Bilateral Incentive Problems and the Form of Start-Up Financing

We analyze the efficiency of different contracting arrangements between a venture capitalist and an entrepreneur when their relationship is subject to both hidden information and hidden action. In particular, we assume that the entrepreneur must expend unobserved effort to complete the project if the venture capitalist finances it, and that the venture capitalist possesses private information about the firm's future cash flow if the project is successfully completed. We analyze the efficiency of financial contracts that include (a) pure equity, (b) pure debt, and (c) combinations of equity and debt with contingent claims. The model analyzes two different environments regarding the final claims on the cash flow if the product is successful: (a) the entrepreneur and the venture capitalist commit to hold onto the firm until the liquidating cash flow is generated, and (b) the entrepreneur and venture capitalist commit to sell the firm to the market through an initial public offering (IPO) after the project is successfully completed but before the liquidating cash flow is generated. In both cases, the cash flow received by the entrepreneur and venture capitalist will be shared between them according to the contract negotiated by them at the start of the game. Our main finding is that the venture capitalist strictly prefers to offer the entrepreneur a contract involving debt, equity, and an option to buy the entire firm to the optimal pure equity contract. Furthermore, the venture capitalist strictly prefers to offer the entrepreneur the optimal pure equity contract to the optimal pure debt contract. Although our results regarding the venture capitalist's preference ordering over contracts are similar to other findings in the theoretical literature, the economic motivation for our result is new. Our results regarding the venture capitalist's preference ordering arise based on the efficiency with which the different contracts trade off the two motivational problems — inducing efficient effort from the entrepreneur and inducing truthful disclosure of the expected cash flow from the venture capitalist. We also find that when the venture capitalist and the entrepreneur commit to sell the firm to the market, disclosing a report about the project's ex ante probability of success improves contracting efficiency.