A Portfolio Approach to Venture Capital Financing

Abstract

This paper studies the contracting choices between an entrepreneur and different kinds of venture capitalists in a portfolio context. The optimal contract for the entrepreneur features investor choice, share of investment, and equity dilution as a function of her bargaining power. In our portfolio approach, the choice of investor type is dictated by project size and risk, entrepreneur's risk aversion and investor's funding characteristics. A panel analysis of VC fund flows for five European countries provides strong support for the portfolio approach and establishes it as a new rationale for venture capital contracting along with other existing theories.

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

JEL Classification: L26, G32, G24