DP2097 Venture Capital Finance: A Security Design Approach

Author(s): Rafael Repullo, Javier Suarez
Publication Date: March 1999
Keyword(s): convertible preferred stock, Incomplete Contracts, stage financing, start-ups, Venture Capital, warrants
JEL(s): D92, G24, G32
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=2097

This paper provides a theory of venture capital financing based on the complementarity between the financing and advising roles of venture capitalists. We examine the interaction between the staging of investment that characterizes young firms with a high growth potential and the double-sided moral hazard problem that arises from the managerial contributions of entrepreneurs and venture capitalists. The optimal contract combines an incentive-related insurance motive that makes the initial financiers bear the start-up's downside risk and a financing motive that protects their claims against dilution. These motives can explain the widespread use of convertible preferred stock in venture capital financing.