Venture Capital Contracting Under Asymmetric Information

The author develops a model of venture capital contracting in which the entrepreneur and venture capitalist contract under symmetric information. A condition of asymmetric information may arise subsequent to the first contract. The author shows that this condition makes debt contracts infeasible and leads to the use of preferred equity contracts. The author notes that discussions of the relation between venture capital and capital structure are rare. This paper expands the literature by addressing the role asymmetric information plays in determining why venture capitalists use equity, and preferred equity in particular, rather than debt to finance entrepreneurial projects. It suggests that the risk of the entrepreneur observing information about the project type before the venture capitalist may play a role in the contract type selection, not just the project quality uncertainty. To construct a database which demonstrates the stylized facts which this theory implies, a survey of venture capital firms was conducted whose results indicate that preferred stock is by far the most common contract type used in early-state financings. Debt and common equity are used far less frequently. Where they do appear, it usually is in later state financings or in industries where monitoring is less difficult, and hence the probability of asymmetrical information is much lower. The author summarizes that the choice of preferred equity over debt has been shown to be potentially motivated by intertemporal incentive inconsistencies due to the possibility of information asymmetries in certain states of intermediate return. The venture capitalist would foreclose under symmetric information. However, the entrepreneur has an incentive to behave opportunistically under asymmetric infor-mation. If the probability of asymmetric information is high, this effect may make the foreclosure feature of debt a large enough drag on the expected return of the venture capitalist as to make debt contracting unfeasible. Under such circumstances, pre-ferred equity may be desirable, because without foreclosure entrepreneur is not pushed into behaving opportunistically and the venture capitalist may receive some positive return, rather than a total loss. In summary, the author cautions that venture capital financing should not be thought of as simply a matter of making a high risk loan or equity investment. It involves extreme monitoring difficulties, and preferred equity represents the method by which monitoring difficulties can be dealt with in an incentive-compatible manner.