Size and Focus of a Venture Capitalist's Portfolio
50 Pages Posted: 20 Mar 2005
Date Written: December 2004
This paper investigates the optimal size and scope of a Venture Capitalist's (VC's) portfolio. We consider a VC who chooses the number of start-ups to invest in his portfolio. In our model, both the VC's and the entrepreneurs' inputs are necessary for the success of the project, making their contributions complementary. We show that the size and scope of the VC's portfolio have an important impact on the investment incentives of both the VC and the entrepreneurs. A small portfolio impacts entrepreneurial incentives positively by reducing competition between start-ups for the VC's limited amount of resources, and impacts the VC's incentives negatively by reducing the VC's rent extraction ability. Furthermore, the VC benefits from portfolio focus, since a greater level of relatedness between portfolio companies allows the VC to reallocate his resources and human capital more efficiently from one start-up to another and to extract more rents. We also show that, because of the complementarity between the VC's investment and entrepreneurial effort, a large portfolio may lead to better incentives for both the VC and the entrepreneurs. Whether the VC chooses a small or large portfolio depends on the effect of size on entrepreneurial incentives, the VC's rent extraction ability and responsiveness of VC's incentives to the level of entrepreneurial incentives. Finally, we show that the VC benefits from managing his portfolio strategically by selectively divesting some of the portfolio companies.
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