Musings on Entrepreneurship and Innovation
Saturday, April 16, 2005It's Not Who You Know, It's Who Trusts You
Informal, private investors ("angels") typically invest in situations where:
- There is a high degree of uncertainty regarding the development of the venture over time;
- The aptitude and intentions of the entrepreneur can't be gauged accurately; and
- Time and financial constraints inhibit extensive due diligence.
Transaction cost economics and agency cost theory suggest that interpersonal trust and detailed contracts are substitutes in such situations. In other words, theory would suggest that a high degree of trust between an investor and an entrepreneur would increase an investor's tolerance for contractual ambiguity up front.
The granting or withholding of trust between individuals is contingent upon the expectation that the trustee will not behave opportunistically, especially when there are substantial incentives to do so.
In the context of angel investing, does a high level of trust mitigate the need for detailed contractual safeguards? As a co-founder of a new venture, it's a highly relevant and extremely pragmatic one for me, as the answers may well influence our funding strategy.
At one end of the spectrum, a high degree of trust seems to be a substitute for complete contracts: friends and family money tends to be invested, more or less, on a handshake. At the level of professional venture capital, contracts tend to be more sophisticated (see the term sheet series by Brad Feld at Mobius), but there is also a marked tendency toward optimal parochialism as a means to enable frequent trust-building and reinforcing interactions.
Nevertheless, a study of real world investor behavior reaches some seemingly mixed conclusions regarding the degree to which trust and contracts can substitute for each other in the context of angel investing. The study's authors found support for the following hypotheses:
- The greater the level of relevant industry experience of the entrepreneur/team relative to that of the investor(s), the more comprehensive the contractual deal struck ex ante. On the one hand, investors like the entrepreneur to have relevant industry experience. On the other hand, the perception of differences in relative expertise can undermine trust.
- The more effective active involvement in the venture development process is viewed by investors as a means for managing risk, the more comprehensive the contractual deal struck ex ante. That surprised me. A classic prescription for incomplete contracts is to be in the position to constantly observe agent (i.e., the entrepreneur's) behavior. The authors' (quite plausible) explanation is that "Rather than being viewed as a protection mechanism per se, contractual safeguards appear to be a means by which mutual expectations of all parties to the transaction can be clarified."
- The higher the equity stake retained by the inventor, the more comprehensive the contractual deal struck ex ante. This seems right. If the entrepreneur/management team retains a relatively small equity stake, the opportunity cost of acting opportunistically in a way that is detrimental to the investor(s) goes down, thus increasing the potential value of more complete contracting to the investor(s).
What was particularly interesting was that the research data resulted in the authors' rejecting the hypothesis that the greater the level of trust between the investor and entrepreneur, the less comprehensive the contractual deal struck ex ante. Not only did the researchers' analysis find any measurable direct impact between trust and contractual deal between investor and entrepreneur, there weren't any moderating effects on other measured variables. (I'll return to the issue of trust below.)
Even so, the researchers found strong support for the hypothesis that "If the opportunity has been referred on by a source that is both trusted by the investor and who has personal knowledge of the proponents involved, the less comprehensive the contractual deal struck ex ante." In fact, a key conclusion of the research was:
"Which investor to approach" appears to be not nearly as important an influence on the structure of the contractual deal as "how to approach them." This study has highlighted the importance of making the approach through a referral source that knows you and whose opinions and judgements are trusted by the investor. The key question for entrepreneurs when deciding how to approach is not "who do you know" by rather "who trusts you."
So, trusted referrals not only serve as a useful screen for prospective investors, they can also benefit entrepreneurs by mitigating the cost and difficulty of trying to craft a comprehensive investment agreement at a time when there are many, many uncertainties about how the future will unfold.
That conclusion makes sense to me and is consistent with my experience. But, I'm not so sure about the author's presumption of a high degree of a priori trust between angel investors and entrepreneurs. ("We have reason to believe that the relationship between private investor and entrepreneur is infused with a high degree of interpersonal trust from the outset.") I strongly suspect that angel investors and entrepreneurs tend to have a high propensity to trust, but I tend toward the view of Luis Luna-Reyes and his colleagues* when they distinguish propensity to trust (on the trustor side), trustworthiness (on the trustee side), and trust (a willingness to be vulnerable). "Trust is learned and reinforced, hence a product of ongoing interaction and discussion." Most active entrepreneurs aren't rich, nor do they have wealthy friends and family. Consequently, angel investors tends to be friends-of-friends or even friends-of-friends-of-friends. In such cases, how much a priori trust can there be between an angel and an entrepreneur?
The research cited above leads its authors to question the applicability of transaction economics and agency theory in the context of angel investing. I think that their conclusions may be premature. For what it's worth, here is what I suspect may be true:
- Angel investors have a propensity to trust, but most often don't have the experiential basis to have a high degree of trust with entrepreneurs at the outset. Consequently, the validation of an entrepreneur's trustworthiness by a third party is important.
- Notwithstanding the factors that inhibit complete contracting at the early stages of a venture, a key value of negotiating investment documents may derive from the ensuing alignment of expectations and the clarification of roles.
- Investors tend toward a "trust but verify" posture. Consequently, investment contracts tend to reduce obvious sources of agency risk (e.g., the company's ability to engage in acquisitions, divestitures, and issue debt and equity; non-compete clauses) and construct appropriate incentives (e.g., future funding contingent upon meeting performance benchmarks; equity linked compensation). Furthermore, investors do care about geographic proximity and social affinity - factors that influence the opportunity for the frequent interactions that will confirm or disconfirm the trustworthiness of the entrepreneur over time.
When it comes to raising money for your new venture, having lots of LinkedIn contacts may help. But, there is a limit to the number of contacts who can truly trust you. They are the ones that matter the most.
*See "Knowledge and the Development of Interpersonal Trust: a Dynamic Model" in Proceedings of the 37th Hawaii International Conference on System Sciences - 2004.
