etp-vc in emerging markets networks and institutional change_etp2006

Venture Capital inEmerging Economies:Networks andInstitutional ChangeDavid AhlstromGarry D. Bruton

Emerging economies are characterized by fundamental and comprehensive institutionaltransformations as their economies begin to mature. How venture capitalist functions inenvironments that differ so fundamentally from those of the mature markets where venturecapital was initially developed has only begun to be addressed. This article builds a frame-work to further the understanding of venture capital practice in emerging markets. Specificattention is focused on the impact of networks in the model, in particular, how networks andother informal institutions can act to supplement or replace formal institutions when they areweak. The article goes on to examine what the implications are for venture capital and therole of informal institutions in emerging economies as formal institutions become moreestablished. The research and resulting model is grounded in 65 semistructured interviewswith venture capitalists in emerging economies around East Asia. This article contributes tothe literature by drawing attention to the impact of networks and changing institutionalenvironments on venture capital during different phases of an economic transition processin emerging economies. The findings have implications for understanding institutionalimpact on venture capital activity as well as entrepreneurs and entrepreneurial ventures thatseek venture capital financing in emerging economies.

Introduction

High-growth potential businesses have typically relied on financing from sourcesother than traditional lenders such as banks during their early growth phases. In the moredeveloped economies of the United Kingdom, Canada, and the United States, venturecapitalists have filled this gap by providing capital to early stage ventures with goodgrowth potential (Wright & Robbie, 1998). The availability of such capital has helped topromote the emergence of numerous high-growth firms in the United Kingdom, UnitedStates, and several other developed economies. This has led many to conclude that venturecapital is a crucial factor in fostering a regions economic growth (Jeng & Wells, 2000;Saxenian, 1994). More recently, venture capital has started to reach into emerging econo-mies have encouraged the establishment of their own venture capital industries (Bruton,

Please send correspondence to: David Ahlstrom, e-mail: [email protected] at The ChineseUniversity of Hong Kong, Department of Management, Shatin, N.T., Hong Kong.

PTE &

1042-2587 2006 byBaylor University

299March, 2006

Ahlstrom, & Yeh, 2004; Lockett & Wright, 2002). This has proved to be a challenge asmany emerging economies are undergoing significant economic transition and offer littleprotection for either investors or private property (Peng, 2001). Such an ambiguousenvironment adds to the already difficult task faced by venture capitalists in the selectionof firms to fund and monitoring those investments effectively (Bruton & Ahlstrom, 2003;Pruthi, Wright, & Lockett, 2003).

Venture capitalists count on a stable institutional regime with a predictable rule of lawand enforcement regime to facilitate and safeguard their investments (Cardis, Kirschner,Richelson, Kirschner, & Richelson, 2001). In addition to legal stability, venture capitalistslook for environments with efficient markets for corporate control and capital, whichreadily allow exit from ventures as well as systems with minimal corruption (Wright &Robbie, 1998). This institutional stability and predictability reduces uncertainty and risk,and enhances the likelihood of success in new ventures.

Institutional stability is largely unknown in most emerging economies. Instead,emerging economies such as those of China and Russia are known for their unpredict-ability, volatility, and uncodified institutional environments (Meyer, 2001; Peng, 2000).Startup firms in emerging economies share the liability of newness that all new firms have(Stinchcombe, 1965) but have the added risk of being domiciled in environments that areunpredictable and volatile, where property rights are uncertain, and markets for goods andcapital are in a very nascent stage (Bruton & Ahlstrom, 2003; Lockett & Wright, 2002).

How do venture capitalists make and manage investments under such unsettledconditions with little protection of private property? Much past research emphasizesventure investments made in relatively stable institutional regimes (e.g. Busenitz, Fiet, &Moesel, 2005). Thus, much is not known about how venture capital functions in environ-ments lacking in many formal institutions that venture capitalists expect.

While important to venture capitalists everywhere, network connections amongentrepreneurs, venture capitalists, and enterprises may play a greater role in helpingventure capitalists navigate the challenging environment in emerging economies. Theydo this by partially substituting for weaker formal institutions such as the market forcorporate control and the rule of law (Butler, Brown, & Chamornmarn, 2003; Peng,2003; Hoang & Antoncic, 2003) and offering some protection from government inter-ference (Henisz, 2000, 2003). Previous empirical evidence has suggested the importanceof networks in East Asia for entrepreneurship as a whole (Butler et al., 2003). There isalso research on venture capital that considers, among other things, the function ofnetworks in emerging economies in East Asia (Bruton, Ahlstrom, & Singh, 2002; Brutonet al., 2004; Bruton, Dattani, Fung, Chow, & Ahlstrom, 1999; Lockett, Wright, Sapienza,& Pruthi, 2002), India (Wright, Lockett, & Pruthi, 2002), and China (e.g., Ahlstrom,Bruton, & Chan, 2000; Bruton & Ahlstrom, 2003). The present study expands on thatexisting literature and suggests that venture capital can still function in spite of a lack offormal institutions such as laws, regulations and enforcement. It also implies that socialnetwork ties, including those of venture capitalists, can help substitute for the formalinstitutions present in the Anglo-American system and take on more importance in theemerging market setting.

This article examines the venture capital function in a cross-section of East Asianeconomies in seeking to understand how venture capitalists manage the unpredictabilityinherent in emerging economies. Although not identical, there are a number of similaritiesamong the emerging economies of East Asia (Burton, Butler, & Mowday, 2003), particu-larly in terms of their nascent institutional development and dependence on informalinstitutions (Bruton et al., 2002). We pay particular attention to how venture capitalists usenetworks to substitute for the lack of formal institutions such as the rule of law, accounting

300 ENTREPRENEURSHIP THEORY and PRACTICE

standards, and an enforcement regime. The focus is on how institutions impact venturecapitalist actions in emergent markets.

This article also examines the controversy on whether the relational content of venturecapitalists transaction structures will decrease as the institutional environment becomesmore developed and formalized (Guthrie, 2002; Shane & Cable, 2002), or remain highlysocialized (Wank, 2002). This article thus investigates the role that networks play inventure capital in emerging economies and how venture capitalists expect this to changewith continuing economic development. These findings have implications not only forventure capital and how it may differ in emerging markets today, but also for the broaderissue of how venture capital and other entrepreneurial activities will be impacted in thefuture as institutions become more formalized in emerging markets.

To accomplish this, we first examine institutional theory as it relates to networks andventure capital in emerging markets. Second, the data gathering and analysis employinga grounded theory approach is described. The article will then examine the specific impactof the institutional environment present in certain emerging economies and how venturecapitalists manage this inherent unpredictability often through the use of social networks.Finally, implications for theory, practice, and future research are discussed.

Need for New Theoretical Perspectives

The past understanding of the venture captial process was built primarily on agencytheory, with some input from stewardship theory. There are, however, increasing questionsabout the ability of these theories to provide a full theoretical base for understandingventure capital and its application across a range of environments (Ahlstrom et al., 2000;Arthurs & Busenitz, 2003). While providing some insight, these theories do not fullyrepresent the social nature of venture capital, particularly in settings outside of the moredeveloped economies (Bruton et al., 2002; Shane & Cable, 2002).

The emphasis of agency and stewardship foundations and lack of focus on networksin venture capital stands in contrast to their application to the entrepreneurship domain(Hoang & Antoncic, 2003). Some early work by Bygrave (1987, 1988) proposed thatnetworks were important for U.S. venture capitalists. Recent resesarch by Shane andCable (2002) and Stuart, Hoang, and Hybels (1999) supported this view by examiningventure-funded entrepreneurs using samples of large numbers of venture capital-backedfirms and a variety of other companies. Additionally, fields such as sociology (Sorenson& Stuart, 2001) and geography (Powell, Koput, Bowie, & Smith-Doerrs, 2002) haveaddressed the role of networks in venture capital and attest to their importance. Overall,although there is a wide acknowledgement that networks can have an impact on venturecapital financing even in mature markets, the reliance on agency and stewartship theorieshas not encouraged the specific examination of such networks in different venture capitalsettings.

Networks and InstitutionsWhile agency and stewardship theory do not emphasize the role of networks in

venture capital, there are other theoretical foundations that can be used to examine thedomain which add to the insight about venture capital activity in emerging markets.Institutional theory specifically adds social and cultural elements that help provide a moresocialized explanation about how networks in an institutional context impact the function

301March, 2006

of venture capital (Scott, 2002). Institutions are conceptualized as the rules of the gamein a society (North, 1990). They are subtle but pervasive, and strongly influence thegoals, and beliefs of individuals, groups and organizations (North, 1990; Scott, 2002).

Scott (2002), building on prior research efforts (DiMaggio & Powell, 1991; North,1990), more finely categorized formal and informal institutions into normative, regulatory,and cognitive groupings. The most formal are the regulatory institutions. These representthe standards provided by laws and other sanctions. Normative institutions tend to be lessformal, and they define the roles or actions that are expected of individuals. Normativeinstitutions often manifest through accepted authority systems such as accounting ormedical professional societies. Sometimes they are codified; other times they are under-stood practices of a profession or work function. Finally, cultural-cognitive institutionsrepresent the most informal, taken-for-granted rules and beliefs that are established amongindividuals through social interactions among various participants and guide behavior.A principal means by which cultural-cognitive and less formal normative institutionspropagate and influence a society is through a communitys culture (Jepperson, 1991;Scott, 2002).

The organizing scheme of institutions proposed by Scott (2002) of regulatory, nor-mative, and cultural-cognitive institutional pillars is not without controversy (e.g., Hirsch& Lounsbury, 1997). However, it has been widely used and has proved helpful foranalytical purposes and will be used here also. Additionally, the conceptualization ofinstitutions as formal or informal is also useful for describing environmental settings anddiscussing differing institutional effects and is employed here.

In venture capital, it is thought that certain institutions common to the industry willlead to a general uniformity in venture capitalist behavior (Fried & Hisrich, 1994).Institutions have an impact on the formation of goals and the processes of venture capitalfirms (Wright, Thompson, & Robbie, 1992). However, as we begin to examine venturecapital, there would appear to be a more finely grained set of institutions that need to beconsidered directly and from the perspective of very different institutional regimes.

The reason for this is that organizations are embedded not only in the institutionalarrangement in their industry but also in country-specific institutional settings (Busenitz,Gomez, & Spencer, 2000). The institutional differences in countries extend beyond basicdifferences in culture to fundamental elements of a nations laws and regulations, enforce-ment, business norms, and commercial traditions (Kostova, 1997; Orru, Biggart, &Hamilton, 1991). Institutions are typically situation specific; therefore institutional char-acteristics of a country should be evaluated with regard to a specific phenomenon ratherthan in terms of general arrangements (Busenitz et al., 2000; Orru et al., 1991).

Recent empirical evidence demonstrates that both organizational practices and rou-tines (Biggart & Guillen, 1999), and strategic choices (Hitt, Ahlstrom, Dacin, Levitas,& Svobodina, 2004) are influenced by institutional forces in the environment. Thus, itfollows that venture capital is also likely to be influenced by the local institutionalenvironment. If institutional differences in emerging economies mean that strategicdecisions operate differently, then traditional venture capital mechanisms may becomedifficult to implement directly without some modification (Bruton & Ahlstrom, 2003).This can also lead to differences in the function and use of networks in emergingmarkets.

Emerging Economies and InstitutionsInstitutional theory has much to say about managing in emerging economies (Henisz,

2003; Hoskisson, Eden, Lau, & Wright, 2000; Peng, 2002, 2003). Emerging economies


are rapid-growth countries that are reforming their economies to increase the number oftransactions governed by market forces. Moreover, institutional change in emergingeconomies differs from what one might expect in the West (Newman, 2000). Yet there isa lack of understanding of how firms should respond to these differing institutionalenvironments. Particularly, it is unclear how firms would respond to those environ-ments undergoing both internal and external reform, with a less codified institutionalenvironment.

There is some evidence that the operation of venture capital in emerging marketsshares some features with that in the more developed markets of the West, but that thereare also substantial differences (e.g., Bruton & Ahlstrom, 2003; Bruton et al., 2002;Bruton et al., 2004). Previous studies have examined specific countries such as China(Bruton & Ahlstrom, 2003) or Singapore (Bruton et al., 2002). These studies have foundthat while the model of venture capital in developed markets has relevance to the practiceof venture capital in emerging markets, little is known about how these models requirechange for emerging markets.

Emerging Economies and Networks

Because of the paucity of formal institutions in emerging markets, networks, thoughimportant to venture capital anywhere, take on increasing importance (Chen, 2001;Hoang & Antoncic, 2003). In large part, this is because the networks become a valuedtool to overcome the lack of other institutional structures (Peng, 2000). In an emergingeconomy where there is an environment with few enforceable accounting standards orlegal recourse, if something is not as promised, individuals rely on the interconnectionof individuals in networks and alliances to negotiate contracts (Meyer, 2001). Addition-ally, in such settings, since information dispersion is so inefficient and corruption islikely to be more prevalent, network connections can be more valuable to overcomesuch settings.

Some past research has suggested that networks play an important role in venturecapital in emerging markets. For example, Batjargal and Liu (2004) and Bruton andAhlstrom (2003) suggest that networks play an important part in Chinas venture capitalindustry both to help gather information and to substitute for key formal institutions suchas the rule of law. The exact nature of these networks and how they may change inresponse to institutions becoming more stable, with added regulations becoming morepredictable, the rule of law more reliable, and corruption lessened, has not been addressed.

Methods

This research will develop a model to explain the function of venture capital inemerging economies with a particular focus on networks. The model will also payattention to changes over time in the interactions in business and how that may impactnetworks. This model is founded on the well-supported assumption that emerging econo-mies tend to have less formal institutional structures and many institutional differencesfrom those of the more developed economies (Peng, 2000). This can create constraints aswell as some opportunities for venture capitalists operating in those environments (Bruton& Ahlstrom, 2003).

However, the model will also consider that as regulatory institutions become moreestablished, the firms reported performance is more likely to be reflective of its actual

303March, 2006

performance, because legal recourse is open to investors if the information they receive isnot accurate or other financial shenanigans occur. In addition, official corruption in suchsettings becomes more addressable through legal protections. Thus, it is possible that thereis a longitudinal process in emerging markets to move from a relationship-based trans-action structure that requires a network-centered strategy to a rule-based, impersonalexchange system of venture capital (Peng, 2003). This suggests that venture captial inemerging markets will migrate from being network centered to one that is more marketcentered over time. Thus, in addition to addressing potential change in venture capitalsettings, this model also identifies the critical points of transition and predicts strategicchoices for venture capitalists that must be made differently at these transition pointsbased on the institutional setting.

The model will be based on a grounded theory approach to data gathering to examineinstitutional effects on venture capital in emerging markets. Glaser and Strauss (1967)were the first to develop grounded theory, while subsequent work by Strauss (1987) andStrauss and Corbin (1990) has further systematized and widened its application. Ingrounded theory, extensive cases and qualitative information are purposively gathered sothat patterns of behavior can be determined. Although grounded theory has been usedregularly in sociology and anthropology, it has only recently been applied in organiza-tional research (Lee, 1999).

Research DesignThe foci of interest are how venture capitalists manage the unpredictability inherent

in emerging economies due to their underdeveloped institutional environments, withparticular attention given to their network association, whether that be with other venturecapitalist, entrepreneurs, or others in the environment. To explore this issue, multiplesources of data, including interviews with venture capitalists, were used. Other sources ofdata, including archival material about the venture capital firms and the venture capitalindustry in East Asia, as well as published stories about the venture capital firms and thefirms they funded, were also gathered. The research also involved multiple researchers toensure divergent perspectives (Eisenhardt, 1989).

A grounded theory approach to data gathering and analysis can be aided through thea priori definition of certain baseline concepts in the study (Strauss & Corbin, 1990). Asthe phenomenon under study is complex, exploratory in nature, and represents a conflu-ence of factors, qualitative data with content analysis proved to be the best approach todevelop a model of venture capital in East Asia (Lee, 1999). Yet the terms qualitative data,interviews and ethnographies, and case studies are often confused. Qualitative data are atype of evidence, whereas interviews and ethnographies are data collection methods, andcase studies are a type of research strategy (Yin, 2003). Case studies are appropriate toexamine: (1) contemporary or ongoing phenomena not divorced from its real-life context;(2) phenomena that are systemic in nature, with a number of forces acting upon the systemsimultaneously; (3) phenomena that are contextualized such that it is difficult to separatethe phenomena from their context, as can be done in an experiment (Yin, 2003; Tsoukas,1989). The still novel nature of venture capital and institutional influences in emergingmarkets is consistent with the exploratory nature of case-study investigations, facilitatedthrough interview data collection, coupled with content analysis of similar and dissentinganswers (Yin, 2003).

The venture capitalists to be included in the sample were identified from Guide toVenture Capital in Asia (2003). The authors conducted a total of 65 semi-structured,face-to-face in-depth interviews with 60 leading venture capital fund managers and five


government officials in Hong Kong, Taiwan, China, Singapore, Taiwan, and South Koreafrom 1999 to 2003.1 Such interviews were employed since the sensitive nature of the datareduced the likelihood that any method other than face-to-face interviews would beresponded to in emerging markets. Interviews were used in this research for four reasons.First, the venture capitalists often preferred face-to-face interviews to questionnaires.Second, in East Asia it is important to establish a relationship with respondents in orderto receive an accurate response, which also militates against using questionnaires. Third,interviews are less structured than are questionnaires as they allow the spontaneousdiscussion of problems and solutions and for follow-up questions on a topic with thedevelopment of recommendations (Lee, 1999). Interviews also permit iteration andfollow-up as required in grounded theory. Finally, as this is a new area of study andresearch site, the benefit of conducting in-depth interviews to develop a theoreticalunderstanding of such a domain is well established (Eisenhardt, 1989; Daft & Lewin,1990).

The interviews lasted from one hour to two and half hours. We followed a purposivesampling approach to the sample selection and subsequent follow-up (Lincoln & Guba,1985). Purposive sampling calls for selecting participants with specific characteristics(Lincoln & Guba, 1985). In this case, the effort was made to ensure that there was a rangeof firm sizes (large and small venture capital firms). Additionally, the authors ensured thatthere was diversity in the origin of the firms (locally founded as well as internationalventure capital firms). This helped to ensure that a range of investment focus by theventure capital firms (early and later stage investments) would be included in thedatabase.

The questions asked of the top management team of each firm were semi-structuredin that they provided some direction to the respondent but permitted additional openresponse beyond the basic question. The questions addressed primary venture capitalactivities and how they were actually undertaken. Top managers of each venture capitalfirm were asked similar questions focusing on the nature of the firms investment approachand participation in monitoring and managing funded firms. However, as the respondentsraised issues that provided rich insights, the discussion would then further pursue thoseparticular issues in depth. Other experts in the given field in which the venture capitalfirms competed were also interviewed. Additionally, printed material prepared by theventure capital firms and articles about the firm were also gathered and compared with theinterviews.

The semi-structured interviews were conducted, transcribed, and coded in a mannerconsistent with a grounded theory research design (Glaser & Strauss, 1967; Strauss &Corbin, 1990). Using this research design, researchers seek to examine a topic and buildtheory or new variable relationships through an iterative process of comparing data witha limited baseline framework or to completely new theory as it emerges from the data(Strauss & Corbin, 1990). After interview transcripts and key points were coded (Strauss& Corbin, 1990; Miles & Huberman, 1994, chap. 4), those codes were entered manuallyinto an open-coded database. The inventory of open codes (Strauss & Corbin, 1990) wasbased on the lines of inquiry established through exploratory interviews and categoriessuggested by institutional and network theory.

1. Sixty-five venture capitalists from 62 firms were interviewed in the emerging economies of East Asia.These included nine in Thailand, twelve in Taiwan, fourteen in Singapore, ten in Korea, two in China, andeighteen in Hong Kong. Most of the venture capitalists located in Hong Kong, Singapore, and Taiwan investedaround the region and not only in their own economies. The Hong Kong and Taiwan venture capitalists inparticular were active investors in mainland China.

305March, 2006

Once the core categories of venture capital activity had been identified and discussed,and elements of their implementation examined, comparison charts were developed foreach category. The coding database was revised and the codes were further refined toillustrate venture capital action, methods of implementation (e.g., of entrepreneurial firmselection), and differences from the developed market model. Possible causal relation-ships between variables suggested by institutional and network theories were noted onmemos, along with alternative explanations. These were also suggested to venture capi-talists in subsequent interviews, as is common in a grounded theory approach to the data.

Finally, once the categories of venture capitalist activity and their specific actions hadreached saturation, that is, after about 30 interviews, and no new concepts were emerging(though sometimes new stories and implementation ideas were), the resulting explanationcould be said to account for most of the reported behavior in the sample. Specifically, thevarious authors initially identified the key terms and patterns in the data independentlyalong the baseline dimensions of deal selection, due diligence, monitoring, value added tofunded firms, and exit as well as four concepts that emerged from the data and repeatedoften enough to warrant discussion. Then, the authors did comparisons on those patterns,with a focus on the similarities and differences identified by the various interview sub-jects. A graduate student that was familiar with the categories of venture capital activitybut was not part of the study aided in the identification of the patterns and any additionalconcepts. Reliability among the three coders (two authors and one graduate student) onidentifying categories was nearly 90%. The model that emerged essentially explores whatventure capitalists do in emerging markets under conditions of a weaker rule of law, ashorter history of venture capital-funded entrepreneurial firms and the limited legitimacyof private enterprise. The model also examines how venture capitalists respond to thesedifferences from the more developed economies through the specific implementation ofthese actions and why they do so. The categories of venture capital actions, key concepts,and areas of agreement and two areas of disagreement among the interview subjects arenoted and discussed. Short quotes from interview respondents are also included.

Results

The results from the interviews provide two broad outcomes. First, as expected, thedeveloped economy model of venture capital as commonly practiced in the United Statesand United Kingdom and that of the East Asian emerging markets studied have bothsimilarities and differences. They are similar in that the steps taken by venture capitalistsin both regions are the same. The four major venture capital activities of firm selection anddue diligence, structuring and monitoring the deal, value-added, and exit were emphasizedby all venture capitalists in the sample. In terms of differences, the venture capitalistssummarized these by stating that although the goals were fundamentally the same (returnfor their investors and the building of good companies), the path to achieving those goalsdiffered somewhat in emerging East Asia. For example, the selection of firms to funddiffered somewhat, and venture capital networks were particularly crucial. Venture capi-talists talked about the need to know (or know of) the friends and family of the entrepre-neur as part of the selection process. This would be added insurance that the entrepreneurcould not easily walk off with the venture capital firms cash (The Economist, 2004a). Thisparticular application of the venture capitalists network was quite familiar to venturecapitalists in East Asia but would probably not be common to venture capitalists in theUnited States. Several other implementation differences emerged. Specifically, venturecapitalists in our sample used networks to replace some of the formal institutions missing


in the emerging markets. Second, the results also suggest ways in which the practice ofventure capital appears to be influenced by changing institutions.

We will first explore venture capitalist: selection of firms to fund, structuring therelationship and monitoring the firm, value added, and exit from the venture, based ondiffering institutions in the two regions. The results, organized along the three main pillarsof institutional theory, are summarized in Table 1.

Selection of Firms to Fund in Emerging MarketsTwo of the key elements of picking which firms to fund in the Anglo-American model

are due diligence (Fried & Hisrich, 1994) and knowing of the entrepreneur (Bruton, Fried,& Hisrich, 1998). Venture capitalists operate differently in emerging markets. The relativeabsence of formal institutions such as laws and accounting standards results in a venturecapitalist having difficulty knowing whether proposed ventures are what they seem to beand not merely a vehicle for funneling money to an overseas account (The Economist,2004b). Given that emerging-market venture capitalists in our sample repeatedly men-tioned the importance (and difficulty) of finding competent and backable managers, it isno surprise that they relied heavily on close connections with entrepreneurs whom theyknew to ensure they had the necessary capabilities.

This reliance on relationships and their networks helps to overcome any shortcomingsthat result from the absence of formal institutions in the emerging economy. This mani-fests in two main ways. First, the initial screening of ventures to fund appears lessdependent on industry criteria and more on the entrepreneur associated with the venture,and with whom that entrepreneur was in turn connected. One influential venture capitalistin Southeast Asia observed:

For example, I love to do deals with people I have done deals with before. So you willfind that although we might have done sixty or seventy transactions over the years,they have not been done with sixty or seventy different entrepreneurs, they have beendone with twenty-five to thirty entrepreneurs. Many of them are repeat deals. Thebiggest risk in our business . . . is the people risk and when you do a repeat thing withthe guy you wanted to have a good experience with, you have eliminated what Iconsider the biggest risk in the businessthe people risk . . . I know that the chancethat this guy would rip me off and cheat me is probably less than [someone I do notknow] . . . because this guy has history with me.The focus on relationships in more developed markets such as that of the U.S. is also

present to some degree (Shane & Cable, 2002), but venture capitalists that have worked inboth East Asia and the United States reported that the reliance on networks in emergingmarkets appears to take a more central role than in developed markets due to the lack ofinstitutional supports in the former. Thus, rather than being one of multiple criteria that aidin selecting which ventures to fund, who the entrepreneur is and their potential affiliationwith a network of known individuals is a hurdle that all ventures must cross before beingconsidered or selected for funding in emerging markets.

The importance of networks manifests itself in a second key way. Not only is theentrepreneurs history with or connections to the venture capitalist important, but also theentrepreneurs connection to key government officials. Several venture capitalists in ourstudy mentioned the importance of the entrepreneur having government connections. Oneventure capitalist from a mainland China venture capital firm remarked:

On some deals, connections with [various levels of ] government are crucial. Theentrepreneur may need to get land, or permits to sell certain items, or a favorable

307March, 2006

Tabl

e1

Inst

itutio

nsan

dN

etw

ork

sin

Ventu

reCa

pita

lin

the

Emer

ging

Econ

omie

sofE

astA

sia

Inst

itutio

nsA

nglo

-Am

eric

ansy

stem

East

Asia

nem

ergi

ngec

on

om

ies

Net

wo

rks

and

thei

rapp

licat

ion

inem

ergi

ng-e

cono

my

ven

ture

capi

tal

Reg

ulat

ory

Stro

ngle

galf

ram

ewo

rk,

tran

spar

ent,

and

wel

l-reg

ulat

edfin

anci

alm

arke

tsan

def

fect

ive

corp

orat

ego

ver

nan

cesy

stem

;w

ithst

rong

prot

ectio

nfo

r

insti

tutio

nali

nves

tors

and

min

ority

shar

ehol

ders

(Frie

d&

Hisr

ich,

1995

;Sap

ienz

a&

Gup

ta,1

994).

Lega

lsys

tem

and

corp

orat

ego

ver

nan

cem

echa

nism

sar

e

rela

tivel

yw

eak,

buts

eem

tobe

mov

ing

tow

ard

Ang

lo-A

mer

ican

stan

dard

s,al

thou

ghat

diffe

ring

rate

s.R

epor

ting

stan

dard

sten

dto

bem

ore

lax

,cr

oss

hold

ings

are

pres

ent,

mo

rein

sider

con

trol

ofi

nfo

rmat

ion,

and

flex

ibili

tyo

fins

ider

actio

nba

sed

on

finan

cial

s.

Ven

ture

capi

talis

tsin

ou

rst

udy

poin

ted

ou

ttha

tthe

lega

lsys

tem

sar

ou

nd

East

Asia

,tho

ugh

impr

ovin

g,w

ere

still

lack

ing

inpr

oper

pro

tect

ion

for

inves

tors

.Se

ver

alven

ture

capi

talis

tspo

inte

do

utt

hatE

astA

sian

cou

rts

wer

en

ota

rem

edy

ope

nto

them

.Thi

sw

astr

uen

oto

nly

for

Chin

a,w

here

the

lega

lsy

stem

isst

illin

an

asce

nts

tage

,bu

talso

for

Hon

gK

ong

and

Sing

apor

e,w

here

Brit

ishCo

mm

onLa

wis

still

prev

alen

t.Th

ere

aso

ngi

ven

isth

atit

isbe

ttert

oso

lve

con

trac

tual

con

flict

san

do

ther

prob

lem

sou

tsid

eo

fthe

cou

rts

topr

eser

veo

ne

sco

nn

ectio

nsan

dre

puta

tion,

parti

cula

rlyam

on

gth

eover

seas

Chin

ese

busin

ess

com

mu

nity

aro

un

dth

ere

gion

.N

orm

ativ

ePr

ofe

ssio

nals

tand

ards

play

an

impo

rtant

role

inco

nfin

ing

busin

ess

activ

ities

(Frie

d&

Hisr

ich,

1994

).

Prof

essio

nals

tand

ards

play

anim

porta

ntro

lein

defin

ing

ven

ture

capi

talp

ract

ice.

Ven

ture

capi

tala

sso

ciat

ions

hold

trai

ning

and

enco

ura

gece

rtai

nbe

hav

iors

.Sim

ilar

educ

atio

nalt

rain

ing

asU

.S.

ven

ture

capi

talis

ts.Ve

ntu

reca

pita

lists

repo

rted

that

they

are

som

etim

esbr

ingi

ngn

ew

no

rms

ofb

ehav

iort

oth

em

anag

ers

off

un

ded

firm

sby

insis

ting

on

pro

fess

iona

lsta

ndar

dssu

chas

that

cert

ain

acco

un

ting

prac

tices

beu

phel

d,re

gard

less

ofl

ocal

law

s

and

cust

om.

Ther

ew

asge

nera

lagr

eem

entt

hatt

hepr

ofe

ssio

nals

tand

ards

of

Ang

lo-A

mer

ican

ven

ture

capi

talis

tsw

ere

anid

ealt

obe

purs

ued

and

wer

e

reas

on

ably

uph

eld

inEa

stA

sia.V

entu

reca

pita

lists

and

gover

nm

ento

ffici

als

inth

eEa

stA

sian

eco

no

mie

sbo

then

cou

rage

dven

ture

capi

talt

rain

ing

con

siste

ntw

ithth

eA

nglo

-Am

eric

anm

ode

l.So

me

ven

ture

capi

talis

tsdi

ssen

ted,

how

ever

,st

atin

gth

atth

ere

aliti

eso

fem

ergi

ngec

on

om

ies

inEa

stA

siare

quire

dth

atven

ture

capi

talis

tsth

emse

lves

beha

ve

diffe

ren

tly.

For

exam

ple,

they

poin

ted

ou

ttha

titw

asim

porta

ntfo

rthe

mto

mo

nito

rfirm

s

ver

ycl

osel

yan

dpl

ace

thei

row

nm

iddl

em

anag

ers

(notju

stto

pm

anag

ers)

inth

ela

rger

inves

tmen

ts.

Cultu

ral-c

ogni

tive

Stro

ngem

phas

iso

nin

ves

tor

and

shar

ehol

derr

ight

s.Pr

evio

usre

latio

nshi

pca

nbe

impo

rtant

un

ders

om

eco

ndi

tions

.U

nder

soci

aliz

edv

iew

ofv

entu

rein

ves

ting

isco

mm

on

lyac

cept

ed(A

rthurs

&B

usen

itz,2

003).

Stro

ngin

fluen

ceo

fover

seas

Chin

ese

com

mer

cial

cultu

rein

mu

cho

fem

ergi

ngEa

stA

sia.C

ultu

ral-c

ogni

tive

insti

tutio

nala

spec

tssu

chas

the

use

and

mai

nten

ance

of

guan

xin

etw

ork

sar

ever

yim

porta

ntto

ven

ture

inves

ting.

Mai

ntai

ning

harm

ony

with

inan

dbe

twee

no

rgan

izat

ions

cou

pled

with

the

lack

ofd

isclo

sure

ofi

nfor

mat

ion

take

s

prim

acy

over

ase

nse

ofo

blig

atio

nto

inves

tors

.Tha

tm

ean

sit

may

bedi

fficu

ltfo

rw

eake

rm

anag

ers

or

supp

liers

tobe

repl

aced

.

Mos

tven

ture

capi

talis

tsin

the

stud

yag

reed

that

they

try

toge

tto

know

the

prin

cipa

lso

ffu

nde

dfir

ms

wel

las

part

ofd

uedi

ligen

cepr

oces

s.O

neven

ture

capi

talis

tadd

edth

atgu

anxi

was

less

help

fuli

nse

curin

gfu

ndi

ng,b

uti

twas

a

nec

essa

rypa

rto

fmo

nito

ring

the

firm

.For

exam

ple,

man

yven

ture

capi

talis

tsev

enem

phas

ized

the

impo

rtanc

eo

fkno

win

gw

hoth

efri

ends

and

fam

ilyo

fth

een

trep

rene

urar

eso

asto

prov

ide

anex

tra

mea

sure

ofm

on

itorin

g.G

over

nm

ento

ffici

als

poin

ted

ou

ttha

tgua

nxiw

asle

ssim

porta

ntin

secu

ring

fund

ing

asth

ebu

sines

sm

ode

lsn

eede

dto

beat

trac

tive,

butt

hey

did

no

tco

mm

ento

nth

em

on

itorin

gpr

oce

ss.

Ven

ture

capi

talis

tsad

ded

that

know

ing

gover

nm

ento

ffici

als

supe

riors

inCh

ina

can

prov

ecr

uci

alat

times

.


ruling from a government official. In the legal systems around Asia, governmentbureaucrats tend to have more power than in the U.S. In the U.S. system, the courtsmake a lot of decisions. Around Greater China, it is the government officialsandthey are usually local officialsthat are most influential . . . and even for certain keyfirm functions such as personnel management, venture capitalists and the funded firmmust carefully consider the government factor.Although emerging markets are commonly thought to be all about who you know,

some limits to the use of connections and networks also emerged. Most venture capitalistsin the study were quick to point out, for example, that although connections with gov-ernment officials and the military (in certain countries such as Thailand or China) wereimportant, they were quite hesitant to structure a whole deal around someone in politicaloffice. A Singapore venture capitalist summed up venture capitalists concerns regardingpolitically connected deals:

[W]e try not to do deals that are politically centered . . . The minute someone comeswith a deal that says he has a special angle because in China my brother-in-law is themayor of this province, I just get a glaze over my eyes . . . As long as your politicalmentor remains in that position, sure, its probably a good thing to have him there butthe problem is, in politics, people dont last forever and the minute the politicalmentor loses his position, its not that you just lose your political mentor, but youactually inherit all of his or her enemies.The venture capitalists felt that it is important to have connections to open doors,

obtain information, locate markets, and better secure the investment, but they must beacquired and used judiciously, particularly with regard to government or military connec-tions. Thus, although networks are important and can be a substitute for many missingformal institutions, there are limits to what they can do.

Structuring and MonitoringStructuring and monitoring the funded firm is also impacted by the differing institu-

tional regimes in emerging markets. In developed markets such as those of the UnitedStates and United Kingdom, legal institutions such as codified laws and regulations, thecourts, and the enforcement regime create a powerful role for the board of directors of afirm (Sapienza, 1992). This is utilized by the venture capitalist when funding the firm toensure that they have a significant role in the board of the firm. The venture capitalist alsotypically places strong covenants in the funding agreement that limit the actions ofentrepreneurs (Fried & Hisrich, 1995). For example, typically removing key officers in thefirm may be limited without approval of the board. These actions will normally beenforced without incident.

By contrast, in emerging economies, legal institutions are generally flimsy. To illus-trate, the role of the board of directors and corporate governance are weak (Young, Peng,Ahlstrom, & Bruton, 2002) and are not a robust way to monitor firms in much of East Asia(Low, 2002; Young, Ahlstrom, & Bruton, 2004). Several venture capitalists stated that itis not uncommon for firms to develop and actually circulate meeting minutes as if theboard had met when in fact no meeting had occurred. Others added that firms would holdtheir board meetings at home in the evening and would not give the venture capitalistinvestor enough notice to attend.

Given the limited corporate governance mechanisms, venture capitalists must oftenemploy a network of contacts to monitor the firm properly. For example, a venture

309March, 2006

capitalist may have weak ties to a previously funded firm. However, if the venturecapitalist knows that the given individual is part of a network he or she can hire someonefrom that network to assist in the monitoring process. Thus, the funded firm may not beworried about being fully forthcoming with the venture capitalists, but they would notwant to destroy their relationships with the given network by not being fully forthcomingwith them. Therefore, the monitoring process may be easier for the individual or firm hiredthan it would be for the venture capitalist.

Although boards are not very powerful in the emerging markets of East Asia, that doesnot mean that venture capitalists do not use the board. Venture capitalists in our studyindicated that they usually secure one to two board seats on funded firms. Several venturecapitalists in the sample also mentioned that they tried to place someone from theirnetworks on boards, both for information and to influence decisions.

Through these sources the venture capitalist were able to monitor their investmentsreasonably effectively, although it took more time and effort than in the West. The need forsuch monitoring, however, is greater in East Asia due to problems with the rule of law. Asa result, venture capitalists report that they must watch over the firm more carefully,sometimes employing junior staff to do this. One Singapore venture capitalist withextensive experience around East Asia and in mainland China recalled:

If you are not quite vigilant, your assets will walk out the door. We had a wholefirm full of equipment vanish on us. In another firm we were working with, theentrepreneur absconded with all the money, the saleable assets, and even thecompany car. One manager we know of went further than that; he secretly sold allof a funded joint ventureeven the part that the local investors did not ownto agovernment department [in China]. In another funded venture, the guy borrowedmoney under the company namea lot of itand disappeared. He left everythingbehind, including his family and slipped out of the country completely. We havelearned you must have people on the ground near your investment in East Asia,especially China. In Singapore, it is a lot tougher to disappear completely, becauseit is a small place. But in other East Asian countries, it is easier; the laws and courtsare of little help.

The venture capitalists interviewed generally indicated that they continued to rely onrelationships with the funded firm and key connections with the government, local lawofficials, lawyers, and judges to further aid in the monitoring process and in legal matterswith the firm. This network of relationships provided them with improved and timelyaccess to top management and other key individuals and to more reliable information.Sometimes a ready network was acquired by hiring someone with connections to manysuch officials in the legal professions. Such relationships are also helpful with assessingambiguous and poorly codified information, which is important in early stage monitoring(Aoki, 2001).

Value AddedThe venture capitalist in mature markets typically seeks to add value to the funded

firm (Zider, 1998). It is this value added that is believed to be one of the critical aspectsof the success of venture capital-backed firms in mature markets such as the United States.However, as noted above, the official role of the venture capitalist is limited in the fundedfirm in emerging markets. There may or may not be a board seat for the venture capitalist;any formal covenants in the funding agreement are also likely be limited and difficult to


enforce. The prevalence of family business in the emerging economies of East Asia is alsoa factor with which venture capitalists contend.

In developed markets, the ability of the venture capitalist to aid the funded firm comesfrom the fact that venture capitalists are readily able to replace the chief executive officer(CEO) of the funded firm and enforce other directives. However, several venture capital-ists from East Asia that were interviewed mentioned that entrepreneurs would ignore thewishes of the venture capitalist and disregard decisions of the board. If the entrepreneurhad the backing of the employees and other local stakeholders, it could be very difficultfor venture capitalists to receive compliance with their recommendations. In East Asia, ifthe venture capitalist seeks to remove the firm founder, there can be a strong backlashfrom the workforce or society. One venture capitalist from Thailand commented:

Although the [Thai] government has made many attempts at reform in the formallaws, the system changes very slowly. People here will not follow the laws they do notagree with. Sometimes they defy them outright as in the case of TPI [Thai Petro-chemical Industries] here, in other cases they will just stonewall. They will say yesyes yes but then they wont do anything. If you want to remove a guy for not doinghis job, or violating an agreement he made with you, it will be difficult, particularlyif he has a lot of family in the firm, or has built up a loyal workforce.

Venture capitalists with experience in China mentioned similar difficulties. In addi-tion, most of the venture capitalists added that the ability to attract future ventures forfunding will be negatively impacted if CEOs are removed from their funded ventures. Thenetwork of the entrepreneur can rally the support of their relatives or friends, and not theventure capitalist that funded them. The difficulty in replacing the CEO is compounded bythe weak legal environment, which may make it very difficult to replace the CEO in atimely manner even if the venture capitalist has majority control of the firm. Therefore,there is a strong tendency for venture capitalists to not replace a CEO of a funded venture,even in economies where this is easier such as Singapore and Hong Kong, but to generallytry to work with that CEO is a face saving manner, however difficult that may be.

The result is that there are limits on certain ways venture capitalists can add value totheir investments. Nevertheless, network asociations can be quite useful on balance. Afirm founder may not take advice from the venture capitalist, but he or she may be willingto do so from peers or individuals seen as his or her senior. Therefore, the venturecapitalist is able to use those relationships with the network to subtlely push the fundedfirm in the desired direction.

The use of networks to add value to the funded firm is consitent with the importantcultural-cognitive institution of minziface (respect). The venture capitalists also pointedout that the process by which advice is given can be very important. Sometimes it is bestto give advice on the side and let the CEO disseminate the information to the staff. In thisway, the manager can remain in charge and take credit for the changes if successful, orcan blame the venture capitalist if unsuccessful (Chen, 2001).

ExitThe last key aspect of venture capital is exiting the deal (Sahlman, 1990). The ability

to exit funded ventures is severely constrained in emerging markets in East Asia. Theability to list a firm is limited. There are several NASDAQ-type share markets in East Asiaincluding new growth equity markets in Hong Kong, Singapore, and Taiwan. Thesehave had very limited success creating funding opportunities for fast-growth firms, and

311March, 2006

investors have proved skittish about committing much money to the firms that did securelistings on these markets. Thus, a major source of exit for venture capitalists is still thestrategic purchase of the funded venture. International firms looking for new technologyor entry into a new market can be a major source of such international purchases. Aventure capitalist from Singapore recalled:

With careful attention to firm and government connections, venture capitalists outhere [in East Asia] will be able to package strategic sales of firms, provided financing,debt coverage and customer relations have been well managed. Venture capital staffmust keep a close eye on these issues because they can get out of hand. Some venturecapitalists and private equity specialists maintain a rather fraternal relationship withthe entrepreneur, but sometimes they dont want to call the loan back from an Uncle[an individual with whom they are connected]. This can create problems as well.Local purchase of a funded firm often comes from large firms that are somehow

knowledgeable of the entrepreneur or of individuals in that entrepreneurs network. Thiscan also facilitate the putting together of business groups that are quite common in muchof East Asia. Several venture capitalists in our sample also pointed out that the lack of amarket for corporate control in the East Asian economies also hindered the ability ofventure capitalists to exit their investments in a timely fashion. Several venture capitalistsalso mentioned the problem of the lack of enforceable bankruptcy codes, which hamperedtheir efforts to participate in restructuring efforts in the emerging economies under study.No venture capitalist was particularly sanguine about the prospects for developing suchmarkets and codes around East Asia, although some progress has been made in Singapore,Hong Kong, and Taiwan in terms of bankruptcy laws. China and Thailand lag consider-ably behind in terms of the latter.

This article contributes to the literature by drawing attention to the impact of changinginstitutional environments on venture capitalist strategic choices during different phasesof an economic transition process in emerging economies. It brings particular attention tothe role of networks in this transition. The findings have implications beyond venturecapitalists to what is unique about entrepreneurs and entrepreneurial ventures that seekventure capital financing. Therefore, the article concludes with the discussion of how thisperspective can be applied to understanding the value added to these various stakeholdersof the venture capital industry in emerging economies.

Discussion

The developed-economy model of venture capital as commonly practiced in theUnited States and United Kingdom has both similarities and differences with those ofemerging East Asia. They are similar in that the steps taken by venture capitalists in bothregions are the same. They differ in that although the goals of venture capitalists in bothdeveloped and emerging markets were fundamentally the same, the path to achievingthose goals somewhat differed.

Venture capitalists in our sample generally used networks to substitute for formalinstitutions such as the rule of law and enforcement regimes not yet well established inemerging markets. Emerging economies in East Asia represent a conundrum for venturecapitalists. The formal institutional development has not kept up with the headlongrush toward economic development (Peng, 2000, 2003). Informal institutions are veryimportant in substituting for formal institutions such as laws, regulations, and enforce-ment mechanisms that are not yet in place (Peng & Heath, 1996). The result is that while


more formal institutions are slowly being created to fill gaps in emerging economies, thereare still many domains of an economy where there are few formal institutions in place.Experienced and successful venture capitalists from the region regularly reported that theyemployed informal institutions such as their networks with entrepreneurs and governmentofficials to help manage their funded firms. The parties to the transaction may not be ableto rely on formal institutions to select, monitor, add value to, and exit from their invest-ments, but the informal institution of personal relationships helps to ensure that thetransaction involves what it is alleged to and that there will be the fulfillment of anyagreement between the parties.

Changes in the AirIn the future, however, it can be expected that more formal institutions will be

introduced and will take hold at varying speeds, whether they be rather sudden, such as inRussia and Poland, or more gradual, as in China (Hitt et al., 2004). Even countries suchas China and Thailand, where the rule of man (as opposed to the rule of law) is still quitestrong, changes toward codified and consistently applied rules have been gradually occur-ring, although reform will take some time (Ahlstrom, Young, & Nair, 2002; Backman,1999; The Economist, 2004a). Thus, in the future it is expected that as institutions becomemore formal, venture capitalists will come to rely more on these formal institutions andless on informal institutions such as personal relationships and networks (Guthrie, 2002).

The evidence gathered here supports the view that institutions are becoming moreformal. A number of venture capitalist with extensive experience in the region commentedon the increasing value of accounting data that were generated and their increasingreliance on board membership to add value to the firm. Venture capitalists are actuallyhelping this along, functioning as institutional entrepreneurs (Ahlstrom & Bruton, 2001;DiMaggio, 1988). Venture capitalists mentioned several ways that they were introducingchange to their institutional environments. One method is that venture capitalists havefound ways to unofficially import U.S. venture capital law to their countries. For instance,venture capitalists in Taiwan stated that they are using California law to draft contracts forlocally funded firms. They asked firms to adhere to U.S. law on intellectual property.When Taiwanese firms perform reverse engineering, they are asked to follow strict legalprotocols and standards of reverse engineering and product design and development.Singapore lawyers working in the venture capital area reported something similar withU.K. laws. One venture capital that funded firms primarily in Taiwan commented:

We ask firms to sign contracts that are consistent with California law and the contractsused there. Our courts [in Taiwan] recognize the validity of such contracts and userelevant law and even previous U.S. cases as guidance and for interpretation.Although we need more laws on the venture capitalentrepreneur relationship, laws tocontrol opportunistic behavior and ensure better enforcement, the use of U.S. venturecapital law is helpful to us.

Venture capitalists reported that they are sometimes bringing new norms of behaviorto the managers of funded firms by insisting on professional standards such as that certainaccounting practices be upheld, regardless of local laws and custom. Venture capitalistshave also encouraged application of laws more consistent with an Anglo-Americancorporate governance approach, whether or not it was locally required.

As a result, it can be expected that venture capital will change ultimately from a focuson informal, network-centered venture capital strategy toward a more rule-based, imper-

313March, 2006

sonal exchange system. Thus, in the future it can be expected that the actual implemen-tation of venture capital in emerging markets will grow to act more like those in moredeveloped markets such as those of the United Kingdom and United States. This does notimply that less formal cultural-cognitive institutions will no longer have an impact onventure capital in emerging economies. The presence of informal institutions will con-tinue to exert some influence on venture capital in East Asia in the future. As a result, itcan be expected that in the future, economic models based on agency and stewardshiptheory will have increasing explanatory power for venture capital and venture capitalistactions in East Asia.

Implications for PracticeIt is crucial that venture capitalists recognize that venture capital in emerging markets

may appear similar to what they know and understand in the developed markets. Theventure capitalist in this environment is likely to have been educated in a leading univer-sity in the West, has worked for a number of years in a developed market, and has grownaccustomed to the formal institutions and commercial conventions that everyone acceptsand generally adheres to. It is expected that an entrepreneur will listen to the venturecapitalist and perform his or her duties more or less according to the contract without toomuch oversight. There are exceptions, but these can usually be dealt with through formalchannels such as the board of directors. Venture capitalists that move to emerging marketsquickly learn that while goals of a solid annual return on investment are about the sameas in Silicon Valley, many specific actions to attain these goals will be fundamentallydifferent. As noted, finding backable entrepreneurs is more difficult, and the venturecapital firm may need its own people inside the firm in the larger investments. Venturecapitalists find that their networks take on added importance in the emerging economy.

Networks are used in emerging economies for information purposes and reciprocationpurposes as in the West. But the use of networks to substitute for formal institutions suchas the rule of law, monitoring, and enforcement of contracts are common around East Asiaand indispensable in some regions. Thus, simple things such as establishing a contractwith the entrepreneur and enforcing that contract requires different actions on the part ofthe emerging-economy venture capitalist. The venture capitalist may ask someone con-nected to the entrepreneur to act as an intermediary or even a partial guaranteur for theinvestment. Indeed, much of the actual enforcement of the contract may come throughinformal methods that are related to the network of the venture capitalist.

Quite often, venture capitalists from mature markets see tremendous opportunities inemerging markets and feel they can parachute in and make successful investments. Theoperation of venture capital in an emerging market should instead follow the classicadvice given to any business seeking to move into a new unknown domainlearn thecharacteristics of the market first. For flat, small organizations like a venture capital firm,this means that they need to have someone on location that understands that market. Majormistakes have been made when firms have tried to send people in from outside to startmaking major private equity deals. They need to be there over a significant period of time,working on building relationships and integrating themselves into various networks ofbusiness and government to prepare the way for the firms investments.

There seems to be an increasing practical recognition of the high level of commitmentnecessary to be successful in such emerging markets. This may limit the potential increasein venture capital activity in emerging markets in East Asia for the foreseeable future. Asa practical matter, as venture capitalists look at the difficulty in building such a framework,some venture capitlists will continue to cherry-pick potentially higher return ventures in


markets that they understand rather than take the risk associated with moving slowly butmore broadly into such markets. This would be unfortunate as there is still a great deal ofopportunity all around emerging East Asia. However, it will take venture capital firms timeand commitment to realize this.

Implications for ResearchThe findings here also have strong implications for theory and research. In emerg-

ing markets today the use of institutional theory as a foundation would appear to havegreater explanatory power than economic-based theories such as agency and steward-ship theory. Agency theory has underpinned much of our understanding of the venturecapital in developed markets. However, from the evidence here it would appear that aricher theoretical foundation is needed. Informal institutions can be utilized to fill thevoids that exist in the formal institutional structure. Networks are very important for theventure capitalist now as they seek to fill voids in formal institutions. We expect formalinstitutions to increase in importance in the future as the necessity of relying on net-works to perform activities such as investment selection and monitor decrease. A lon-gitudinal study has a great potential to provide insight into this process in the future.However, such a study should employ a richer theoretical perspective than agency orstewardship theory.

Much past research applying institutional theory to various settings has argued thatinstitutions will change very little or will only change so slowly that institutional changeis not strongly considered (Brint & Karabel, 1991; DiMaggio, 1988; for exceptions, seeHitt et al., 2004; Leblebici, Salancik, Copay, & King, 1991). This may be true in particularfor cultural-cognitive institutions. However, normative institutions relating to how indi-viduals in different professions act and legal/regulatory institutions are changing steadilyin emerging economies, and they can be changed by institutional entrepreneurs such asventure capitalists that bring California contracts to deals signed in Taiwan for a fundedfirm in mainland China. The result is a movement toward greater convergence betweendeveloped and emerging markets in terms of normative and regulatory elements ofinstitutional structures. As individuals interact more with each other in a country and withothers outside the country, they learn more about what is expected in business relation-ships. This, in turn, shapes a greater consistency in their normative values no matter wherethey are located. Similarly, the pressure from international business is producing greaterhomogenization of normative values. This is particularly true in domains where there arestrong international interconnections between various parties and strong industrial tradi-tions such as venture capital.

This growing similarity should result in greater convergence in norms of professionalbehavior of individuals in a varied emerging-market settings. Thus, ensuing theory musttake care to recognize that this theoretical foundation is providing a picture at one pointand time. Institutional regimes do change, and the changes occurring in some emergingeconomies in the normative and regulatory (if not cultural-cognitive) pillars can besubstantial.

For researchers, this recognition of the partial convergence of institutions is veryimportant. Today, researchers typically look at single points in time and argue that thefindings have wider application. However, the evidence here is that the findings haverelevance to that one point in time. If the researcher does not look at longitudinal data anddetermine how managerial actions and decisions are changing over time, it will not bepossible to predict what the future will hold.

315March, 2006

Conclusion

This article has examined the role of the institutional environment on the practice ofventure capital in emerging economies in East Asia. Efficiency and accessibility toinvestors are important to venture capitalists in both developed and emerging economies.But in emerging economies, venture capitalists need to place greater importance onemploying personal networks to carry out needed activities to select, monitor, add value,and someday exit from their invested firms. Personal connections and relationships withentrepreneurs, government officials, and customers, while important in any setting, arelikely to be more important in emerging markets.

Our findings indicate that the venture capital practice in emerging economies divergesfrom Anglo-American models in several specific areas. With the weak formal institutionsin emerging economies, less formal institutions sometimes provide some substitute for thelack of formal institutions. Venture capitalists monitor firms through informal ties toentrepreneurs and their families. They create links to key customers, the government andother important allied firms through personal connections, something that they stated wasparticularly important and essential in emerging economies.

Informal cultural-cognitive factors often create the requirement for existing relation-ships, in order for firms to achieve funding. These networks have been found to beparticularly important for financing in East Asian economies and to be useful in theabsence of more formal monitoring and control mechanisms that exist in the moredeveloped economies. The venture capital industry is also less regulated and establishedthan the mainline financial sector in emerging economies. This suggests that relationshipsand other similar institutions could be even more important for venture capitalists andtheir potential clients. Nearly all of the venture capitalists interviewed agreed that this wasone facet of their work that they did not expect to change soon.

The findings have implications for the research and practice of venture capital and fortheory development. Researchers should take these findings and build on them to explorethis critical topic. The findings will have significant impact not only on venture capital andentrepreneurship research but also on the broader understanding of networks, institutions,and their effects on key sectors in the numerous emerging economies of the world.

REFERENCES

Ahlstrom, D. & Bruton, G.D. (2001). Learning from successful local private firms in China: Establishinglegitimacy. Academy of Management Executive, 15, 7283.

Ahlstrom, D., Bruton, G.D., & Chan, E.S. (2000). Venture capital in China: Ground-level challenges for hightechnology investing. Journal of Private Equity, 3(2) WinterSpring, 110.

Ahlstrom, D., Young, M.N., & Nair, A. (2002). Deceptive managerial practices in China: Strategies forforeign firms. Business Horizons, 45(6), 4959.

Aoki, M. (2001). Towards a comparative institutional analysis. Cambridge, MA: MIT Press.

Arthurs, J.D. & Busenitz, L.W. (2003). The boundaries and limitations of agency theory and stewardshiptheory in the venture capitalist/entrepreneur relationship. Entrepreneurship Theory and Practice, 28(2),145162.

Backman, M. (1999). Asian eclipse: Exposing the dark side of business in Asia. Singapore: John Wiley &Sons.


Batjargal, B. & Liu, M. (2004). Entrepreneurs access to private equity in China: The role of social capital.Organization Science, 15, 159173.

Biggart, N.W. & Guillen, M.F. (1999). Emerging difference: Social organization and the rise of the autoindustries of South Korea. American Sociological Review, 64, 722747.

Brint, S. & Karabel, J. (1991). Institutional origins and transformations: The case of American communitycolleges. In W.W. Powell & P.J. DiMaggio (Eds.), The new institutionalism in organizational analysis (pp.337360). Chicago: University of Chicago Press.

Bruton, G.D. & Ahlstrom, D. (2003). An institutional view of Chinas venture capital industry: Explaining thedifference between China and the West. Journal of Business Venturing, 18, 233259.

Bruton, G.D., Ahlstrom, D., & Singh, K. (2002). The impact of the institutional environment on the venturecapital industry in Singapore. Venture Capital: An International Journal of Entrepreneurial Finance, 4,197218.

Bruton, G.D., Ahlstrom, D., & Yeh, K.S. (2004). Understanding venture capital in East Asia: The impact ofinstitutions on the industry today and tomorrow. Journal of World Business, 39, 7288.

Bruton, G.D., Dattani, M., Fung, M., Chow, C., & Ahlstrom, D. (1999). Private equity in China: Differencesand Similarities with the Western model. Journal of Private Equity, 2(2) Winter, 714.

Bruton, G., Fried, V., & Hisrich, R.D. (1998). Venture capitalist and CEO dismissal. Entrepreneurship Theoryand Practice, 21(3), 4154.

Burton, J.P., Butler, J.E., & Mowday, R.T. (2003). Lions, tigers, and alley cats: Human resource manage-ments role in Asian business development. Human Resource Management Review, 13, 487498.

Busenitz, L.W., Fiet, J.O., & Moesel, D.D. (2005). Signaling in venture capitalistnew venture team fundingdecisions: Does it indicate long-term venture outcomes? Entrepreneurship Theory and Practice, 29, 112.

Busenitz, L.W., Gomez, C., & Spencer, J.W. (2000). Country institutional profiles: Interlocking entrepre-neurial phenomena. Academy of Management Journal, 43, 9941003.

Butler, J.E., Brown, B., & Chamornmarn, W. (2003). Informational networks, entrepreneurial action andperformance. Asia Pacific Journal of Management, 20, 151174.

Bygrave, W.D. (1987). Syndicated investments by venture capital firms: A networking perspective. Journal ofBusiness Venturing, 2(2), 139154.

Bygrave, W.D. (1988). The structure of the investment networks of venture capital firms. Journal of BusinessVenturing, 3(2), 137157.

Cardis, J., Kirschner, S., Richelson, S., Kirschner, J., & Richelson, H. (2001). Venture capital: The definitiveguide for entrepreneurs, investors, and practitioners. New York: John Wiley & Sons.

Chen, M. (2001). Inside Chinese business: A guide for managers worldwide. Boston: Harvard BusinessSchool Press.

Daft, R.L. & Lewin, A.Y. (1990). Can organization studies begin to break out of the normal sciencestraightjacket? Organization Science, 1, 111.DiMaggio, P.J. (1988). Interest and agency in institutional theory. In L.G. Zucker (Ed.), Institutional patternsand organizations: Culture and environment (pp. 321). Cambridge, MA: Ballinger.

DiMaggio, P.J. & Powell, W.W. (1991). Introduction. In W.W. Powell & P.J. DiMaggio (Eds.), The newinstitutionalism in organizational analysis (pp. 138). Chicago: University of Chicago Press.

317March, 2006

Eisenhardt, K.M. (1989). Building theory from case study research. Academy of Management Review, 14,532550.

Fried, V. & Hisrich, R. (1994). Towards a model of venture capital investment decision making, financialmanagement. Financial Management, 23(3), 2837.

Fried, V. & Hisrich, R. (1995). The venture capitalist: A relationship investor. California Management Review,37(2), 101113.

Glaser, B.G. & Strauss, A.L. (1967). The discovery of grounded theory: Strategies for qualitative research.Chicago: Aldine Publishing Co.

Guide to Venture Capital in Asia. (2003). Hong Kong: Asian Venture Capital Journal Ltd.

Guthrie, D. (2002). Information asymmetries and the problem of perception: The significance of structuralposition in assessing the importance of guanxi in China. In T. Gold, D. Guthrie, & D. Wank (Eds.), Socialconnections in China: Institutions, culture, and the changing nature of guanxi (pp. 3756). New York:Cambridge University Press.

Henisz, W.J. (2000). The institutional environment for multinational investment. Journal of Law Economicsand Organization, 16(2), 334364.

Henisz, W.J. (2003). The power of the Buckley and Casson thesis: The ability to manage institutionalidiosyncrasies. Journal of International Business Studies, 34(2), 173184.

Hirsch, P.M. & Lounsbury, M. (1997). Ending the family quarrel: Toward a reconciliation of old and newinstitutionalisms. American Behavioral Scientist, 40, 406420.

Hitt, M.A., Ahlstrom, D., Dacin, M.T., Levitas, E., & Svobodina, L. (2004). The institutional effects onstrategic alliance partner selection in transition economies: China versus Russia. Organization Science, 15(2),173185.

Hoang, H. & Antoncic, B. (2003). Network based research in entrepreneurship: A critical review. Journal ofBusiness Venturing, 18, 165187.

Hoskisson, R.E., Eden, L., Lau, C.M., & Wright, M. (2000). Strategy in emerging economies Academy ofManagement Journal, 43(3), 249267.

Jeng, L.A. & Wells, P.C. (2000). The determinants of venture capital funding: Evidence across countries.Journal of Corporate Finance, 6, 241289.

Jepperson, R. (1991). Institutions, institutional effects, and institutionalism. In W.W. Powell & P.J. DiMaggio(Eds), The new institutionalism in organizational analysis (pp. 143163). Chicago: University of ChicagoPress.

Kostova, T. (1997). Country institutional profiles: Concepts and measurement. Proceedings of the Academy ofManagement, Academy of Management, Briarcliff Manor, NY, 180185.

Leblebici, H., Salancik, G.R., Copay, A., & King, T. (1991). Institutional change and the transformation ofinterorganizational fields: An organizational history of the U.S. radio broadcasting industry. AdministrativeScience Quarterly, 36, 333363.

Lee, T.W. (1999). Using qualitative methods in organizational research. Thousand Oaks, CA: SagePublications.

Lincoln, Y.S. & Guba, E.G. (1985). Naturalistic inquiry. Beverly Hills, CA: Sage Publications.

Lockett, A. & Wright, M. (2002). Editorial: Venture capital in Asia and the Pacific Rim. Venture Capital, 4(3),183195.


Lockett, A., Wright, M., Sapienza, H., & Pruthi, S. (2002). Venture capital investors, valuation and informa-tion: A comparative study of the U.S., Hong Kong, India and Singapore. Venture Capital, 4(3), 237252.

Low, C.K. (2002). Corporate governance: An Asia-Pacific critique. Hong Kong: Sweet & Maxwell Asia.

Meyer, K.E. (2001). Institutions, transaction costs, and entry mode choice in Eastern Europe. Journal ofInternational Business Studies, 32(2), 357367.

Miles, M.B. & Huberman, A.M. (1994). Qualitative data analysis: An expanded sourcebook. Thousand Oaks,CA: Sage Publications.

Newman, K.L. (2000). Organizational transformation during institutional upheaval. Academy ofManagement Review, 25(3), 602619.

North, D. (1990). Institutions, institutional change and economic performance. Cambridge, UK: CambridgeUniversity Press.

Orru, M., Biggart, N.W., & Hamilton, G.G. (1991). Organizational isomorphism in East Asia. In W.W. Powell& P.J. DiMaggio (Eds.), The new institutionalism in organizational analysis (pp. 361389). Chicago:University of Chicago Press.

Peng, M.W. (2000). Business strategies in transition economies. Thousand Oaks, CA: Sage Publications.

Peng, M.W. (2001). How entrepreneurs create wealth in transition economies. Academy of ManagementExecutive, 15(1), 95110.

Peng, M.W. (2002). Towards an institution-based view of business strategy. Asia Pacific Journal of Manage-ment, 19(2/3), 251267.

Peng, M.W. (2003). Institutional transitions and strategic choices. Academy of Management Review, 28(2),275286.

Peng, M.W. & Heath, P.S. (1996). The growth of the firm in planned economies in transition. Academy ofManagement Review, 21(2), 492528.

Powell, W.W., Koput, K.W., Bowie, J.I., & Smith-Doerrs, L. (2002). The spatial clustering of science andcapital: Accounting for biotech firm-venture capital relationships. Regional Studies, 36, 291305.

Pruthi, S., Wright, M., & Lockett, A. (2003). Do foreign and domestic venture capital firms differ in theirmonitoring of investees? Asia Pacific Journal of Management, 20(2), 175204.

Sahlman, W.A. (1990). The structure and govenance of venture capital organizations. Journal of FinancialEconomics, 27, 473521.

Sapienza, H. (1992). When do venture capitalists add value? Journal of Business Venturing, 7, 927.

Sapienza, H.J. & Gupta, A.K. (1994). Impact of agency risks and task uncertainty on venture capitalist-CEOinteraction. Academy of Management Journal, 37, 16181632.

Saxenian, A.L. (1994). Regional advantage: Culture and competition in Silicon Valley and Route 128.Cambridge, MA: Harvard University Press.

Scott, W.R. (2002). Institutions and organizations. Thousand Oaks, CA: Sage Publications.

Shane, S. & Cable, D. (2002). Network ties, reputation, and the financing of new ventures. ManagementScience, 48(3), 364381.

Sorenson, O. & Stuart, T.E. (2001). Syndication networks and the spatial distribution of venture capitalinvestments. American Journal of Sociology, 106, 15461588.

319March, 2006

Stinchcombe, A.L. (1965). Social structure and organizations. In J.G. March (Ed.), Handbook of organiza-tions (pp. 153193). Chicago: Rand McNally.

Strauss, A.L. (1987). Qualitative analysis for social scientists. Cambridge, UK: Cambridge University Press.

Strauss, A. & Corbin, J. (1990). Basics of Qualitative Research: Grounded Theory Procedures and Tech-niques. Newbury Park, CA: Sage Publications.

Stuart, T.E., Hoang, H., & Hybels, R.C. (1999). Interorganizational endorsements and the performance ofentrepreneurial ventures. Administrative Science Quarterly, 44, 315349.

The Economist (2004a). Milking it; investing in China, 373 (October 9), 6970.

The Economist (2004b). A disorderly heaven, 370, (March 20), 10.

Tsoukas, H. (1989). The validity of idiographic research explanations. Academy of Management Review,14(4), 551561.

Wank, D. (2002). Business-state clientelism in China: decline or evolution? In T. Gold, D. Guthrie, & D. Wank(Eds), Social connections in China: Institutions, culture, and the changing nature of guanxi (pp. 97116).Cambridge, UK: Cambridge University Press.

Wright, M., Lockett, A., & Pruthi, S. (2002). Internationalization of Western venture capitalists into emergingmarkets: Risk assessment and information in India. Small Business Economics, 19(1), 1329.

Wright, M., Thompson, S., & Robbie, K. (1992). Venture capital and management-led leveraged buy-outs: AEuropean perspective. Journal of Business Venturing, 7(1), 4771.

Wright, M., Thompson, S., & Robbie, K. (1998). Venture capital and private equity: A review and synthesis.Journal of Business Finance & Accounting, 25(5), 521570.

Yin, R.K. (2003). Case study research: Design and methods. Thousand Oaks, CA: Sage Publications.

Young, M.N., Ahlstrom, D., & Bruton, G.D. (2004). The globalization of corporate governance in East Asia:The transnational solution. Management International Review, 44(2), 3150.

Young, M.N., Peng, M.W., Ahlstrom, D., & Bruton, G.D. (2002). Governing the corporation in emergingeconomies: A principalprincipal agency perspective. Academy of Management Best Papers Proceedings:CDI ROM. Academy of Management, Briarcliff Manor, NY.

Zider, B. (1998). How venture capital works. Harvard Business Review, 76(6), 131139.

David Ahlstrom is a professor of Management at The Chinese University of Hong Kong, Shatin, Hong KongSpecial Administrative Region (SAR).

Garry D. Bruton is a professor of Management at the M.J. Neeley School of Business at Texas ChristianUniversity, Fort Worth, Texas.

The authors would like to thank Vance Fried and the participants of the UNIEI Entrepreneurship ResearchConference Workshop (June 2004), University of Nottingham, Nottingham, U.K. for comments on earlierversions of this article. The work in this article was substantially supported by a grant from Lee HysanFoundation Research Grant and Endowment Fund (for 20022003) of United College, The Chinese Univer-sity of Hong Kong, the Hong Kong SAR. Additionally, the second author received research support from theTexas Christian University Entrepreneurship Center.


etp-vc in emerging markets networks and institutional change_etp2006

Documents