The Incentives to Start New Companies: Evidence from Venture Capital

Abstract

The standard venture-capital contract rewards entrepreneurs only for creating successful companies that go public or are acquired on favorable terms.As a result, entrepreneurs receive no help from venture capital in avoiding the huge idiosyncratic risk of the typical venture-backed startup.Entrepreneurs earned an average of $9 million from each company that succeeded in attracting venture funding.But entrepreneurs are generally specialized in their own companies and bear the burden of the idiosyncratic risk.Entrepreneurs with a coefficient of relative risk aversion of two would be willing to sell their interests for less than $1 million at the outset rather than face that risk.The standard financial contract provides entrepreneurs capital supplied by passive investors and rewards entrepreneurs for successful outcomes.We track the division of value for a sample of the great majority of U.S. venture-funded companies over the period form 1987 through 2005.Venture capitalists received an average of $5 million in fee revenue from each company they backed.The outside investors in venture capital received a financial return substantially above that of publicly traded companies, but that the excess is mostly a reward for bearing risk.The pure excess return measured by the alpha of the Capital Asset Pricing Model is positive but may reflect only random variation.

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