Question a
Venture Capital’s (VC) strategies are to establish majority share ownership in the small businesses. As stated, they target small businesses that cannot raise funds and invest in them, providing capital, and claiming shares. The strategy indicates that they end up owning a more significant fraction of the shares in every company, and thus, conflicts of incentives arise.
The incentive conflicts between VC and the managers arise from the division of interest that the managers (who run these companies but have a relatively smaller share in the business) and VC have. The principle conflict arises from the disparity in the shares held. The agents to this conflict are the VC firms and the managers to the small companies. The managers have a reduced interest to work harder to realize more profits and are likely to keep their efforts to the minimum that secures their jobs and keeps the businesses running, but not to make more profits (since the benefits are obligatorily divided according to the shareholdings).
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Question b
The component of ‘managers maintain some ownership in the company and often earn additional equity if the company performs well’ accentuates the conflict in the sense that the managers have relatively low levels of ownership, despite the additional equities provided, which translates to relatively lower incentives. Managers are driven by self-interest, which aims to maximize their utility. By VC owning much of the shares, and are absent at management, the additional equity provided is less likely to be motivational factors. By VC demanding a seat on the board yet, it is not part of the management, the VC is overstepping its boundaries and is likely to be accused of micro-managing their investments. Managers have the broader mandate of running the company and maximize the value of the firm, but this is sounder when they have a considerable amount of shares. Unless the management and VC agree on a fair compensation package, their conflicts will continue to spiral.
