Optimal Staging of Early Startups

Abstract

When early startups stage the financing of their capital investments, they are at risk of being severely diluted by venture capitalists later on. It is puzzling that early startups do so in a competitive financial market. This paper shows that staging is beneficial to an early startup with a small upside return and a high capital intensity of early development. In this case, absent staging, the entrepreneur gets a small number of shares, which provides him with weak incentives to increase the startup's value. If the financing is staged, reevaluation of the startup during the follow-on round incorporates all the nonverifiable information about interim performance. Staging provides additional incentives since the entrepreneur gets more shares when interim performance is better. Between round financing and tranched financing, the two most prevalent forms of staging, round financing generates stronger incentives for the entrepreneur, but a lower payoff to the venture capitalist, than tranched financing. As a result, with a smaller upside return and a higher capital intensity of early development, the venture capitalist is less likely to participate in round financing, and tranched financing is more likely to be used to ensure his participation. All the above results are robust in a mechanism design framework.

Keywords: Early Startup, Venture Capital, Incomplete Contracts, Mechanism Design

JEL Classification: D82, D86, G24, G32