Optimal Allocation of Control Rights in Venture Capital Contracts
45 Pages Posted: 4 Jul 2011 Last revised: 16 Mar 2012
Date Written: February 27, 2012
This article questions the allocation of control rights to venture capitalists with particular focus on liquidation decisions. The literature has shown that the venture capitalist acts as the principal to prevent the agent (i.e., the entrepreneur) from pursuing private objectives and destroying value. I develop a two-staged model in which an entrepreneur asks a venture capitalist to finance her project. The VC (venture capital) firm immediately makes a first investment but may not make the second investment, depending on its horizon preference (e.g., short-term or long-term).
The results show that the investor makes optimal decisions only if he is able to remain throughout the lifetime of the project. If this is not possible, he will opportunistically decide to sell the project, whatever its quality, thereby generating inefficient continuation of bad projects. If the entrepreneur holds control rights, she will follow the same strategy. However, under certain conditions (especially projects with higher liquidation proceeds), she will make the correct decisions, unlike the investor. This proves that the short-term constraints of VC investors create inefficiencies and that allocating control rights to entrepreneurs may reduce them. An empirical study on the portfolio of two venture capitalists illustrates this result.
Keywords: venture capital, control rights, limited partnerships, entrepreneurial finance
JEL Classification: D81, G21, G24, G32
Suggested Citation: Suggested Citation