Agency Problem, Information asymmetry

Question 1

The Agency problem

- the conflict of interest between entrepreneur and investor

Answer 1

these are the consequences of agency problem

Moral Hazards – Management
Management may misuse funds
Management may take undue risks
Management may reduce efforts

Moral Hazards – Venture capitalist
May focus on limiting downside not on achieving potential
May lack motivation in the provision of support services

there are 2 types of approaches to this problem
Ex –ante
Attempts to control problem by pre-investment screening due diligence and contract design
Ex –Post
Allocation of control ex-post is key rewarding performance replacing poor performers

Question 2

The information problem-asymmetric information

- difficulty conveying the entrepreneurs ‘information’ to the investor leading to adverse selection

Answer 2

Entrepreneurs have private Information
They cannot credibly reveal that information because they have an incentive to lie.
The information may be difficult to understand
If the V C gives too little the good entrepreneurs will go elsewhere
If the VC gives too much they lose on the deal

Question 3

How to solve agency problem

Answer 3

Management benefit only if the firm succeeds

Minimal salaries
Compensation tied to profits
Prior claim by Venture Capitalists in the event of failure
Clear targets

Monitoring
Board participation and voting rights

Question 4

Solving the Information problem

Answer 4

1. Personal commitment by founders
2. Specialisation by venture capitalists
3. Structure of deal should leave sufficient upside for founders-keep the good prospects in the game
4. Structure of deal should limit downside for investors- deter the bad prospects
5. Staging –asymmetry will reduce over time
6. Active investment- asymmetry is reduced by participation

Question 5

What is Angel Investor?

Answer 5

Angel Investment is the biggest single source of funding for start-up businesses
A funding gap exists between internal funds $100,000 and the $2m where larger investors may be interested this is where Angel Investors are positioned
A further gap exists between $2m and $5m where the amounts are too large for Angels and too small for many Venture funds- these require Angel Alliances

Question 6

Problems in understanding the Angel Investor

Answer 6

Private transactions
Desire for Anonymity
Informal networks 
Small amounts
Significant differences across countries
Significant differences between Angels

Question 7

-Angel Investors V Venture Capitalists

Answer 7

Primary focus is on the person
Pay more attention to Investment Fit
Invest in Younger companies
Less than one year old
Invest smaller amounts
Half of average investment of VCs
Invest at pre-revenue stage
69% had yet to produce revenue

Question 8

Angel Investors and the agency problem

Answer 8

1. Use prior relationships to mitigate information problems
2. Less control of agency problems than Venture Capitalists less stringent contracting.
3. Less ability to monitor ex-post.

Question 9

Angel Investors investment criteria

Answer 9

Sector should be familiar
Geographical limit – 2 hours
Early stage-expansion financing
Importance of Management team credibility will override other factors
A Trusted source may also over-ride other factors

The reason they could reject is
1. lack of credible concepts and lack of credible management team
2. Pay relatively little attention to financials
3. Distrust Financial data
they might just rely on gut instinct

Question 10

Typical Deal by Angel investor

Answer 10

1. Equity straight or convertible preferred
2. Occasionally personal loans or guarantees
3. Main incentive mechanism is managerial equity ownership
4. Prefer to see significant equity retained by management
5. Representation in Board is main control mechanism
6. Will also use staged financing
7. Rarely use sophisticated covenants