Mitigation of Moral Hazard and Adverse Selection in Venture Capital Financing: The Influence of the Country’s Institutional Setting

Abstract

A venture capitalist (VC) needs to trade off benefits and costs when attempting to mitigate agency problems in their investor-investee relationship. We argue that signals of ventures complement the VC’s capacity to screen and conduct a due diligence during the pre-investment phase, but its attractiveness may diminish in institutional settings supporting greater transparency. Similarly, whereas a VC may opt for contractual covenants to curb potential opportunism by ventures in the post-investment phase, this may only be effective in settings supportive of shareholder rights enforcement. Using an international sample of VC contracts, our study finds broad support for these conjectures. It delineates theoretical and practical implications for how investors can best deploy their capital in different institutional settings whilst nurturing their relationships with entrepreneurs.