Venture Capital: An Experiment in Computational Corporate Finance

42 Pages Posted: 2 Jan 2005

See all articles by Zsuzsanna Fluck

Zsuzsanna Fluck

Michigan State University - Department of Finance

Kedran Rae Garrison

Massachusetts Institute of Technology (MIT) - Economics, Finance, Accounting (EFA)

Stewart C. Myers

Massachusetts Institute of Technology (MIT); National Bureau of Economic Research (NBER)

Date Written: March 1, 2004

Abstract

process, incorporating moral hazard and asymmetric information problems. The structure of the model, involving managerial effort, staged investment, and later-stage syndication, replicates what we know empirically of venture-capital financing. An entrepreneur raises funding for a positive NPV project by selling shares in the project. Terms-of-financing must take into account incentives for entrepreneur effort. After the entrepreneur's effort provision, if performance is strong, the entrepreneur will raise funds in the next financing stage, until the project is ultimately cashed out. We explore several financing scenarios, including first-best, monopolistic, and competitive syndicate financing. We solve numerically for initial effort levels and participants' project shares and option values, then measure value loss from first-best. We find that when financed by outside investors, the value loss from under-provision of effort is sizable, and that many positive-NPV firms cannot be financed. Syndicate financing in later stages alleviates under-provision of effort and increases the value of all parties. The initial venture capitalist, despite no longer being able to profit from a monopoly on late-stage financing, benefits from the entrepreneur's increased effort incentives. Allowing limited renegotiation between the incumbent venture capitalist and the entrepreneur leads to further increases in continuation efficiency and NPV. The syndication case is not as efficient with private information as with public information. The "fixed-fraction" rule of Admati-Pfleiderer (1994) for efficient project continuation does not hold, due to the endogeneity of effort. However, in many cases, requiring the initial investor to take an increasing share of the company can promote efficient continuation.

Suggested Citation

Fluck, Zsuzsanna and Garrison, Kedran Rae and Myers, Stewart C., Venture Capital: An Experiment in Computational Corporate Finance (March 1, 2004). AFA 2005 Philadelphia Meetings. Available at SSRN: https://ssrn.com/abstract=642143 or http://dx.doi.org/10.2139/ssrn.642143

Zsuzsanna Fluck (Contact Author)

Michigan State University - Department of Finance ( email )

Eli Broad Graduate School of Management
315 Eppley Center
East Lansing, MI 48824-1122
United States
517-353-3019 (Phone)
517-432-1080 (Fax)

Kedran Rae Garrison

Massachusetts Institute of Technology (MIT) - Economics, Finance, Accounting (EFA) ( email )

77 Massachusetts Avenue
Cambridge, MA 02139-4307
United States

Stewart C. Myers

Massachusetts Institute of Technology (MIT) ( email )

Sloan School of Management
Cambridge, MA 02142
United States
617-253-6696 (Phone)
617-258-6855 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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