H Exploring the informal capital market in the Netherlands: characteristics, mismatches and causes

Transcription

1 H Exploring the informal capital market in the Netherlands: characteristics, mismatches and causes Zulaicha Parastuty Zoetermeer, June, 2006

2 This report is published under the SCALES-initiative (SCientific AnaLysis of Entrepreneurship and SMEs), as part of the 'SMEs and Entrepreneurship programme' financed by the Netherlands Ministry of Economic Affairs. Most recent EIM reports and much more on SMEs and Entrepreneurship can be found at: The responsibility for the contents of this report lies with EIM bv. Quoting numbers or text in papers, essays and books is permitted only when the source is clearly mentioned. No part of this publication may be copied and/or published in any form or by any means, or stored in a retrieval system, without the prior written permission of EIM bv. EIM bv does not accept responsibility for printing errors and/or other imperfections. ii

3 Exploring the informal capital market in the Netherlands: characteristics, mismatches and causes Zulaicha Parastuty These are the main results taken from the Master s thesis by Zulaicha Parastuty, supervised by prof. dr.ir. J.G. Wissema, dr. M.S van Geenhuizen, dr. J. Meijaard and ir. B.R. Joseph iii

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5 1 The Dutch informal capital market This study analyses the Dutch informal capital market by using perspectives from finance theory and agency theory. Matched data are collected from informal investors and innovative entrepreneurs. The first chapter of this shortened version outlines the potential imperfections of the Dutch informal capital market. The second chapter discusses the empirical results. The third chapter summarizes the results and draws conclusions. 1.1 Imperfections in the informal capital market Some studies in entrepreneurship have shown that entrepreneurial ventures contribute to economic growth by creating new jobs. However, because of the risks of these ventures, the institutional capital market could confine the economic development of these entrepreneurial ventures. In such a situation, the availability of informal investors is inevitably needed. Ironically, informal capital markets in some countries are also not well developed. Some researchers regard the market inherently imperfect (Mason and Harrison 1991; Lumme, Mason et al. 1998). Why is this market imperfect? Imperfections arise mainly from information inefficiencies between informal investors and entrepreneurs. Both parties, the start-ups and the informal investors, contribute significantly to these inefficiencies. Start-ups are not able to provide perfect information for the informal investors due to their characteristics, such as limited operating history, low-scale potential or unforeseeable prospects. As newcomers in business, entrepreneurs may not have reputable names to be used as personal collateral. This makes it hard for informal investors to assess the track record of entrepreneurs. On the other side, informal investors, who may prefer to remain anonymous, make information about them unavailable. This situation creates serious problems for entrepreneurs to get to trust the informal investors. Informal investors also face difficulties to find attractive investment proposals. These factors lead to the following hypothesis: Several studies have shown that many private investors are unproductive, in the sense that there exist a large numbers of virgin angels 1, or investors that are inadequately experienced in identifying prospective business. In the US (and many other countries), informal investors often feel disappointed as they have a number of uncommitted funds available for investment but they hardly find suitable investment proposals (Stevenson and Coveney 1994; Van Osnabrugge and Robinson 1 Virgin angels are potential informal investors but they have not made any investments yet. 5

6 2000). Therefore, one could argue that the unfortunate situation for entrepreneurial ventures occurs not because of the absence of sufficient funds for the start-ups, but because of the difficulties faced by the investors and start-ups to tie each other s interests. In addition to the problem of anonymity mentioned above, the difficulties to identify and to search for informal investors are contributed by the fact that there are no directories of informal investors (Gaston 1989; Van Stel, Carree et al. 2005). The governments also find it difficult to obtain the precise records of informal investors investment transactions and therefore they cannot build a directory of informal investors. Match-making agents have made parts of the directory available. The directory cannot be accessed freely and easily though. Since informal investors come from a diverse and dispersed population of affluent people, it makes it difficult for start-ups to identify the investors. Some information about opportunities for investment in new or small companies is definitely available through informal communication channels. This makes the market fragmented. In this case, informal investors rely on some sorts of primitive informal networks of trusted friends and business associates to levy their search process. The use of such informal networks eventually leads to the proliferation of highly invisible networks (Equinox Management Consultant 2000). Parties who provide information in the search process are: business brokers, commercial bankers, attorneys, accountants and investment bankers. However, some investors feel dissatisfied with this kind of information channel. As a consequence, we can find the existence of virgin angels, namely potential investors who have not invested their money yet. Particularly in the Netherlands, the underdeveloped informal capital market may be caused by an aspect of the Dutch culture namely that the affluent people are a hesitant to expose their wealth. This may cause specific weak ties of the informal investors networks. As personal networks play a very important role in informal capital markets, the weak ties of informal investors can lead to a specifically underdeveloped informal capital market (Van Osnabrugge and Robinson 2000). Informal investors, due to the difficulty in assessing the performance of start-ups, carefully scrutinize the received proposals. In many cases, informal investors underestimate the quality of business proposals due to limited availability of information about the opportunities. The underestimation of the quality of business opportunities is compounded by the fact that informal investors, ironically, often receive many low-quality proposals. According to a survey conducted by Bureau Bartels, informal investors in the Netherlands found that seventy-five percent of business proposals provided by match-making agents were considered low-quality (Bureau Bartels B.V. 2003). If informal investors mainly receive low-quality business proposals, they will take precautionary actions to minimise the uncertainty. One of such precautionary actions is a demand for a higher return in the contracts. There are two possibilities that could arise from this situation, indicating an adverse selection problem. The first possibility occurs when entrepreneurs agree with the 6

7 artificially high return of the contracts. As a consequence, entrepreneurs will take high-risk actions to leverage the firms as required by informal investors. Taking high-risk actions could actually drive the firms towards uncertainty. It could be argued that artificially levelling up the returns of the contracts will make informal investors, eventually, bear more failure by entrepreneurs. The second possibility arises when the parties fail to reach agreement about the value of the proposed contracts, either because the informal investors step out or the entrepreneurs withdraw from the (proposed) contracts. The informal investors may refuse the contract because they calculate the proposed contracts to yield a smaller return that they require. On the other hand, rational entrepreneurs will refuse the artificially high return required by informal investors. The investors may fail to reach agreements with entrepreneurs who have good business proposals. As a result, the investors have to deal with entrepreneurs whose proposals are of a lower quality. The investors may further tailor their requirement by demanding an even higher return from the contract, forcing even more entrepreneurs with better business proposals to withdraw from the agreement. Eventually, the market of informal investors might collapse since the market involves only the lowest quality business proposals with which the investors do not wish to deal. A situation in which good business proposals are driven out of the market by bad business proposals due to asymmetric information is indeed the indication of an adverse selection situation. (Himmelweit, Simonetti et al. 2001). The refusal of entrepreneurs towards the offer of informal investors may be caused by several factors such as: the amount of money offered, the networks of informal investors, the willingness of informal investors to call for management change etc. The decision to accept or refuse the offer from informal investors may differ based on how informal investors perceive some factors related to the success of making start-ups investments. It is then important to understand the factors that lead entrepreneurs to accept the offer of informal investor, and compare these factors with the factors perceived by informal investors as the success factors in making informal investments. Furthermore, due to the asymmetric information, start-ups and informal investors are subject to serious moral hazard problems. This can be seen from the following situation. Once entrepreneurs have raised funds from informal investors, they could have an incentive to misallocate these funds by spending on activities that benefit themselves disproportionately. For example, entrepreneurs might choose to invest the funds in research activities that bring fame and status for the scientists yet result in little return for the investors. Therefore, to ensure that entrepreneurs do not behave 7

8 undesirably and opportunistically for the sake of their own interests, informal investors may demand entrepreneurs to bear a part of the risk. In practice, informal investors demand the participation of entrepreneurs in the capital structure. Furthermore, a mismatch of investment preferences also contributes to the inefficiencies of informal capital markets (Mason and Rogers 1996). This problem is also concerned with the unavailability of information about informal investors investment preferences. Informal investors often keep their preferences private and personal (Gaston 1989; Van Stel, Carree et al. 2005). As a result, entrepreneurs are less informed about the investment preferences of informal investors. This situation will generate problems for the entrepreneurs to match their proposals with the actual demand of informal investors. On the other hand, informal investors have also limited information about the entrepreneurs preference for such investments. The mismatch could impose high search cost on both parties. In some cases, however, due to the difficulty to meet the investors preferences to investments (interests), entrepreneurs could reject the opportunity (money) offered by the investors (Mason and Harrison 1996a). If this is the case, there is a need to better inform parties, entrepreneurs, and informal investors, about how to effectively negotiate such proposals to reach mutually satisfactory outcomes and to inform both parties about their preferences and expectations. The unfamiliarity with the techniques of successful venture financing faced by many entrepreneurs and informal investors can escalate the search cost. The high search cost may trigger the start-ups to use financing sources other than informal investors (e.g. self-financing). Scholars found that in the imperfect capital market, entrepreneurs have a certain pecking order in their finance preference (Myers 1984; Myers and Maljuf 1984) 2. The imperfections of informal capital markets may induce the start-ups to prefer using internal financing in order to reduce the high cost of capital if they find it difficult to obtain capital from external sources. Nevertheless, due to the limitations of self-finance, start-ups may have to postpone their investments. From an economic point of view, self-financing can be inefficient, since it holds back economic growth, especially if it involves start-ups and small firms (Carpenter and Petersen 2002). 2 Pecking-order theory states that when a company is planning an investment, it will firstly look at the possibility to self-finance through retained earnings. If this is impossible, the entrepreneur will search to get a loan, and if a loan is not possible as well, then company will search for new equity. 8

9 Match-making services, banks, and governments are expected to serve as third parties that could bridge the gap between informal investors and entrepreneurs. The first generation of studies in the area of informal investors (Mason and Harrison 1999) researched empirical issues such as the size of the market, investors characteristics, decision processes, information channels and the availability of public and private initiatives in stimulating the informal investors capital market. They conclude that the informal investor capital market is very heterogeneous. The authors also note the importance of classifying informal investors. The aim of such a classification is to provide a picture of informal investors as homogeneous groups. Given a specific informal investor, such a picture will enhance the efficiency of the informal capital market because it could allow the investors with quite similar characteristics to gather and exchange information among them. For example, a certain group of informal investors may need a forum or meeting to find interesting business proposals while other types of informal investors may not need or want this. From the entrepreneurs point of view, the classification could also be very important since it could enable them to search for the most suitable investors. Recalling the reasons that have curtailed the investment activities of informal investors: Lack of business proposals which match the informal investors investment criteria Lack of quality in business proposals, which causes entrepreneurs to fail to present their business proposal on paper Lack of trust in the entrepreneur and the management team Lack of experience in the monitoring and interaction The lack of trust worsens the relationship between entrepreneurs and informal investors, especially in situations where both parties are facing asymmetric information. Although both parties have reasons to put less trust in the transaction, trust is still an essential part to make the relationship work. This is a dilemma for both parties. Informal investors may want to trust the entrepreneurs, but information that can support the entrepreneurs behaviour is hardly found. On the other hand, entrepreneurs may try to trust the informal investors, but since entrepreneurs have no power, when investors decide to leave the deal, they have nothing to say. Recalling the solutions to overcome the information asymmetry problem, we see that, in a nutshell, the problem can be solved through the use of a control mechanism. Informal investors may influence this mechanism by putting getting closely involved in the firm. In the UK, more than 75 percent claimed to play a hands-on role (Mason and Harrison 1996a). Further studies in UK and Sweden confirm that a minority of business angels prefer to monitor their investee firms just by receiving periodic financial and reports (Van Osnabrugge and Robinson 2000) 9

10 A more efficient market may be developed by improving the efficiency of information about sources of funds and investment opportunities. If we refer to the financial theory discussed earlier, we will agree that a more efficient market will evolve if there is full and free information about the sources of funds and investment opportunities, available both for buyers and sellers. In this regard, Wetzel (Wetzel 1987) suggests that to understand how informal capital markets work, one should understand the characteristics of the informal investors, the investment criteria they apply, the characteristics of firms they finance, the nature of investment they prefer, and the performance of their portfolio. If such information could be made available to both parties, the market would work much better. A further point to understand is the level of investment activity (Sorheim and Landstrom 2001). For instance, informal investors who have high levels of investment activities will act differently from those who have low levels of investment activities. A better understanding could be enhanced by knowing the competences of informal investors. Some informal investors are willing to contribute their skills, expertise and know-how, whereas others do not. 1.2 Informal capital market: Agency theory perspective Before we analyse further the market of informal investors and entrepreneurs from the perspective of agency theory, we first describe the entrepreneurial activity. According to Knight, the entrepreneur is the organiser of uncertainty. This means that uncertainty is embedded within entrepreneurship (Knight 1921) 3. As an organiser of uncertainty, the entrepreneur possesses the ability to creatively reorganise the relationship between factors of production and market opportunities in such a way that create value that otherwise would not have been generated. In the classical view of entrepreneurship, it is assumed that entrepreneurs will firstly notice opportunities, and then they will act and create new hierarchies to organise transactions. If the entrepreneur, as an explorer of opportunities, becomes the firm s manager or if the management function becomes separated from the entrepreneurial function, agency problems arise. The change of the role possibly takes place when informal investors enter the firm. Let us now examine some agency problems that usually occur in the relationship between informal investors and entrepreneurs. To be parallel with the agency theory, it should be noted from the outset that we use the term principals to refer to the informal investors and the term agents to the entrepreneurs. 3 If I follow the approach of Knight (1921) and Schumpeter (1934), uncertainty is defined as a situation that exists when there is imperfect foresight or human inability to find the best solution to complex problem. Entrepreneurs create value by acting in the context of uncertainty, thus entrepreneurship is bound up with uncertainty. 10

11 In the investors-entrepreneurs relationships, the entrepreneurs, as the agents, work for the investors money, while the investors, as the principals, cannot closely monitor how efficient the entrepreneurs are allocating and using their money. When entrepreneurs successfully reach the investor s goal, they receive a normal salary and they may get fired by the investors if they fail to reach the goal. Thereby entrepreneurs may conceal or manipulate the information about actual situation. Alternatively, if entrepreneurs do not manipulate information, they will take low-risk actions, which result in lower outcomes, in order to keep them secured. Certainly, this behaviour contradicts with the interest of investors, i.e. the maximization of their wealth. If we review the reward structure of entrepreneurs explained above, we better understand why some entrepreneurs have little incentive to take entrepreneurial actions. When entrepreneurs are engaged in the firm and they have special skills valued less elsewhere, entrepreneurs will take actions that will enable them to stay in the firm. Over and over again, entrepreneurs may prefer taking low-risk projects resulting in lower profits for investors. The illustrated agency problem gives rise to a misalignment of the interests of principals (investors) and agents (entrepreneurs) and result in the decrease of firm s entrepreneurial ability. Thus from the perspective of agency theory, the core issue is to align the interests of entrepreneurs and investors. The alignment can be done by arranging the ownership structure. For this reason, informal investors could plausibly demand the participation of entrepreneurs in the capital structure. Many entrepreneurs would actually demand this as a core condition. A survey held by GEM in 2004 found that informal investors provide 66% of their start-up capital while the remaining is provided by the entrepreneurs themselves. This survey implies the participation of entrepreneurs in the capital structure. Due to limited information about start-ups, in terms of start-ups operational performance and integrity, investors will find it difficult to predict the performance of the firm. As suggested, a control mechanism is required. The control mechanism can be translated into a contractual agreement. The deal negotiation can also help to minimise the agency problems that possibly arise later. 1.3 Characteristics of informal investors One of the inefficiencies in the market between informal and entrepreneurs occurs due to the fact that information is not freely and fully available. In many cases, entrepreneurs cannot fully understand the characteristics and the attitudes of informal investors, and, hence, they may approach the wrong investors. Based on this argument, this section attempts to shed light on the 11

12 investment behaviour of business angels as well as their personal attributes. Knowing what type of investors to approach as well as when and how to make such an approach is crucial for entrepreneurs. On the other hand, informal investors have to understand the characteristics of entrepreneurs to successfully make deals 4. The discussion will also describe the issues that link both parties. The functioning of the informal capital market will be analysed based on the flowchart below: Figure 1.1 Flowchart of discussion in on characteristics of informal investors and entrepreneurs The following blocks link up informal investors and start-ups: 1. Motives for investments and criteria for assessment 2. Investment activity and networks 3. Interaction 4. Exit The attributes of informal investors will be discussed first before we go to discuss these blocks. 4 As characteristics of Dutch entrepreneurs have been discussed in chapter 2, the attributes of Dutch entrepreneurs will not be discussed in this section. 12

13 1.3.1 Attributes of informal investors A study carried out by Mason and Harrison (Mason and Harrison 1996b) has identified some characteristics of informal investors 5. In this study, the authors observe that informal investors are generally experienced investors and have been involved in some forms of investments. Hence, the investors in this study are confident in their ability to assess the merits and the risks of their investments. Nevertheless, the investment decisions in this study are taken under opportunistic considerations rather than scientific considerations. In other words, the investors rely more on their commercial intuition and sound business rather than on the detailed documentation, by means of which financial rewards are assessed (Timmons 1990). Since informal investors can make decisions for themselves while basing their assessments only partly on documents, they are quicker in reaching decisions than their counterparts in formal institutions, such as banks and venture capitalists. Regarding the business sectors they prefer to be involved in, informal investors tend to invest in sectors that they have experience about (Fiet 1995). In addition, the more specialised or technical the sector, the more likely the investor, become experienced in that area. Informal investors also invest in businesses which will produce socially useful products or that will bring economic benefits to the community. Although informal investors have many common interests, attitudes and preferences towards investments, their heterogeneities have been recognised as well. There have been many studies explaining the categorisation of informal investors. Freear and others for example, divide the US informal investors into two types: the active informal investors and potential informal investors (Freear, Sohl et al. 1994) 6. In relation to Swedish investors, studies of Landstrom classify the informal investors into four types (Landstrom 1993; Evanson 1998), namely the lotto investors, traders, the analytical investors and business angels. In Norway, the classification of informal investors follow the classification of Landstrom (Sorheim and Landstrom 2001). For the British investors, Stevenson and Coheney put the informal investors into six types (Stevenson and Coveney 1994), called the virgin investor, the latent investor, the wealth maximizing, the entrepreneurial, the income seeker, and the corporate investor. Those researchers describe the characteristics and behaviour of each type. Since this thesis is not devoted to analyse the classification of informal investors, the detailed descriptions of types of informal investors for some studies are presented in appendix A2. To illustrate the differences attributes of informal investors, let us recall some surveys. In the US, business angels are primarily male and the average age is forty-eight to fifty (Freear, Sohl et al. 5 However, it is importantly to note that the study use the British informal investors as its sample. 6 Another study about the US informal investors has also been conducted by Evanson Evanson, D. R. (1998). Where to go when bank says no: Alternatives for financing your business. New York, Bloomberg Press. 13

14 1994), while in the UK the average age is above forty-five (Harrison and Mason 1992). In Norway, the age of informal investors is ranging from 35 and 55 years (Sorheim and Landstrom 2001). With respect to the educational background of informal investors, it is observed that most business angels are well educated. In overall, from 80% to 94% of business angels graduated from college and from 42% to 56% graduated from a university. However, the numbers may vary depending on the geographical region. For example, Finish and Canadian business angels have a higher formal education level compared to those in the UK (Van Osnabrugge and Robinson 2000). Previous surveys show the diversity among business angels regarding their number of investments. Although the numbers vary, in general business angels lack investment experience and on average they invest infrequently (Wetzel 1987; Mason and Harrison 1995). Business angels in the U.S. make 2.45 investments in the last five years (Freaar and Wetzel 1991). In the UK, business angels invest 4 times during their career Motives for investments and criteria for assessment Informal investors motivations for investing in entrepreneurial firms influence the way they assess the opportunities. Hence, it is of high importance for this thesis to understand the motivations of informal investors towards start-ups. I highlight some reasons why informal investors make investments in start-ups. Firstly, there is a possibility that informal investors are motivated by the opportunity for capital rewards appreciation. It means, although investors might consider the rate of return on investment as an important aspect, they are not primarily motivated by this aspect in involving in the start-ups. This is because, as Batty has observed, business angels are sufficiently wealthy such that they do not necessarily need returns from a successful investment (Batty 1991). Secondly, there is also motivation in terms of the opportunity to play an active role in the entrepreneurial process. It is connected to the willingness of investors to gain personal satisfaction and excitement from being involved in an entrepreneurial firm and from helping it to get started and grow. Informal investors are willing to do this because they have been successful in managing their businesses, and hence they want to try to carry out their investee firms in the way they have experienced themselves. The possibility of being a active part of the firm has often created a significant impact for the informal investors decisions to invest in the start-ups. Thirdly, informal investors are motivated to make investments to create a job for themselves. This motive is supported by the second motive, which is the willingness to play an active role in the entrepreneurial firms. By creating a job for themselves, they may gain some income apart from the return on investment. The fourth motive is the fun of making informal investments. The fifth is that investments could be motivated by a belief that having been successful in business, investors should give something back to the system that has previously allowed them to achieve prosperity. This obligation is undertaken by assisting the next generation of entrepreneurs (Batty 1991). This 14

15 altruism appears because the investors want to stimulate entrepreneurship and therefore to create more jobs and increase the economic prosperity of the society. To conclude, a number of researchers have noted that a significant proportion of private investors are willing to trade-off some financial returns for various non-financial benefits (Van Osnabrugge and Robinson 2000; Sorheim and Landstrom 2001; Erikson and Sorheim 2005). The reasons above seem to argue that, although it is not the only reason, a certain level and period of investment returns has, to a certain extent, motivated informal investors to be involved in startups business. As we have discussed in section and previous part of this section, informal investors seem not to give emphasis on the detailed financial information. To illustrate the expectation of informal investors over the returns of investment, let us recall a report of GEM 2004 on Financing Report (GEM 2004b). According to the report, Informal investors expect that their investee companies will pay the investments back in two years. However, 34% of informal investors do not expect to receive their investment back, and 17% of informal investors expect to get their return back in 16 months. Few expect to get it back in 20 years. To sum up, there is a large variation in the time of returns expected by informal investors. The amount of the return, calculated using Internal Rate of Return (IRR), is expected to be zero, or even negative, by 51% of informal investors. Only 22% of investors expect a 100% return. However, we could by no means argue that informal investors do not care about the return at all. They do care about the return; in some cases, they might even consider it as the primary reason 7. We have shown the motives of informal investors in making investments. A question, however, arises as to what matters the most for the investors when they are making the assessment of business opportunities. To answer such a question, one needs to consider the criteria used by investors to assess new business opportunities they face. In this regard, we could refer to a study of Mason and Stark in which the investment criteria are described as follows (Mason and Stark 2004): 7 Some studies, such as that of Van Osnabrugge and Robinson, show that return on investment is the primary concern of business angels in making investment (Van Osnabrugge and Robinson 2000). 15

16 Table 1.1 Description of investment criteria No Investment Criteria Description 1 Entrepreneur/management team The background, experience and track-record of the entrepreneur, their personal qualities (e.g. commitment, enthusiasm) and the range of skills/function of the management team 2 Strategy The overall concept and strategy of the business 3 How the business is organized to produce and deliver Operations (practicalities of the the product (i.e. issues associated with the production business functioning) process) 4 Product/service The nature of the product/service, in term of its concept, uniqueness, distinctiveness and innovativeness. It also includes the quality, standards and performance, appearance, styling and aesthetic appeal and ergonomics, function and flexibility of the product/service 5 Market The potential and growth of the market, demonstrated market need, level/nature of competition and barriers to entry 6 Financial consideration This includes three aspects: (i) the financial structure of the business (e.g. costs and pricing, revenue stream financial projections), (ii) the value of the equity/worth of business and (iii) the likely rate of return and exit route possibilities 7 Investor fit This includes two elements: (i) the relationship between the investor s background, skills and knowledge of the industry, market, technology, etc. and the investment opportunity, and (ii) the investor s preferences (i.e. an industry, market etc. that investor want to be in) 8 Business plan The whole package/plan 9 Other Comments on any aspects of the business which cannot be coded in any other category Business angels, venture capitalists and banks take different considerations in assessing investments. In addition, a more thorough observation reveals that the use of criteria selections among informal investors is less consistent due to the heterogeneity of investors nature. Mason and Stark also observe that informal investors tend to invest in the industry or market where they have knowledge or experience. In their study, they find that finance is the most important criterion 8. However, they put more consideration on the growth potential of the business and the potential returns that they might expect. Correspondingly, they emphasize on the market- its size, growth, and the level of competition. Apart from the investment criteria presented above, Mason and Harrison (Mason and Harrison 1996b) find that informal investors consider the quality of entrepreneurs or management team as a critical criterion. Another crucial criterion is the market potential of the products/services. They also 8 This finding contradicts with the typical finding in the researches of the informal capital market. 16

17 observe that informal investors put attention to the agency risk, i.e. the risk caused by the divergent interests between entrepreneurs and investors Investment activity and networks As informal investors tend to be anonymous, it is important for entrepreneurs to know how to reach them. Van Osnabrugge and Robinson (Van Osnabrugge and Robinson 2000) propose ten ways to get to know and contact business angels. a. Personal networks Entrepreneurs can start searching business angels through their own networks, their former colleagues, friends, or business partners. From these personal networks, some people may be interested in making an investment. b. Professional Networks Attorneys, accountants and other professionals may have contacts with business angels since they may know wealthy individuals who make investments. These wealthy people may be attracted by the investment opportunity proposed by their trusted professionals. Other formal professional organisations such as local chambers of commerce, boards of trade, and business associations such as the Amstel Private Equity Club may perhaps be of similar importance in suggesting contacts of business angels. c. Snowballing Having contacted one business angel may lead to more business angels because business angels also have their own personal networks. Once the ball is rolling, entrepreneurs have a greater possibility to meet other business angels who are also willing to fund their business. In some cases, there is a situation in which a business angel invites their colleagues to join in the deal in order to spread risks and leverage business expertise as much as possible. d. Formal matching services The matching service is an organisation aimed to provide business angels, as well as its members, with various venture forums in which entrepreneurs and investors can meet face-toface. The organisation also offers entrepreneurs accesses to private investors while maintaining the anonymity of the investors. Investors who join matching services may also be wealthier since they can access more business opportunities and can actively search for potential investee firms. (Sohl 1999) e. Angel Alliances An Angel Alliance is a club set up by business angels themselves like the Cambridge Angels or the Bay Angels. Compared to an individual angel, these alliances may be able to offer larger sums of money. Moreover, they also offer more resources on know-how and expertise. However, some alliances may require that angels meet more professional standards and documents before participating in the alliances. The alliances may also appear to be more 17

18 formal in the negotiations and contract. When this group of angels convene, they usually discuss the quality of a business, which has been funded by one of them, rather than a means of identifying new opportunities. The availability of these loosely organised informal investors groups contributes to the growth of deals between entrepreneurs and the angels. In the years to come, the impact of these alliances is expected to benefit the informal capital market. f. Venture Capital Clubs Venture capital clubs offer several services to their members. They usually have meetings for investors and entrepreneurs allowing them to share their opportunities (Sohl 1999; (Van Osnabrugge and Robinson 2000). Sometimes, they have a small number of informal investors who invest together, while others help entrepreneurs to sharpen their business plans and presentation skills. Compared to angel alliances, these groups are less professional. They use the venture forum (the meeting) to listen to several entrepreneurs rather than to discuss the merits of an opportunity that one of the members has invested in. g. Internet There are several electronic matching networks on the internet, specialising in finding start-up funds for entrepreneurs and investment opportunities for informal investors. These virtual networks have limited access. The low use results from the preferable nature of face-to-face communication and the lack of value-added component of informal investors investments. h. Matchmakers (individual) There are many individuals who act as matchmakers and who specialise in introducing entrepreneurs to informal investors. In the Wall Street Journal for instance, there is a stack of ads concerning their services. However, since they act individually, entrepreneurs should be careful in using the matchmakers services, e.g. by checking the track records and asking references from friends who have been involved. Entrepreneurs should also ask to the matchmakers about the source of fund raising from which he or she has raised money in the past, respectively, how much they charge and under which conditions. i. Mailing List and Publications Some researchers (Haar, Starr and MacMillan 1988; Postma and Sullivan 1990) find that by research publications, inventors and entrepreneurs may attract some informal investors. Mailing lists may be a way to provide contacts to informal investors. j. Investee Firms Informal investors may also be contacted through the company they have invested in the past. The investee firms can act as intermediaries to introduce informal investors to entrepreneurs and vice versa. However, this requires the investee firms to perform this role. In addition, since many informal investors are usually business owners, entrepreneurs may be guided to an angel contact. 18

19 According to an earlier study by K+V, in the Netherlands, informal investors receive most business proposals, about 75%, from intermediary organisations 9. The mismatch may occur because entrepreneurs use different networks to search for informal investors Interaction After making an investment, informal investors actively monitor their ventures and may prefer to be involved in the firms in which they have put their money. They may want to participate in the management because they have the experience that they want to share to help developing their investee firms. Several surveys conducted in the US, UK and Sweden, show that angels are highly involved in the entrepreneurial activities. Only a small number of them are passively involved in the entrepreneurial process (Van Osnabrugge and Robinson 2000). A study by Wetzel confirms that the involvement of informal investors contributes significantly to the performance of the firm (Wetzel 1987). There are large differences in the involvement of informal investors in their investee firms. They may play an active role in management, or be part of the board of directors and or act only as a money provider. However, it should be noted that although entrepreneurs also confirm that they need the experience of investors in managing the firm, they are sometimes also concerned that they will have less power in the firm Exit route At the time of investment, one of the ways to assess the risk-reward ratio is by estimating returns and targeting opportunities to exit. Compared to venture capitalists, informal investors are less aware of the moment to exit when ventures grow and become mature. Not all business angels put their focus on the exit route, partly because if firms are still young there are inadequate exit routes available for them (Landstrom 1993). Several studies have confirmed the level of such awareness towards the exit route. A study of Freear and Wetzel, for example, finds that the US business angels give little thought to the exit. They confirm that instead of speculating the returns of their money, 9 Unfortunately, informal investors found that the quality of the proposals is considered as of very low quality. In this study, we have not investigated why informal investors consider the proposals have poor quality. 19

20 business angels prefer to pay more attention to make the investment itself successful (Freear and Wetzel 1991). According to Mason and Harrison (Mason and Harrison 1999), the most common exit routes used by informal investors are: a. Acquisition of the company by some other party b. Sale of shares to other shareholders c. Go public (Initial Public Offering) d. Liquidation of assets. Following the discussion about the informal capital market, as well as the characteristics and the attitudes of informal investors and start-ups in the previous parts, a causal model is developed to explain what may cause the Dutch informal capital market to be underdeveloped. 1.4 Causal Model of the Dutch underdeveloped informal capital market The underdevelopment of informal capital market in the Netherlands is indicated by the limited number of informal investments made into new businesses (Bosma and Wennekers 2004; Brinkhorst 2004; Brinkhorst and Van der Hoeven 2004). Some may be hesitant towards this conclusion since the number of informal capital investments is not accurately and well documented. However, as many have argued, the informal capital market is also considered to be imperfect. The imperfection is indicated by high transaction costs as a result of information problem, namely, incomplete and asymmetric information. All in all, when the costs are too high to make a transaction, both parties will be precluded to reach agreement and will eventually withdraw from the market. Hence, market can become imperfect and perhaps also underdeveloped. The underdevelopment and imperfection in the Dutch informal capital market can be illustrated by designing a causal model, which captures the central problem and its causes. The central problem that is going to be depicted in the causal model is the underdevelopment of the informal capital market in the Netherlands. Direct causes are: 20

21 1. the Dutch regulation and policy The first cause relates to government policies and regulations. They may not be very conducive for informal investment. There are few facilities or services provided by the government to promote informal investments. Through its policy and regulation, the government may play an important role in improving the capital market. In the US, for example, the reduction in the capital gains tax is one of the primary factors that have spurred the rapid growth of the formal venture capital market (Wetzel 1983; Gompers 1998). In the Netherlands the Durfkapitaalregeling (the former Tante Agaath does provide some relief, especially for family and friends, but not to those who want to invest in a range of firms. 2. the Dutch socio-culture The second cause relates to the Dutch socio-cultural situation. The networks of informal investors in the Netherlands are difficult to observe, primarily because the Dutch affluent people are unwilling to expose their wealth. This can weaken the ties of informal investors networks, important aspects on which the investors rely as a channel to exchange information. 3. moral hazards The third cause is the moral hazard problem. The problem occurs due to asymmetric information. Entrepreneurs may take actions for their own interest regardless of whether the actions will entail considerable costs to another party. Moral hazard could increase the transaction costs in the following ways. First, moral hazards increase the frequency of the meetings between parties before they reach an agreement. In this case, it is assumed, plausibly, that the more frequent the parties have to meet before reaching an agreement, the higher the transaction costs will be. Secondly, an increase in transaction costs emerges because the opportunistic behaviour of the parties. One party, who has better information, uses his favourable position to act opportunistically for his own benefits, regardless of whether such an act will compromise the interest of other party or not. Thirdly, moral hazard could increase the transaction costs if a party withdraws from the agreement after another party has invested in assets. In this case, the withdrawal will cause one party to incur sunk cost. In addition, an opportunistic withdrawal may also cause the hold-up problem, namely a situation in which the parties fail to cooperate due to the fear that doing so will increase the bargaining power of other party and simultaneously reduce their own power. If the moral hazard problem occurs often, informal investors might prefer to have other forms of investments which are less risky. As a result, informal investors will eventually reduce their investments on the informal capital market. 4. adverse selection The fourth cause is the adverse selection problem, which is also caused by asymmetric information. The adverse selection problem occurs when bad business opportunities drive out the good ones. In this regard, informal investors are willing to invest in new business (startups), under the asymmetric information. Unfortunately, the investee firms may not have the 21

22 quality required or expected by informal investors. Consequently, informal investors have to establish their own standards, such a demand for a high rate or return, applied to all entrepreneurs. In this situation, only those with bad proposals could possibly agree with such a demand. The repetition of this situation will eventually open a possibility that good business proposals will be driven out by the bad ones, leading to the collapse of the informal capital market because the parties leave the market. It is indicated by the low number of transactions in the market. One way to deal with the adverse selection is by providing signals about the quality and integrity of the parties (Meijaard 2001). Although signalling could improve the market, it should be taken carefully so as to not create excessive costs. This also means that adverse selection requires additional costs, in this case to provide the signal. The additional costs can be regarded as transaction costs. 5. mismatches between informal investors and entrepreneurs The last direct cause that contributes to the underdeveloped market is the mismatches between informal investors and entrepreneurs. The mismatches occur due to the incomplete information. In addition, mismatches may increase the transaction costs because in the absence of necessary information both parties have to incur additional costs to search for each other and for the information about their preferences and criteria. This type of costs is known as search costs. When one party or both parties cannot bear the high search costs, they may be precluded from making transactions. Let us further discuss the information problems. Information asymmetry arises when information about sources of funds and investment opportunities is not fully and freely available for both buyers and sellers of capital. In this case, the players in the capital market possess unequal information necessary to make a transaction. One has more information than the other. This problem may result in the increase of transaction costs through the moral hazard problem and adverse selection. From the literature, we could observe four factors that could cause information asymmetry in the informal capital market. Firstly, information asymmetry may arise due to limited track records about the entrepreneurs, mainly because the entrepreneurs are newly established. Moreover, due to the newness in the business, entrepreneurs may not have reputation. Secondly, the asymmetry may occur when entrepreneurs have limited information about investors because of the anonymity of the investors. Thirdly, the asymmetry occurs because of the limited record about investors profile. Finally, the asymmetry emerges because the lack of physical information channel that can be used by the parties to meet and directly interact. Incomplete information problems occur when the parties in the informal capital market cannot sufficiently access necessary information. It could directly increase the transaction cost because it may force the parties to make an excessive contract in order to prevent them from incurring the unexpected outcomes. In addition, incomplete information may also exacerbate the bounded rationality, which may cause an increase in transaction cost, especially when the bounded rationality leads to a severe error in the decision-making. With regard to the mismatches, incomplete information may cause investors and entrepreneurs to use different criteria in the 22