An Overview Of Research On Early Stage Venture Capital Current Status And Future Directions

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11. An overview of research on early stage
venture capital: Current status and future
directions
Annaleena Parhankangas, Helsinki University of
Technology, Finland1
INTRODUCTION
Entrepreneurship can be seen as an engine of innovation and growth, and a provider of
economic and social welfare (Schumpeter, 1934; Birch, 1979; Birley, 1986; Kortum and
Lerner, 2000). Entrepreneurs developing revolutionary new products require a
substantial amount of capital during the formative stages of their companies’ lifecycles.
Even though most entrepreneurs prefer internal funding to external one, few
entrepreneurs have sufficient funds to finance early stage projects themselves. It is also
at this stage of development, when collateral-based funding from banks, the second
most preferred source of funding by entrepreneurs (Myers, 1984), is often inappropriate
or even potentially life-threatening to the new firm (Gompers, 1994; Murray, 1999).
Therefore, the alternative provision of venture capital has become an attractive source
of finance for potentially important companies operating on the frontier of emerging

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technologies and markets (Tyebjee and Bruno, 1984; Bygrave and Timmons, 1992;
Murray, 1999).
However, the management of early stage venture capital investments has proved to
be challenging. Early stage investors are obliged to deal with multiple sources of
uncertainty spanning the commercial, technical and managerial aspects of the new
enterprise (Storey and Tether, 1998). Early stage investments typically involve new
products targeted to non-existing markets developed by management teams with little or
no prior history, exposing investors to significant information asymmetries (Chan,
1983; Amit et al., 1990; Chan et al., 1990; Sahlman, 1990; Amit et al., 1998). In
addition, it will usually take several years to transform an early stage company to a firm
capable of being floated or sold to a trade buyer (Dimov and Murray, 2006). As a result,
early stage venture capitalists are faced with the combination of long term commitment
in a young venture and a considerable likelihood of failure. The venture capital industry
has partly responded to these challenges by rejecting early stage financing activity as
too uneconomic (Dimov and Murray, 2006). Some go as far as to state that efficient
markets do not exist for allocating risk capital to early-stage technology ventures and
that most funding for technology development in the phase between invention and
innovation comes from angel investors, corporations, and federal governments, not
venture capitalists (Branscomb and Auerswald, 2002).
Given the significant challenges and opportunities associated with early stage
venture capital, the volume of research on this topic is increasing, whether measured in
terms of published research articles, publication outlets, or support provided by private
donors or policy. The initial empirical research was mostly conducted during the 1980s,
four decades after the first venture capital firm was established in the United States. The
pioneers in early stage venture capital research focused on fundamental questions, such

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as “what do venture capitalists do’ and “how do they add value in their portfolio
companies.” For instance, the seminal paper of Tyebjee and Bruno (1984) developed a
model of venture capital activity involving five sequential steps: deal origination, deal
screening, deal evaluation, deal structuring and post-investment activities. MacMillan et
al. (1985; 1987) analyzed the criteria used by early stage venture capitalists to evaluate
new venture proposals. Bygrave and Timmons (1986) and Gorman and Sahlman (1989)
focused on the role of venture capitalists’ in promoting innovation and growth in early
stage companies. Bygrave (1988) investigated the logic of syndication in the early stage
venture capital industry. It is noteworthy that these questions still continue to attract the
attention of new generations of researchers.
The pioneers in early stage venture capital research focused primarily on the US
market. However, the diffusion of US style venture capital practices to other nations
was followed by a stream of international venture capital research describing the
European and Asian context (Muzyka et al., 1996; Sapienza et al., 1996; Brouwer and
Hendrix, 1998; Bruton and Ahlstrom, 2002; Kenney et al., 2002a; 2002b; Wright et al.,
2005). These studies typically address the cross-country differences in early stage
venture capital activities and the role of the early stage venture capital investments in
revitalizing the entrepreneurial systems of Europe and Asia.
Another significant trend in (early stage) venture capital research is the sharpening
distinction between research on early stage and later venture capital activities, perhaps
reflecting the recent tendency of venture capitalists to shift away from early stage
investments to later stage deals (Tyebjee and Bruno, 1984; Bygrave and Timmons,
1992; Camp and Sexton, 1992; Gompers, 1994; Mason and Harrison, 1995; Sohl, 1999;
Gompers and Lerner, 2001; Balboa and Marti, 2004). As the original definition of
venture capital involves investments in young firms characterized with high risk and

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pay-off (Crispin-Little and Brereton, 1989; Bygrave and Timmons, 1992; Gompers et
al., 1998; Sahlman, 1990; Wright and Robbie, 1998; Gompers and Lerner, 2001),
investments in early stage firms may be regarded as classic venture capital. Later stage
investments, in turn, are sometimes labeled as private equity (Lockett and Wright, 2001)
or merchant capital (Bygrave and Timmons, 1992). It was not until later that the notion
of early stage venture capital emerged as several authors demonstrated that the stage
focus of a venture capitalist is one of most important features along which venture
capital firms could be distinguished (Robinson, 1987; Ruhnka and Young, 1987; Fried
and Hisrich, 1991).
As research on early stage venture capital continues to grow and proliferate, it is
important to take a look back and evaluate the progress made and to identify gaps in the
existing knowledge. This chapter is based on a review of 179 peer-reviewed articles and
other relevant publications focusing on early stage venture capital financing.2
Even
though a great effort was taken to provide a reasonable overview of the existing
knowledge, the size and scope of the research field makes it impossible to provide a
detailed description of every article reviewed or an exhaustive listing of all studies
published on the topic this far. Instead, the focus of the literature review is primarily on
scholarly research. It is also important to note that the studies focusing on the co-
evolution of venture capital, regions and industries (see for instance Manigart, 1994;
Martin et al., 2002; Klagge and Martin, 2005) and the policy aspects of early stage
venture capital are beyond the scope of this study, as these topics will be covered in
other parts of this book.
This chapter organizes the literature on early stage venture capital financing by first
analyzing the special characteristics of the early stage ventures, investors and funds.
Thereafter, I continue with the implications of these differences for managing venture

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capitalist investment activity (Tyebjee and Bruno, 1984) over the venture capital cycle
(Gompers and Lerner, 2001) in different institutional settings. Finally, this chapter is
concluded with a synthesis and analysis of prior knowledge and suggestions for future
research. The approach for presenting and analyzing prior studies is illustrated in Figure
11.1.
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Insert Figure 11.1 about here
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EARLY STAGE VENTURE CAPITAL INDUSTRY: KEY
CHARACTERISTICS AND CHALLENGES
In order to gain a better understanding of the challenges and opportunities faced by
early stage investors, I will first identify those key characteristics that distinguish early
stage ventures from later stage deals. Thereafter, I will discuss the major risks faced by
early stage investors and recent trends in the global early stage investment activity. This
subchapter ends with a description of the key characteristics of early stage investors and
funds.
Classification of venture capital investments based on their development stage:
early stage ventures vs. later stage deals
Prior literature classifies venture capital investments based on the development stage of
the portfolio company (Robinson, 1987; Bygrave and Timmons, 1992). Stanley Pratt,

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the publisher of Venture Capital Journal, distinguishes between “seed, start-up, first
stage, second stage, third stage and bridge financing (Bygrave and Timmons, 1984;
Ruhnka and Young, 1987). These investment stages have been found to differ in terms
of their key characteristics, developmental goals, and major developmental risks
(Ruhnka and Young, 1987; Flynn and Forman, 2001), as presented in Table 11.1.
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Insert Table 11.1 about here
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The seed, start-up capital and first stage financing are usually considered early stage
venture capital (Pratt’s Guide to Venture Capital Sources, Ruhnka and Young, 1987;
Crispin-Little and Brereton, 1989). Seed financing involves a small amount of capital
provided to an inventor or an entrepreneur to prove a concept (Sohl, 1999; Branscomb
and Auerswald, 2002), before there is a real product or company organized (NVCA,
2005). Ruhnka and Young (1987) found that characteristic for the seed stage is the
existence of a mere idea or a concept, and the absence of the management team beyond
the founder and one or more technicians. The critical goals for the seed stage include
producing a product prototype and demonstrating technical feasibility, as well as
conducting a preliminary market assessment. Contrary to public perception, seed stage
companies are not likely candidates for venture capital investments, but are more likely
to be backed by informal investors (business angels), family and friends (Tyebjee and
Bruno, 1984; Crispin-Little and Brereton, 1989; Sohl, 1999).
Start-up financing provides funds for product development and initial marketing. In
the start-up stage, the investigation of the feasibility of the business concept has

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generally progressed to the point of having a formal business plan together with some
analysis of the market for the proposed product or service. Major benchmarks for this
stage include establishing the technological, market and manufacturing feasibility of the
business concept (Ruhnka and Young, 1987; Crispin-Little and Brereton, 1989).
The first stage financing provides funds to initiate commercial manufacturing and
sales. The first stage is characterized by having a full management team in place, a
market receptive to the product, a need for a ramp-up of the production process, and the
existence of a ready prototype for the market (Ruhnka and Young, 1987; Crispin-Little
and Brereton, 1989; Sahlman, 1990; Sohl, 1999; Branscomb and Auerswald, 2002).
Even though there exists less consensus on the typical characteristics of the ventures
in later stages of their development (Ruhnka and Young, 1987), it is possible to
distinguish more mature portfolio companies from early stage investments. As later
stage investments targets have already established their market presence, their key
developmental goals include achieving market share targets and reaching profitability in
order to make it possible for venture capitalists to successfully exit the investment. In
comparison to early stage ventures struggling with challenges related to product, market
and organization development, the later stage investments face the threat of
technological obsolescence and unanticipated competition caused by new entrants
(Ruhnka and Young, 1987; Crispin-Little and Brereton, 1989; Branscomb and
Auerswald, 2002).
Major risks associated with early stage investments3
Of all themes related to early stage venture capital research, perhaps most attention has
been paid to the nature and extent of risks related to investments in nascent ventures. It

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is widely believed that early stage ventures imply higher overall risks and volatility of
returns than more established portfolio companies (Brophy and Haessler, 1994). These
risks are particularly serious for new technology-based firms (Bygrave, 1988; Mason
and Harrison, 1995; Balboa and Marti, 2004), such as university spin-outs (Wright et
al., 2006), due to the long lead time of product development and severe difficulties
associated with the transfer of technology into the market place.
The high level of risks inherent in early stage venture capital investments can be
partly explained by the existence of information asymmetries between the venture
capitalist and the entrepreneur (Chan, 1983; Amit et al., 1990; Chan et al., 1990;
Sahlman, 1990; Amit et al., 1998;). In early stage companies characterized with
intangible assets and a heavy reliance on RandD (Gompers and Lerner, 2001), the
venture capitalist has only a limited understanding of the quality of the project, and the
competence and willingness of the entrepreneur to act in the interest of the other
shareholders. Stated differently, early stage venture capitalists are exposed to high
levels of “hidden information” and “hidden action” on the part of the entrepreneur
(Akerlof, 1970; Holmstrom, 1978). As Amit et al. (1990) put it: an early stage
technology investment often involves (Murray and Marriott, 1998) …
“ ….a technology that has not yet been proven; which is to be incorporated into
novel products and/ or services which still remain solely in the mind of the
entrepreneur; and will eventually be offered to markets and customers whose
existence remains purely hypothetical. On the top of these uncertainties, the new
enterprise may uncommonly be managed by a technological entrepreneur or a
founding team whose experience of commercial practices and disciplines is

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negligible, as are their personal assets by which the venture may be financed or
the investment guaranteed….”
The risks inherent in venture capital investments in general and in early stage
investments in particular can be further divided to market and agency risks (Gorman
and Sahlman, 1989; Ruhnka and Young, 1987, 1991; Barney et al., 1994; Fiet, 1995;
Murray and Marriott, 1998; Gompers and Lerner, 2001). Market risk refers to risks due
to unforeseen competitive conditions affecting the size, growth, and accessibility of the
market, and upon factors affecting the level of market demand. Because of high levels
of market risks inherent in young ventures, the early stage investors’ overriding
concerns include failures to capture a large enough market share or ramp-up the
production process (Ruhnka and Young, 1991; 1987; Muzyka et al., 1996).
Agency risk, in its turn, is a risk that is caused by separate and possibly divergent
interests of agents and principals (Sahlman, 1990; Fiet, 1995). Agency risks may result
in opportunism, shirking, conflicting objectives or incompetence (Parhankangas and
Landström, 2004). For example, early stage entrepreneurs might invest in research
projects that bring great personal returns but low monetary payoffs to shareholders
(Gompers and Lerner, 2001). Agency risks may also result in delays in product
development, or the failure of the founders to comply to the development objectives of
their investors (Ruhnka and Young, 1991; 1987; Murray and Marriott, 1998; Gompers
and Lerner, 2001).
Recent trends in the frequency of early stage investments

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The market and agency risks inherent in nascent ventures are likely make investors
doubtful of their ability to appropriate returns from early stage investments (Branscomb
and Auerswald, 2002). These doubts may be reflected in the decreasing interest in early
stage investments all over the world. Figure 11.2 shows that the share of early stage
investments of the total value of all deals has fallen from approximately 50 per cent in
the 1960s to 15 per cent in 2005. The corresponding figure for European early stage
investments was 12 per cent in 2004 (EVCA, 2005).
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However, the situation looks less alarming, if the percentage of early stage deals of
all investments is used as a proxy. As Figure 11.3 shows that 60 per cent of all deals in
Europe are seed or early stage investments (Bottazzi et al., 2004).
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Characteristics of early stage venture capitalists and funds
As early stage ventures differ from later stage deals along several dimensions, it should
come as no surprise that prior studies also report venture capital firms investing in early
stage companies being fundamentally different from their counterparts focusing on

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more mature portfolio companies. It has been proposed that early stage investments are
typically made by venture capital firms;
• located in the United States, especially on the West Coast (Crispin-Little and
Brereton, 1989; Black and Gilson, 1998; Gompers et al., 1998; Schwienbacher,
2002),
• located in countries with strong laws for contract repudiation and shareholder rights
(Cumming et al., 2006a),
• hiring investors with a higher degree of education than venture capital firms
focusing on later stage investments (Flynn and Forman, 2001; Bottazzi et al., 2004),
• being older and larger than venture capital firms focusing on later stage deals
(Gompers et al., 1998; Dimov and Murray, 2006) and the dominance of older and
larger firms may be explained by their greater expertise and ability to extract
benefits from early stage investments. However, Bottazzi et al. (2004) and
Schwienbacher (2002) report some contradictory evidence from the European and
US context, suggesting that young venture capital firms are more likely to engage in
seed financing,
• being more often independent than captive (Wright and Robbie, 1996; Kenney et al.,
2002), and
• being less often involved in cross-border investments (Schwienbacher, 2002; Hall
and Tu, 2003).
In a similar vein, funds focusing on early stage investments tend to have some
distinct characteristics. Prior research has paid a significant amount of attention to the
relationship between fund size and early stage investments, producing somewhat mixed

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results. Some studies suggest that as venture capital funds become larger, their interest
and involvement in early-stage investments fades (Bygrave and Timmons, 1992; Elango
et al., 1995). This aversion is closely related to the fact that early stage investments are
typically very small and highly uncertain in terms of their outcome. For growing funds,
such investments are often uneconomic given the diversion of scarce investment
manager talent (Gifford, 1997). However, Dimov and Murray (2006) found a U-shaped
relationship between fund size and the number of seed investments, even though the
number of seed investments decreases as the amount of invested capital increases, seed
investments nevertheless become a viable investment option after some minimum
capital point has been reached. This finding is consistent with idea that funds with a
seed focus need to have a minimum scale of efficiency given their fixed cost structures
(Murray and Marriott, 1998; Murray, 1999).
STUDIES FOCUSING ON THE MANAGEMENT OF THE EARLY
STAGE VENTURE CAPITAL INVESTMENTS
As information asymmetries, market risks and agency risks are an integral part of young
ventures, much of the prior literature highlights how venture capitalists may deal with
these challenges over the venture capital cycle and in their relationship with the
entrepreneur. In particular, special attention will be paid to fund raising, appraisal
strategies, structuring the deal, monitoring and adding value, as well as exit strategies
deployed by the early stage venture capitalists (see Figure 11.4). The availability and
feasibility of these risk reduction strategies depend, to a large extent, on the institutional
context of early stage investors. Therefore, this section ends with a review of

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management practices applied by early stage venture capitalists embedded in different
institutional contexts.
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Fund raising
Funds to be invested in early stage ventures may be raised from pension funds,
insurance companies, banks, government agencies, private individuals or corporate
investors. Prior research reports that corporate and individual backed funds, academic
institutions and in some cases, pension funds, prefer investments in firms at an early
development stage, whereas banks more often invest in later stage deals (Mayer et al.,
2005; Schertler, 2005; Cumming, 2006).
Venture capital commitments to early stage firms have been highly variable over
time (Gompers and Lerner, 2001) and across countries (for example, Black and Gilson,
1998; Jeng and Wells, 2000; Megginson, 2004; Mayer et al., 2005). Even though the
United States dominates the early stage scene by the sheer volume of funds directed to
nascent ventures, the share of early stage venture capital of GDP is even higher in many
other industrialized nations (see Figure 11.5).
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These drastic cross-national and temporal variations may partly explain the fact that
several studies focus on the role played by various macro-economic and institutional
factors (for example, Söderblom and Wiklund, 2006) in either alleviating or aggravating
risks associated with investments in young ventures. In a similar vein, investors’
experience, size and prior performance (for example, Gompers et al., 1998; Marti and
Balboa, 2000; Kaplan and Schoar, 2005) seem to facilitate commitments to venture
capital funds. A more detailed review on early stage fund raising activities will be
provided in section dedicated to institutional environment and the management of
venture capital activities.
Appraisal of early stage deals
Prior research has identified several stages of venture capitalists’ appraisal process,
including deal generation, initial screening, second/detailed screening and deal approval
(Bygrave and Timmons, 1992; Fried and Hisrich, 1994; Wright and Robbie, 1996).
Traditionally, little time was spent for searching for deals, as most proposals received
by early stage venture capitalists were referrals from third parties (Tyebjee and Bruno,
1984). However, increasing competition between the venture capitalists has created a
need to allocate more time to deal generation process (Sweeting, 1991; Shepherd et al.,
2005). In a similar vein, early stage venture capitalists exposed to information
asymmetries and adverse selection problems (Amit et al., 1990) spend a significant
amount of time and effort in evaluating and screening early stage investment
opportunities (Carter and Van Auken, 1994; Kaplan and Strömberg, 2001).

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In deal generation and initial screening phases, early stage venture capitalists
typically focus on rather general (non-financial) investment criteria, which enable them
to conclude whether a proposal is viable for further consideration (Zacharakis and
Meyer, 2000). Such general evaluation criteria include a wide variety of factors, such
as;
• completeness and track record of the management team,
• attractiveness of the business opportunity and industry,
• liquidity of the venture,
• possession of proprietary products and product uniqueness,
• innovation output, and
• similarity of the founding team in comparison to the investor (Tyebjee and Bruno,
1984; MacMillan et al., 1985; 1987; Sandberg et al., 1988; Rea, 1989; Fried and
Hisrich, 1991; Elango et al., 1995; Muzyka et al., 1996; Zacharakis and Meyer,
1998; Shepherd et al., 2000; Kaplan and Strömberg, 2001; Engel and Keilbach,
2002; Franke et al., 2002).
Much of the prior research concludes that the entrepreneur and the entrepreneurial
team are the most important decision criteria in distinguishing between successful and
failed ventures (MacMillan et al., 1985; 1987). Therefore, it is widely believed that
most venture capitalists prefer an opportunity that offers a good management team and
reasonable financial and product market characteristics even if it does not meet the
overall fund and deal requirements (Muzyka et al., 1996). However, some more recent
studies contradict this logic by suggesting that the most important selection criteria
center on the market and product attributes (Hall and Hofer, 1993; Zacharakis and

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Meyer, 1995). Finally, it is important to note that prior research reports various
interactions between the evaluation criteria presented above. For instance, the study by
Zacharakis and Shepherd (2005) suggests that the more munificent the environment, the
more importance the venture capitalist attaches to general experience in leadership. In
addition, start-up experience may in some cases substitute leadership experience.
Prior studies give us a reason to believe that the evaluation criteria applied by early
stage venture capitalists differ fundamentally from those employed by later stage
investors. For instance, Birley et al. (1999) found that the leadership potential and
operational skills of entrepreneurs dominate when making investments in early stage
ventures. However, when evaluating buyouts, the leadership capability of the whole
team increases in importance. In addition, several researchers suggest that early stage
investors attach more importance to the possession of proprietary products, product
uniqueness, high growth markets and the quality of the entrepreneurial team, whereas
late-stage investors are more interested in demonstrated market acceptance, profitability
and cash flow as well as relatively short exit horizons (Fried and Hisrich, 1991;
Bygrave and Timmons, 1992; Elango et al., 1995; Wright and Robbie, 1996).
For early stage venture capitalists, the single most important source of information
is the business plan, projecting the future of the company (MacMillan et al., 1985; 1987;
Wright and Robbie, 1996). Adverse selection problem arises, as venture capitalists have
to rely greatly on information provided by the entrepreneur. Therefore, venture
capitalists exercise considerable efforts in due diligence in order to verify the robustness
of reported accounting information, especially profit and cash flow forecasts (Wright
and Robbie, 1996; Manigart et al., 1997). The due diligence process often involves
auditing the macro and legal environment, as well as financial, marketing, production,
and management aspects of a firm (Harvey and Lusch, 1995). In company valuations,

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venture capitalists use various standard methods for valuing investments, such as
variations of price earnings ratio multiples and capitalized maintainable earnings (EBIT)
multiples. However, it has been found that venture capitalists focusing on early stage
investments place significantly less emphasis on valuation methods based on past
performance information (Wright and Robbie, 1996; Wright et al., 1997). When
assessing the quality of human capital, past oriented interviews and work samples tend
to increase the decision accuracy for early stage investors (Smart, 1999), even though
this process is usually less time-consuming for seed and start-up investments with
smaller entrepreneurial teams with little or no track record (Cumming et al., 2006b).
The valuation processes of early stage investments are intrinsically difficult
(Tyebjee and Bruno, 1984; Branscomb and Auerswald, 2002). Paradoxically, prior
literature has identified situations, where these difficulties have lead to a herd mentality
(Lerner et al., 2005) creating an overflow of venture capital in particular sectors
(Sahlman and Stevenson, 1987). It is more common, however, that venture capitalists
impose higher minimum internal rates of return (IRR) and market size hurdles on new,
technology-based firms to compensate for higher levels of risk (Elango et al. 1995; Fiet,
1995; Murray and Lott, 1995; Wright and Robbie, 1996; Manigart et al. 1997; Lockett
et al., 2002). According to a British study, two-thirds of early stage investors look for
rates of return of at least 46 per cent, whereas 75 per cent of later stage investors settle
for an IRR of 35 per cent or below (Wright and Robbie, 1996). As a result, information
asymmetries between investors and entrepreneurs are often cited as one of the major
reasons for which positive net cash flow projects fail to get funded (Leland and Pyle,
1977; Amit et al., 1998).
While relatively little attention is paid to the role of the entrepreneur in the early
stages of the venture capital process, Smith (1999) and Timmons and Bygrave (1986)

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report that entrepreneurs evaluate venture capitalists in terms of their value-added,
reputation, industry specialization, the amount of capital, experience, and physical
location. It has been argued that the entrepreneurs are more likely to accept offers from
venture capitalists with a good reputation, often at a substantial discount of the venture’s
value (Hsu, 2004). Finally, entrepreneurial teams may also assume an active role in
signaling the value of their venture to prospective investors (for example, Amit et al.,
1990; Busenitz et al., 2005). In some cases, third parties, such as technology transfer
offices, may assist new ventures in the signaling process by participating in screening
and preparation of proposals for venture capitalists (Wright et al., 2006).
Venture capitalists seem to be relatively skilled in picking the most successful new
ventures in the industry (Timmons and Bygrave, 1986; Timmons, 1994; Amit et al.,
1998). Their superior screening skills may partly explain the growing research interest
in the cognitive processes of early stage venture capitalists embedded in highly
uncertain and ambiguous environments conducive to cognitive biases and the use of
heuristics in decision-making (Baron, 1998). As a starting point for this stream of
literature is the notion of a venture capitalist as an intuitive decision-maker (Khan,
1987), who does not understand his or her decision process (Zacharakis and Meyer,
1998). Reliance on intuition may stem from information richness or “information
overload” surrounding new ventures making it impossible for investors to increase the
quality of decision making by collecting and processing more information (Zacharakis
and Meyer, 2000; 1998). Prior studies have identified several heuristics characteristic to
the venture capitalist’s decision-making, such as representative and satisfying heuristics
(Gompers et al., 1998; Zacharakis and Meyer, 2000). Even though these heuristics may
speed up the decision making process and allow more time for value adding activities,
they may also lead to the underestimation of risks and a herding phenomenon (see

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Chapter 7 by Zacharakis and Shepherd). It has also been found that venture capitalists
may suffer from overconfidence and attribution bias, causing them to overestimate the
likelihood of success and to attribute failure to external, uncontrollable events, rather
than to their own actions or competence (Zacharakis et al., 1999; Zacharakis and
Shepherd, 2001; Shepherd et al., 2003).
Within this cognitive research stream, there are also studies analyzing the attempts
of seed and early stage investors to reduce ambiguity surrounding their investment
decisions. For instance, Fiet (1995) focuses on the reliance of formal and informal
networks in venture capital decision making. Moesel et al. (2001) and Moesel and Fiet
(2001), in their turn, set out to explore how early stage venture capitalists use various
sense-making techniques to perceive and interpret different forms of order amidst the
apparent chaos of the emerging industry segments. Finally, there is a growing stream of
literature analyzing how venture capitalists may use various decision aids to improve
their decision making quality (Khan, 1987; Zacharakis and Meyer, 2000; Shepherd and
Zacharakis, 2002; Zacharakis and Shepherd, 2005).
Structuring early stage investments and investment portfolios
Prior literature has extensively scrutinized how venture capitalists structure individual
venture capital investments and investment portfolios as a safeguard against moral
hazard and information asymmetries inherent in early stage investments (Sahlman,
1990; Kaplan and Strömberg, 2001; Cumming, 2005b). Prior studies have identified
four major mechanisms of risk reduction: 1) contractual covenants included in the
venture capital contracts; 2) the use of preferred convertible stock; 3) staged capital

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infusion, and 4) compensation schemes aligning the interests of venture capitalists and
entrepreneurs.
First, venture capital contracts typically give investors cash-flow rights, voting
rights, board rights, liquidation rights, as well as non-compete and vesting provisions
(Sahlman, 1990). Prior studies suggest that these rights are more often granted to early
stage investors, fraught with information asymmetries and hold-up problems (Carter and
Van Auken, 1994; Kaplan and Strömberg, 2001; Cumming et al., 2006b). Second, there
is some empirical evidence indicating that convertible preferred equity may minimize
the expected agency problems associated with start-up and expansion stage investments
(see, for instance, Sahlman, 1990; Gompers, 1997; Bascha and Waltz, 2001; Kaplan and
Strömberg, 2001; Cumming 2002),4
whereas debt and common stock are more
appropriate at the later stages of venture financing (Trester, 1998). Third, staged capital
infusion gives investors the option to cut off badly performing ventures from new
rounds of financing (Sahlman, 1990; Gompers, 1995; Gompers and Lerner, 2001), thus
minimizing the losses carried by the early stage venture capitalist. Fourth, while both
venture capitalists and entrepreneurs receive a substantial fraction of their compensation
in the form of equity and options, they also have an additional incentive to maximize the
value of the portfolio company. The venture capitalist may also employ additional
controls on compensation, such as vesting of the stock option over a multi-year period,
making it impossible for the entrepreneur to leave the firm and take his or her shares
(Gompers and Lerner, 2001). It is interesting to note that similar compensation schemes
contingent on performance, contractual covenants and high levels of monitoring are also
applied to mitigate agency problems between venture capitalists and their fund
providers (Sahlman, 1990; Robbie et al., 1997; Wright and Robbie, 1998).

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Venture capitalist may also manage risks on the portfolio level by focusing on
particular industries or geographical areas, limiting the size of investments, or by
investing in syndicates. For instance, there are studies indicating that venture capitalists
prefer less industry diversity and a narrower geographical scope, when dealing with
high risk (early stage) investments (Gupta and Sapienza, 1992; Norton and Tenenbaum,
1992). According to Robinson (1987), venture capitalists generally favor a larger
number of smaller investments in early stage ventures in comparison to larger
investments in more mature portfolio companies. Ruhnka and Young (1987), in their
turn, suggest that venture capitalists may elicit risks by distributing their investments
across various investment stages. Finally, several authors suggest that the risk sharing
motivation for syndication is significantly more important for early stage venture
capitalists than to venture capital firms investing in later stages only (Bygrave, 1988;
Lerner 1994; Gompers and Lerner, 2001; Lockett and Wright 2001; Lockett et al., 2002;
Kut et al., 2005; Cumming, 2006; Cumming et al. 2006b).
Monitoring and adding value in early stage investments
It is argued that venture capital investors may address the problems of asymmetric
information not only by intensively scrutinizing firms before their investment decision
and structuring their investment portfolios with great care, but also by monitoring their
portfolio companies afterwards (Lerner, 1999). As an evidence of a more hands-on role
of early stage investors, several scholars found that they spend more time with their
portfolio companies than later stage investors (Barney et al., 1989; Gorman and
Sahlman, 1989; Sapienza and Gupta, 1994). In a similar vein, early stage investors are
reported to be more eager to require corrective actions, such as changes in management,

22
if the new venture fails to not live up to the expectations (Carter and Van Auken, 1994;
Hellman and Puri, 2002). However, there exists some contradicting evidence suggesting
that portfolio companies receive more venture capitalists’ attention as they mature
(Gomez-Mejia et al., 1990). In addition, some studies propose that the differences in the
level of venture capital involvement are not stage-related (MacMillan et al., 1988; Fried
and Hisrich, 1991; Sapienza, 1992), but depend on a host of other factors, such as the
size of the venture capital firm, its level of experience, the size of the investment, the
power of the board of directors or the characteristics of the portfolio company (Flynn,
1991; Fiet et al., 1997; Flynn and Forman, 2001). For instance, Sweeting and Wong
(1997) demonstrate that venture capitalists adopting a hands-off approach tend to focus
on companies that are well-managed and led by experienced teams with proven track
records.
In addition to intensive monitoring, early stage venture capitalists may attempt to
increase the value of their investment by providing several “value-added services” to
their portfolio companies. Several scholars conclude that venture capitalists investing in
earlier stages take a more active managerial role in a young firm (Rosenstein et al.,
1993; Carter and Van Auken, 1994; Sapienza and Gupta, 1994; Sapienza et al., 1994;
Elango et al., 1995; Sapienza et al., 1996). The value-adding activities provided by
venture capitalists involve evaluating and recruiting managers after the investment
decision, negotiating employment contracts, contacting potential vendors, evaluating
product market opportunities, or contacting potential customers (Timmons and Bygrave,
1986; MacMillan et al., 1988; Gorman and Sahlman, 1989; Fried and Hisrich, 1991;
Elango et al., 1995; Kaplan and Strömberg, 2001; Hellman and Puri, 2002). Flynn
(1991) go as far as to state that early stage venture capitalists take a leadership role in
administrative and strategic responsibilities of a new firm. It seems that the level of

23
early stage venture capitalist’s involvement in value-adding activities is determined by
various human capital and fund characteristics: prior consulting, industry, and
entrepreneurial experience of the venture capitalist contribute to a higher level of value-
adding activities. Prior studies also report that investment managers of diversified
portfolios and captive funds spend less time with their portfolio companies (Sapienza et
al., 1996; Lockett et al., 2002; Megginson, 2004; Knockaert et al., 2006).
The active involvement of the venture capitalist in the operations of a new venture
seems to matter from a financial point of view (Barney et al., 1994; Flynn and Forman,
2001; Cumming et al., 2005). It has been suggested that the involvement of venture
capitalists may help the professionalization of young firms and speed up the
commercialization of innovations (Timmons and Bygrave, 1986; Cyr et al. 2000; Engel
and Keilbach, 2002; Hellman and Puri, 2002). Venture capital financing may enhance
the portfolio company’s credibility in the eyes of third parties, such as suppliers,
customers and other investors, whose contributions will be crucial for the company’s
success (Megginson and Weiss, 1991; Steier and Greenwood, 1995; Black and Gilson,
1998). Flynn (1995) provides preliminary evidence that the degree of analysis,
assistance in the articulation of strategy, and pressure to view issues from a longer term
perspective by the venture capitalist are positively associated with the overall
performance of a new venture.
Prior studies also emphasize the importance of the relationship quality between the
venture capitalist and the entrepreneur (for example, Fried and Hisrich, 1995). Sapienza
and Koorsgaard (1996) highlight the importance of entrepreneurs’ timely feedback of
information in building trustful relationships with the investor and securing future
funding. Higashide and Birley (2002) argue that conflict as disagreement can be
beneficial for the venture performance, whereas conflict as personal friction is

24
negatively associated with success. In a similar vein, Busenitz et al. (2004) report a
positive association between new venture performance and procedurally just
interventions by venture capitalists.
Exit strategies and performance of early stage investments
There exists some evidence suggesting that early stage venture capitalists view either
trade sales or initial public offerings (Carter and Van Auken, 1994; Murray, 1994; Amit
et al., 1998; Black and Gilson, 1998; Das et al., 2003) as their preferred route to exit.
Surprisingly enough, very few early stage venture capitalists regard later stage investors
as an attractive exit option (Murray, 1994). In their study focusing on the duration of
venture capital investments, Cumming and MacIntosh (2001) found that earlier stage
deals are likely to be held for a shorter period of time than later stage investments,
suggesting significant culling of early stage deals.
Several scholars report higher returns to later stage investments in comparison to
early stage deals (Murray and Marriott, 1998; Murray, 1999; Cumming, 2002; Manigart
et al., 2002; Hege et al., 2003; Cumming and Waltz, 2004). However, early stage
investors in the United States tend to outperform their colleagues focusing on later stage
deals and investors in other parts of the world. These differences in performance may
reflect the superior ability of the US investors to manage early stage investments
(Sapienza et al., 1996) or, alternatively, structural issues related to the minimum viable
scale for a technology-based venture capital fund (Murray and Marriott, 1998; Murray,
1999). The performance of the US and European venture capital funds by stage of
investment is depicted in Table 11.2.

25
-----
Insert Table 11.2 about here
-----
A wealth of studies focuses on the determinants of returns to venture capital
investments (for example, Cumming, 2002; Gottschlag et al., 2003; Ljungqvist and
Richardson, 2003; Kaplan and Schoar, 2005). However, it is important to note that these
studies focus on venture capital funds in general, not on early stage funds in particular.
These studies report that;
• specialization exerts a positive impact on returns, possibly due to learning curve
effects enjoyed by venture capitalists accumulating superior knowledge in a specific
industry sector (Gupta and Sapienza, 1992; De Clerq and Dimov, 2003),
• successful venture capitalist firms outperform their peers over time, suggesting
“persistence phenomena” or the development of core competences that cannot be
easily imitated (Gottschlag et al., 2003; Ljungqvist and Richardson, 2003; Cumming
et al., 2005; Diller and Kaserer, 2005; Kaplan and Schoar, 2005),
• the relationship between experience and performance is ambiguous. For instance,
Manigart et al. (2002) and Diller and Kaserer (2005) report a positive relationship,
Fleming (2004) reports no relationship and De Clerq and Dimov (2003) an adverse
relationship between experience and performance,
• larger funds outperform smaller funds, but only up to a point, suggesting an inverted
U-shaped relationship between fund size and performance (Gottschlag et al., 2003;
Hochberg et al., 2004; Laine and Torstila, 2004; Kaplan and Schoar, 2005),

26
• fast fund growth is negatively associated with performance (Kaplan and Schoar,
2005),
• the number of portfolio companies per investment manager and performance exhibit
an inverted U-shaped curve (Jääskeläinen et al., 2002; Schmidt, 2004),
• performance is positively associated with the number of endowments and negatively
associated with the number of banks investing in the fund (Lerner et al., 2005), and
• narrow geographical focus is associated with lower performance (Manigart et al.,
2002).
It is hardly surprising that various management practices applied over the venture
capital cycle have the potential to contribute to the performance of venture capital
funds. For instance, the ability to generate a continuous stream of high quality
investment opportunities (Ljungqvist and Richardson, 2003; Megginson, 2004) and
sharp screening and selection skills (Hege et al., 2003; Schmidt, 2004, Diller and
Kaserer, 2005) are reported to lead to superior performance. In a similar vein, a number
of factors related to deal structuring, such as the type of contracts (Kaplan et al., 2003),
staged financing (Gompers and Lerner, 1999, Hege et al., 2003), convertible securities
(Hege et al., 2003; Cumming and Walz, 2004), venture capitalists’ ownership stake
(Amit et al., 1998; Cumming, 2002), syndication (Jääskeläinen et al., 2002; De Clerq
and Dimov, 2003; Cumming and Waltz, 2004) and acting as a lead investor (Sahlman,
1990; Manigart et al., 2002a; Gottschalg et al., 2003), have performance implications.
Prior research also emphasizes venture capitalists’ ability to add value in their portfolio
companies (Barney et al., 1994; Flynn, 1995; Flynn and Forman, 2001; Diller and
Kaserer, 2005) from a financial point of view. In terms of exit strategies, it has been

27
stated that going public is the most profitable exit route for venture capitalists (Black
and Gilson, 1998).
Institutional context and the management of early stage investments
Cross-national differences in the management of early stage investments have received
a fair amount of attention in venture capital literature. Prior studies report that such
differences may exist in the way in which the venture capital firms are organized, as
well as in fund raising, deal generation, deal screening, investment structure and post-
investment activities. On the whole, these institutional differences may play a major role
in determining the ability of early stage investors to shield themselves from risks and
profit from their investments.
For instance, Megginson (2004) shows that venture capital firms in the United
States usually take the form of independent limited partnerships and obtain their funding
from institutions, such as pension funds. This structure and larger average fund size
offer substantial contracting benefits for investors operating under information
asymmetries and uncertainty (Murray and Marriott, 1998; McCahery and Vermeulen,
2004; Söderblom and Wiklund, 2006). Europeans, in their turn, organize their venture
capital firms as investment companies or subsidiaries of larger financial groups (Wright
et al., 2005).
Factors promoting fund raising activities include GDP growth and the growth rate of
RandD (Gompers et al., 1998; Jeng and Wells, 2000; Romain and Pottelsberghe, 2004),
favorable tax, regulatory and legal environments (La Porta et al., 1997; Gompers et al.,
1998; Marti and Balboa, 2000; Da Rin et al., forthcoming), and government programs
facilitating investments in young ventures (Lerner, 2002; Leleux and Surlemont, 2003;

28
Cumming, forthcoming). Commitments to early stage ventures are negatively affected
by labor market rigidities (Black and Gilson, 1998; Jeng and Wells, 2000; Romain and
Pottelsberghe, 2004), high capital tax gains (Gompers et al., 1998), and, in some cases,
the presence of government programs crowding out private venture capital investors
(Armour and Cumming, 2004). There is some disagreement among the researchers
regarding the role of deep and liquid stock markets. While some researchers argue that
venture capital fund raising is boosted by well-functioning public markets that allow
new firms to issue shares (Black and Gilson, 1998; Armour and Cumming, 2004; Da
Rin et al. forthcoming), others argue that this positive effect exists only for later-stage
investments and not for early stage deals (Jeng and Wells, 2000). As the aforementioned
determinants of fund raising have mostly been studied in the context of venture capital
in general,5
future research should confirm these results for early stage venture capital in
particular.
It is worth mentioning that the studies focusing on the determinants of funds raised
by early stage venture capitalists largely ignore cultural and social factors (Wright et al.,
2005). A notable exception is the study by Nye and Wassermann (1999) showing that
differing levels of cultural learning contribute to different rates of growth of venture
capital industries in India and Israel. In a similar vein, cultural factors may play a
significant role in either promoting or hindering entrepreneurship, thus affecting the
supply of high quality investment opportunities available for early stage venture
capitalists (Acs, 1992; Baygan and Freuedenberg, 2000; Hayton et al., 2002; Kenney et
al., 2002b).
Relative to deal generation, deal screening and valuation, several researchers
conclude that venture capitalists in the United States apply a more comprehensive set of
criteria for evaluating risks associated with new ventures than their colleagues in other

29
parts of the world (Ray, 1991; Ray and Turpin, 1993; Knight, 1994; Hege et al., 2003).
Also the relative importance of evaluation criteria may vary across nations. Americans
tend to value potential for significant market growth, whereas venture capitalists in
transition economies rely on foreign business education or exposure to Western
business practices as an important signal of managerial ability. Asian venture capitalists,
in their turn, seek personality compatibility when assessing management teams (Ray,
1991; Knight, 1994; Bliss, 1999). In addition, prior studies suggest that venture
capitalists in developed markets use external specialists for investment appraisal and
apply sophisticated valuation procedures based on standard corporate finance theory.
Investors in emerging venture capital industries, in their turn, rely on their own
expertise and cash flow methods for valuation and put greater emphasis on information
related to product, market, and proposed exit (Ray, 1991; Ray and Turpin, 1993; Wright
and Robbie, 1996; Karsai et al., 1999; Manigart et al., 2000; Lockett et al., 2002; Wright
et al., 2004).
Variations in corporate and tax law environments may have implications for the
financing structure of venture capital investments (Wright et al., 2005). For example,
convertible instruments are more widely used in common law countries than in civil law
countries (Cumming, 2002; Cumming and Fleming, 2002; Hege et al., 2003; Kaplan et
al., 2003; Cumming, 2005a; Lerner and Schoar, 2005). Kaplan et al. (2003) report that
venture capital contracts vary across legal regimes in terms of the allocation of cash
flow, board, liquidation, and other control rights. However, more experienced venture
capitalists all over the world seem to implement US style contracts regardless of the
legal regime. Finally, the motivations for and the use of syndication strategies tend to
differ depending on the institutional context (Manigart et al., 2006).

30
Although investors’ monitoring behavior shares many similarities across nations
(Ray, 1991; Pruthi et al., 2003; Bruton et al., 2005), there exist some differences relative
to the nature of post investment relationship between the entrepreneur and the venture
capitalist. The active managerial role adopted by the venture capitalist tends be
particularly visible in the US high tech industries, where many senior partners have
become legendary for their skills in finding, nurturing and bringing to market high-tech
companies (Megginson, 2004). In line with this reasoning, Sapienza et al. (1996) found
that venture capitalists in more developed venture capital markets (the United States and
the United Kingdom), are more involved in their portfolio companies and add more
value than their colleagues in less developed venture capital markets (France). Hege et
al. (2003) and Schwienbacher (2002), in their turn, report that US venture capital firms,
in comparison with European firms, are more likely to take corrective actions in their
portfolio companies. Unlike Westerners, Asians view capitalist firms and their portfolio
a single collective entity, which reduces the need to manage and control the agency
risks (Bruton et al., 2003). This greater relationship orientation stemming from a more
collectivistic culture is also reflected in the value-added services provided by venture
capitalist: while American venture capitalists are more involved in serving as a
sounding board to the venture and in financially oriented services, Asian venture
capitalists emphasize the efforts to build relationships both inside and outside of the
firm. Prior research also reports cross-national variations in preferred exit strategies and
the timing of exit (Cumming and MacIntosh, 2003; Cumming et al., 2006b). For
instance, IPOs are reported to be a more common exit vehicle in countries where legal
investor protections are strong, whereas buybacks gain importance in countries with a
weaker legal framework protecting the interests of investors.

31
The effect of various environmental and institutional factors on fund performance is
mostly indirect in nature (Söderblom and Wiklund, 2006). However, there exists some
evidence that overall business cycles, industry cycles and stock market cycles
(Gottschlag et al., 2003; Avnimelech et al., 2004; Diller and Kaserer, 2005 Kaplan and
Schoar, 2005) directly influence the returns to early stage funds. A factor that also
seems to have a major impact on fund performance is the allocation and level of funds.
Several researchers show that an increase in the allocation of money exerts a significant
negative impact on fund performance (Gompers and Lerner, 2000; Ljungqvist and
Richardson, 2003; Hochberg et al., 2004; Da Rin et al., forthcoming; Diller and Kaserer,
2005). Finally, legal protections available for investors have been reported to contribute
to the superior performance of venture capital funds (Armour and Cumming, 2004;
Kaplan et al. 2003; Cumming and Walz, 2004; Lerner and Schoar, 2005).
To sum up the discussion above, investors in successful early stage venture capital
markets (in terms of the volume of and return on investments) tend to be more active in
alleviating risks associated with early stage venture capital investments. This more
extensive reliance on risk reduction strategies may be explained by the superior skills of
investors operating in mature markets and institutional environments with favorable
legislations, government policies and tax regimes. It is noteworthy, however, that the
very nature of risk, or at least the perception of it, may differ depending on the
institutional environment. Therefore, the solutions originating mostly from the Anglo-
Saxon context may not be readily applicable in nations with drastically different
normative, cognitive and regulatory institutions.
CONCLUSIONS AND DISCUSSION

32
The purpose of this book chapter was to review decades of research on early stage
venture capital, basically focusing on two major research themes. The first one
describes the differences between investments in early stage ventures and later stage
deals. The second dominant theme identifies several management practices available for
early stage venture capitalists exposed to high levels of information asymmetries and
related risks. I will first summarize the key findings emerging from these two research
streams. Thereafter, I will continue with some theoretical and methodological
considerations, as well as suggestions for future research.
Summary of key findings
Based on the studies discussed above, it is possible to argue that early stage investment
targets, investors and funds differ from those involved in later stage venture capital
activities. Perhaps most importantly, early stage ventures struggle with challenges
associated with new product and market development, building up a competent
management team and managing growth, making them more susceptible to market and
agency risks than more mature investment targets. The venture capital firms focusing on
early stage investments tend to be shielding themselves from these risks by relying on
their experience and size. In a similar vein, there seems to be a minimum scale of
efficiency, after which early stage investments become a viable option for venture
capital funds. Early stage venture capital has also been found to flourish in institutional
environments enjoying favorable tax, regulatory and legal environments, providing
investors with incentives and protection from various market and agency risks.
Prior literature suggests that early stage venture capitalists actively seek to reduce
the risks and uncertainties at every stage of the venture capital cycle. First, prior studies

33
list several criteria along which early stage venture capitalists and entrepreneur may
assess each others’ potential. The most recent literature pays increasingly attention to
the cognitive processes of venture capitalists in highly uncertain decision contexts.
Second, early stage investors may alleviate information asymmetries and risks through
contractual covenants included in the venture capital contracts, the use of preferred
convertible stock and staged capital infusion, as well as compensation schemes aligning
the interests of venture capitalists and entrepreneurs. Venture capitalists may also
attempt to control the risks by focusing on particular industries or geographical areas,
limiting the size of the investments, or investing in syndicates. Third, early stage
venture capitalists typically devote a substantial amount of time to monitoring and
value-adding activities in the post investment phase. Finally, relative to the exits and
fund performance, early stage investors are reported to severely under-perform later
stage deals. In a similar vein, American early stage funds enjoy significantly higher
returns than their counterparts in Europe. The factors determining the performance of
early stage venture capital investments include the characteristics of venture capital
firms and funds, the management of the investment process, as well as various macro-
economic and institutional factors.
Theoretical and methodological considerations
Research on early stage venture capital has been conducted by scholars representing
many different disciplines, most notably finance and economics, entrepreneurship and
cognitive psychology. First, finance scholars (for example, Chan, 1983; Amit et al.,
1990; 1998; Gifford, 1997; Gompers, 1997, 1995; Elitzur and Gavious, 2003; Hsu,
2004; Lerner, 1994) have primarily relied on asymmetric information, signaling and

34
agency theories when trying to explain the nature of the relationship between venture
capitalists and early stage ventures. Given this theoretical orientation, the focus tends to
be on the dark side of the venture capitalist - entrepreneurship interaction and how
venture capitalists may alleviate problems associated with moral hazard and asymmetric
information all over the world (for example, Cumming and Fleming, 2002; Hege et al.,
2003; Kaplan et al., 2003; Lerner and Schoar, 2005).
Second, entrepreneurship scholars have traditionally taken a rather atheoretical
approach (for example, Camp and Sexton, 1992; Carter and Van Auken, 1994; Elango
et al., 1995; Brouwer and Hendrix, 1998; Balboa and Marti, 2004) or borrowed from
“Stages of Development Theories” of new ventures (Ruhnka and Young, 1987; Flynn
and Forman, 2001), when describing the global trends in early stage venture capital
investments or identifying characteristics distinguishing early stage ventures from later
stage deals. However, more recently, entrepreneurship scholars have turned to strategy
and sociology literature – drawing mostly on the resource-based theory, procedural
justice theory and institutional theory, when analyzing the intricacies of the social
relationships in early stage venture capital investments (Fiet et al., 1997; Karsai et al.,
1999; Bruton and Ahlstrom, 2002; Bruton et al., 2002; Busenitz et al., 2004; Manigart et
al., 2002; Bruton et al., 2005). Unlike the studies conducted by finance scholars, this
research stream tends to emphasize more the sunny side of early stage venture capital
investments as engines of growth and innovation and the crucial role of venture
capitalists as providers of value-added services to nascent ventures.
It is important to note that both finance and entrepreneurship scholars emphasize
issues embedded in the venture capitalist - entrepreneur relationship and the external
environment surrounding nascent ventures. An emerging stream in early stage venture
capital research has taken a more introspective view by focusing on the role of cognitive

35
and sensemaking processes of venture capitalists (for exemple, Zacharakis and Meyer,
1998; Moesel and Fiet, 2001; Moesel et al., 2001; Zacharakis and Shepherd, 2001). This
shift in focus is hardly unexpected, as cognitive processes are likely play a crucial role
in the reduction of uncertainty and chaos surrounding new ventures.
In terms of research methods used, there is relatively little variation in early stage
venture capital research. A vast majority of studies reviewed adopt a quantitative
approach relying on information derived from surveys or data base data. Only a fraction
of papers represents either a purely theoretical or qualitative approach. However, it
seems likely that as our need for a more in-depth understanding of early stage venture
capital grows, other research methods, such as experiments and ethnographies, will
increase in importance in the future.
Moving forward: Suggestions for future research
After decades of research, our knowledge on early stage venture capital remains limited.
For instance, although several scholars have acknowledged the recent declining trend in
investments in early stage ventures, we still know very little about the reasons
underlying this development. Therefore, future studies should set out to identify
changes in the incentive systems and governance structures within the venture capital
industry, potentially explaining the relative decline in investments in young ventures.
Approaching this question would also necessitate a shift toward more longitudinal
research methods than hitherto applied in early stage venture capital research.
Second, several studies suggest that the financial needs of nascent ventures might be
best addressed by a combination of public funding schemes and informal venture capital
(Branscomb and Auerswald, 2002). An interesting area for future research would thus

36
be addressing the complementarities between public funding and early stage venture
capitalists (Lerner 2002) or the synergies between angel funding and early stage venture
capital (Harrison and Mason, 2000).
Third, there seems to be significant regional differences in the operations and
performance of early stage venture capitalists. On the one hand, prior literature gives us
a reason to believe that the Anglo-Saxon nations in general and the United States in
particular have managed to create an institutional environment conducive to early stage
venture capital, and therefore, could act as role models for other nations. On the other
hand, it is also possible to argue that nations with institutional environments drastically
different from that of the United States should develop their own versions of early stage
venture capital. An interesting avenue for future research would thus involve exploring
how this modified version of venture capital should look like, operate and help investors
deal with risks inherent in early stage investments.
Fourth, the greatest challenges associated with early stage venture capital
investments are cognitive in nature. These challenges relate to the perceptions of risks
and sense making processes of venture capitalists facing chaotic environments
surrounding new ventures. As Fried and Hisrich (1994) put it, successful venture
capitalists are, above all, efficient information processors and producers. This gives us a
reason to believe that research on early stage venture capital will continue to benefit
from borrowing from research on human cognition and information processing
mechanisms.
ENDNOTES
1
The author would like to thank Hans Landström, Mike Wright, and the participants
of Workshop on Venture Capital Policy in Lund for their invaluable comments on
the earlier version of this chapter.

37
2
I used ABI Inform/Proquest, JSTOR, Google Scholar and SSRN electronic
databases to identify suitable references. In addition, I reviewed the reference
sections of all articles to find more relevant references. The main focus of the
literature search was on papers focusing explicitly on early stage venture capital and
on articles comparing early stage venture capital to investments in later stage deals.
3
Strictly speaking, there is a distinction between uncertainty and risk: risk is an
uncertainty for which probability can be calculated (with past statistics, for example)
or at least estimated (doing projection scenarios). However, for uncertainty, it is
impossible to assign such a (well grounded) probability (www.wikipedia.org). In
this paper, these two terms are often used as synonyms, reflecting their usage in
prior studies.
4
However, Norton and Tenenbaum (1993) and Cumming (2006; 2005) found that the
use of preferred stock is not more frequent in early stage ventures.
The studies reviewed herein focus on the performance of venture capital funds,
excluding buyouts. However, these studies do not focus solely on seed, start-up and
first stage investments.

38
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An Overview Of Research On Early Stage Venture Capital Current Status And Future Directions

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