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Vesting and control in venture capital contracts

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  • David R. Skeie

Abstract

Vesting of equity payments to an entrepreneur, which is a form of time-contingent compensation, is very common in venture capital contracts. Empirical research suggests that vesting is used to help overcome asymmetric information and agency problems. We show in a theoretical model that vesting equity to an entrepreneur over a long period of time acts as a screening device against a bad entrepreneur type. But incomplete contracts due to hold-up by the venture capitalist imply that equity compensation, in the form of either short-term or long-term vesting, cannot provide standard contractible equity incentives for the entrepreneur to take an unobservable action involving effort. We introduce a new model of effort based on a verifiable choice of an effort-intensive project, for which the short-term vesting of equity can provide incentives, but which results in a trade-off between incentives and screening. Contingent control rights are a substitute for short-term vesting and provide the largest incentives for effort by fully protecting the entrepreneur from hold-up. We also show that a new link between equity cash flow claims and control rights is that residual equity control rights over the firm are necessary to protect residual equity claims from hold-up.

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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 297.

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Date of creation: 2007
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Handle: RePEc:fip:fednsr:297

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Related research

Keywords: Venture capital ; Corporations - Finance ; Financial risk management ; Equity;

This paper has been announced in the following NEP Reports:

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  3. Kaplan, Steven & Strömberg, Per Johan, 2000. "Financial Contracting Theory Meets The Real World: An Empirical Analysis Of Venture Capital Contracts," CEPR Discussion Papers 2421, C.E.P.R. Discussion Papers.
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  17. Thomas Hellmann, 1998. "The Allocation of Control Rights in Venture Capital Contracts," RAND Journal of Economics, The RAND Corporation, vol. 29(1), pages 57-76, Spring.
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