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Venture Capital Contracts and Market Structure

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  • Inderst, Roman
  • Mueller, Holger M

Abstract

We examine the relation between optimal venture capital contracts and the supply and demand for venture capital. Both the composition and type of financial claims held by the venture capitalist and entrepreneur depend on the market structure. Moreover, different market structures involve different optimal forms of transferring utility: sometimes it is optimal to transfer utility via equity stakes, sometimes it is optimal to use debt. Transferring utility via equity stakes affects incentives. Consequently, the net value created, the success probability, the market (or IPO) value, and the performance of venture-capital backed investments all depend on the supply and demand for capital. Similarly, venture capitalists face different incentives to screen projects ex ante if the capital supply is low or high. We then endogenize the capital supply and study the relation between venture capital contracts and entry costs, public policy, investment profitability, and market transparency. Finally, we show that entry by inexperienced investors creates a negative externality for the value creation in ventures financed by (regular) venture capitalists.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3203.

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Date of creation: Feb 2002
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Handle: RePEc:cpr:ceprdp:3203

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Keywords: market structure; optimal contracting; venture capital;

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  1. Patrick Legros & Andrew F. Newman, 2004. "Competing for Ownership," Boston University - Department of Economics - The Institute for Economic Development Working Papers Series dp-148, Boston University - Department of Economics.
  2. Klaus M. Schmidt, 2003. "Convertible Securities and Venture Capital Finance," Journal of Finance, American Finance Association, vol. 58(3), pages 1139-1166, 06.
  3. Hellmann, Thomas F. & Puri, Manju, 2000. "Venture Capital and the Professionalization of Start-up Firms: Empirical Evidence," Research Papers 1661, Stanford University, Graduate School of Business.
  4. Michelacci, C. & Suarez, J., 2000. "Business Creation and the Stock Market," Papers 0009, Centro de Estudios Monetarios Y Financieros-.
  5. Giacinta CESTONE, 2001. "Venture Capital Meets Contract Theory: Risky Claims or Formal Control?," UFAE and IAE Working Papers 480.01, Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC).
  6. Casamatta, Catherine, 2002. "Financing and Advising: Optimal Financial Contracts with Venture Capitalists," CEPR Discussion Papers 3475, C.E.P.R. Discussion Papers.
  7. Kaplan, Steven & Strömberg, Per Johan, 2002. "Characteristics, Contracts and Actions: Evidence from Venture Capitalist Analyses," CEPR Discussion Papers 3243, C.E.P.R. Discussion Papers.
  8. Rafael Repullo & Javier Suarez, 2004. "Venture Capital Finance: A Security Design Approach," Review of Finance, Springer, vol. 8(1), pages 75-108.
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  12. Steven N. Kaplan & Per Stromberg, 2003. "Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts," Review of Economic Studies, Wiley Blackwell, vol. 70(2), pages 281-315, 04.
  13. Inderst, Roman, 2001. "Screening in a Matching Market," Review of Economic Studies, Wiley Blackwell, vol. 68(4), pages 849-68, October.
  14. Bengt Holmstrom & Jean Tirole, 1994. "Financial Intermediation, Loanable Funds and the Real Sector," Working papers 95-1, Massachusetts Institute of Technology (MIT), Department of Economics.
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  17. Hellmann, Thomas, 2002. "A theory of strategic venture investing," Journal of Financial Economics, Elsevier, vol. 64(2), pages 285-314, May.
  18. Rajan, Raghuram G, 1992. " Insiders and Outsiders: The Choice between Informed and Arm's-Length Debt," Journal of Finance, American Finance Association, vol. 47(4), pages 1367-400, September.
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Cited by:
  1. Christian Keuschnigg & Soren Bo Nielsen, 2002. "Start-ups, Venture Capitalists, and the Capital Gains Tax," University of St. Gallen Department of Economics working paper series 2002 2002-05, Department of Economics, University of St. Gallen.
  2. Michelacci, Claudio & Suarez, Javier, 2002. "Business Creation and the Stock Market," CEPR Discussion Papers 3513, C.E.P.R. Discussion Papers.
  3. Christian Keuschnigg, 2003. "Optimal Public Policy For Venture Capital Backed Innovation," University of St. Gallen Department of Economics working paper series 2003 2003-09, Department of Economics, University of St. Gallen.

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