Time-Inconsistent Preferences and Venture Capital Contracting

49 Pages Posted: 15 Apr 2011 Last revised: 29 Jul 2014

See all articles by Manuel A. Utset

Manuel A. Utset

Florida State University College of Law

Date Written: May 2011

Abstract

Agency explanations of the venture capital process routinely assume that entrepreneurs and venture capitalists have time-consistent (“TC”) preferences, and thus perfect self-control. Given the growing evidence on self-control problems, from both experiments and field studies, it is natural to ask how our understanding of the venture capital process would change if one were to relax the TC assumption. This paper begins this process. It develops a model of venture capital contracts in which time-inconsistent (“TI”) parties may repeatedly procrastinate undertaking onerous tasks - e.g., innovators may procrastinate finishing the innovation, and venture capitalists may procrastinate monitoring and advising entrepreneurs. Similarly, TI entrepreneurs and venture capitalists may overindulge in self-dealing. The time-inconsistent contracting model developed in the paper helps explain why venture capital contracts include incentive and governance mechanisms that are much more high-powered than those used in innovation-intensive publicly traded companies, which not only have many of the same types of moral hazard problems, but are also more complex and less transparent. The model also helps explain some of the standard features of contracts between venture capitalists and their investors.

Keywords: venture capital, private equity, self-control problems, procrastination, time-inconsistent preferences

JEL Classification: K22, G24, M13, O31

Suggested Citation

Utset, Manuel A., Time-Inconsistent Preferences and Venture Capital Contracting (May 2011). The Oxford Handbook of Venture Capital Finance, 2012, FSU College of Law, Public Law Research Paper No. 498, FSU College of Law, Law, Business & Economics Paper No. 11-6, Available at SSRN: https://ssrn.com/abstract=1810147

Manuel A. Utset (Contact Author)

Florida State University College of Law ( email )

425 W. Jefferson Street
Tallahassee, FL 32306
United States
(850) 644-7274 (Phone)

HOME PAGE: http://www.law.fsu.edu/faculty/mutset.html

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