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Venture Capital Finance: A Security Design Approach

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  • Rafael Repullo
  • Javier Suarez

Abstract

This paper provides a theory of venture capital financing based on the complementarity between the financing and advising roles of venture capitalists. We examine the interaction between the staging of investment, that characterizes young firms with a high growth potential, and the double-sided moral hazard problem arising from the managerial contributions of entrepreneurs and venture capitalists. The optimal contractual arrangements have features that resemble the securities actually employed in venture capital financing. In particular, we identify an incentive-related insurance motive for making the initial financier bear the start-up's downside risk, as well as a financing motive for protecting him against dilution. This can explain the widespread use of convertible preferred stock.

Suggested Citation

  • Rafael Repullo & Javier Suarez, 1998. "Venture Capital Finance: A Security Design Approach," Working Papers wp1998_9804, CEMFI.
    • Handle: RePEc:cmf:wpaper:wp1998_9804
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    1. Mukesh Eswaran & Ashok Kotwal, 1984. "The Moral Hazard of Budget-Breaking," RAND Journal of Economics, The RAND Corporation, vol. 15(4), pages 578-581, Winter.
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    5. Gompers, Paul A, 1995. "Optimal Investment, Monitoring, and the Staging of Venture Capital," Journal of Finance, American Finance Association, vol. 50(5), pages 1461-1489, December.
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    7. Black, Bernard S. & Gilson, Ronald J., 1998. "Venture capital and the structure of capital markets: banks versus stock markets," Journal of Financial Economics, Elsevier, vol. 47(3), pages 243-277, March.
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    More about this item

    JEL classification:

    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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