Working Paper: CEPR ID: DP5711
Authors: Roman Inderst; Holger M. Mueller; Felix Münnich
Abstract: This paper shows that investors financing a portfolio of projects may use the depth of their financial pockets to overcome entrepreneurial incentive problems. While competition for scarce informed capital at the refinancing stage increases the investor?s ex post bargaining position, it may nevertheless improve entrepreneurs? ex ante incentives. This is because projects funded by investors with 'shallow pockets' must have not only a positive NPV at the refinancing stage, but one that is higher than that of competing portfolio projects. We also show that, besides mitigating moral hazard, committing to shallow pockets may have benefits in dealing with adverse selection problems. Our paper may help to understand provisions used in venture capital finance that limit a fund?s initial capital and make it difficult to add on more capital once the initial venture capital fund is raised. Our paper also provides a number of empirical implications, some of which have not yet been tested.
Keywords: deep versus shallow pockets; venture capital; portfolio
JEL Codes: G31; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| constrained finance (G19) | entrepreneurial incentives (O31) |
| competition for informed capital (G24) | investors' bargaining position (G24) |
| competition for informed capital (G24) | entrepreneurs' incentives (O31) |
| constrained finance (G19) | adverse selection problems (D82) |
| competition effect (D41) | expected payoffs for entrepreneurs (L26) |
| investors' bargaining power (G24) | entrepreneurial incentives (O31) |
| constrained finance (G19) | expected payoffs for entrepreneurs (L26) |