Working Paper: CEPR ID: DP13640
Authors: Roman Inderst; Vladimir Vladimirov
Abstract: We analyze how relationship finance, such as venture capital and relationship lending, affects growth firm's capital structure choices. We show that relationship investors that obtain a strong bargaining position due to their privileged information about the firm, optimally cash in on their dominance by pushing it to finance follow-up investments with equity. The firm underinvests if its owner refuses to accept the associated dilution. However, this problem is mitigated if the firm's initial relationship financing involves high leverage or offers initial investors preferential treatment in liquidation. By contrast, if initial investors are unlikely to gain a dominant position, firms optimally lever up only in later rounds. Our implications for relationship and venture capital financing highlight that the degree of investor dominance is of key importance for growth firm's capital structure decisions.
Keywords: financial contracting; relationship financing; dominant investors; equity financing
JEL Codes: G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| relationship finance (G59) | capital structure decisions (G32) |
| investor dominance (G11) | preference for equity over debt financing (G32) |
| initial capital structure choices (D25) | subsequent financing rounds (G24) |
| initial debt (F34) | bargaining power in later stages (L14) |
| high leverage (G19) | reduce underinvestment risks (G11) |
| stronger investor position (G19) | shift towards equity financing (G32) |
| lack of dominant position (L49) | leverage up in later financing rounds (G32) |