DP1738 Venture Capital Financing, Moral Hazard and Learning

Author(s): Dirk Bergemann, Ulrich Hege
Publication Date: November 1997
Keyword(s): dynamic financial constraints, optimal stopping, relationship finance, Security Design, share contracts, venture financing
JEL(s): D83, D92, G24, G31
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=1738

We consider the provision of venture capital in a dynamic agency model. The value of the venture project is initially uncertain and more information arrives by developing the project. The allocation of funds and the learning process are subject to moral hazard. The optimal contract is a time-varying share contract which provides intertemporal risk-sharing between venture capitalist and entrepreneur. The share of the entrepreneur reflects the value of a real option. The option itself is based on the control of the funds. The dynamic agency costs may be high and lead to an inefficiently early end to the project. A positive liquidation explains the adoption of strip financing or convertible securities. Finally, relationship financing, including monitoring and the occasional replacement of management improves the efficiency of the financial contracting.