Financier Search and Boundaries of the Angel and VC Markets

This paper studies how critical entrepreneurial finance outcomes such as the investment return and equity division are shaped by venture characteristics, financier risk preferences, and competitive searching. Our analysis uses a double-hazard agency model in which financiers determine the equity division to maximize the expected utility of their investment return while entrepreneurs search for the best deal. Model results provide new theoretical insights on the venture funding cycle, the coexistence of angels/venture capitalists (VCs) with heterogeneous risk aversion, and risk separation in the entrepreneurial finance market. The model predicts that financiers with higher funding capacity and advisory capabilities (e.g., VC firms) will prefer to fund at later stages as their expected investment return rises with the venture’s initial value and financier productivity. Competitive searching by entrepreneurs enables financiers with a diverse set of risk preferences to coexist profitably by reducing the advantage (disadvantage) of lower (higher) risk aversion financiers and making investment returns more similar. Further, the model shows the emergence of a risk separation cutoff beyond which only angels/VCs with lower levels of risk aversion can profitably fund riskier ventures.