Friends Don’t Lie: Monitoring and Communication With Risky Investments

Abstract

Venture capital (VC) investors have been criticized for lax monitoring and for being too “founder-friendly.” We identify an overlooked benefit of such behavior: entrepreneurs lie less to friendly VCs. The entrepreneur is privately informed about project success, enjoys private benefits of control, and recommends a project to the VC. The VC chooses the project and can intervene in the interim. The equilibrium features a “monitoring trap”: possible intervention leads the entrepreneur to lie, which prompts further intervention. However, both are better off if the VC commits to intervene less. We characterize implications for information acquisition, control rights, and staged financing.

Keywords: Venture Capital, Cheap Talk, Delegation, Governance

JEL Classification: G24, G32, G34, D83