployment and care)”

(Hülsmann, 2003; cited in Ehnert, 2009: 70; emphasis in original).

Actively managing the indirect relationship between shareholders and entrepreneurs, but

also addressing the stakeholder’s interests requires integrating the different dimensions

into a comprehensive framework. While the shareholders and parts of the stakeholders

(i.e. network experts and syndication partners) comprise part of the group of gatekeepers,

the potential entrepreneurs and the portfolio companies are outside the field of experts. If

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“sustainability circuits” to direct or indirect survival resources are interrupted for too

long the position within a gatekeeper framework is at stake (see Fig. 5.5).

Fig. 5.5 Sustainability Circuit Source: compiled by the author

The “board of directors” (see Sect. 2.4) can be identified as the execution instrument of the

venture capital firm and can be described as in between the indirect relationship of the

shareholders and the entrepreneurs. These instruments carry out the following functions:

(1) governance function the alignment of shareholder (LP) and management interest

(entrepreneur) through incentive structures and monitoring mechanisms (see Sect. 5.2.1);

(2) strategic decision‐making and value adding for their portfolio companies by serving as a

“sounding board”, assisting entrepreneurs in formulating a business strategy,

recruitment of new managers etc. (see Sect. 2.4); and (3) networking function which helps to

link the portfolio company to its external environment (Williamson, 1996) (and secure

critical resources from the sources of resources (Müller‐Christ and Gandenberger, 2006).

The governance function involves acting as a financial intermediary between

shareholders and entrepreneurs. The venture capital firm monitors and incentivizes the

entrepreneurial management team on behalf of shareholders. The board of the venture

fund screens and authorizes investment proposals, approves decisions, and might

remove poor‐performing entrepreneurs or management teams. Strategic decision‐making

and value adding is basically the main part of the governance function, but its focus in on

supporting the entrepreneur in order to bring an innovation to market. In addition,

market or policy changes may force the portfolio company to adjust direction and seek

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new market segments. The venture capitalist needs to guide and advise the entrepreneur

to reformulate the business strategy.


Cyclicality and the various dependencies of a venture capital firm require an

understanding of strategic orientation in the context of the gatekeeper framework. Based

on Müller‐Christ’s (2001) approach, a venture capital firm needs to balance its short‐term

profit interests and long‐term resource supply (through reputation). Through reputation,

the resource supply can be distinguished between main “sources of resources” (i.e.

shareholders and entrepreneurs) and other “sources of resources” (i.e. network experts,

syndication partners, and portfolio companies), which are both subject to specific

conditions of development. The former consists of “direct survival resources”, which are

about the circularity of capital inflow and outflow, while the latter involves “indirect

survival resources”.

Coping with challenges of indirect survival resources can be ascribed to the management

of paradoxes because of the complexity of the relationships with various stakeholders.

Paradoxes characterized “by oppositions or contradictions, mutually exclusive elements

which operate simultaneously and create tensions” (Ehnert, 2009, p. 135). This implies

that the indirect survival resources expand the framework towards a “sustainability

circuit” (see Fig. 5.6 above), which opens up the suggestion of “Janusian thinking”, i.e.

“holding two or more opposites together in mind accepting their coexistence” (Ehnert,

2009, p. 135). For instance, venture capitalists are competing with other venture capitalists

for scarce resources, e.g. high‐potential entrepreneurs, in order to generate qualitative

deal flow, but they also need to share information and deals with them to mitigate the

risk.

The managing the “sustainability circuit” demands the development strategic and

operational tools to cope with the complexity of this “future trends industry” that are able

to adapt to industry and market changes.

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5.3 Trust‐Control Balance

”Trust men and they will be true to you; treat them greatly, and they will show

themselves great.” ‐‐Ralph Waldo Emerson

Sustainability and long‐term success of venture funds depend on the gatekeeper

decisions of the venture capitalist and vital exchange relationships with the entrepreneurs

to help to bring innovation to market. Venture capital firms act as gatekeepers who filter

out unpromising business ideas and select ventures with potential. Selecting the right

candidates and bringing innovation to market is an iterational process that is time

consuming. Venture capital research focuses primarily on rational choice and agency

when addressing complex relationships. Chapter 3 shows that control instruments and

rational choice can be exhausted when it comes to complex exchange relationships. Trust

seems to be a viable concept when addressing the venture capitalist‐entrepreneur

relationship. Two stages need to be considered, primarily, the decision process, and

secondly, the relationship itself.

Many novelties and technologies that promise high ROI are still filtered out by

gatekeepers. Thus, other filter criteria play a role in the decision process. Venture

capitalist Fred Wilson (Wilson, 2009; accessed 11.11.2009) gave a valuable insight when he

was asked “how his venture capital firm would select an entrepreneur?”, and he replied

that his firm would seek out cultural fit and shared values. In addition, he commented on

the relationship by comparing it to a marriage (see Sect. 1.1). “If you treat [the

relationship] like a marriage […] and work hard at them, communicate early and often,

are tolerant, and most importantly share your vision and values, it can be a very

rewarding experience, both emotionally and financially” (Wilson, 2009; accessed

11.11.2009). Apparently, the reflexive process of the value creation (see Sect. 5.1.4) plays

an important role in building up a long‐term relationship.

The venture capitalist does not only rely on personal experience, but rather also utilizes

the information and resources of other gatekeepers (such as scientists, early‐adopter etc.)

to determine whether the novelty has the potential to become a successful innovation.

Other gatekeepers within the venture capitalists’ network help to evaluate the likelihood

of a successful innovation.

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In general, new ventures bear radical uncertainty because inexperienced entrepreneurs

operate in volatile and less predictable markets. The amount of value that can be added

by the contribution of the venture capitalist depends not only on the resources and

capabilities of the venture capitalist, but also on the mutual trust and reflexive process

with the entrepreneur (see Sect. 5.1.4).

Goals and interests are not always aligned and it turns out that these are difficult to

enforce, thus it requires a “leap of faith” for both to enable shared understandings and to

create “shared visions”. First, this chapter analyzes the embeddedness of actors, the

decision process, and how to build trust in a venture capitalist‐entrepreneur relationship

considering the duality of trust and control. Second, having the capacity for actively

trusting the trustee, both parties have to acknowledge the need to communicate and

make commitments. Finally, based in the research it seems necessary that both parties

need to develop shared visions in order to build a strong and fruitful relationship.

5.3.1 The Trust‐Building Process

In practice, the difference between trustor and trustee is not as sharp as in theory.

Frequently, individual actors are trustor and trustee at the same time, “either directly

towards each other or in complex chains and networks of relationships” (Möllering, 2006,

p. 134). Trustor and trustee have relationships with each other, but also with third parties

who are integrated in the network, and thus trust is considered the defining feature of

social capital in networks.

Social networks are very significant for the nature of embeddedness. From an

embeddedness perspective (Granovetter, 1985), individuals actively develop trust due to

the socio‐economic benefits derived from personal attachment to a network. When

sociologists discuss the nature of personal relationship between actors, they distinguish

between direct (strong) and indirect (weak) ties within a social network (e.g. Granovetter,

1985). Strong ties provide, under the conditions of uncertainty and information

asymmetry, an advantage to agents who seek to obtain resources from others because

they produce social obligation and enable access to private information (Podolny, 1994).

Strong ties are typically associated with trust and thus ease the transfer of tacit

knowledge (Uzzi, 1996). Social ties that are more indirect, instead, have the advantage of

transferring expectations about people’s behavior from one relationship to another (Uzzi,

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1996). It allows them to obtain information about others with whom they do not have a

direct contact which enables the venture capital firm to use the network as a screening

tool by making nonpublic information available. Even weak ties reduce the cost of

obtaining information, which is usually costly to acquire.

Nahapiet and Ghoshal (1998) argue that “social relations, often established for other

purposes, constitute information channels that reduce the amount of time and investment

required to gather information” (p. 252). Relational trust refers to cases in which a trustor

is confident in the trustee’s actions because the trustee cares about the trustor’s interests

(Rousseau et al., 1998). This emerges from repeated interactions between individuals over

time and creates positive expectations. Relational trust is not only based on routines

established between trustor and trustee but also the reciprocity of their continual

interactions which lead to economic exchanges and cooperative behavior promoting the

transfer of private information and resources. Organizations face substantial uncertainty

and information asymmetries in obtaining reliable information on the attributes, quality,

and trustworthiness of potential new exchange partners, so they prefer to exchange with

existing partners (Gulati, 1995). These prior relationships enable the creation of

collaborative relationships that radiates reliability and trustworthiness.

Deals that originate from referrals with direct or indirect ties provide information about

the quality of the business plan and the entrepreneur itself, and thus work as a screening

device to exclude the unqualified ones. For example, Hisrich and Jankowicz (1990) found

that most of the deal flow come as “cold‐calls” (without any introduction), but they do

not receive much attention, thus “funded proposals come by referral” (p. 31). If, however,

information is already publicly available, the entrepreneur will not need a referral to

obtain financing. An actor has to trust the partners, but still faces the problem of the

promises which are hardly to evaluate ex ante and barely controllable ex post.

“[V]enture capitalists tend to favor teams that are similar to themselves” (Franke et al.,

2006, p. 1; adapted by the author), which means similar training and professional

experience. Similar backgrounds or challenges enable a better understanding of the other

party and it simplifies interaction between the parties. This similarity translates to

familiarity which is the starting point for trust and facilitates the familiarization process.

Familiarity is also important beyond the development of personal relations for the

79

screening process because it reflects “a tendency to limit investments to areas with which

the VC is familiar, particularly in terms of the technology, product and market scope of

the venture” (Tyebjee and Bruno, 1984, p. 1052).

Trust needs social interaction, a process in which actors can reflexively exchange their

expectations, and lessen the uncertainty and make themselves vulnerable towards the

trustee. As Uzzi (1996) shows in his empirical study of entrepreneurial firms that trust

acts as a pivot in a network of embedded actors which has a positive effect on economic

performance and that “actors do not selfishly pursue immediate gains, but concentrate on

cultivating long‐term cooperative relationships that have both individual and collective

level benefits for learning, risk‐sharing, investment” (p.693).

Timmons and Bygrave (1986) propose that the co‐operative relationship between a

venture capitalist and an entrepreneur is more crucial to the success of the business than

the financing itself. While it appears that the development of fruitful relationships

provides substantial benefits it does not apply to all relationships (Sahlman, 1990). Some

entrepreneurs have an incentive to behave unaligned to the venture capital firm (see

principal‐agent problems, e.g. hidden information and hidden action). There is also room

for conflict between the entrepreneur and venture capitalist on the feasibility and

relevance of various goals, and while entrepreneurs are mostly narrowly focused on a

single goal, the venture capitalist will have a reasonably diversified portfolio. The term

“success” might have different meanings for venture capitalists or entrepreneurs, what

causes conflicts on strategy.

The various goals of venture capitalists and the entrepreneurs of their portfolio

companies are not always aligned. Both aiming to generate profits, however, Table 5.1

models the competing purposes in regards to their goals, relevant time horizon, and

orientation.

Tab. 5.1 Contrary Interests

Venture Capital Firm Entrepreneur Goals maximizing profits, ROI

of the fund survival of the firm,

personal and financial goals Relevant Time Horizon from investment

till exit perpetuity

Orientation portfolio-orientated focused on their venture Source: compiled by the author

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These significant gaps that exist between the expectations and the perceived contributions

of entrepreneurs and venture capitalists create problems that have been discussed by

venture capital scholars by applying rational choice theories. The problem with applying

rational choice theories such as the game theory to the venture capital‐entrepreneur

relationship is that both actors are pursuing different goals (e.g. financial return versus

prestige) which may complicate the determination of proper outcomes. From an

economic perspective, contract provisions select appropriate entrepreneurs by shifting

the risk of inappropriate selection to the entrepreneur. As Sahlman (1990) noted, “it

would be foolish for the entrepreneur to accept these terms if they were not truly

confident of their own abilities and deeply committed to the venture” (p. 510).

Venture capitalists have the power and knowledge to have substantial impact on their

portfolio firms (Sapienza et al., 1996), and thus portfolio companies can easily become

very dependent on their mighty partners. These stages of influence range from almost no

intervention to complete replacement of the management team. If the venture capitalist

reaches the point where she or he is the only one making decisions regarding strategy

and business development, the entrepreneur will become frustrated from losing its

influence and is more prone to opportunistic behavior.

In the context of contract negotiation, Nooteboom (2006) argues that “trust and control

are substitutes, in that with more trust there can be less control, but they are also

complements, in that usually trust and contract are combined, since neither can be

complete. Trust is needed, since contracts can never be complete, but it can go too far,

since trust also can never be complete” (p. 247). For understanding trust in the venture

capitalist‐entrepreneur relationship it is helpful to analyze the relationship between trust

and contracts. Bottazzi et al. (2009) identified two opposite views of the relationships

based on trust and contracts. The concept of substitutes became a counter weight in

management literature to the assumption of opportunistic behavior in economic

transactions.

The substitute concept assumes that contracts are an effective mechanism against

opportunistic behavior, but are costly in structuring (Bottazzi et al., 2009). This concept

views trust as a substitute for contractual safeguards. The more trust, the less detailed the

contracts and vice versa. If trust and control are substitutes, it seems that both constitute a

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form of dualism (i.e. maximal control is required when trust is absent) and there is an

optimal level of control. It is about striving for an optimal level of trust and control. This

understanding takes legal enforcement for granted, so that venture capitalists solely face

the trade‐off between costs versus benefits. The alternative view is that trust and contracts

are complements, which can be viewed as a duality. It differs in its explanation of

contractual safeguards; both parties would not even structure complex contracts when

they do not have confidence in the other co‐operative behavior (Nooteboom, 2002). The

cost of contracting would exceed the actual benefits when there is low probability of

successful cooperation. On the one hand, the substitute concept argues that sophisticated

contracts can be used to overcome low trust between investors and entrepreneurs. The

complements concept, on the other hand, argues that investors make use of sophisticated

contracts only when there is sufficient trust. Therefore, it is suggested that one follows a

duality concept of trust and control.

5.3.2 Active Trust

Luhmann (1979) describes that “[t]he problem of readiness to trust, accordingly, does not

consist in an increase of security with a corresponding decrease in insecurity; it lies

conversely in an increase of bearable insecurity at the expense of security” (p. 79‐80;

adapted by the author). Active trust constitutes itself as a reflexive process of trust

development, which demands constant communication and openness from both parties

(see also Beckert and Harshav, 2002). It requires continuous reproduction of trust for the

emergence of stable relationships. The trustor needs to be aware that the trustee has the

freedom to honor or exploit the trust. In sum, active trust is a continuous process of

mutual exchanges that involve openness and displaying trustworthiness to the other

members of the relationship. Giddens would emphasize on “deliberative commitments”

(Beckert and Harshav, 2002, p. 264) when it comes to the active role that trust has in

building up and framing the conditions of the process.

The entrepreneur and the venture capitalist need to balance the level of control and trust

building mechanisms so that the optimal level of confidence in partner co‐operation can

be achieved (Zacharakis and Shepherd, 2001). The study proposes that the entrepreneur

can build trust with the venture capitalist (and vice versa) by signaling commitment and

consistency, being fair and just, obtaining a good fit with one’s partner, and with frequent

82

and open communication. They argue that open and frequent communications can act as

a facilitator for the other trust building mechanisms. For example, the unsolicited

communication of information (especially if that information is sensitive) can provide a

clear and strong signal of commitment to the relationship (Das and Teng, 1998),

encouraging reciprocity. Communication also helps bring the parties closer together,

without explicitly being comprised of adjustments of one party, by helping the partners

further develop common values and togetherness (Leifer and Mills, 1996).

Both communication and commitment have an important impact on venture capital

firms’ value‐added contributions, and subsequently on entrepreneurial company

performance (De Clercq and Fried, 2005). Communication is important to venture capital

firms’ value‐added because it increases the quality of venture capital firms’ value‐adding

activities. Communication creates learning opportunities for both the venture capital firm

and the entrepreneurs. However, it depends on how open the entrepreneur is to accept

the venture capitalists’ advice. DeClercq and Fried (2005) argue that board meetings may

offer an excellent opportunity for interaction which includes, for instance, the portfolio

company’s financial officer report to the venture capital firm about the status of pre‐set

performance targets. Also, the variety of communication channels may reflect the quality

of the exchange of information, that is, the use of different communication forms between

the venture capital firm and portfolio company may enable the transfer of complex, rich

and context‐specific information, and facilitate problem solving. Thus, the employment of

various interaction routines between the venture capital firm and portfolio company may

enhance the venture capital firm’s capability of processing complex knowledge and

understanding the knowledge received from the portfolio company.

DeClercq and Fried (2005) argue that deep commitment from a venture capital firm with

a particular portfolio company will lead to more value‐adding activities, which increases

the likelihood that the portfolio company will benefit from the venture capitalists’

assistance. Given the limited amount of time and the responsibility of diversified

portfolio companies, they cannot spend the same amount of time on every account, so

they come more committed to some of their investments in comparison to others (De

Clercq and Fried, 2005). The venture capital firm can signal its commitment and

consistency via web pages that show their portfolio of companies, press releases,

83

testimonials from entrepreneurs of portfolio companies, qualifications and reputations of

individual venture capitalists, etc. (Zacharakis and Shepherd, 2001). There needs to be

more research to identify other effective tools that accomplish this.

In Möllering’s (2006) work, he argues that trust can be a powerful concept when it

“corresponds via suspension with reason, routine and reflexivity as bases for trust” (p.

111). He goes on to say that “trust is an ongoing process of building on reason, routine

and reflexivity, suspending irreducible social vulnerability and uncertainty as if they were

favorably resolved, and maintaining thereby a state of favorable expectations towards the

actions and intentions of more or less specific others” (p. 111; emphasis in original). For

Möllering, there are three ways to suspension: (1) “as‐if attitude”; (2) “bracketing” and (3)

“matter of willpower”. The as‐if attitude means to anticipate the future and “to behave as

though the future were certain” (Luhmann, 1979, p. 10). He argues that inadequate

information can be surmounted by trust and that uncertainty and vulnerability are

unproblematic. This departs from the idea that there is a lack of certainty. Beckert (2005)

acknowledges the trustee’s role in creating the illusion of uncertainty. The trustee can

testify for herself or himself in order to create the environment that makes the leap of

faith possible. “Trustors rely to great extent on trustees when constructing an image of

those trustees as worthy of trust or not” and continues on to say that “trustee’s

performative acts and high level of familiarity with the situation merely assist the trustor

in making the leap of faith” (Möllering, 2006, p. 114).

The other way of suspending irreducible social vulnerability and uncertainty through

bracketing it out or as Luhmann (1979) describes it as “a movement towards indifference:

by introducing trust, certain possibilities of development can be excluded from

consideration. Certain dangers which cannot be removed, but which should not disrupt

action are neutralized” (p. 25; emphasis in original). Somebody will be trusted, despite the

circumstances. The third pillar of suspension is what Luhmann (1979) calls the “operation

of the will” (p. 32), where the lack of information is acknowledged, but actively

surmounted by the actor. The concept of “active trust” has important implications for

trustor and trustee. Both have to work actively on shared understanding and expectations

in their relationships with each other, and this will eventually result in “shared visions”.

84

5.3.3 Shared Visions

Firms exist not only, and not primarily, to limit transaction costs, but to act as a focusing

device: to align perceptions, interpretations, and evaluations (and hence give motivation)

in order to achieve a common goal. Sweeting (1991) wrote, “VCs ... were seeking to

establish whether or not they could simply “get along with” team members and trust

them. The benefits of this mutual understanding and trust were evident even before the

deal was made” (p. 619; emphasize in original). Beyond drawing on shared historical

relations, the entrepreneur must often go one step further in creating ongoing social

systems of mutual investment and non‐legal‐enforcement. Shared systems of meanings

and language facilitate the exchange of information. Learning and knowledge creation

that allows individuals to share each other’s thinking processes. “Shared understanding

is always going to be filtered, perceived, stored and reconverted in our own individual

‘knowledge frames’ which are going to be slightly different” (Howells, 2000, p. 54;

emphasis in original).


As a venture capitalist compared the relationship between entrepreneurs and venture

capitalist to a marriage by stating that it “is not an easy relationship by any means, [but]

in addition to constant effort and communication, I think there are two other critical

factors ‐ tolerance and shared vision/values” (Wilson, 2009; accessed 11.11.2009). First, it

is not easy maintain this relationship and it needs mutual efforts to build the foundation

of trust. Second, trust enables to build shared values and visions, but also the capacity for

tolerating the other of having their own way of accomplishing goals.

Communicating openly and fairly each other’s interests and goals enables to set

“deliberative commitments” on which both parties will agree on and frame their

interpersonal rules and agreements. Wilson (2009)argues that it is important that venture

capitalist “talk about their hopes and dreams, how they plan to get there, and why [they]

share those hopes and dreams and want to help them achieve them. That is [of] how to

win a deal and it works when both parties are sincere and open and honest with each

other” (accessed 12.11.2009).

85

6. THE GATEKEEPER-MODEL AS AN INTE-

GRATIVE FRAMEWORK FOR ENTRE-

PRENEURS AND VENTURE CAPITALISTS

6.1 An Integrative Framework

The framework is developed to gain a more transparent understanding of complex

“tractive forces” and their interactions that play a pivotal role in the venture capital

business. In general, venture capitalists decide which entrepreneurs will be capitalized

enabling them to realize their business concepts in the market. From this point of view,

venture capitalists act as gatekeepers deciding if a new idea/concept (for a novel product,

service or production process) will have the chance to become an innovation or not.

In a more metaphorical sense: They are facilitators for entrepreneurs to make the invisible

visible. A new venture takes time to emerge, referring to the notion of “run far together”

quoted at beginning of this study. However, today’s business world also requires to “run

fast”. The idea of pursuing either one of these two options as separate entities is replaced

by the need to amalgamate both, “running fast” and “far together” at the same time.

Though formally perceived as contradictory approaches, today’s fast‐moving economy

demands a shift in this strategy in order to stay on top. Opposing elements such as short‐

term efficiency and long‐term effectiveness, profit and sustainability, calculated ratio of

control instruments in a formal agreement and emotional qualities such as trust and

reputation, all have to be integrated in order to enable the amalgamation of both essences.

Over the last decades, venture capitalists have managed these contradictions but mostly

unconsciously. This study is one of the necessary steps to gain deeper insights into this

complexity, especially into the decision process of the venture capitalist. Identifying the

reasons that influence this decision process may also help the entrepreneur develop a

more advanced business plan that meets the expectations of the venture capitalist on a

more professional and effective level.

It is essential to point out that the interaction between the venture capitalist and the

entrepreneur (see Fig. 6.1) is one among many other relationships:

86

Fig. 6.1 Venture Capitalist‐Entrepreneur Relationship Source: compiled by the author

In order to make an investment decision the venture capitalist first needs to raise capital

from LPs. These investors provide capital to the venture fund, and therefore become

shareholders in the relationship (see Fig. 6.2):

Fig. 6.2 Shareholder‐Entrepreneur Relationship Source: compiled by the author

These three parties, LPs, venture capitalists, and entrepreneurs, have a common interest:

they all want to make profit. However, increasing the potential to make profit for one

party may diminish the chances for the others. As these parties form systems embedded

within networks of superior systems, they create direct and indirect relationships with

each other and with third parties. To understand the whole network it is necessary to

start with the underlying assumptions of these connected systems.

The probability an entrepreneur will have the opportunity to execute his or her new idea

completely alone is small at its best. As described in Chapter 2 and based upon the

creativity research by Csikszentmihalyi, an entrepreneur needs the consent of one or

more experts to facilitate the diffusion of the idea. “Creativity” can be described as the

process of an invention through which an idea is developed by an individual or team. It is

important to point out, however, that an invention can only become an innovation when

it is able to instigate changes within a cultural subsystem. Systems consist of hierarchies

that have established some kind of stable structure; a basis for knowledge exchange and

shared rules about what is right or wrong. Any (major) change might threaten the

stability of the system, challenging the rules and making previous valuable knowledge

worthless. To protect the system in its current form a field of experts decides what

belongs to the system and what does not. Although conservative by nature in its selection

process, it is important for a field of experts to also accept new ideas into their domain.

Only then can a system survive and adapt to altering environments. In analyzing this

87

disparity, it becomes apparent that there are two types of field of experts (gatekeepers);

those that act as facilitators for innovations and those that preserve the status quo.

In Chapter 3, some important conceptual aspects of the strategic dimension of the venture

capitalist are revealed. Venture capitalists are constantly confronted with contradictory

interests that include the institutions from which they receive their capital (LP), the

interests of the entrepreneurs to whom they transfer portions of this capital, and the

supposed interests of the participants in the market, seen as the future customers of the

entrepreneur. It is crucial for short‐term considerations to include long‐term necessities

and conditions. The challenge is to find a balance between all these contradictions,

dualities, paradoxes and dilemmas. The work by Müller‐Christ (2001) and Ehnert (2009)

condensed in Sections 3.3 and 3.4 as part of the theoretical fundament of this study, has

been key in trying to understand these premises and developing the corresponding

framework in Chapter 5.

The venture capitalist has to attract entrepreneurs with new and promising ideas and

convince LPs to allocate portions of their capital on risky investments which are illiquid

over a long period of time (but may create profits of about 25 to 30 percent per year).

Therefore, the attention of the venture capitalist has to be on reproducing and sustaining

these fundamental resources. These important resources have been detected as reputation

and trust as shown in Chapters 3 and 4, respectively. Both types of resources need time to

be established and have to be planned along with other crucial resources (such as

network connections, syndication partners etc.). These resources can be categorized as

“direct survival resources” (Sect. 5.2.2) or “indirect survival resources” (Sect. 5.2.4).

Figure 6.3 summarizes the most important stakeholders of a venture capital firm.

88

Fig. 6.3 Integrative Gatekeeper‐Model Source: compiled by the author

Figure 6.3 only shows the actors, their connections and their mutual exchange. The

consequences for the actors are summarized in the following section.

6.2 Summary of the Implications of the Integrative Framework for

Entrepreneurs and Venture Capitalists

The gatekeeper‐model is developed in order to build a more transparent framework for

the entrepreneur‐venture capital relationship in the innovation process, but it is only the

first step in suggesting a new approach on their relationship. It constitutes a theoretical

framework rather than a well‐developed testing model. These first steps are not without

critic. The origin of the gatekeeper and its development needs to be studied in order

support the assumptions of the gatekeeper‐model. In addition, further research of the

innovation process itself needs to be undertaken, as well as the development of testing

models that help verify or adapt assumptions which are made in this study. However, the

study enables the author to derive some recommendations for entrepreneurs and venture

capitalists which are outlined below.

89

6.2.1 Entrepreneurs

It is important for entrepreneurs to keep in mind that their enthusiasm for their new idea

(reflected in a product, a service or a production process) may not be shared at first by

potential customers in the market (as well as gatekeepers). Innovations take time and

need support in order to diffuse against conservative forces of self‐protecting

mechanisms of the market. Therefore, entrepreneurs should invest a lot of time and effort

in reflecting their own idea and strategy of how to succeed in the market (i.e. outlining

conservative forces that might block the innovation from evolving). Being aware of these

forces and acknowledging the special position of venture capital firms as gatekeepers is

an important function in enabling the diffusion of innovation in the market. Since high‐

tech start‐ups base most of their value on intangible resources, entrepreneurs needs to

build up assets such as patents in order to create something that can be exploited by

venture capitalists within uncertain environments. Thorough planning and gathering of

information must be presented to the venture capitalist if any business opportunities are

to be explored or expanded (see radical innovations; Sect. 5.1.2). In this way the venture

capitalist acts as a “door opener” by introducing the entrepreneur to other crucial players

in the market. Nevertheless, if the entrepreneur and the venture capitalist agree to

collaborate they are in a locked‐in position for a longer period of time. This situation is

more problematic for entrepreneurs because the VC is the only source of funding, while

the venture capitalist itself has a diversified investment portfolio.

Today, economic growth is characterized by shorter product cycles and faster shifts of

oscillation between incremental and radical innovations. These changes are responsible

for shorter life of technological knowledge and force firms to be more innovative. Based

on the assumptions of Section 5.1, incremental innovations pledge, on the one hand, to

reap profits in a relatively stable environment from a previously created disruptive

innovation. On the other hand, disruptions are inherently uncertain because they create

an unstable environment and make it difficult for firms to enforce pre‐defined strategies

and perform efficiently. While incremental innovations are important to make profits,

radical innovations are required to harvest the gains beyond an existing product or

market. In comparison to incumbents, start‐ups have an advantage when creating radical

90

innovations in unstable environments. It is assumed that incumbent firms’ main task is

the management of stability (by exploitation of the existing knowledge), while

entrepreneurs are the managers of instability and change (by exploration of new

frontiers). High‐tech entrepreneurs should avoid business ideas that go along with

benchmarking or best practice, which focuses on the improvement of existing

technologies or innovations. In other words, they should create a “pattern change” in a

certain market instead of doing “more of the same”.

6.2.2 Venture Capitalists

In the decision process four standard criteria have been extensively discussed in venture

capital literature:

• competence, personality, experience, professionalism, attitude, flexibility, creativity,

endurance etc. of the entrepreneur and the management team;

• quality of the product or service;

• market/industry size; and

• financial projections and feasibility

However, the venture capitalist has to pay attention also to its overall strategy (e.g.

sustainability dimension; see Sect. 5.2) of its own business model. Considering themselves

as a sole financial intermediary makes their business easily replaceable by other financial

investors (e.g. hedge funds) or groups such as incubators. Agency theory assumes that

investors would invest where information asymmetries are lowest (i.e. less early‐stage,

less high‐tech companies, an established business etc.). Following this assumption, the

venture capitalist is at risk of being replaced by a more knowable gatekeeper (such as

private equity or hedge funds). This in turn creates an investment gap for entrepreneurs.

Venture capitalists in the gatekeeper‐model focus on the filter mechanism, while also

providing value added and monitoring to their portfolio company. Being able to provide

these features implies that venture capitalists in general have to be “innovation

managers” by providing managerial expertise and also occupying positions as domain

experts (e.g. pharmaceutical sector or information technology). Only by incorporating

both aspects in the resource supply, can the venture capitalist help build a sustainable

business model for the portfolio company.

91

There has to be a steady influx of attractive business plans by entrepreneurs. It is also

necessary to establish a successful fund raising system from third parties (e.g. LPs).

Evidently, there is interdependency between both resources: Sufficient fund‐raising is

important to stay attractive for new entrepreneurs and attractive business are necessary

to ensure the continuity of the fund‐raising. Therefore, the selection process that

constitutes the role of venture capitalists as “gatekeepers” not only needs the short‐term

perspective of fast profit results, but also the long‐term perspective of sustainability with

all its inherent contradictions and sometimes paradoxical implications. To fulfill the

requirements of a gatekeeper the venture capitalist has to be clear about his responsibility

to be really an expert in his or her field and should keep up with the developments in that

specific domain and in the society as a whole.

6.3 Concluding Remarks

An economy needs facilitators to function smoothly and to initiate necessary change. A

special group of facilitators has been analyzed in this study and its special position as

gatekeepers of innovations. Venture capitalists as facilitators do not exist isolated but

rather in complex environment of other gatekeepers with whom they exchange

information and resources that are crucial for their agency. Creative individuals initiate

changes by questioning the conditions and existing rules of their surroundings. The

richness of these interactions and resource exchanges open up for a variety of

opportunities but also bear challenges of uncertainty. This study aimed to unfold the

interconnectedness and dependencies of venture capitalists and entrepreneurs. However,

not all questions which have evolved during the development of a theoretical framework

can be answered within the scope of this study. Thus, this study is rather designed as a

“door opener” to a rich field of further research, but also might help practitioners to

understand the innovation process within in a complex and dynamic environment.

92

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Ehrenwörtliche Erklärung Hiermit erkläre ich, dass ich die vorliegende Arbeit selbständig und ohne Benutzung anderer als der angegebenen Hilfsmittel angefertigt habe. Alle Stellen, die wörtlich oder sinngemäß aus veröffentlichten oder nicht veröffentlichten Schriften entnommen wurden, sind als solche kenntlich gemacht. Die Arbeit hat in gleicher oder ähnlicher Form noch keiner anderen Prüfungsbehörde vorgelegen.

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