DP18227 Resolving Tensions between Heterogeneous Investors in a Startup
Legal scholars highlight the tensions that exist between different classes of shareholders in startups. We model a startup owned by undiversified investors with heterogeneous capital contributions and risk preferences. A social planner runs the firm on behalf of all investors. We compare investors' expected utility with a hypothetical first-best decentralized benchmark. The startup's optimal investment policy is pro-cyclical and a time-varying weighted average of shareholders' optimal investment policies. The optimal contracts issued to investors are tailor-made, interdependent, and include equity claims resembling preferred stock with heterogeneous payout caps, leading to a complex capitalization table as more investors join the startup.