Venture Capital: An Experiment in Computational Corporate Finance
42 Pages Posted: 2 Jan 2005
Date Written: March 1, 2004
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.
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