Working Paper: CEPR ID: DP2097
Authors: Rafael Repullo; Javier Suarez
Abstract: This paper provides a theory of venture capital financing based on the complementarity between the financing and advising roles of venture capitalists. We examine the interaction between the staging of investment that characterizes young firms with a high growth potential and the double-sided moral hazard problem that arises from the managerial contributions of entrepreneurs and venture capitalists. The optimal contract combines an incentive-related insurance motive that makes the initial financiers bear the start-up's downside risk and a financing motive that protects their claims against dilution. These motives can explain the widespread use of convertible preferred stock in venture capital financing.
Keywords: venture capital; stage financing; incomplete contracts; startups; warrants; convertible preferred stock
JEL Codes: D92; G24; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal contract structure (D86) | mitigate incentive problems (D82) |
| financing arrangements (G32) | influence incentives of both parties (C78) |
| convertible preferred stock (G12) | protect claims against dilution (O34) |
| convertible preferred stock (G12) | encourage entrepreneur’s effort (L26) |
| financing (G32) | impact on entrepreneurial effort (L26) |
| financing (G32) | impact on project outcomes (O22) |