Working Paper: CEPR ID: DP1738
Authors: Dirk Bergemann; Ulrich Hege
Abstract: We consider the provision of venture capital in a dynamic agency model. The value of the venture project is initially uncertain and more information arrives by developing the project. The allocation of funds and the learning process are subject to moral hazard. The optimal contract is a time-varying share contract which provides intertemporal risk-sharing between venture capitalist and entrepreneur. The share of the entrepreneur reflects the value of a real option. The option itself is based on the control of the funds. The dynamic agency costs may be high and lead to an inefficiently early end to the project. A positive liquidation explains the adoption of strip financing or convertible securities. Finally, relationship financing, including monitoring and the occasional replacement of management improves the efficiency of the financial contracting.
Keywords: venture financing; optimal stopping; dynamic financial constraints; share contracts; security design; relationship finance
JEL Codes: D83; D92; G24; G31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| allocation of funds (I22) | probability of project success (O22) |
| entrepreneur's control over funds (M13) | probability of project success (O22) |
| structure of the optimal contract (D86) | entrepreneur's share of returns (D33) |
| monitoring and relationship financing (G32) | probability of project success (O22) |
| short-term financing (G32) | premature project termination (H43) |
| long-term contracts (L14) | project viability (O22) |