Robust Financial Contracting and the Role of Venture Capitalists

Abstract

Explores the financial contracts that can be entered into by the entrepreneur and the inside investor that permit optimal continuation and investment decisions. The inside investor is assumed to be a venture capitalist. The unique contract under examination is termed the fixed-fraction contract. It gives the venture capitalist an equity-like position in the firm. In addition to enlisting the funds of a venture capitalist, the entrepreneur can approach outside investors. Outside investors do not have the same information that inside investors do. The model presented consists of a three-period project. The analysis of the entrepreneur-led financing highlights the information asymmetry that exists in this type of relationship in addition to agency problems related to investment decisions. On the other hand, the fixed-fraction contract involving the venture capitalist induces optimal continuation because the venture capitalist owns a fixed fraction of the project for which he or she provides the capital. Since the venture capitalist payoff is independent of the pricing of later-issued securities, or she he has no reason to misprice these securities. While the benefits of the fixed-fraction contract are shown, consideration must be given to the venture capitalist's cost of monitoring the firm. (SRD)

Keywords: Inside investors, Agency problems, Venture capitalists, Financial contracts, Information asymmetry, Contracts & agreements