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Weekly UpdatesEntrepreneurs with firm-specific human capital represent both a potential source of competitive advantage and a threat to appropriate the rents that are ultimately generated by a new venture. This situation presents interesting agency and resource dependence challenges. While potential investors in these ventures will want assurances that their interests are protected, they will also want to ensure that these key entrepreneurs remain with the organization. Using agency theory and resource dependence theory, we examine the types of governance mechanisms that are implemented in firms going through an initial public offering comparing those ventures which indicate a dependence on these critical entrepreneurs versus those that do not. Our analysis reveals that ventures exhibiting dependence on key entrepreneurs are associated with higher insider and outsider ownership by the board, greater start-up experience by the board, greater use of contingent compensation, and greater use of involuntary departure agreements.
Introduction
Entrepreneurs pursue new opportunities by developing, recombining, and integrating necessary resources into new configurations which reshape the very patterns of competition (Schumpeter, 1934; Shane & Venkataraman, 2000). Ideas for new ventures often emerge from promising insights that entrepreneurs have about the potential for a new opportunity (Keh, Foo, & Lira, 2002). Such insights usually stem from individual experiences, skills, and capabilities of the entrepreneur(s). When entrepreneurial firms evolve from these insights, the ventures often develop around the specific skills and capabilities of the founder(s), intricately linking them to the venture. Accordingly, entrepreneurs frequently represent a key source for the creation of value and the generation of rents (Alvarez & Busenitz, 2001; Barney, 1991).
While having entrepreneurs as a key resource for a venture can clearly be quite advantageous, it can also create challenges in developing and protecting the firm. Ventures that have such human capital with firm-specific skills and capabilities have the potential to turn these intangible resources into sources of competitive advantage (Barney, 1991; Peteraf, 1993). However, Coff (1999) argues that while a firm may have a competitive advantage, this advantage may not be reflected in the financial performance of the firm because the rents of the organization may be diverted first to other stakeholders such as key personnel with firm-specific capabilities. If indeed a venture has specific resources capable of generating rents, potential investors will want some assurances that the future rents of the firm are distributed appropriately.
When individuals are the source of a firm's competitive advantage, they are in an advantaged position to negotiate for a greater portion of the value that they generate (Coff, 1999). Oftentimes, managers/entrepreneurs inside the firm will have stronger bargaining power due to their position (Alvarez & Barney, 2004). Their power is enhanced, in particular, when they are capable of unified action, have access or control over information, and represent a significant replacement cost to the organization if they should exit (Coff & Lee, 2003). These criteria are particularly salient in many entrepreneurial ventures. Because entrepreneurial ventures seek to build competitive advantages from innovative pursuits, entrepreneurs and their idiosyncratic knowledge and capabilities can become central to the venture's success (Baker, Miner, & Eesley, 2003). Furthermore, the centrality of entrepreneurs within their venture provides them access and control over information. Thus, it would seem that entrepreneurs represent both a source for a competitive advantage but also a threat to appropriate the rents that are ultimately generated. Accordingly, we argue that governance is critical in initial public offering (IPO) ventures, particularly when the entrepreneurs represent a critical resource for the venture. Governance is the set of mechanisms used to manage the relationships among organizational stakeholders and to establish and control the strategic direction of the firm (Hitt, Ireland, & Hoskisson, 2007).
The presence of key entrepreneurs raises two central issues facing potential investors of new ventures with these resources. On the one hand, the investors in such ventures generally desire to see the key entrepreneurs stay with the venture as the future success of the venture is closely linked to the capabilities of the entrepreneurs. If they were to exit the organization, shareholders are likely to suffer significant losses. On the other hand, individuals with such resources tend to have more bargaining power. Consequently, such ventures face the challenge of setting up governance mechanisms that both protect future appropriations for potential shareholders as well as encourage this valuable human capital to stay with the venture. Both of these issues are often present in entrepreneurial ventures and they represent an agency concern and a resource-dependence concern, respectively. As such, the imperative of boards of directors facing these issues is to protect potential shareholder interests while concomitantly ensuring the retention of the key entrepreneurs (or at least reducing the impact of any future exit). We argue that the resolution of these issues involves the establishment of certain protective mechanisms as well as fuller disclosure of information.
By examining these issues, this research makes the following contributions. First, with the growing importance of human capital (e.g., Barney & Wright, 1998; Forbes, 2005; Hitt, Bierman, Shimizu, & Kochhar, 2001), we develop and test theory on governance in entrepreneurial ventures when there is specific dependence on key entrepreneurs. Research has recognized the importance of founders-entrepreneurs and governance issues surrounding their presence (Audretsch & Lehmann, 2005; Nelson, 2003). However, these studies tend to treat founders as a homogenous group when in fact they are not. We specifically examine those entrepreneurs with capabilities that are key to the life of the venture. While governance in IPO ventures is interesting given the uncertainty and the organizational transition occurring, this human capital dimension helps us to better understand this dynamic situation; and we believe that properly governing these critical human actors is likely critical to the success of the venture.
Second, this research addresses the formation of governance mechanisms and the rationale for those mechanisms in an entrepreneurial context. In preparing for an IPO, there are a variety of actors such as earlier stage equity investors, underwriters, and of course key entrepreneurs that shape the governance mechanisms. Such mechanisms are intended to make the venture more attractive to investors in the IPO market while also meeting the needs of the pre-IPO stakeholders. Most governance research does little to consider the various specific actors (Gabrielsson & Huse, 2004; Hoskisson, Hitt, Johnson, & Grossman, 2002). More explicitly, this study probes the types of governance arrangements that are put in place and whether they differ based on the presence of key entrepreneurs. We argue that the presence of key entrepreneurs represents a potentially non-trivial influence on the mechanisms that are used, both from the position of market concerns as well as the influence of key entrepreneurs.
In this study, "key entrepreneurs" are individuals with firm-specific skills that are intimately linked to the financial performance of the venture. We specifically contrast the governance in those ventures which identify a dependence on one or more key entrepreneurs versus those that do not identify any dependence on critical human capital. As such, the dependent variable in our study is binary (e.g., dependence on one or more key entrepreneurs as specified by the venture in the prospectus versus no such dependence). Also, we use the terms "entrepreneur" and "insider" (common in governance research) interchangeably. While our data do not allow us to consistently identify which of the key entrepreneurs are founders, we examine all insiders/entrepreneurs in a governance setting because this set of individuals is the most important and most involved in bringing new innovations to the market. In spite of this data limitation, our examination gives us an important window into how ventures can manage important dependencies.
Governance in the New Venture
This section introduces the rationale for our two theories of focus: agency theory and resource dependence theory. When financial capital is needed from equity investors such as business angels and venture capitalists during the initial stages of a venture, governance arrangements are usually put in place to manage the relationships and to engender accountability among the various stakeholders (Rosenstein, Bruno, Bygrave, & Taylor, 1993). A board of directors is typically established to monitor and implement governance mechanisms designed to mitigate behaviors that may not be in the long-term best interest of the venture. With the raising of additional capital via an IPO, the governance mechanisms often go through substantial changes (Certo, Daily, & Dalton, 2001; Ehrhardt & Nowak, 2003). Given the new set of shareholders that are joining, it is an appropriate time to realign the mechanisms with the expectations of potential investors while also catering to the interests of pre-IPO stakeholders (Eisenhardt, 1989; Fama & Jensen, 1983). Rearrangements can also help to communicate to prospective shareholders that at least symbolically the venture has addressed some of the normal governance issues (Westphal & Zajac, 1998). For example, the number of insiders on the board is often reduced to communicate better governance in preparation for the IPO and perhaps to help "window dress" the venture (Jenkinson & Ljungqvist, 2002; Lerner, 1994). Ventures seeking to go public can also signal the value of their firm through the quality of the board members appointed (Certo, 2003).
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