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On The Double Moral Hazard And Corporate Governance Of The Venture Capital

Posted on:2006-03-17Degree:DoctorType:Dissertation
Country:ChinaCandidate:W TangFull Text:PDF
GTID:1119360182471748Subject:Western economics
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Venture capital plays an important role in the corporate governance of young firms seeking to grow rapidly. The venture capital is a particularly good example of an institution that prides itself on 'nursing' companies, rather than just financing them. They add value to their companies by providing a variety of services: they help shape strategies, provide technical and commercial advice and attract key personnel. For many of these activities the investors and the entrepreneurs have reasonably well-aligned objectives of increasing the company's profitability. The venture capital industry has grown dramatically over the last decade. In the US, venture capital investments grew from$3.3 billion in 1990 to $100 billion in 2000. in Europe funds invested in VC grew from $6.4 billion in 1998 to more than $10 billion in 1999. At the origin of this success is certainly the value-added by these investors. But a closer look at the venture capital business reveals that divergent interests can also create a lot of tension between entrepreneurs and venture capitalists. For example, the entrepreneur and the venture capitalist plunge in a double moral hazard context where they both can exert unobservable efforts to enhance productivity. This paper provides a theory of start-up financing based on the dual, financing and advising, role played by venture capitalist. Entrepreneurs endowed with the creativity and technical skills needed to develop innovative ideas may lack business expertise and need managerial advice. I analyze a model where, in the first best, some effort should be provided both by the entrepreneur and by the venture capitalist. In line with the view that entrepreneurial vision is really key to the success of the venture, I assume the entrepreneur's effort is more efficient than the venture capitalist's. Quite plausibly, I assume the level of effort exerted by the venture capitalist to develop the project, as well as by the entrepreneur, are not observable. Consequently the entrepreneur and the venture capitalist face a double moral hazard problem. In order to induce them to support the firm's project and enhance the profitability of the venture, both the entrepreneur and the venture capitalist must be given proper incentives through the cash-flow rights they receive over the outcome of the project. Firstly, this paper brings forward three main economic hypothesis: opportunism, bounded rationality, and foundational uncertainty. On the basis of these hypothesis, this article reforms the "Buyer-Seller" model resulting from Segal and Hart. Indescribable contingencies cause the mixed structure of information, and thus influence the efficiency of contract. By using the irrelevance theories of Maskin and Tirole, this paper designs a mechanism to eliminate restriction on the complete contract resulting from the indescribable contingencies. It shows that in the absence of contract renegotiation the indescribability of states of nature does not interfere with optimal contracting if the complete contract when contingencies are describable is "welfare-neutral". This paper takes the conclusion that the optimal financial contract with venture capitalist is feasible completeness, which is restricted within the bounded sets of the future preference and feasible behavior of the agents. Subsequently, this paper provides a rationale for the frequently observed use of financial claims like common stocks, preferred stocks, or convertible bond in venture capital agreements. Double moral hazard means that the more powerful the incentives given to one agent, the less the other agent will be induced to provide effort. The optimal contract will take into account the countervailing effects of inducing one agent to work, and reflect both incentives. The analysis of the optimal financial contract provides a rationale for the frequently observed use of financial claims like common stocks, preferred stocks, or convertible bonds in VC agreements. When the joint efforts of the entrepreneur and the investor contribute to improve the profitability of the project, the level of effort provided is related to the amount invested. When the investor's investment is low, high powered financial claims, that enhance her revenue in the upper states of nature, increase her incentives to exert effort, which improves the project's profitability. The results state that when the investor's participation is low, she must be given common stocks, while she obtains convertible bonds or preferred stocks when her investment is high. In running the company entrepreneurs realize a private benefit that cannot be transferred to another party. This involves a conflict of interest, since entrepreneurs want to protect their own private benefit while venture capitalists want to maximize their financial return. The main question I therefore ask in this paper is why, and under what circumstances, do entrepreneurs voluntarily relinquish control rights to venture capitalists?By introducing a staged financing model, this paper analyzes the allocation of liquidation rights between entrepreneur and venture capitalist in the new venture. this paper emphasizes the importance of control rights in the bargaining between venture capitalist and entrepreneur. In order to induce the venture capitalist to supply the capital and efforts, the entrepreneur must relinquish the liquidation rights to the former, and this can maximize the expected income of the entrepreneur, adjusted to the participation constraint and the individual rationality constraint of the venture capitalist. Lastly, this paper considers data from 16 Asian countries, 16 European countries and the US to investigate the relationship between venture capital and corporate governance. There are four main findings. First, the variable measuring law and order is negatively related to the importance of venture capital finance. Second, the allocation of investment across different stages and different industries depends more on macroeconomic factors than on corporate governance variables. Third, in Low-GDP countries the allocation of venture capital is greater for low technology industries than for high technology industries. Finally, a comparison of Asian and European venture capital shows that in Asia there was more investment in early stage projects while in Europe there was more investment in late stage projects. Also, in Europe there was more investment in medical and biotechnology industries.
Keywords/Search Tags:new venture, double moral hazard, convertible securities, financial contracts, corporate governance
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