What Economists Have Taught Us About Venture Capital Contracting

Abstract

Venture capital investments are made under conditions of potentially extreme information asymmetry and agency cost among three sets of parties: the ultimate investors in venture capital funds, the venture capitalist (VC), and the entrepreneur. Venture capitalists commonly have control rights that are disproportionate to their shareholdings. These include the right to hold board seats, the right to veto certain major management decisions, and shareholder voting rights. Early theoretical models of the VC-entrepreneur relationship concentrated on the value of the VC's involvement in screening potential investments. In comparison to other investors, information asymmetry between the VC and the entrepreneur is less severe. Once the investment is made, staged investment provides the entrepreneur with a powerful incentive to meet his milestone. The compensation of the entrepreneur, and the management team, is heavily weighted toward stock options that vest over time.

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