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A Soft Budget Constraint Explanation for the Venture Capital Cycle

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  • Georg Gebhardt
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    Abstract

    We explore why venture capital funds limit the amount of capital they raise and do not reinvest the proceeds. This structure is puzzling because it leads to a succession of several funds financing each new venture, which multiplies the well-known agency problems. We argue that an inside investor cannot provide a hard budget constraint while a less informed outsider can. Therefore, the venture capitalist delegates the continuation decision to the outsider by ex ante restricting the amount of capital he has under management. The soft budget constraint problem becomes the more important the higher the entrepreneur's private benefits are and the higher the probability of failure of a project is. Copyright 2008 The Author. Journal Compilation Verein für Socialpolitik and Blackwell Publishing Ltd. 2008.

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    Bibliographic Info

    Article provided by Verein für Socialpolitik in its journal German Economic Review.

    Volume (Year): 10 (2009)
    Issue (Month): (02)
    Pages: 71-90

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    Handle: RePEc:bla:germec:v:10:y:2009:i::p:71-90

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    1. Dirk Bergemann & Ulrigh Hege, 2005. "The Financing of Innovation: Learning and Stopping," RAND Journal of Economics, The RAND Corporation, vol. 36(4), pages 719-752, Winter.
    2. Schmidt, Klaus M., 1996. "The costs and benefits of privatization: An incomplete contracts approach," Munich Reprints in Economics 19773, University of Munich, Department of Economics.
    3. Schmidt, Klaus M., 2003. "Convertible Securities and Venture Capital Finance," Munich Reprints in Economics 19769, University of Munich, Department of Economics.
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