A Portfolio Approach to Venture Capital Financing

Abstract

We analyze venture capital (VC) financing contracts through a portfolio choice framework. Wealth-constrained, risk-averse entrepreneurs deal with VC investors by displaying a competitive edge either through their cost of capital (equity or debt) or through their ability to enhance project value. The optimal contract involves the separation between the decision of how much of her wealth the entrepreneur decides to allocate to the venture (the `investment'), and the arrangement of her share of equity (the `stake'), which depends on the bargaining power of the contractors. An empirical study of 1,315 European VC investment rounds between 2010 and 2019 validates the main predictions of the portfolio approach: (i) the entrepreneur's investment and stake decrease with her risk aversion, as does her stake with the investor's bargaining power; (ii) the market shares within our three-tier investor typology are impacted nonmonotonically by project size and risk, and by the entrepreneur's risk aversion.

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

JEL Classification: L26, G32, G24