Excessive Risk-Taking and Founder Friendly VCs

Abstract

We provide a theory of excessive risk-taking in startups. An informed entrepreneur, who enjoys private benefits of control, proposes either a safe or risky project. The VC chooses which project to finance and can intervene to fire the entrepreneur in the interim. In equilibrium, the entrepreneur seeks to minimize the likelihood of intervention and recommends the risky project even if she knows it will fail. Stricter monitoring by the VC exacerbates risk-taking, whereas lax monitoring mitigates it. We characterize implications for information acquisition, control rights, outside directors, and stage financing.

Keywords: Venture Capital, Cheap Talk, Delegation, Governance

JEL Classification: G24, G32, G34, D83