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Banks and the business angel

market

The possible contribution of banks to reducing information

asymmetry, and adding value to the business angel market

16-1-2015

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Banks and the business angel market

The possible contribution of banks to reducing information

asymmetry, and add value to the business angel market

Rijksuniversiteit Groningen

Faculty of Economics and Business

Master Small Business and Entrepreneurship

Author

Name : Bart Scholten Student number : 1278819

Address : Botermakerses 9, 7721 KC, Dalfsen Phone : 0031 6 24 28 95 35

E-mail : b.scholten.1@student.rug.nl or bartscholten82@gmail.com

Supervisor

Name : Dr. C.H.M. Lutz

University : Rijksuniversiteit Groningen

Master coördinator

Name : dr. ir. H. Zhou

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Preface

This master’s research on banks and the business angel market is a requirement to complete the Master of Business Administration with specialization in Small Business & Entrepreneurship at the University of Groningen (RUG). The research was carried out between August 2014 and January 2015.

I first became aware of the topic of business angels through my supervisor, Dr. Lutz. Then I began scouting the literature on the business angel market, and it became clear to me that the connection between this market and the banking sector is a poorly researched area. This made the research a challenge, since little prior research exists in some areas. I sincerely hope that my study will make a contribution to the existing academic literature.

My first thank-you goes out to the individuals who kindly took the time and effort to participate in an interview. Without them the case study research would not have been possible. Then, I would like to thank my colleagues and friends who were prepared to consult their network to find relevant persons to interview and give remarks on the structure and content of the thesis. My gratitude is especially extended to Dr. Lutz for his advice and critical remarks.

I sincerely hope that you enjoy reading this thesis and experience the possibilities the business angel market has to offer.

Bart Scholten

Dalfsen, 14 January 2015

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Table of contents

Preface ... 2

Tables and Figures ... 5

1 Introduction ... 6

1.1 Problem statement and research questions ... 9

1.2 Overview of the study ... 10

2 Literature review ... 12

2.1 Venture capital market ... 13

2.1.1 Institutional venture capital ... 13

2.1.2 Corporate venture capital ... 14

2.1.3 Informal venture capital ... 15

2.1.4 Conclusion ... 20

2.2 Business angels... 20

2.2.1 Role of business angels ... 21

2.2.2 Investment strategies business angel ... 24

2.2.3 Barriers to invest ... 27 2.2.4 Conclusion ... 28 2.3 Matchmaking ... 28 2.3.1 Credit rationing ... 29 2.3.2 Information asymmetry ... 29 2.3.3 Matchmaking initiatives ... 30

2.3.4 Critical factors to the success of matchmaking services ... 33

2.3.5 Actions for the matchmaking services ... 34

2.3.6 Conclusion ... 35

2.4 Banks ... 35

2.4.1 Basel III ... 36

2.4.2 Traditional versus non-traditional banking... 36

2.4.3 Conclusion ... 38

2.5 Expected consequences ... 38

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5 Analysis of the interviews ... 49

5.1 Analysis of interview, business angel 1 (B1) ... 49

5.2 Analysis of interview, business angel 2 (B2) ... 52

5.3 Analysis interview, business angel 3 (B3) ... 55

5.4 Analysis interview, entrepreneur 1 (E1) ... 58

5.5 Analysis interview, entrepreneur 2 (E2) ... 59

5.6 Analysis interview, entrepreneur 3 (E3) ... 62

6 Cross-case analysis ... 65

6.1 Cross-case analysis of the interviews with the business angels ... 66

6.2 Cross-case analysis of the interviews with the entrepreneurs ... 69

6.3 Cross-case analysis of the interviews between the business angels and the entrepreneurs. .. 71

7 Discussion and conclusion ... 74

7.1 Sub-question 1 ... 74

7.2 Sub-question 2 ... 75

7.3 Sub-question 3 ... 75

7.4 Sub-question 4 ... 76

8 Suggestions for further research ... 78

9 Limitations ... 81

10 References ... 82

Appendix A: Summaries interviewees ... 88

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Tables and Figures

Table 1: The sub questions and the academic literature ... 10

Table 2: Characteristics of institutional venture capital, business angels & corporate venture capital..19

Table 3: Relevant situations for different research methods (Yin, 2013) ... 44

Table 4: Source of evidence: Strengths and weaknesses (Yin, 2013) ... 47

Table 5: Cross-case analysis... 66

Figure 1: Private equity activity ... 12

Figure 2: General definitions ... 16

Figure 3: Categorization of informal investors using four initial clusters ... 17

Figure 4: Different investment roles ... 22

Figure 5: Categorization of angel investments using four initial clusters ... 26

Figure 6: The standard matchmaking process ... 34

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1 Introduction

As far back as the Golden Century, companies like the Vereenigde Oostindische Compagnie (VOC) knew that to make a profit an investment is needed first. The VOC was the first company to issue shares in order to finance their trading expeditions. In 1602 wealthy merchants invested a large sum of money in a VOC expedition, without first knowing the results of the fleet (Gaastra, 2007). Nowadays, companies face a similar situation. They also need to incur costs before being able to launch an innovative product or expand their company. Moreover, a company needs to pay its bills. To carry out these plans, and keep the bills paid, the entrepreneur needs capital. In short, without capital a (starting) company will not survive.

Venture capital (VC) is and has been important for economic development; it acts as a catalyzer for innovation (Kortum & Lerner, 2000) and supports the development of new industries. An important bottleneck for many startup companies and existing small and medium sized enterprises (SME) is obtaining external financing. This is particularly difficult for certain groups like starting innovative SMEs. Traditional funders like banks and venture capital companies are restrained in financing certain types of SMEs.

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Since the traditional funders are cautious with supplying credit, SMEs are looking for alternative sources of credit. Private investors, also known as ‘informal investors’ can be seen as an alternative. Informal investors mainly consist of (formal) entrepreneurs, in other words, a business angel is:

A high net worth individual, acting alone or in a formal or informal syndicate, who invests his or her own money directly in an unquoted business in which there is no family connection and who, after making the investment, generally takes an active involvement in the business, for example, as an advisor or member of the board of directors (Mason & Harrison, 2008, p. 309).

On the one hand a business angel can play a part in a (startup) company by supplying capital, at a risk. On the other hand, a business angel possesses sector-specific knowledge. With this knowledge, gathered from his or her professional network and years of experience as an entrepreneur, a business angel can not only help a starting SME by supplying capital, but also by sharing valuable knowledge. The combination of capital and sector specific-knowledge makes a business angel an important facilitator of external financing and knowledge for entrepreneurs.

Although large funds are available on the business angel market, new companies find it hard to access these funds because they either cannot find the right angel, or the angel is unable to find a company that is attractive enough to invest in (Mason & Harrison, 1994). This is best summarized in the concept of ‘knowledge gap’. This situation arises from information asymmetry within the business angel or venture capital market. Neither the supplier (business angel) nor the recipients (entrepreneur) of the financing is capable to assess the sensitive balance that exists between risk and return. This lack of ability from both parties to find each other influences the decision to participate in the venture capital market (Harding, 2002). In other words the business angel will not invest in a starting entrepreneur because he cannot properly assess the risk involved. The starting entrepreneur will not attempt to attract external capital because he cannot properly assess the advantage or disadvantages. To reduce the information asymmetries, different initiatives have been set up, under the name of Business Angel Networks (BANs). The Dutch version is called the Business Angel Network Nederland (BAN Nederland). A BAN’s goal is to act as a financial intermediary between investors (BA) and start-ups, and to reduce the information asymmetry between them. By doing so, the matching problem is reduced or overcome (EBAN, 2010).

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report shows a decrease of 3 percent in the funds invested by business angels in the Netherlands, compared to 2012. By rethinking their business model as a response to changing regulations (Basel III) and the financial crisis, banks can try to add value by improving information disclosure to the market, or rethink who their (potential) customers are and how to serve them properly. This all can have a positive influence on the matchmaking process in the business angel market (Chen et al., 2014). The question then arises, could the banks’ ‘reconsidered’ business model decrease the information asymmetry in the BA market? Until now little research has been conducted on the current and potential influence of banks on the matchmaking problem in the BA market, so there is a research gap on this subject. The focus in this thesis is on the potential role of a bank in the matchmaking process; on how banks can have a positive influence on the business angel market by reducing information asymmetry, thus add value.

Why is this interesting for business angels, entrepreneurs, and banks?

Possible consequences for business angels:

- A previous relation often exists between the bank and the entrepreneur. In most of these situations, the relation is limited, and consists of facilitating payments and insurance. Because of this, the bank already has a track record of the entrepreneur which can act as a benefit in the due diligence research in the matchmaking process.

- By dividing the portion of the capital requested between the bank and the business angel, the level of exposed capital per capital provider is smaller, lowering the risk.

Possible consequences for entrepreneurs:

- A business angel is often a (former) entrepreneur who has, in his own active career, built up a relation with a bank. As a result, both the BA and his characteristics and qualities are known to the bank. This is beneficial to a potential match with an (starting) entrepreneur.

- Lower risk results in lower interest rates for the company.

Possible consequences for banks

- An active role in the matchmaking process can result in (improved) relations with both parties. - When an early relationship as result of an active role in the matchmaking process arises, it

becomes possible for the bank to observe the performance of the company in which the business angel is investing. This makes it possible to finance a possible management buy-out on the basis of track record.

Possible consequences for all parties involved:

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completely. A possibility is that later on in the life cycle the entrepreneur wants to finance a buy-out of the BA, which positive for all parties.

- A bank is in a better position to assess the quality of a BA and screen the entrepreneur’s initial financing request. In other words, a bank can act as a filter for both parties by using their core qualities which may, eventually, improve the matchmaking process.

Possible disadvantage(s):

- The bank is an extra party in the business angel market, so instead of only taking into account the business angels’ wishes, a company has to address the will of a bank, and vice versa.

- Banks will use covenants and collaterals to reduce the risks, limiting the flexibility between the business angel and company.

1.1 Problem statement and research questions

It is clear that, despite the creation of BANs, an information asymmetry still remains in the business angel market. This results in difficulties in the matchmaking process between business angels and starting entrepreneurs. The role of banks in the matchmaking process is currently underexplored.

This thesis seeks to research why a matchmaking problem caused by information asymmetry between business angels and starting entrepreneurs, still exists, despite the interference of matchmaking activities like BANs subsidized by the government. The thesis researches the possible role of banks in the matchmaking process and elaborates on whether banks have potential added value in the matchmaking process through the deployment of their skills and knowledge. This is done, to decrease the information asymmetry, improve the matchmaking process between business angels and starting entrepreneurs, and thus add value to the market.

Before researching the role of banks in the matchmaking process in the BA market it is necessary to formulate research questions to build a basis for answering the main research question. The introduction acknowledged some interesting gaps to research which resulted in the following main research question:

What are the main reasons for the information asymmetry between business angels and entrepreneurs, and what are possible contributions of banks on reducing information asymmetry, thereby adding value to the business angel market?

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(sub1.) How is the venture capital market organized, and what is the position of a business angel in this market?

(sub2.) What do (starting) entrepreneurs and business angels look for in each other?

(sub3.) How do information asymmetries occur in the matchmaking process between business angels and entrepreneurs?

(sub4.) How can potential bank initiatives reduce or overcome information asymmetry between business angels and entrepreneurs, thereby adding value to the business angel market?

Table 1 shows an overview of the different sub questions and the main academic articles discussing the themes of the sub questions.

Sub question 1 Landström (2007), Mason and Harrison (1993), Sorheim and Landström (2001) and Avdeitchikova (2008)

Sub question 2 Mason and Harrison (2008), Avdeitchikova (2008), Politis (2008) and Lahti (2011)

Sub question 3 EBAN (2010), Scholtens (1999), Nath (2010), Knyphausen-Aufseß and Westphal (2008) and Harrison and Mason (1993).

Sub question 4 Apergis (2014), Li et al. (2011), Gambacorta and van Rixtel (2013) and Chen et al. (2014)

Table 1: The sub questions and the academic literature consulted

1.2 Overview of the study

This master thesis is divided in chapters. Chapter one consists of the introduction and problem statement explaining the reason for conducting the study and what sub-questions lead to answering the research question. The second chapter is the literature review. This review is important as it explains the venture capital market and defines what identifies a business angel. The literature review has five segments explaining how existing academic literature looks at the venture capital market, business angels, the information asymmetry between business angels and entrepreneur, and the matchmaking initiatives and banks.

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The literature study on the other subjects was performed as follows. First, relevant literature in the Business Source Premier database was found through the use of specific search terms. The most important journals consulted are the Journal of Business Venturing, International Small Business Journal, Venture Capital and Small Business Economics. Books were also consulted, among which Yin, (2013) and Landström, (2007).

In chapter three, the manner in which the study is carried out is displayed graphically in the conceptual model or framework. This displays the expected connections between different variables and how they relate to each other. Chapter four explains why the case study research method was chosen, the design, data collection method and other topics relating to methodology.

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2 Literature review

It is first necessary to explain the broad spectrum of subjects that concern the main research question. In the first section, the venture capital market and various submarkets are discussed. This is followed by a section explaining the definition of a business angel, its role, and the possible investment strategies it uses. Thirdly, the matchmaking process between business angels and entrepreneurs is elaborated upon. This is done by illustrating credit rationing in the context of small start-up businesses. Then, possible solutions are given to solve information asymmetry using matchmaking initiatives like the Business Angel Networks (BANs). In the final section of the literature review, banks’ changing business models, and the reason for this change are explained. Finally, the question whether services can be of help for business angels or starting entrepreneurs is addressed.

The private equity market

Private equity funding is an alternative to traditional methods of funding, like a bank loan or bonds. This form of funding is used by companies which are not able to, or face difficulties in, attracting classic forms of funding. Private equity is often referred to as investments in listed and unlisted companies, accompanied by the active involvement of investors in these companies’ business activities (Tudor, 2013). These include investments in both young, fast growing (technology), and in mature companies. Private equity firms invest in companies in exchange for part of their share capital. Another essential feature of their investment is the expertise they offer (Figure 1).

Figure 1: Private equity activity (Tudor, 2013)

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The venture capital almost primarily is devoted to equity and, or equity related investments in young growing companies. The private equity is committed to investments that cover a wider range of development stages going beyond the venture capital investments, for example, management buyouts (MBOs) and turnarounds of established business.

2.1 Venture capital market

Venture capital can be defined generically as “the provision of finance by an investor to businesses that are not quoted on a stock market and which have the potential to grow rapidly and become significant businesses in international markets” (Mason & Harrison, 1999, p.15). Venture capital is characterized as an active, but temporary partner (five to ten years) for the companies in which it is invested. Another characteristic of venture capital is that the companies in which it is invested usually keep the majority of the shares (Landström, 2007). According to Landström (2007), the venture capital market can be divided into three segments: the institutional venture capital market, the corporate venture capital market, and the informal venture capital market. In the next three sections, the different segments are further elaborated upon.

2.1.1 Institutional venture capital

Institutional venture capital, also called formal venture capital, has been defined in many different ways. One of the definition is: “the institutional VC industry comprises full-time professionals who raise finance from pension funds, insurance companies, banks and other financial institutions to invest in entrepreneurial ventures” (Mason & Harrison, 1999, p. 16). Mason and Harrison (1999) state that institutional venture capital firm can take various forms, depending on the ownership structure. The forms generally concern:

 Independent limited partnerships. In this form, the venture capital firm serves as the general partner, raising funds from limited partners like banks and pension funds.

 Government venture capital organizations. This kind of organization is financed and controlled by government institutions.

 Captive venture capital firms. These firms are generally funded using the internal resources of a parent organization. This parent organization is often a financial institution, like a bank, but occasionally it is a larger non-financial company.

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Bygrave and Timmons (1992) made a distinction between two types of venture capital which can be helpful to exemplify the differences:

 Classical venture capital funds. In this type of fund, capital is raised from patient investors, for example wealthy families and individuals. These fund managers have entrepreneurial experience and knowledge of different industries and invest in early stage companies. Investors actively participate in the companies in which they invest.

 Merchant venture capital funds. The institutional sources from which they raise capital are characterized by short-term investment horizons. The funds are managed by people with a financial background. This type of fund invests in a company at a later stage or undertakes (MBOs). Investors focus strongly on analytical and financial engineering.

Because institutional investments in venture capital have been, and still are, growing in dominance, merchant venture capital funds haven taken over at the expense of classical venture capital in both Europe and the US. In Europe, the venture capital market is often used interchangeably with private equity market in a more general sense and includes investments in starting companies, but also management buyouts. On the other hand, in the US the term venture capital is more narrowly used and refers to investing in early stage companies (Bygrave & Timmons, 1992).

2.1.2 Corporate venture capital

A considerable part of the institutional venture capital market is the corporate venture capital market. This market can be defined as “equity or equity-linked investments in young, privately held companies, where the investor is a financial intermediary of a non-financial corporation” (Maula, 2001, p. 9). When comparing the definitions of the institutional and corporate venture capital market, it can be concluded that the main difference is the fund supplier. The limited partners for the institutional venture capital markets are actors like pension funds and wealthy families, and for corporate venture capital the only limited partner is a corporation.

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of this start-up to other investors and potential customers. This can eventually give an extra stimulus to the return on investment.

The second characteristic of corporate venture capital investment is the extent to which the investing company’s current operational capabilities (i.e. its resources and processes) are linked to the young companies in which it invests. For example, a young company with strong connections to its investing company has the possibility to use their production lines, technologies and distribution channels. Of course the company’s own operational capabilities can become a disadvantage on occasion, for instance when the company is facing new markets or disruptive innovations. The young company can offer the investing company the opportunity to construct new and different capabilities, even ones that may endanger the viability of current corporate capabilities. Accommodating these new capabilities in a discrete legal entity protects them from possible internal efforts to undermine them. If the young company performs well, the investing company can decide to adapt its own processes to the processes used by the young firm, or even to buy the entire venture (Chesbrough, 2002).

2.1.3 Informal venture capital

The third source of venture capital, according to Landström (2007), is the informal venture capital. The previous sections explain the institutional and corporate venture capital market and form a solid basis for the present work. In this section, a core subject of this thesis is introduced, namely the informal venture capital market. From here, the thesis focuses on the informal venture capital part of the venture capital market. The informal venture capital market, and specifically the business angel market, is discussed in this section.

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they may want to remain anonymous. Figure 2 shows an overview of the actors in the informal venture capital market, and the generally accepted definitions for each.

Narrow definition

Broad definition

Business angels

High net worth individuals who invest a proportion of their assets in high risk, entrepreneurial companies with the potential of a high return (Freear, Sohl & Wetzel, 1994). Next to investing money, business angels contribute their

commercial skills, experience, know-how and network. Business angels take an active role in the young company.

Informal investors

Includes private individuals who invest risk capital directly in unquoted

companies to which they have no family connection (Mason & Harrison, 2000). Therefore, informal investors include both business angels and private investors who contribute relatively small amounts of money and do not take an active role in the young company.

Informal investors, including family and friends

Defined as any investment made in young starting companies, other than the

investors’ own businesses. These include family investments, investments by friends, family and fools, but exclude investments in stocks and mutual funds (Reynolds, Bygrave & Autio, 2003)

Figure 2: General definitions (Landström, 2007)

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competence was measured by the educational background, and both professional and entrepreneurial experience (years of experience, self-employed and educational background). The empirical findings of the study point out the notable differences that exist between the four identified groups of informal investors. The most striking differences are the information sources used in the decision process, the level of involvement in the investments, the investment horizons and the co-investment behaviour. This means that entrepreneurs in need of long-term competency-rich owners should pursue the category ‘business angel’, but the company should be aware that the more active an investor is, the more involvement he or she would like in the company. Figure 3 presents the different types of investors.

Figure 3: Categorization of informal investors using four initial clusters (Sorheim and Landström, 2001, p358)

1) ‘Lotto investors’ are characterized by a low investment activity and low ability to found and manage entrepreneurial companies. As a result these investors make very few informal investments and have limited knowledge and skills that would add value to the companies in which they invest.

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3) ‘Analytical investors’ are characterized by a low level of investment activity, with relatively high competence. These investors are called ‘analytical’ because they possess a considerable degree of competence, but are either unable or unwilling to commit themselves to serious investment activity in the informal venture capital market.

4) ‘Business angels’ are characterized by a high level of investment activity and possess a high level of competence. Business angels can contribute both skills and knowledge to the companies in which they invest. In general they invest in many informal investments.

After discussing the three segments of the venture capital market it is possible to determine the similarities and differences between institutional venture capital, informal venture capital and corporate venture capital (Table 2). In Table 2 the three segments of venture capital market are described on the basis of five characteristics. Now it is possible to describe the differences and characteristics of the informal venture capital market compared to the institutional venture capital market and the corporate venture capital market.

1) The first characteristic is the source of funds used for funding. Informal venture capital is money from the investor himself, whereas institutional and corporate capital is raised from formal companies like pension funds, banks and corporate funds.

2) The legal form of informal venture capital also differs from the institutional and corporate venture capital market. The informal venture capital investors are private individuals, in contrast to the institutional capital ventures which are controlled by limited partners. On the corporate venture market, the young firm often has the same legal form as the corporate venture. An advantage of the legal form of informal investors is that they are often less costly structures (Aernoudt, San José & Roure, 2007).

3) The third is the motive for investments. All venture capitalists have some form of financial motive, but there are other reasons as well. The corporate venture capital investors can have a strategic reason and the informal venture capital investor can be motivated by intrinsic rewards. 4) The fourth characteristic seen in Table 2 is the investment. This characteristic is divided into three

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of the informal venture capital market, and the business angel market, as they were supplying smaller amounts of funds for companies in the early stages (Mason & Harrison, 2000; van Osnabrugge & Robinson, 2000). The last sub-characteristic is the level of due diligence research. A due diligence research is a total scan of a company. The due diligence research includes a scan of the financials, legal status, permits and other legal issues. Compared to institutional and corporate venture capital investors, informal venture capital investors have limited time to conduct a due diligence research, or lack the capacity or means to perform a due diligence research. On the other hand the institutional venture capital investors have to be thorough in the due diligence research for their fund providers. Because informal investors are not under such pressure and they often participate in the company in which they invest the due diligence research can be less thorough (van Osnabrugge, 2000).

5) The last characteristic is monitoring, which is much more informal for the informal venture capital investors than at the institutional and corporate venture capital investors. This is also a result of the limited time the informal venture capital investor has, and the fact that informal investors often actively participate in the young company.

Characteristics Institutional venture

capital Business angels

Corporate venture capital

1. Source of funds

Primarily institutional investors who act as limited partner

Investing their own money

Investing corporate funds

2. Legal form Limited partnership Private individual Subsidiary of a large company

3. Motive for investment Equity growth Equity growth Intrinsic rewards

Strategic and equity growth 4. Investment Experienced investors Large investments capacity Extensive due diligence Experience varies Limited investment capacity

Limited time for due diligence Experience within industry/technology Large investment capacity Extensive due diligence

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2.1.4 Conclusion

This chapter seeks to answer the following sub question: “How is the venture capital market

organized, and what is the position of a business angel in this market?”

Venture capital itself is part of the private equity capital market. This market is used by companies which are not able to, or face difficulties in attracting classic forms of funding. The venture capital market itself can be divided into three segments: the institutional, the corporate and the informal capital market. A segmentation of the venture capital market can be made on the basis of five characteristics, form which the source of the funds, is the most distinctive, because it shows that an informal investor or business angels invests with his or her own money instead of using limited partners or corporate funds.

The informal capital market is not defined in a uniform way, caused, among others, by the general wish from the informal investor to remain anonymous. This makes it hard to identify the different actors on the market even causing the use of definitions of informal investors and business angels interchangeably. The informal capital market is heterogeneous and it has different kinds of investors. The group of investors with a high investment activity and high competence are called business angels. In order to further explain the definition of a business angel, their role, and heterogeneous character of the business angels market the next chapter will be dedicated to those issues.

2.2 Business angels

In the previous segment the informal capital market was described as a part of the venture capital market and it was explained that the business angels are a part of the informal capital market. This segment will interpret the existing research on business angels. First, the definition of a business angel is presented. This is followed by a discussion on the role of a business angel based on the work of Avdeitchikova (2008). Third, the investment strategies from a business angel perspective are described by Lahti (2011a) using two approaches for reducing agency problems. This segment is concluded possible investment barriers for business angels based on the work of Mason and Harrison (2002).

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The definition of Mason and Harrison (2008) serves to better understand business angels and their activities. According to the authors a business angel is:

A high net worth individual, acting alone or in a formal or informal syndicate, who invests his or her own money directly in an unquoted business in which there is no family connection and who, after making the investment, generally takes an active involvement in the business, for example, as an advisor or member of the board of directors (p. 309).

This is in accordance with the ‘narrow’ definition used by Landström (2007) (Figure 2). There are several reasons why business angels are important:

1) They are responsible for the supply of the largest external early-stage risk capital (Wetzel, 1987; Sohl, 2003; Mason & Harrison, 2000).

2) They don’t have the same amount of transactions costs of other venture capital investors. As a result business angels are capable of making smaller seed and start-up stage investments.

3) Venture capital funds are less geographically dispersed than business angels. The latter tend to invest locally in companies within 50-100 miles of their hometown (Harrison, Mason and Robson, 2010). As a result the local region of the business angel benefits from the investment, helping to retain and recirculate wealth within the region in which it was generated.

4) The money from informal venture capital investors is often referred to as ‘smart money’. The reason for this is that the business angel, a part of the funding, wants to actively participate in the young company sharing entrepreneurial knowledge, experience and network for the benefit of the company in which he or she invests.

2.2.1 Role of business angels

Avdeitchikova (2008) developed a categorization somewhat similar to the one developed by Sorheim and Landström (2001) (Figure 4). Avdeitchikova (2008), however, also makes a separation in the financial and the knowledge, or human capital, which are related dimensions of resource contributions in the informal venture capital market environment. According to earlier studies, young entrepreneurial companies in the seed and start-up stages face two big resource shortages, namely a shortage of financial capital (capital gap or funding gap) and human capital (knowledge gap).

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acquire other types of financing (Lumme, Mason & Suomi, 1998). Notably, these young companies often require relatively smaller amounts of funding than established companies. Yet institutional venture capital companies are not interested in investing because the small investments are not attractive enough in terms of profitability to be worth the effort. In the early stages of a company, knowledge and involvement are very important because the company needs to acquire sufficient knowledge for the early development stages, before it has assembled its own knowledge base (Sapienza, 1992). Furthermore, the extent of the capital and knowledge gap possibly faced by a starting company depends on the complexity of the industry, the initial resources required in the specific sector and, finally, the initial resource base of the company.

As a result of variations in resource requirements for companies and the different levels of contribution in financing and knowledge delivered by the informal investor, four roles can be distinguished (Figure 4):

1) ‘Micro investor role’ refers to when the investors’ contributions are low on both levels.

2) ‘Capital-oriented role’ is characterized by an individual who invests a large amount of financial resources in a start-up company rather than by the contribution of any human capital resources. 3) ‘Knowledge-oriented role’ describes an investor who is actively involved in the activities of the

start-up company he is investing in, but with a low financial contribution.

4) ‘Classical business angel role’ is defined as investors who contribute large amounts of both financial resources and human capital resources. Often referred to in the literature as ‘smart money’ (Mason & Harrison, 1994).

Figure 4: Different investment roles (Adapted from Avdeitchikova, 2008)

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what the investor is able or willing to supply are the main factors influencing the role a venture capital investor plays in a company. On the other hand, the needs of the portfolio company also have an impact on the role a venture capital investor plays, as companies in the early stages and active in a highly innovative sector tend to receive more human capital support than companies in other phases or sectors (Sapienza, Amason, & Manigart, 1994). The background of the investor influences the role he or she plays in the portfolio company. Venture capital investors with a financial background place more emphasis on their financial role, while investors with more business experience prefer to contribute non-financial resources to their portfolio companies. Politis (2008) reviewed different studies that analyzed the value-added activities provided by business angels and attempted to categorize them at the aggregate level. These roles are:

Sounding board/strategic advice role

In this role, business angels provide strategic advice to the entrepreneur based on their own professional experience and expertise. Business angels can fill this role in various ways, such as helping with formulating a business strategy, reflecting on ideas, enhancing the available management resources in the company, and foreseeing how to realize value creation in the company. Business angels seem to possess unique personal capabilities developed throughout their own careers, which enable them to combine a wide arrange of competencies to generate ideas and creativity for the benefit of the entrepreneurial company. In theory, the supply of business knowhow and management expertise can be linked to resource-based theory, where a company’s resources and capabilities are essential for creating sustainable competitive advantage. Resources and capabilities are critical to building competitive advantage and realizing high returns, but small companies often lack these resources. The unique capabilities often possessed by a business angel can be considered a key strategic resource for the company, one that is neither perfectly imitable nor easily to substitute and, in this perspective, of great value.

Mentoring role

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Supervision and monitoring role

In this role, the emphasis lies on the protection of the investments of the main resource-providers of the company from potential misbehavior of the entrepreneur. The common way to exercise this role is by instituting proper accounting information systems and by serving on the board of directors of the portfolio company. This will enable a business angel to oversee everyday business, protect company assets and hold the managers or entrepreneur accountable for his actions in order to maximize profits. The supervision and monitoring role can be linked back to agency theory, because business angels can provide added value though their involvement in supervision and monitoring because these activities help to reduce potential information asymmetries, and reduce agency costs.

Resource-acquisition role

Business angels can add value by acquiring resources for a company through their own networks. This can be related to activities like providing essential business relations, and fundraising. These activities developed by a business angel can be helpful when unexpected opportunities arise in the marketplace, because the company will be better able to take advantage of them. The resource acquisition role can be linked to the resource dependency perspective, which stresses that the success of a company is dependent on its ability to contact external resources. The access to the personal network of the business angel can also bring legitimacy to the young company and give access to important resources.

Legitimacy role

Legitimacy is not recognized by Politis (2008) as an individual role, but Festel and De Cleyn (2013) consider it as such. More and more researchers recognize that the importance of attracting funding goes further than supplying resources, advice and contacts. For example companies active in the high-tech sector do not have the same possibilities for accessing funding, given their more limited credibility (Becker-Blease & Sohl, 2007). The risks associated with a startup, particularly the absence of a previous track record hinders an objective assessment. New companies that succeeded in attracting external funding from a business angel of other venture company gain credibility and legitimacy. The reputation and legitimacy of the investor can act as a quality label of sorts (Chang, 2004). Furthermore, the investment serves as a source of legitimacy, but the ongoing relation with the investor acts as an extra source of credibility and legitimacy, which ensures new resource acquisition from follow-up investors.

2.2.2 Investment strategies business angel

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categorizing business angels, aiming not at the investor, but on the investment as a basis of their research. It is important to recognize that not all business angels have the same investment strategy. They can spread the risk in their portfolio by deploying different investment strategies, so it is important to understand the factors influencing their choices. Lahti (2011a) used two approaches for reducing agency problems to eventually come up with two dimensions dividing business angel investments, namely ‘the comprehensiveness of their due diligence’ and ‘the level of involvement in the investee business’ (Figure 5).

The due diligence phase is the time it takes to reduce the risk of uncertainties about the quality of the investment opportunity. In section 2.1.3, which deals with informal venture capital, due diligence is explained based on the work of Van Osnabrugge (2000). The description of due diligence by Lahti (2011a) is in line with this explanation, but there are a few additions. For example business angels are more interested in the risks associated with entrepreneurship and management. In contrast, venture capital investors are more focused on market risks in investment decisions. Because startup companies, generally the preferred investment option by business angels, lack sufficient information to perform an investment analysis, business angels tend to rely more on the characteristics of the entrepreneur and their own intuition. The due diligence phase helps reduce the agency problems of adverse selection by establishing the characteristics of the entrepreneur in the pre-investment phase.

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Figure 5: Categorization of angel investments using four initial clusters (Adapted from Lahti, 2011a)

Cluster 1: Gambles

Both comprehensiveness of due diligence and involvement are low. This means that the business angel had limited attention to managing risks both in the pre and post-investment phase. The name of the cluster already refers to the gamble taken, because information asymmetries are not effectively reduced. This cluster includes the business angels who lack the competence to fill the information gaps both in the pre and post-investment phase.

Cluster 2: Conventional angel investments

In this cluster, the investments are most in line with the business angel style of investing. The business angel relies on his or her intuition to assess the investment opportunity (low comprehensiveness of the due diligence). This is compensated by gaining active post investment involvement in the company.

Cluster 3: Due diligence-driven investments

In this cluster, the focus lies on due diligence (pre-investment) rather than active involvement (post-investment). Information asymmetries are reduced before the investment is made to ensure that no funds are invested in low quality companies. This style of investing is in line with venture capital investments.

Cluster 4: Professionally safeguarded investments

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2.2.3 Barriers to invest

The study by Mason and Harrison (2002) clarifies that the informal venture capital market is an important source of financing for unlisted companies, and that there is an enormous investment potential. However business angels experience different constrains which limit their ability to invest as frequently or as heavily as they would wish. Therefore, it is important to identify the different barriers and try to lower or remove them.

A way to structure the discussion of potential barriers for business angels’ investment is in terms of the three key stages in the investment decision-making process proposed by Mason and Rogers (1997), namely screening, evaluation and negotiation. When screening an investment opportunity, a business angel first tries to find out if it meets their own personal investment criteria, if there is a ‘fit’. When he has found an opportunity that satisfies his investment criteria the business angel then proceeds evaluate the intrinsic quality. The last stage in the investment process is the negotiation on the terms and conditions of the investment.

Investment criteria

The research by Mason and Harrison (2002) shows that business angels have clearly defined investment criteria which influence the type of companies in which they are willing to invest. Examples of these investment criteria are industry, stage of business development, technology, and location. The types of company business angels are primarily interested in are established companies seeking (early) expansion financing; they show much less interest in companies in need of start-up financing or seed staged companies. The main barrier is that business angels may not find enough companies that meet their investment criteria, and are unwilling to adjust these criteria because they are reluctant to invest in unfamiliar industries and markets.

Quality of investment opportunities

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Failure to negotiate

A final reason why a business angel does not invest as frequently as he might is that he fails to negotiate an agreement with the entrepreneur that is acceptable to both. The main areas where a lack of agreement occurs are price or the shareholder structure. The barrier is the failure of the business angel and the entrepreneur to negotiate acceptable terms and conditions.

2.2.4 Conclusion

This chapter seeks to provide answers to the following sub question: What do (starting) entrepreneurs

and business angels look for in each other?

When researching why an entrepreneur wants to find and collaborate with a business angel, many articles quickly refer to the need for capital as the main reason. Avdeitchikova (2008) differentiates between financial, and knowledge or human capital dimensions of resource contributions in the informal venture capital market environment. Starting companies face a shortage of capital (capital gap), but also experience a shortage of human capital resources (knowledge gap). Thus these companies face a resource gap derived form a shortage of financial and non-financial resources. To establish the possible role of a business angel two characteristics are important, namely those of the venture capitalist, and those of the portfolio company. In order to overcome their shortages, the companies need to find suitable business angels. However, to realize a match both parties need to overcome different barriers. Possible solutions to lower these barriers are described in the next section.

2.3 Matchmaking

In this section the matchmaking process between business angels and entrepreneurs is discussed. First, credit rationing in the context of small start-up businesses is illustrated. Then, possible solutions are proposed to solve the asymmetry on the basis of the matchmaking initiatives like Business Angel Networks (BANs).

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2.3.1 Credit rationing

In a marketplace, the price of a product or service is determined when the quantity supplied equals the quantity demanded. When the demand is higher than the market is offering, prices rise. When too much is offered in the market, prices drop. This encourages consumers to buy more, and additional suppliers are lured into the market. When a market is functioning properly, the demand will always be satisfied, because the price will balance the needs of consumers and suppliers. Capital can also be a product on the market and, as noted before, entrepreneurs, especially those with start-up companies, complain that they have difficulty finding the capital they need to satisfy their financing needs. If entrepreneurs who are denied capital are willing to pay more for capital but are refused, credit then appears to be ‘rationed’ from an apparently finite supply of capital, a phenomenon called credit rationing (Stiglitz and Weiss, 1981).

There are different theories about how situations can lead to credit rationing, and this situation could have the following consequences:

 Entrepreneurs who do not have access to financing and as a result face obstacles in their development and survival.

 It can disadvantage companies whose competitors belong to industrial groups or are owned by larger companies that have better access to capital.

 Non optimal levels of investment; this in turn affects economic growth, inflation, employment, and other factors.

2.3.2 Information asymmetry

Theories about credit rationing are based on information asymmetries between lenders and borrowers. The relation between lender and borrower is also referred to as the principal-agent relationship. It refers to the differences between the information available for the company in need of capital (agent) and the supplier of capital (principal) who is usually assumed to have an informational disadvantage compared to the insiders of the company (Scholtens, 1999). Two direct aspects of informational asymmetry are usually identified: adverse selection and moral hazard.

 Adverse selection occurs when the entrepreneur or the management team has more information about the company or a project and, for example, this information is not shared with a potential external supplier of capital. When this occurs, the supplier of capital cannot assess the true value of the company or project and therefore can only offer average terms. This can result in high quality firms neglecting external financing, discouraging investments.  Moral hazard refers to the difficulties faced by an external supplier of capital to control the

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contracts that discourage borrowers from acting against the interest of the lender. These precautionary measures can lead to credit rationing.

Furthermore, the costs made by the capital provider to verify and monitor the performance of the companies can lead to credit rationing. For a small company, information asymmetry can occur in two main ways, (Schmitz, 2002):

 The ‘hidden information’ which occurs when one party in a transaction has relevant information which is not available to the other party. An example in the bank-company context can be that the company has certain information, but has a motive to misinterpret the information in its favor. The possibility of benefiting from access to the information can lead to a higher entrance of ‘low quality’ projects to the market. Because banks lack information to assess the quality of projects, they are faced with the option of raising interest rates on all loans. As a result, the ‘high quality’ projects will exit the market because they think interest rates are too high, leaving the banks with ‘low quality’ projects (adverse selection).

 Also, there is a chance that, after signing a contract, the company will not act as agreed upon in the contract; this is called ‘hidden action’. There is a possibility that the company may act out of self-interest, even when it has adverse effects on the bank (moral hazard).

2.3.3 Matchmaking initiatives

An attempt to reduce the imperfections in the informal capital market, primarily the invisibility issue and the fragmented nature of this market, as well the lack of proper communication channels, has resulted in a variety of matchmaking initiatives, supported through the efforts of both the private and public sectors. The aim of these services is to bring entrepreneurs and (potential) investors together. Nath (2010) suggests four initiatives for reduce the different gaps between the business angel and the entrepreneur.

Business Angel Network

A Business Angel Network (BAN) is defined by the European Business Angel Networks (EBAN) as “national or regional, local, commercial or industry sector organizations set up to promote means of introduction between small and medium sized enterprises and private investors with entrepreneurial experience (business angels)” (EBAN 2010, p. 2). In order to reduce the market inefficiency and to stimulate potential business angels, the EU has attempted to spread the concept of BANs since the late 1990s. According to Knyphausen-Aufseß and Westphal (2008) BANs that try to serve start-ups and business angel have two main goals:

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venture capital market. It also attempts to ensure a sufficient number of matches for the business angel and starting company. Media used to facilitate the contacts are internet, magazines, or fora. 2) Arrange a pre-selection process to ensure that only sufficiently qualified partners meet.

In addition to the two main business goals stated by Knyphausen-Aufseß and Westphal (2008), Gullander and Napier (2003) recognize additional services initiated by BANs:

- Creating awareness for the business angel and the role he plays in the innovation systems. By doing this, new and existing business angels will be attracted to joining BANs, attract entrepreneurs, and therefore make the business angels less invisible to other parties, such as entrepreneurs;

- Fostering a higher understanding of the role of business angels, together with the forming of BANs, which will result in the professional development of business angels;

- Providing legitimacy of the business angels entering the BAN. This is realized through the internal rules of a BAN, like ethical guidelines;

- Arranging deal flow;

- Increasing the option for forming syndications;

- Giving assistance to business angels and entrepreneurs; - Arranging training for both business angels and entrepreneurs.

Knyphausen-Aufseß and Westphal (2008) conclude that BANs are failing to add sufficient value to business angels and starting entrepreneurs with their services, because:

1) They lack a unique selling proposition. There are other players on the capital market, like banks or accountants who offer the service of matching contacts free of charge, because of the nature of their business relationship (business angels are very important customers).

2) The advantage of mobilizing and selection services that are generated by a closed marketplace such as a network are not convincing when compared to the same services offered in the open market. One of the differences between an open and closed market is that an open market has no pre-selection of entrepreneurs and the closed market does. Knyphausen-Aufseß and Westphal (2008) state that the transparency of the closed market influences the terms and is disadvantageous to the business angels, making it unattractive for business angels to participate.

3) Consulting services generate insufficient value added relevant to the starting companies, and business angels do not generate sufficient demand for consulting services. This can lead to incorrect assignments.

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information, a goal achieved by putting together the information possessed by the different business angels. Thus, it is possible for business angels to deliberately look for co-investors to share the risk and each other’s knowledge (Nath, 2010). Syndication is growing in popularity for different reasons. Firstly, the solo capability of a business angel is limited. Secondly, syndicated groups of business angels invest more in early-stage companies than solo business angels. Thirdly, the best way to learn the essentials of informal investing is by co-investing with an experienced investor. By doing so, latent business angel capital is also activated (Aernoudt et al., 2007).

Co-investment schemes

Co-investment schemes have been developed, among others, with the objective of encouraging the development of the business angel market. It can help to fill a financing gap by providing extra capital. This type of financing of an entrepreneurial company is usually done in the form of loans or equity. Public sector contributions of capital often match the capital provided by the business angel (CSES, 2012). Some are not open to use public money, tax money, to help business angels, but it should not be forgotten that not all business angels are wealthy, and the best way to avoid business angels leaving an investment is stimulating them to spread the risks in their portfolio. If no other investor is ready to take over the investment of a business angel, this will lead to the concentration of financial means in only a few projects, with high portfolio risk for the business angel. If some of these projects go bankrupt the business angel could lose the money invested, and as a result a part of these business angels will stop their investment activity (Nath, 2010). By setting up co-investment schemes the business angels will be stimulated to invest.

Integrated finance approach

The integrated finance approach is a concept that aims to reduce the cost of financing for start-up companies, and others. The approach tries to reach its goal by pro-actively analyzing the expected financing needs in the performance of a business plan or project. It tries to get conditional offers from different capital providers against performance achievements. An investor can therefore commit himself, in theory, to an investment at a given point in a company’s development. As a result this may offer comfort to a business angel who is asked to fund early stage investments to a company.

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components may not be competitively priced (Nath, 2010). Companies and entrepreneurs can only be successful at exploiting the potential of the integrated finance approach if they are very well prepared.

2.3.4 Critical factors to the success of matchmaking services

Harrison and Mason (1993) suggest three factors they believe are critical for the success of matchmaking services. First, it is necessary to build a large database of investors and entrepreneurs as clients. This would help promote the visibility and credibility of such networks in a general business environment. Moreover, business angels’ individual preferences are diverse; therefore, the probability of such an individual investing in a specific venture is small, but a large database would help increase the chances. Getting enough input for creating such a large database is challenging. Business angels have shown limited interest in systematic referral services, compared to entrepreneurs. To build up a large database and attract business angels, it is necessary to offer them incentives like lower registration fees.

Furthermore restrictions like passwords are used in the databases to guarantee the anonymity of the business angels. Another point of conflict is the geographic coverage of the network. As mentioned earlier, business angels favor a regional service, but entrepreneurs are interested in having access to as many business angels as possible. The preference of the business angels is to invest regionally, because they know the area, and can oversee and participate in the running of their investments. A possible solution for these contradictions between business angels and entrepreneurs is a nationwide network built from regionally based networks. Second, it is necessary for the service to have good resources, because it is unlikely that it would be self-sustaining. Services are therefore dependent on public sector support and sponsorship. Research suggests there is a direct correlation between funding and the number of business angels and entrepreneurs recruited into the service (Harrison & Mason, 1993).

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Figure 6: The standard matchmaking process (Gullander & Napier, 2003) 2.3.5 Actions for the matchmaking services

The main action that must be performed by matchmaking services is preparing the entrepreneurs for investments by helping them to cope with the investment criteria used by business angels (Mason & Harrison, 2002). The two most important criteria are the quality of management, and the market potential of the opportunity. Addressing these two criteria could significantly reduce the level of rejection by business angels. Entrepreneurs need to find out what they want from a business angel and, before approaching potential business angels it is of utmost importance that they put together good management teams. For example, different investment structures could be used to attract different groups of business angels. Considerations here include, among others, the size of the investment, the duration, and the type of the investment vehicle (debt, common stocks or preferred shares). Entrepreneurs who do not have the required capabilities in their management teams should try to find professional help for drawing up the investment plan.

An important job for matchmaking services is identifying people with characteristics similar to those of business angels, but who are not yet participating in the informal capital market. These people are also referred to as ‘virgin angels’. The number of virgin angels is far higher than the number of business angels. Roughly 71 percent of virgin angels are open to invest in the informal venture capital market (Freear et al, 1994). As a result, the informal venture capital market is potentially far larger than its present size. The question arises how that potential group of business angels can be stimulated to actually invest in the informal venture capital market. The research done by Mason and Harrison (1993) shows that 50 percent of virgin angels state that the inability to identify companies requiring finance as the major reason why they have never invested in entrepreneurial companies. Other reasons were the high risks involved, concerns about possible exit routes, and the lack of expertise in the valuation of the possible investments. Mason and Harrison (1993) also asked the virgin angels what would stimulate them to enter informal capital market. The top three most cited factors were personal knowledge about the management team (risk factor), the supply of information about companies in search of finance by a trustworthy source (risk factor), and tax incentives (which will be explained later). Setting up matchmaking programs to stimulate virgin angels should try to address these concerns. Possible solutions could be referral services that help business angels to identify possible investment opportunities. Workshops would help equip the business angels with the necessary skills and information as well as with experienced business angel mentors who could assist the virgin angels

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take their first steps in the informal capital market. Furthermore, prior screening of investment projects by referral services can give virgin angels a certain level of comfort.

It is important to stimulate business angels to invest and reinvest in companies. This can be slowed down by high capital gains tax in two main ways. First, it reduces the enthusiasm of investors to realize their maximum added value. Then, it decreases the amount of realized added (financial) value that goes into the pockets of the business angel. The reduction of the tax on informal investments in the US is one of the main reasons for the spur in rapid growth of the formal venture capital market (Wetzel, 1983). Similar reductions could have the same effect on the informal capital market and by doing so attract virgin angels to become active angels. (Freear et al., 1994).

2.3.6 Conclusion

This chapter attempts to assist in answering the following sub question: How do information

asymmetries occur in the matchmaking process between business angels and entrepreneurs?

Credit rationing might arguably oblige companies to seek capital elsewhere because they are not able to obtain debt capital. A possible solution is equity financing provided by business angels. This would particularly be the case for smaller, riskier companies, suggesting equity financing from business angels may not be a matter of choice. Theories about credit rationing are based on information asymmetries between lenders and borrowers. Information asymmetry occurs in two main ways: ‘hidden information’ and ‘hidden actions’. To reduce these risks, collaterals and covenants are used by external capital providers. Other options to reduce information asymmetry in the matchmaking process are matchmaking services or initiatives. A BAN is an example of a network that provides, among others, matchmaking services for bringing companies and business angels together. To date BANs and other services have not proven to be effective in overcoming the information asymmetry in the matchmaking process. The main reason why BANs are not effective is that they lack a unique selling proposition and other players on the capital market offer the service of matching contacts free of charge. One such player is a bank, mainly because business angels are an attractive target group for them. In the next section the possible contribution of banks in the business angel market is described, both from a bank and a market perspective.

2.4 Banks

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