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Staged financing: a trade-off theory of holdup and option value

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  • Lei Gao

    (Shandong University)

Abstract

This paper investigates financial contract design in venture capital investments and shows that staged financing is the implementation of optimal contracts. In designing contracts, venture capitalists consider the value of real options and the costs of holdup. This consideration boils down to contract rigidity and flexibility: rigid contracts mitigate the holdup problem of entrepreneurs, but have little option values, whereas flexible contracts create real options for venture capitalists in corporate decision-making, but yield weak bargaining power when ventures appear promising. In optimal contracts, venture capitalists choose flexibility by separating capital into stages and then strategically allocating control rights at each stage. This strategy creates option value in corporate governance, and can protect sunk investments in distress while capturing the potential benefits of good outcomes.

Suggested Citation

  • Lei Gao, 2017. "Staged financing: a trade-off theory of holdup and option value," Journal of Economics, Springer, vol. 121(3), pages 197-237, July.
    • Handle: RePEc:kap:jeczfn:v:121:y:2017:i:3:d:10.1007_s00712-017-0524-x
    DOI: 10.1007/s00712-017-0524-x
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    More about this item

    Keywords

    Venture capital; Staged financing; Incomplete contracts; Holdup; Real options;
    All these keywords.

    JEL classification:

    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance

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