Pivots and Prestige: Venture Capital Contracts with Experimentation

73 Pages Posted: 18 Nov 2019 Last revised: 11 May 2020

See all articles by Xuelin Li

Xuelin Li

University of South Carolina - Department of Finance

Martin Szydlowski

University of Minnesota - Twin Cities - Carlson School of Management

Date Written: November 5, 2019

Abstract

We study venture capital finance with experimentation. An entrepreneur contracts with an investor and has private information about a project, which requires costly experimentation by both parties to succeed. In equilibrium, investors learn about the project from the arrival of exogenous information and from the entrepreneur's contract offers. The optimal contract features vesting and dilution, consistent with empirical evidence. Early payouts, pivots, and prestige projects emerge as signaling devices. Surprisingly, technological progress, which lowers the cost of experimentation or which increases the rate of learning, delays separation of types and worsens adverse selection. Liquidation rights for investors also delay separation.

Keywords: Venture Capital, Experimentation, Signaling, Pivots, Prestige Projects

JEL Classification: G24, G32, D82, D83

Suggested Citation

Li, Xuelin and Szydlowski, Martin, Pivots and Prestige: Venture Capital Contracts with Experimentation (November 5, 2019). Available at SSRN: https://ssrn.com/abstract=3481301 or http://dx.doi.org/10.2139/ssrn.3481301

Xuelin Li

University of South Carolina - Department of Finance ( email )

1014 Greene Street
Columbia, SC 29208
United States

Martin Szydlowski (Contact Author)

University of Minnesota - Twin Cities - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States

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