Time-Inconsistent Preferences and Venture Capital Contracting

Abstract:     
Agency explanations of the venture capital process routinely assume that entrepreneurs and venture capitalists have time-consistent (“TC”) preferences, and thus perfect self-control. Given the growing evidence on self-control problems, from both experiments and field studies, it is natural to ask how our understanding of the venture capital process would change if one were to relax the TC assumption. This paper begins this process. It develops a model of venture capital contracts in which time-inconsistent (“TI”) parties may repeatedly procrastinate undertaking onerous tasks - e.g., innovators may procrastinate finishing the innovation, and venture capitalists may procrastinate monitoring and advising entrepreneurs. Similarly, TI entrepreneurs and venture capitalists may overindulge in self-dealing. The time-inconsistent contracting model developed in the paper helps explain why venture capital contracts include incentive and governance mechanisms that are much more high-powered than those used in innovation-intensive publicly traded companies, which not only have many of the same types of moral hazard problems, but are also more complex and less transparent. The model also helps explain some of the standard features of contracts between venture capitalists and their investors.

Number of Pages in PDF File: 49

Keywords: venture capital, private equity, self-control problems, procrastination, time-inconsistent preferences

JEL Classification: K22, G24, M13, O31

Accepted Paper Series