The Influence of the venture capitalist's governance activities on the entrepreneurial firm's control systems and performance.

Venture capitalists (VCs) contribute to entrepreneurial firms by engaging in governance activities, such as providing services and monitoring the entrepreneurial firm's operations and performance. This study examines the role and influence of the VC's governance activities on 93 Dutch entrepreneurial firms. Results suggest that while the VC's governance activities may help to stimulate the use of the entrepreneurial firm's control systems, they also moderate the relationship between the entrepreneurial firm's use of control systems and its financial performance. It appears in particular that cost control systems contribute positively to the entrepreneurial firm's financial performance when the VC provides service activities. However, the use of cost control systems tends to be negatively related to the entrepreneurial firm's financial performance when the VC is highly focused on monitoring.

Introduction

Venture capitalists (VCs) provide risk capital to high-potential entrepreneurs. By owning a large stake of the ownership rights, VCs usually gain substantial influence over the entrepreneurial firm, which allows them to play an active role in the firm's strategy development by offering value-adding activities. Although seminal work has reached general consensus as to which value-adding activities are provided to entrepreneurial firms (e.g., Deakins, O'Neill, & Mileham, 2000; Ehrlich, Noble, Moore, & Weaver, 1994; Fried, Bruton, & Hisrich, 1998; Gabrielsson & Huse, 2002; Gorman & Sahlman, 1989; MacMillan, Kulow, & Khoylian, 1989; Rosenstein, Bruno, Bygrave, & Taylor, 1993; Sapienza, 1992; Sapienza & Timmons, 1989), there is still little agreement on the extent to which these activities influence the entrepreneurial firm's performance (Barney, Busenitz, Fiet, & Moesel, 1996; Busenitz, Fiet, & Moesel, 2004; Flynn, 2001; Higaside & Birley, 2002; Rosenstein et al., 1993; Sapienza, Manigart, & Vermeir, 1996).

Previous research on the impact of VCs has mainly focused on direct effects of the VC's value-adding activities on the one hand, and the entrepreneurial firm's features and financial performance on the other hand. Little work has been done to investigate these relationships in a more complex manner, such as considering the impact of moderating mechanisms through which the VC may enhance or damage the entrepreneurial firm's financial performance. This article attempts to resolve the "VC added value" problem from a corporate governance point of view by proposing that the contribution of the VC's value-adding activities to the entrepreneurial firm's performance depends on the way the VC tries to govern the entrepreneurial firm. As such, the value-adding activities provided by the VC's representatives on the board, the investment manager, and all other VC staff who are involved with the entrepreneurial firm combined, are regarded as the VC's governance activities. Accordingly, two main sets of VC's governance activities can be distinguished, which are related to agency theory and resource dependency theory (Daily, Dalton, Johnson, & Ellstrand, 2003; Hillman & Dalziel, 2003; Zahra & Pearce, 1989). The first comprises the VC's monitoring activities that arise from the VC's perception of an agency problem, which occurs when the entrepreneurial firm's management possesses more or better information than the VC and when there is a mismatch between the goals and interests of the two parties (see e.g., Cable & Shane, 1997; Jensen & Meckling, 1976; Lynall, Golden, & Hillman, 2003; Sapienza, Korsgaard, Goulet, & Hoogendam, 2000). The second comprises the VC's service activities that result from an asymmetric resource-dependency relationship between the VC and the entrepreneurial firm. This implies that the viability and continuity of the entrepreneurial firm depends on critical resources controlled by the VC (see e.g., Johnson, Daily, & Ellstrand, 1996; Pfeffer & Salancik, 1978). This article takes into account that due to the VC's information needs and experience with many other firms, each governance activity influences the degree of sophistication of control systems in the entrepreneurial firm, albeit for a different purpose. The VC's monitoring activities are aimed at value protection, while the VC's service activities are aimed at value creation.

A resource-dependency perspective suggests that sophisticated control systems enable the entrepreneurial firm to grow and expand more quickly (see also Churchill & Lewis, 1983; Flynn, 2001) as they promote efficient and effective use of the resources provided by the VC to the entrepreneurial firm. Accordingly, when sophisticated control systems are present in the entrepreneurial firm, the VC should be able to align its governance activities to the information or resource needs revealed by these systems, and hence create value. Therefore, the VC's service activities may not only have an impact on the degree of sophistication of the entrepreneurial firm's control systems, but also moderate the effect of such systems on the entrepreneurial firm's financial performance. An agency theory perspective suggests that sophisticated control systems in the entrepreneurial firm facilitate the ability of the VC to protect the value of its investment (cf. Ruhnka & Young, 1987), as VCs tend to be short-term and efficiency-oriented investors (Gomez Meija, Balkin, & Welbourne, 1990; Steier & Greenwood, 1995; Zahra, 1996b). However, given the potentially negative effects of too much control, we expect that VC monitoring activities might negatively moderate the effect of the entrepreneurial firm's control systems on its financial performance.

This article proceeds in the following manner. First, we explore the contribution of the VC to the entrepreneurial firm from an agency theory and resource-dependency theory perspective. Next, we provide information about our sample, measures and statistical procedures. Finally we report the results, and conclude with a discussion of the implications of our findings.

Theory and Hypotheses

Resource-Dependency Perspective: VC's Service Activities and the Entrepreneurial Firm's Control Systems

Resource-dependency theory suggests that corporate boards, and thus VCs, are effective mechanisms which help the firm to manage external resource dependencies (Pfeffer & Salancik, 1978). As such, VCs play the role of "boundary spanners" (cf. Daily et al., 2003, p. 372) between the firm and its environment by providing or facilitating access to external resources which are critical to the entrepreneurial firm's success. Apart from their help to access and develop networks with other external organizations (e.g., suppliers, customers, investors, and regulatory agencies), VCs contribute by using their information expertise and cognitive capabilities to enhance the comprehension, creativity, and coherence of a firm's decisions (cf. Ginsberg, 1994). In this context, VCs reduce the entrepreneurial firm's uncertainty regarding control of resources, strategy development, and transaction costs related to external relationships (cf. Hillman, Cannella, & Paetzold, 2000). Several studies in the corporate governance literature recognize the added value of service activities, such as the provision of access to key constituents (e.g., investors, advisors, and regulatory agencies), tangible resources as well as information, advice, legal counsel, and legitimacy (Fried et al., 1998; Hillman et al., 2000; Judge & Zeithaml, 1992). Very much in line with these findings regarding the contribution of corporate boards, research into the VC's postinvestment activities indicate that VC service activities include recruiting additional managers to the firm, acting as the interface with the investor group, providing assistance on operations, helping to approach new finance partners, establishing contacts with advisors, or providing assistance for the introduction of new products/ services to the market (e.g., Ehrlich et al., 1994; Gabrielsson & Huse, 2002; Harrison & Mason, 1992; MacMillan et al., 1989; Rosenstein et al., 1993; Sapienza & Timmons, 1989). From a resource-dependency perspective, the main goal of these service activities is to enhance or facilitate the implementation of corporate decisions through the flow of critical resources to the entrepreneurial firm.

The resource-dependency perspective indicates that powerful coalition partners of the organization, such as VCs, who provide resources, capabilities, and advice that are most needed or desired by the organization, have influence and control over the organization (Pfeffer & Salancik, 1978, p. 27). One way to establish the VC's influence and control over the entrepreneurial firm is to stimulate the use of control systems. These control systems might enhance the importance of the VC as a powerful partner in the entrepreneurial firm, as control systems can help to identify potential behavior, resources, and capabilities that are most appropriate and might be supplied by the VC. Moreover, they can help the entrepreneurial firm to use its resources in an efficient and effective manner.