The boundaries and limitations of agency theory and stewardship theory in the venture capitalist/entrepreneur relationship *.

The dynamic ownership arrangements surrounding the venture capitalist--entrepreneur (VC-E) relationship inherent in new ventures make the examination of principals' or venture capitalists' (VCs) and agents' (entrepreneurs) governance arrangements interesting to explore. This article examines the limitations of agency theory and then stewardship theory in explaining the behaviors of individuals in the VC-E relationship. Our analysis points out the potential problems inherent in each theory's explanatory ability as it relates to the VC-E relationship. Lastly, theoretical gaps in the VC-E relationship are discussed along with suggestions for new theory surrounding this important and intriguing relationship.

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Entrepreneurs typically start firms with an innovative idea with the anticipation that the venture will become a long-term success. Often the new venture obtains some business angel financing to aid its development (Mason & Harrison, 1996). If the venture achieves some early success, resource gaps often emerge and need to be filled if the venture is going to achieve its potential. As the venture progresses through the initial startup phase, venture capital investments are often sought. In addition to providing risk capital to high potential ventures in exchange for partial ownership of the firm, venture capitalists (VCs) are typically active investors who seek to add value through their interaction with and advice for the managers of the entrepreneurial venture (Macmillan, Kulow, & Khoylian, 1989; Bygrave & Timmons, 1992), as well as through their monitoring and reorganization of the companies in which they participate (Sapienza & Gupta, 1994). Given the substantial equity stake that VCs typically take in a firm, the relationship between VCs and the entrepreneurs that they fund has been compared to that of large block stockholders in leveraged-buyout firms (Jain & Kini, 1995).

Efforts to explain this intriguing VC-E relationship have relied on agency theory and its assumptions (e.g., Barney et al., 1989; Sahlman, 1990; Sapienza & Gupta, 1994). Agency theory prescribes actions that focus on the protection of the investment of the principal (VC) against the harmful behaviors of the agent (entrepreneur) (Jensen & Meckling, 1976). Whereas agency theory has been developed primarily in the context of publicly traded firms with diffuse ownership structures and managers with very limited equity stake, its logic has some appeal for explaining the VC-E relationship. When VCs buy into a venture, they are like outside stakeholders (or large blockholders) who carefully observe the firm to track its business potential and monitor agent behavior to protect against opportunism. Except for a few isolated articles (e.g., Cable & Shane, 1997; Sapienza & Korsgaard, 1996), agency theory has been the dominant theoretical perspective applied to the VC-E relationship. However, some cracks are beginning to appear in the agency logic as applied to VC-backed firms (Bruton et al., 1997; 2000; Busenitz et al., 2001). This article probes temporal issues in the VC-E relationship. It appears that the dominance of agency theory in explaining the VC-E relationship is partially misdirected because of its insensitivity to temporal boundaries. Researchers applying agency theory to explain certain phenomena in the VC-E relationship will likely generate theoretical misspecifications or draw indefensible conclusions unless the timing for the use of agency theory is appropriate. Interestingly, recent research fails to find much relevance of agency theory in explaining the business angel/entrepreneur relationship (e.g., Kelly & Hay, 2001; Landstrom, 1992; van Osnabrugge, 2000).

At issue is the idea of goal congruence between the VC and the entrepreneur. When there is goal congruence between the two, agency theory is silent. Only when there is goal incongruence between the two is agency theory applicable. Thus, researchers must provide a theoretical rationale for why goals between the two have diverged before applying agency theory to explain the behaviors.

Like agency theory, stewardship theory also focuses on goal alignment between the principal (VC) and the steward (entrepreneur). Since stewardship theory assumes that the goals of the principal and steward are aligned, it would seem that this theory could further inform our understanding of the VC-E relationship. However, our analysis will indicate that stewardship theory is inadequate to explain most of the VC-E relationship because it implicitly assumes the subordination of the steward's (entrepreneur's) goals. More specifically, the steward subdues his or her self-interest in order to serve the interests of the principal. This assumption pushes stewardship theory outside the nomological net surrounding the actual dynamics of the VC-E relationship. In essence, researchers have tended to ignore the individual entrepreneur and his or her goals and vision for the venture and have instead placed overemphasis on the principal.

This article proceeds in the following manner. First, it addresses agency concerns and attempts to clarify the contribution and limitations of agency theory as it pertains to the VC-E relationship. Second, it analyzes stewardship theory and shows why it is a particularly limited paradigm for explaining the VC-E relationship. Lastly, the theoretical gaps in explaining the VC-E relationship are discussed and directions for theory are offered. In viewing the shortcomings of agency and stewardship theories in explaining the VC-E relationship, attention is focused on how these theories tend to overlook the goals and motivations of the entrepreneurs and overemphasize the centrality of the VC.

Agency Theory in the VC-E Relationship

Agency theory has emerged as the dominant theory in explaining the VC-E relationship in entrepreneurship literature (cf. Barney et al., 1989; Amit et al., 1990; Sapienza & Gupta, 1994; Sahlman, 1990). This principal-agent relationship arises when the entrepreneur engages a VC for funding of a new venture (Amit et al., 1990; Sahlman, 1990). According to agency theory, an agency problem can arise between the entrepreneur (agent) and VC (principal) as a result of incongruent goals and potentially different risk preferences (Eisenhardt, 1989; Bruton et al., 1997). This theory assumes that both the agent and principal are self-interested and boundedly rational (Eisenhardt, 1989), consequently, individual utility-maximizing behavior is likely to emerge if proper incentives and controls to align the goals of the entrepreneur with the VC are not enacted.

Bounded rationality on the part of each actor gives rise to information asymmetry between the parties (Amit et al., 1990; MacIntosh, 1994; Amit et al., 1998; Bohren, 1998). This information asymmetry may allow an entrepreneur to engage in opportunistic behavior, more specifically, adverse selection or moral hazard (Amit et al., 1998; Chan, 1983; Williamson, 1985). Adverse selection is the misrepresentation of ability on the part of the agent. For example, the entrepreneur may attempt to "oversell" the merits and viability of the venture (Levy & Lazarovich-Porat, 1995) in order to secure more favorable financing terms (Amit et al., 1998). In addition, the entrepreneur may claim to have greater knowledge about a particular technology than is true. Moral hazard refers to negative behaviors such as a lack of effort or shirking by the agent. For example, an entrepreneur may expend effort on activities that maximize personal utility but such efforts may add little or no value to the venture. Furthermore, the entrepreneur may use VC funds to purchase excessive perquisites.

Normative Versus Positivist Elements of Agency Theory

Bacharach (1989) has argued that the primary goal of a theory is to answer the questions of when, how, and why. A primary concern here is to identify the temporal boundaries of agency theory's explanatory ability for the VC-E relationship. Thus, this article first addresses when agency theory has the greatest potential in explaining behaviors in the VC-E relationship. In order to point out agency theory's limitations for the VC-E relationship, the difference between the normative and positivist elements of agency theory are specified (cf. Jensen, 1983). Normative elements are prescriptive and are directed toward accomplishing some objective given certain limitations. Jensen (1983, p. 320) states, "Answers to normative questions always depend on the choice of the criterion or objective function which is a matter of values. Therefore, normative propositions are never refutable by evidence." A normative question for agency theory would be: "How can the principal best avoid the agency problem?" In contrast, positivist elements are explanatory in nature--they provide explanation for a given phenomenon. On this point, Jensen (1983, p. 320) writes, "Answers to positive questions, on the other hand, involve discovery of some aspect of how the world behaves and are always potentially refutable by contradictory evidence." A positivist question for agency theory would be: "How does separation of ownership and control affect the value of a firm?"