Moral Hazard by Inside Investors in the Context of Venture Financing
22 Pages Posted: 6 Mar 2002
Date Written: February 28, 2002
Abstract
We look at moral hazard by an insider investor in the context of venture financing The inside investor has experienced the entrepreneur's quality in a previous stage. An outside investor cannot assess the quality. Thus, generally, an outside investor offers financial terms reflecting the average entrepreneurial quality. If the entrepreneur is a good one the inside investor may have an incentive to appropriate rents due to his information monopoly by demanding a higher share on the venture's return before financing the next stage. If it is more costly for the entrepreneur to switch to an outside investor, she sticks to the inside investor, though. However, she may not choose the efficient level of effort or specific investments, rather she underinvests. This problem of expropriation depends on the information structure and may be mitigated when the parties ex ante fix the financial terms of future capital infusions conditionally on the performance of previous stages. These provisions are quite common. So far, the literature considered them as a device to mitigate moral hazard by entrepreneurs. But they can also mitigate the inside investor's incentive to negotiate opportunistically. The syndication of venture capital investments may mitigate the moral hazard problem, too, since co-investors are likely to be better informed than outside investors. Debt financing or mixed financing may be more favorable than equity financing since legal boundaries on interest rates limit the extent to which an inside investor could hold up an entrepreneur.
Keywords: venture capital, stage financing, moral hazard by investor, insider information
JEL Classification: G24, D82, G32
Suggested Citation: Suggested Citation
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