Optimal Financing Contracts in Venture Capital Partnerships

This paper analyzes a business venture’s financing problem where an entrepreneur and an advisor exert complementary efforts to improve the productivity of a risky investment project under moral hazard. With verifiable contracts, it is optimal for the entrepreneur to sign contingent contracts directly with the advisor and the investors. With unverifiable contracts, the entrepreneur cannot write contingent contracts and she is constrained to employ either angel financing or venture capital financing. In the case of angel financing, the entrepreneur finds it expensive to raise money. In the case of venture capital financing, the entrepreneur contracts only with the advisor like a venture capitalist who has formed a limited partnership with the investors. In competitive capital and labor markets, the entrepreneur maximizes her expected payoff by choosing venture capital financing, which explains its prevalence in practice. The entrepreneur issues convertible securities to respond to different incentives from the venture capitalist and the investors.