Valuation and Control in Venture Finance

Abstract:     
I present a model in which a venture capitalist and an entrepreneur are engaged in the complex and risky task of forming a new company. I show that a reallocation of control rights can alleviate some commitment and incentives problems and lead to an improved outcome.

In contrast to earlier studies, I assume that control is a continuous, rather than a binary variable. I show that the equilibrium distribution of control rights depends on the degree of adverse selection. In equilibrium, the higher the degree of adverse selection, the more control rights are allocated to the venture capitalist. This explains why in practice venture capitalists receive control levers that are significantly higher than the size of their equity investment.

I also show that allocating more control rights to the investor results in a smaller dilution of the entrepreneur's ownership in the venture at higher share prices, less informationally efficient prices, and a higher share of risks shifted to the investor. In other words, the entrepreneur is compensated for a greater loss of control through better terms of financing, ability to extract higher rents from asymmetric information, and better risk sharing.

Finally, since contractual provisions conditional on the entrepreneur's private value of control cannot be enforced, I investigate how an optimal allocation of control rights can be implemented through indirect mechanisms. I prove that an optimal allocation of control rights can be implemented via a competitive market for control or bilateral bargaining procedures.

JEL Classification: G24, G34

Accepted Paper Series