How Are Venture Capitalists Rewarded? The Economics of Venture Capital Partnerships

Abstract:     
We develop a model showing how investors, venture capitalists (VCs), and entrepreneurs integrate into a venture capital fund (VCF). Investors' demand for VC services will depend on their beliefs about the accuracy of VC screening and their expected revenue without a VC. The quality of screening will depend on VCs' information, incentives, and expected profits. The model characterizes equilibrium prices that VCs charge for their services and the individual payoff schedules of VCs and investors as function of project cash flows. We calibrate the model using data from existing empirical studies and find results that match the management fees charged by real-world VCs and the industry returns. Our analysis provides new insights into the formation of VC-investor partnerships and suggests that the services provided by VCs improve capital market efficiency.

Number of Pages in PDF File: 43

Keywords: Venture capitalists, project screening, capital markets efficiency, model calibration

JEL Classification: G32

working papers series