Robust Financial Contracting and the Role of Venture Capitalists

This paper analyzes a model of financing for start-up companies, focusing on the investment decisions that are made in later stages of financing and on the interaction between entrepreneurs, venture capitalists and other capital providers. We show that when a venture capitalist is not involved in the financing, information asymmetries cannot generally be resolved costlessly through the entrepreneur’s choice of securities at each financing stage. We then show that unresolved information asymmetries can lead to suboptimal investment decisions. When a venture capitalist is involved in making the investment decisions in later stages of the project, we show that optimal decisions will be made in all contingencies if and only if the venture capitalist is given what we call a fixed-fraction equity contract. In such a contract the venture capitalist receives the same fraction of the project’s payoff independent of the continuation decision, and also finances that same fraction of any future investment. This implies that capital providers other than the “lead” venture capitalist will be involved in later financing rounds. When given a fixed-fraction equity contract, the venture capitalist can play an important role in facilitating the interaction with other investors, since with this contract he has no incentives to misrepresent his information or to misprice new securities._x000B__x000B_