The Allocation of Control Rights in Venture Capital Contracts
Stanford GSB Research Paper No. 1362
Posted: 4 Mar 1996
Date Written: Undated
Venture Capitalists hold extensive control rights over entrepreneurial companies, including the right to fire the entrepreneurs with little severance. I examine why, and under what circumstances, entrepreneurs would voluntarily choose to relinquish control. I show that control may be necessary for the venture capitalists to have incentives to add value to their companies. Entrepreneurs may give up control and risk being replaced, even if the loss of private benefits under replacement outweighs the monetary benefits to the company. The model is also used to explain further stylized facts about governance and financial structure in venture capital contracts. It explains the use of redeemable convertible preferred shares, and why venture capitalists do not provide long-term finance, but rather provide a sequence of short-term financing rounds. Finally it examines why venture capitalists decided on the timing of an IPO, even if they have an incentive to "grandstand."
JEL Classification: G24, G32, G34, L14, M13
Suggested Citation: Suggested Citation