Independent Directors and Board Control in Venture Finance

Abstract:     
The financial contracting literature treats control as an indivisible right held either by a firm's entrepreneurs or by its investors. In contrast, data from VC-backed firms shows that board control is typically shared, with a third-party independent director holding the tie-breaking board seat ('ID-arbitration'). In this article I use a bargaining game similar to final offer arbitration to model a firm's choice of action under ID-arbitration. I show that ID-arbitration can reduce holdup by moderating each party's ex post threat position. Consequently, ID-arbitration can lead to the efficient outcome in circumstances where alternative governance arrangements - entrepreneur control, investor control, or state-contingent control - are either unavailable or likely to lead to suboptimal results.

Keywords: Venture capital, control rights, incomplete contracting, corporate governance, board of directors

JEL Classifications: G24, G32, G34. K12, K22, M13

Working Paper Series