Incentive Provision in Light of Expertise and Operational Involvement of Angel Investors

Angel investors provide a unique role in startup entities: in addition to providing financing, they also provide expertise and make critical operational and managerial decisions. As a result, a startup not only seeks funding from its angel investor, but also strives to ensure that their expertise promotes entrepreneurial success. This study formalizes a model of optimal equity sharing with angel investors in light of the facts that (i) they have private information about their expertise, (ii) the expertise impacts the efficacy of subsequent operating decisions, and (iii) equity sharing alters control rights linked to these decisions. We demonstrate that an entrepreneur will exhibit seemingly excessive optimism in decision‐making when angel investors claim they bring high expertise (skills) to the table. This apparent optimism is not a sign of naiveté but rather an effective device to discipline boasting by angels. The results demonstrate the critical role of expertise and decision rights in constructing ownership‐sharing agreements with angel investors. They also demonstrate a case in which the private information of investors (rather than that of insiders) is important, and how such adverse selection concerns entail aggressive operational choices, rather than the typical response of caution, coupled with limited equity usage that accounts for not just the transfer of ownership, but also the transfer of decision rights.