Relational Contracting and Business Norms in Entrepreneurial Finance

21 Pages Posted: 27 Jun 2018 Last revised: 2 Mar 2019

See all articles by Brian J. Broughman

Brian J. Broughman

Indiana University Maurer School of Law

Date Written: October 9, 2018

Abstract

Contracts between parties who have an on-going relationship often rely on informal norms, rather than formal legal rights, to resolve disputes and reduce transaction costs. Investors financing startup firms, however, may need to look outside of their existing network to find an entrepreneur with an innovative business plan. The search for innovation poses a challenge for relational models of contracting and may limit the effectiveness of social norms in entrepreneurial settings. Recognizing a tension between innovation and social embeddedness, one might expect to see greater use of arms-length contracting, especially when an investor finances an unknown entrepreneur. By contrast, I argue – using examples from angel/VC financing arrangements – that the tension between innovation and social embeddedness is resolved not through arms-length contracting, but rather by bolstering the network position of the unconnected entrepreneur through third-party intermediaries and staged financing. Third-party intermediaries – such as lawyers, board members, managers, scientists, and other entrepreneurs – are able to transform the relationship between the entrepreneur and investor by serving as ‘matchmakers’, ‘chaperones’, and ‘arbitrators’. These mechanisms allow entrepreneurs and investors to commit to informal business norms, even though the parties may have no pre-existing relationship. This study extends the literature in relational contracting and in entrepreneurial finance. Furthermore, my analysis suggests that studies of financial contracts, which focus exclusively on formal terms may overstate the relevance of holdup problems in the allocation of control rights.

Keywords: venture capital, relational contracting, relational finance

JEL Classification: G24, K12

Suggested Citation

Broughman, Brian J., Relational Contracting and Business Norms in Entrepreneurial Finance (October 9, 2018). Indiana Legal Studies Research Paper No. 402. Available at SSRN: https://ssrn.com/abstract=3196033 or http://dx.doi.org/10.2139/ssrn.3196033

Brian J. Broughman (Contact Author)

Indiana University Maurer School of Law ( email )

211 S. Indiana Avenue
Bloomington, IN 47405
United States

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