DP5806 Venture Capital Financing: The Role of Bargaining Power and the Evolution of Informational Asymmetry

Author(s): Yrjö Koskinen, Michael Rebello, Jun Wang
Publication Date: August 2006
Keyword(s): asymmetric information, bargaining power, financial contracting, investment distortions, venture capital
JEL(s): D82, G24, G32
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5806

We model a situation where the entrepreneur has an informational advantage during the early stages of an investment project while the venture capitalist has the informational advantage during the later stages. We examine how this evolution of informational asymmetry affects venture investment and the nature of financing contracts under two different scenarios with regard to the distribution of bargaining power between the venture capitalist and entrepreneur: when the venture capitalist has the bargaining advantage and when the entrepreneur has the bargaining advantage. Our results demonstrate that the distribution of bargaining power has a profound influence both on the terms of contracts and on investments in venture-backed projects. Changes in bargaining power can completely alter the payoff sensitivity of contracts offered to entrepreneurs, and, as witnessed in the recent past, when entrepreneurs hold the bargaining advantage, venture capitalists may acquiesce to excessive investments in early stages of projects and subsequently terminate a larger number of projects.