A Portfolio Approach to Venture Capital Financing

Abstract

Venture capital (VC) financing contracts are analyzed through a portfolio choice framework. The risk transfer opportunity provides sufficient incentive for the wealth-constrained, risk-averse entrepreneur to transact with a VC investor. The optimal contract separates the entrepreneur's investment from her stake, the latter depending on her bargaining power. The entrepreneur's investment and stake decrease with her risk aversion, as does her stake with the investor's bargaining power. Project size and risk, and the entrepreneur's risk aversion affect the market shares across investor types. These predictions are validated in an empirical study of 1,315 European VC investment rounds between 2010 and 2019.

Keywords: Venture capital, portfolio theory, financial contracting, entrepreneur's risk aversion, cost of capital

JEL Classification: L26, G32, G24