Size and Focus of a Venture Capitalist's Portfolio

Abstract

In this paper we take a portfolio approach to analyze the investment strategy of a venture capitalist (VC), and study the optimal size of a VC's portfolio. We show that portfolio size and scope a¤ect the incentives of both entrepreneurs to exert e¤ort and VCs to make start-up speci…c investment. A small portfolio improves entrepreneurial incentives because it allows the VC to concentrate his limited human capital on a smaller number of start-ups, adding more value to each start-up. In addition, by holding a small portfolio, the VC commits not to extract higher rents from the entrepreneurs, with a positive impact on their incentives. A large and focused portfolio is bene…cial for the VC because it allows the VC to reallocate his limited resources and human capital from one start-up to another in case of a startup failure. Furthermore, a large and focused portfolio allows the VC to extract greater rents from the start-ups because the VC can induce competition for his limited resources. We show that the VC …nds it optimal to limit his portfolio size when start-ups have higher quality prospects ex ante, that is, when providing strong entrepreneurial incentives is most valuable. The VC expands his portfolio size only when start-up fundamentals are more moderate and only when he can form a su¢ ciently focused portfolio.Finally we show that the VC may …nd it optimal to engage in portfolio management by divesting some of his start-ups early since this strategy allows him to extract a greater surplus from the remaining start-ups in his portfolio. Surprisingly, we …nd that under certain conditions, portfolio management, despite being socially ine¢ cient ex post, improves ex ante social welfare by enlarging the set of economically viable start-ups.

Early-stage financing and firm growth in new industries

“…7 Cestone and White (2003) consider the financing of competing ventures through a single investor. Inderst and Mueller (2003) consider competition among start-ups for VC financing in the capital market, while Kanniainen and Keuschnigg (2003), Fulghieri and Sevilir (2005), and Inderst et al (2007) consider competition among portfolio companies of the same VC for the VC's scarce resources.…”

Private Information and Bargaining Power in Venture Capital Financing

“…As proved in Lemma A.2, constraints (13) and (14) always bind, The result for constraint (12) follows directly from that result as the left hand side of (12) is a weighted average of the left hand sides of (13) and (14). The results for constraints (15), (16), and (17) follow by first order stochastic dominance argument in addition to constraints (13) and (14) (20) is satisfied because (21) is satisfied and (18) …”

“…Thus, the investment I 1 is also financed solely by the venture capitalist. Keuschnigg (2004), Inderst, Mueller, and Munnich (2007), and Fulghieri and Sevilir (2009)). In addition, market conditions induce over-and under-investment in private equity (Axelson, Strömberg, and Weisbach (2009)).…”

“…This cost may reflect the present value of the premium a new venture capitalist has to pay to investors to raise capital. 16 This premium θ is likely to be higher when conditions in capital markets are tighter. Alternatively, θ can be interpreted as the cost of establishing the infrastructure necessary to become a venture capitalist.…”

“…We first analyze optimal contracts when the contracts reveal the venture capitalist's private information. To characterize these contracts we solve the reduced problem of (24) with the constraints (13), (14), (16), (17), (18), (21), (23) and (22). Then we show that the solution to this reduced problem satisfies the remaining constraints ( (15)), ( (19)) and (20).…”