A Multi-Period Game Theoretic Model of Venture Capitalists and Entrepreneurs

Abstract

As venture capitalists (VCs) have an important role in financial start-ups, most studies have focused on venture capital as a short-term source of financing. The authors examine the relation between a VC and an entrepreneur in a multi-period game in which the contract is set at the beginning of the game, and follows the relation from its start to the end. This multi-period game theoretic model focuses on the problem of moral hazard – the entrepreneur's hidden effort and how a VC can cope with it, using staged investments. First a game between a VC and an entrepreneur is presented, in which the VC is unable to notice the entrepreneur’s effort. Next, a multi-period game between the parties is examined, where the contract is established at the beginning of the multi-period game. The results of the model are presented, and several propositions and theorems are advanced. The multi-period aspects of the model allow for deriving the strategic behavior of the VCs and entrepreneurs over time. The model is consistent with reality, where the average duration of the relation between venture capitalists and entrepreneurs is several years and the investment is made in stages. The study provides insights on optimal contracts and the characterization of an endogenous exit point. It is suggested that the optimal incentive scheme back load all incentive payments to the entrepreneur, and a straight debt contract is optimal in venture financing. Recommendations are made for further studies on the contracts among VCs who syndicate together, as well as the bargaining between the VC and the entrepreneur.(CBS)

Keywords: Staged investments, Contracts & agreements, Moral hazard problem, Organizational behavior, Venture capital, Game theory, Closing firms, Strategic planning, Venture capitalists, Incentives