2 Definitions and Basic Concepts
3.1 Approach to Theory Selection
3.1.1 Theories Commonly Applied to Financial Markets
In academic literature, there are many theoretical concepts that are frequently applied to financial markets. It would certainly go beyond the scope of this study to explain all of them in a detailed way. Still, within this section, three major fields of financial theories are highlighted, including the neo-classical perspective on financial markets, a behavioral approach, as well as the theories of the so-called new institutional economics. Each of these areas will be sketched briefly in the following.
In a traditional view, financial or capital markets are theoretically analyzed based on neo- classical theories of finance, in which future cash flows of equity or fixed income securities are valued to derive a present value.216 The underlying assumptions refer to perfect or efficient capital markets:217
216 See Brealey/Myers (2000), pp. 16 ff. For a detailed review on the valuation of fixed income securities, see also Bodie/Kane/Marcus (1999), pp. 399 ff.
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• Market participants are rational and they are utility maximizers.218
• All securities on the market are arbitrarily divisible.219
• There are no transaction costs, i.e., transaction costs are zero.
• Market participants have all and the same information, i.e., information is immediately accessible for all market participants.220
Theories that evolved based on these basic assumptions are the theory of Modigliani and Miller regarding the value additivity and the irrelevance of the choice of capital structure,221 the theory on informational efficiency by Grossmann and Stiglitz,222 the separation theorem by Tobin,223 and the Capital Asset Pricing Model (CAPM).224
A younger field of research on financial markets, mainly developed in the US, is represented by the so-called behavioral finance.225 This line of research emerged due to the fact that several phenomena observed in financial markets cannot be explained by the neo-classical perspective alone. These phenomena refer to anomalies that are contradictory to, for example, the neo-classical argument of information efficiency. The anomalies include, for example, the observation that companies that are to be included in a stock index, experience an incline in its share price shortly before being included in the index.226
218 In neo-classical theories of finance, investors seek to maximize their return given varying risk preferences. Non-monetary measures are not incorporated into the utility maximization. See Brealey/Myers (2000), pp. 187 ff.
219 See Modigliani/Miller (1958), p. 266.
220 There are various forms of market efficiency or informational efficiency. The most common differentiation was pioneered by Fama (1970), referring to a weak form, semi-strong form, and strong form of information. See Fama (1970), pp. 389 ff.
221 See Modigliani/Miller (1958), pp. 266 ff. The fundamental statement holds that the value of a company is unaffected by its capital structure, i.e., the debt-equity-ratio.
222 See Grossman/Stiglitz (1976), pp. 246 ff. 223 See Tobin (1958), pp. 65 ff.
224 For the development of the CAPM, see the seminal works of Treynor (1961), Sharpe (1964), and Lintner (1965).
225 For this area, see for example the works of Kahneman/Tversky (1979), Kahneman/Slovic/Tversky (1982), De Long et al. (1990), Shleifer/Vishny (1997b), Rabin (1998), Kahneman/Tversky (2000), Shleifer (2000), Barberis/Thaler (2003).
In contrast to the neo-classical approach, behavioral finance incorporates psychological and sociological aspects to explain the partially irrational behavior of market participants. The concept is based on two major building blocks, i.e., limits to arbitrage and psychology.227 Limits to arbitrage refers to the argument “…that it can be difficult for rational traders to undo the dislocations caused by less rational traders…”.228 Psychology relates to experimental evidence from the field of cognitive psychology, stating that traders act irrationally based on their beliefs and their preferences.
Abstaining from going into too much detail on this field of research,229 in essence, behavioral finance does not assume market participants to always act in a rational way. Rather, due to imperfect capital markets and due to limited cognitive capacity, humans act irrationally. In consequence, this leads to market participants making mistakes in perceiving and processing information, and in making decisions based on the information perceived. These irrational behavior is based on mental mechanisms also referred to as heuristics, i.e., behavioral patterns.230 For example, one of these heuristics is denoted as the so-called anchoring: When people are asked to form an estimate on a certain number, they often start with an initial, possibly arbitrary, value and then adjust it. However, empirical evidence shows that people heavily ‘anchor’ on this initial value and thereby form estimates in an irrational way.231
Another well-established field of theory refers to the so-called new institutional economics.232 New institutional economics is a broader framework basically comprised of
three theoretical concepts: Property rights theory, principal agent theory, and transaction cost theory.233 The principal agent theory is a core framework in information economics. It
227 For further literature on the topic of limits of arbitrage, see for example De Long et al. (1990) or Shleifer/Vishny (1997b). For further literature on psychological aspects, see for example Kahneman/Slovic/Tversky (1982), Camerer (1995), or Rabin (1998).
228 Barberis/Thaler (2003), p. 1052.
229 Further below it will be shown that the approach of behavioral finance is not well suited to be applied in the context of this study.
230 See for example Goldberg/von Nitzsch (1999), pp. 49 ff. 231 See Barberis/Thaler (2003), p. 1066.
232 See for example Williamson (1979b), p. 233.
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builds on the property rights theory since it refers to the delegation of decision rights from the principal to the agent and can be defined as “[…] a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf, which involves delegating some decision making authority to the agent.”234 The separation of ownership and control as well as the fact that both parties are assumed to be utility maximizers generate the agency problem.235 Instead of acting in the best interest of the principal, the agent may prefer to maximize his private wealth.236
While the principal agent theory focuses on conflicts arising from asymmetric information between the principal and the agent, the transaction cost theory elaborates on institutions, which aim at rationalizing exchange, information, and communication processes.237 Since in this study, the syndication network of VCs is intended to be analyzed, and since transaction cost theory is a concept that could serve as a basis for analyzing networks, it has to be looked at in more detail to decide whether it could also serve as theoretical basis for the present study.
The transaction cost theory has originally been pioneered by Coase (1937)238 and has later been refined by Williamson.239 In this approach, specifically, two institutions, markets and hierarchies, are examined regarding the question, why specific transactions are executed on the market while others are executed within organizations.240 The elements under consideration are single transactions, which can either be the physical transfer as an "…exchange of goods or services from one party to another"241 or, in a
234 Jensen/Meckling (1976), p. 308.
235 This situation of conflict was first discussed by Adolf Berle and Gardiner Means in 1932, see Berle/Means (1932). For seminal works in this field, see Akerlof (1970), Spence (1973), Jensen/Meckling (1976), Rothschild/Stiglitz (1976), Fama/Jensen (1983a), Fama/Jensen (1983b), Arrow (1985), Shleifer/Vishny (1997a). For an overview, see Spremann (1990), pp. 561 ff.
236 See Jensen/Meckling (1976), p. 308; Fama/Jensen (1983a), p. 302; Fama/Jensen (1983b), p. 332. 237 See Picot/Reichwald/Wigand (1996), pp. 36-38.
238 See Coase (1937), pp. 386 ff.
239 In this context, see the seminal works of Williamson (1985). In this context, see also further works of Williamson to this topic: Williamson (1975), Williamson (1979a), Williamson (1979b), Williamson (1981a), Williamson (1981b), Williamson (1984), Williamson (1989), Williamson (1990).
240 This refers to the classic 'make-or-buy' decision. 241 Williamson (1985), p. 1; Jones/Hill (1988), p. 160.
juridical context, the transfer of certain rights.242 The efficiency criterion is the sum of the production and transaction cost, the basis on which transaction cost theory compares the alternative institutional arrangements markets and hierarchies, i.e., organizations. Consequently, the institutional arrangement is supposed to be more efficient, for which production and transaction costs are lower.243
Based on the transaction cost theory, an organization has a 'right' to exist if it is able to solve the tasks and problems of coordination internally for lower costs than would be possible compared to the same transaction if executed involving an external partner on the market.244 Influencing factors for transaction costs are the so-called human factors, i.e., assumptions on human behavior, and environmental factors. Human factors refer to the human's bounded rationality due to imperfect information and limited information processing capacity as well as to opportunistic behavior.245 Environmental factors include the factor specificity, and the uncertainty and frequency of the transaction.246 Factor specificity refers to investments in assets, in human capital, and in the production site. On the one hand side, the more specific the investments, the lower the production costs. On the other side, specific transactions, which are executed on the market, may lead to a situation with significant asymmetric information between the transaction parties, i.e., one of the parties can potentially exploit the fact of having more information than the other, finally leading to higher transaction costs.247 On the one hand side, uncertainty refers to the conditions of the transaction. On the other hand, it refers to uncertainty regarding the behavior of the other party, i.e., uncertainty with respect to a potentially opportunistic behavior. In both ways, transaction costs increase due to the need to gather more information on the transaction partner upfront, and due to ex-post amendments of the contracts or conditions of the transaction. Finally, the more frequent a transaction
242 See Commons (1931), p. 648.
243 See Ebers/Gotsch (1999), pp. 225-227. Furthermore, it is differentiated between ex-ante and ex-post transaction costs. Ex-ante transaction costs are those that occur prior to closing the contract. Ex-post transaction costs are comprised of three categories: Control costs to ensure that contracts are fulfilled, costs to solve (legal) conflicts, and costs arising due to ex-post changes of the contract. In this context, see Williamson (1985), p. 22.
244 See Picot/Reichwald/Wigand (1996), p. 41.
245 See Arrow (1985), pp. 37 ff.; Arrow (1987), p. 201; Picot/Reichwald/Wigand (1996), pp. 41-43. 246 See Ebers/Gotsch (1999), pp. 227-228; Williamson (1985), p. 281.
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occurs, the lower the production and transaction costs, representing reasons to organize a transaction within an organization.248
Based on the above explanations, the economic institution market is characterized by independent actors, who spontaneously execute single transactions. These transactions are coordinated by the price mechanism and rights and obligations are fixed in contracts. Access to the market is open for all actors, and laws of various kinds control for situations of conflicts or fraud.249
In contrast to the market, the economic institution hierarchy refers to organizations or companies that are structured into hierarchical levels and departments. Despite modern management concepts regarding employee-oriented management styles, the organization functions based on formal rules to which the employees adhere when signing the employment contract. Situations of conflict can be solved by authoritarian instruction of a supervisor.250
However, in both cases, markets and hierarchies, it is questionable whether these two extreme and ideal forms are suitable to describe the relevant situation in reality. In the case of real markets, transactions can usually not be executed without being embedded in institutions and some form of formal rules.251 This means, that partners to a transaction need to show a minimum of cooperative behavior, institutional arrangements such as contract law must be in place, and the involved parties need to be willing to adhere to these rules.252
248 See Williamson (1985), pp. 281 ff. 249 See Weyer (2000), pp. 5-7. 250 See Weyer (2000), pp. 8-9.
251 See Granovetter (1985), pp. 482 ff. In this paper, Granovetter refers to the dispute of the so-called undersocialized view and the oversocialized view underlying opposing theories. On the one hand, the new institutional economics tend to view actors, i.e., individuals or companies, as undersocialized since transactions are executed without any human or social contact between the parties being taken into account. In this context, see also Hirschman (1982), p. 1473. On the other hand, the oversocialized perspective prefers a point of view in which market participants are seen as human beings that have relations and underlie behavioral constraints. In this context, see the early works of Piore (1975) and Phelps Brown (1977). On the topic of under-/oversocialized view with respect to VCs and entrepreneurs, see Shane/Cable (2002).
In the case of hierarchies such as organizations, it is questionable whether a modern company can be described as simple hierarchical structure or whether the informal, internal relationships and networks are not also a factor that accounts for the success of the firms.253 Transaction cost theory also provides a third form of institutional coordination, which is a hybrid one, situated somewhere along the continuum between the endpoints (market and hierarchy). This form of coordination is also referred to as network. Some authors view networks as being part of the continuum,254 others denote networks as a form of coordination having an own quality, excluding the gradual transition to the endpoints of the continuum.255
The essence here is that, although 'market' and 'hierarchy' are used as reference points in both perspectives, networks constitute a form of coordination with an own character, joining elements of markets and hierarchical structures: Networks combine the flexibility of market transactions with the efficiency and security provided by organizational structures.256 This leads to two advantages that networks deliver:
• They reduce the uncertainty regarding the behavior of other actors. • They enable an organization to produce a higher output.
While the theories explained above are commonly applied in analyses of financial markets, for several reasons it is abstained from applying them as theoretical foundation in the present study. These reasons are described in detail in the following section.
253 See Hirsch-Kreinsen (1995), pp. 422 ff.
254 Authors that represent this line of thought are, for example, Sydow (1992) or Schneider/Kenis (1996). 255 In this context, for example see the works of Powell (1990) or Willke (1995).
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3.1.2 Reasons for Abstaining from Frequently Applied Theories
With respect to the neo-classical perspective, and looking at the venture capital market and the market for investment opportunities VCs can invest in, it becomes obvious that the assumptions of the neo-classical finance theories are not fulfilled:257
Information on potential investment opportunities is not freely and immediately available to all market participants. Quite the opposite, this information is unequally distributed among market participants and, since it is private and potentially valuable information, it might not be transmitted deliberately.258
Although market participants are utility maximizers, the utility function might also incorporate non-monetary elements, which is to a large extent not conformable to neo- classical theories. This becomes obvious based on the discussion on the rationales for syndicating venture capital investments. One example in this context is the expected reciprocation of deal flow.259
Often, the VCs engage in early stage investments, i.e., they invest in a financing phase, in which the risk of the investments theoretically can hardly be assessed.260 Taking this thought one step further, not only for the case of early stage investments but also in later financing stages, the risk profiles of portfolio companies are difficult to evaluate.
The value of equity and especially the question why the search for equity capital frequently constitutes a challenge for potential portfolio companies, cannot be explained based on the neo-classical finance theory.261
257 In his work on the informal venture capital market, i.e., on business angels, Brettel (2004) also shows that the neo-classical assumptions do not hold. Although in his work applied to the case of business angels, parts of the line of argumentation are also valid for the formal venture capital market, finally leading to the same result, namely that the neo-classical theories provide an insufficient basis in the context of the study.
258 On the topic of the sharing and the transmission of knowledge, see also Hansen (1999), Cross et al. (2001), Tsai (2001), Borgatti/Cross (2003), Maula/Autio/Murray (2003), Aalbers/Dolfsma/Koppius (2004). 259 See section 2.1.4.3.
260 See Copeland/Weston (1992), p. 145.
261 See Schefczyk (2004), p. 134. In his work on informal venture capital providers, Brettel (2004) adds two further arguments why the neo-classical perspective is not a useful theoretical foundation for the analysis of the market under consideration. First, securities in the informal venture capital industry are only theoretically divisible. In practice, however, high costs have to be incurred to achieve separation. Here, the author refers to the costs that have to be incurred for notaries. For the purpose of this study, i.e., the formal venture capital market, this argument might not weigh as much as it does in the informal counterpart. This is assumed because in the formal venture capital market, investments are frequently syndicated, i.e., securities are separated. Second, Brettel (2004) argues that the separation theorem does
Based on these arguments it could be shown that, for the formal venture capital market, the underlying assumptions of neo-classical finance theories are not fulfilled. Therefore, this traditional perspective on financial markets is not employed as a theoretical basis within this study.
In contrast to the neo-classical theories of finance, the behavioral approach is able to incorporate psychological and sociological aspects into explaining phenomena observed in financial markets. However, for one simple reason, also the behavioral finance perspective does not seem to provide a solid theoretical foundation in the context of this study: The focus of this work is to examine the VCs’ syndication network by characterizing the individual VC’s network position and drawing conclusions on their deal flow. Behavioral finance, however, is more tailored to explain phenomena occurring on the stock market (stock price movements, behavior of traders), rather than explaining network structures in general, apart from the specific case under consideration (structure of the syndication network). Moreover, based on the approach of behavioral finance it would not be possible to draw conclusions with respect to the deal flow of VCs. Therefore, it is abstained from applying this approach as theoretical foundation to the present study.
With respect to the framework of the new institutional economics, the transaction cost approach is the concept that could theoretically be employed as basis for a study on networks. Although representatives of the transaction cost approach would place the syndication network of VCs on the continuum between markets and hierarchies, the question arises whether transaction cost theory is a suitable approach for the purpose of this study. In the following it will be explained what exactly needs to be analyzed regarding the VCs' syndication network, and it will be checked whether the transaction cost approach is a suitable theoretical foundation to achieve this goal.
not hold, i.e., investment plans and financing are not separated in early stage investments. Instead, single and specific investments are financed. Again, for the formal venture capital market this argument might not apply to the full extent, since venture capital firms also invest in later stage companies that have been in business for several years. Here, it is assumed, that not only single and specific investments are being financed but that portfolio companies also receive funds that they then can invest in several projects. For the original arguments, see Brettel (2004), pp. 100-101.
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In industrial or market systems, firms are in contact with each other to exchange goods or services.262 These systems can be viewed as relationship networks, i.e., relationships the firms have among each other.263 To establish and further develop these relationships, firms have to invest time and effort.264 Furthermore, based on these relationships, firms are