Staging of Venture Financing, Moral Hazard, and Patent Law

The literature on venture financing mainly focuses on entrepreneurial moral hazard. The investor, however, may behave opportunistically, too. We look at the case where the investor demands a higher share on the venture’s return before financing the next stage. Possibly, the staging of capital is the most salient feature of venture financing. The entrepreneur may be forced to accept the investor’s offer, when she is supposed to lose something by changing the investor. For instance, if the property rights on the invention are not sufficiently protected - because the entrepreneur has not filed for a patent or the invention does not meet the legal requirements for patent protection - the investor may use the idea for his own purposes once the entrepreneur terminates the relationship. This threat may force the entrepreneur to continue although the investor demands a higher share. As a consequence, she sticks with the investor, however, she may not choose the efficient level of specific investments, rather she underinvests. The impact of patent law is important. In the law and economics literature patent law is primarily seen as an instrument balancing the trade-off between setting incentives to innovate and limiting monopoly power of patent holders. It, however, overlooks the fact that an entrepreneur’s idea often only develops to a market product with the help of investors providing financial resources. Thus, I argue that there is an additional goal of patent law: mitigating conflicts in the venture financing process thereby making innovations more likely.