Working Paper: CEPR ID: DP5806
Authors: Yrj Koskinen; Michael Rebello; Jun Wang
Abstract: We model a situation where the entrepreneur has an informational advantage during the early stages of an investment project while the venture capitalist has the informational advantage during the later stages. We examine how this evolution of informational asymmetry affects venture investment and the nature of financing contracts under two different scenarios with regard to the distribution of bargaining power between the venture capitalist and entrepreneur: when the venture capitalist has the bargaining advantage and when the entrepreneur has the bargaining advantage. Our results demonstrate that the distribution of bargaining power has a profound influence both on the terms of contracts and on investments in venture-backed projects. Changes in bargaining power can completely alter the payoff sensitivity of contracts offered to entrepreneurs, and, as witnessed in the recent past, when entrepreneurs hold the bargaining advantage, venture capitalists may acquiesce to excessive investments in early stages of projects and subsequently terminate a larger number of projects.
Keywords: asymmetric information; bargaining power; financial contracting; investment distortions; venture capital
JEL Codes: D82; G24; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Distribution of bargaining power (C78) | Terms of financing contracts (G32) |
| Distribution of bargaining power (C78) | Level of investment in projects (G31) |
| Venture capitalist's bargaining advantage (G24) | Structure contracts that limit entrepreneur's payoff (L14) |
| Venture capitalist's bargaining advantage (G24) | Higher incidence of project terminations in later financing stages (G33) |
| Venture capitalist's ability to screen out poor projects (G24) | Positive NPV projects receiving funding (H43) |
| Entrepreneur's bargaining advantage (L14) | Excessive investments in early project stages (G31) |
| Entrepreneur's bargaining advantage (L14) | Higher likelihood of project failures later on (H43) |
| Evolution of informational asymmetry (D82) | Contractual agreements (L14) |
| Evolution of informational asymmetry (D82) | Investment strategies (G11) |
| Venture capitalist's bargaining power (G24) | Sensitivity of claims to project performance (O22) |
| Entrepreneur's bargaining power (L14) | Sensitivity of claims to project performance (O22) |