Peer Monitoring, Syndication, and the Dynamics of Venture Capital Interactions: Theory and Evidence

Abstract

We develop a new rationale for the formation of VC syndicates, and theoretically analyze the dynamics of VC syndicates. In our model, an entrepreneur needs financing from VC investors to implement his firm’s positive NPV project. In addition to financing, VCs can provide the firm with two inputs (each in a different area of activity), which can increase the probability of project success: these inputs can be provided either by a single VC, or by two different VCs, each operating in his own area of expertise. We analyze the firm’s equilibrium choice between financing the project by contracting with a single VC, by contracting individually with two VCs, or by contracting with a syndicate consisting of two VCs. Our analysis generates several testable predictions for the equilibrium choice of the structure of VC financing, for the evolution of this structure across financing rounds, as well as for the dynamics of the composition of VC syndicates and for how this dynamics affects entrepreneurial firms’ probability of successful exit. We also present empirical evidence that is consistent with the predictions of our model.

Keywords: Peer Monitoring, Venture Capital, Syndication

JEL Classification: G24