Pivots and Prestige: Venture Capital Contracts with Experimentation
62 Pages Posted: 18 Nov 2019
Date Written: November 5, 2019
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
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