Borrower Lender Relationships in High Technology Ventures

Information asymmetry is present when one party to a transaction has more or better information than the other party. The other party knows something about the properties of the transaction that the other does not know, and that is not directly observable.

Knowledge specificity creates a division of labour between entrepreneurs and venture capitalists . Entrepreneurs specialize in the awareness of unexploited opportunities and of the resources to exploit these. Entrepreneurs also specialize in the day to day development of new business activities. Venture capitalists specialize in creating networks of individuals and institutions to reduce the cost of acquiring capital, to find customers and suppliers and to establish the venture's credibility (Shane & Cable, 1997).

Under the Principal-Agent theory it is assumed that people are self centered and concerned with actions that lead to personal benefits. If hiding the information from the other party will benefit them, they will do so. This creates the problem of moral hazard (Reid & Smith, 2003). Moral hazard problems may occur whenever information asymmetries exist; in other words, when one side is more informed than the other. Thus, one party has an incentive to shift risk onto an uninformed other party (Shane & Cable, 1997). For instance, entrepreneurs may withhold any negative information about market and competition situation because it may affect the venture capitalist's decision about investing in the venture. The entrepreneur may not reveal underlying poor performance of the company because it may also spur the investor to bring in professional management to replace the entrepreneur (Shane & Cable, 1997).

First time lending refers to an arrangement between an investor and an entrepreneur to finance the new high-technology venture, where the investor has had no previous dealing or relationship with the borrower (entrepreneur). First time lending to a new technology venture poses great risks for the investor as we will see below, in the form of agency and business risk. In Reid's study (2003), most investors regarded lending to completely new technological firms (seed ventures and start-ups) as being risky because there is no data available on the credibility of the entrepreneur as well as the potential of the new technology. The chart below shows that lending to first time technologies is lower than lendings to ventures in other stages (Camp & Sexton 1992).

However, lenders do make first time loans/investments by gathering as much information as possible, about the entrepreneur and the proposed venture . This information can be obtained from the business plan that the entrepreneur submits to the investor for reviewal. However, as noted above the entrepreneur may not give accurate information due to moral hazard, to increase the chances of getting the funding.

Repeat lending is when an investor reinvests in a venture to help further development or finances another venture for the same entrepreneur. Venture capitalists may reinvest in the venture if they are satisfied with the work of the entrepreneur and if the venture takes off profitably, creating larger profit margins in lesser time. For example, if the entrepreneur provides accurate and timely feedback to the venture capitalists, they are more likely to be more committed to providing further finance. Timely feedback will also reduce investors' uncertainty regarding the future of a venture, enhancing their ability to negotiate a fair reinvestment price. Thus timely feedback will increase their willingness to provide repeated funding to entreprenurs (Sapienza, H. & Korsgaard, A. (1996).

WHY ARE HIGH TECH VENTURES RISKY FOR LENDERS?

High technology ventures can be defined as those in which the owner develops and brings new cutting edge technology to the market involving new products or processes. Usually a high tech entrepreneur has had little or no business experience and majority tend to be young graduates. (Corman, J. et. al., 1988).

High technology entrepreneurs have a range of financing options like angel investors , venture capital , commercial banks, finance companies and factoring companies . However this essay will focus on venture capitalists and commercial banks.

Venture Capitalists

Venture capital is used to finance the launch, early growth and expansion of firms. Investors are now increasingly willing to fund more risky high technology investments (e.g. start-up). However high technology ventures are still ranked highly risky. Research by Gavin and Smith (2002) demonstrates this as seen from the graph below:

The main reasons for this are (Reid & Smith, 2002; )Ð'-

a) Business risk

b) Agency risk

a) Business risk is caused by the uncertain competitive environment in which high technology ventures operate (Kaplan, S. & Stromberg, P., 2000). High technology industries are constantly in flux are subject to breakthroughs that permit attractive business opportunities to develop. Investments are often high risk but with potentially high returns. However there is little reliable information to indicate the potential success of an idea or business concept and the new businesses have little or no asset base creating a risky situation (Wasserman, J., 1988). Business risk thus arises because it is difficult to predict the value of a new product in such competitive market (Reid, G. & Smith, J., 2003). Thus, the investor has no idea whether or not the new venture will succeed.

b) Agency risks are caused by incomplete alignment of investor and borrower interests. When entering the contract, it is intended for both parties to benefit, yet, often one party gains from an action that will cause a loss to the other party. This is agency risk. It arises because of information asymmetry between principal and agent (Reid & Smith, 2003).

Entrepreneurs may be reluctant to give up technical details because the information is not always protected by Intellectual Property Rights and the entrepreneur may withhold information about the technology to protect himself from an opportunistic venture capitalist. Although this may benefit the entrepreneur, it is very risky for the investor because accurate information is needed to evaluate the venture's probability of success in order to decide an appropriate level of funding. Another example is when the entrepreneur shifts his attention to other activities instead of focusing on the success of the venture. Although entrepreneurs