Working Paper: CEPR ID: DP5758
Authors: Georg Gebhardt; Klaus M. Schmidt
Abstract: When a young entrepreneurial firm matures, it is often necessary to replace the founding entrepreneur by a professional manager. This replacement decision can be affected by the private benefits of control enjoyed by the entrepreneur which gives rise to a conflict of interest between the entrepreneur and the venture capitalist. We show that a combination of convertible securities and contingent control rights can be used to resolve this conflict efficiently. This contractual arrangement is frequently observed in venture capital finance.
Keywords: control rights; convertible securities; corporate finance; venture capital
JEL Codes: D23; G24; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| control rights (P14) | decision to replace entrepreneur (M13) |
| state of the firm (L21) | control rights (P14) |
| control rights (P14) | hiring of outside manager (M55) |
| successful firm (L25) | entrepreneur retains control (L26) |
| less successful firm (L19) | venture capitalist exerts control (G34) |
| convertible securities (G12) | resolution of conflicts (D74) |
| cash flow rights linked to control rights (G39) | incentivize efficient actions (D61) |
| anticipation of replacement (D84) | limit private benefits (J32) |
| control rights structured by state of firm (G38) | align incentives (M52) |