The Entrepreneur's Initial Contact with a Venture Capitalist: Why Good Projects May Choose to Wait

Abstract

We show that a profit-maximizing entrepreneur may deliberately shun approaching a venture capitalist in the very first stages of a project's life. To avoid a potential moral hazard problem the entrepreneur will instead develop the project on his own up to a certain stage. By doing so, the entrepreneur will enhance his bargaining position, and capture a larger share of the total surplus. In this paper we construct a highly stylized model for the decision problem faced by the entrepreneur. With this model we derive the condition for the optimal delay from the birth of the project until a contact with a venture capitalist is established. This delay will depend on the competitive pressure in the market, and on the skill of the entrepreneur. Our model implies that the market for a venture capitalist's services at the start-up stage of a project is likely to fail due to adverse selection.

JEL Classification: G24