The optimal portfolio of start-up firms in venture capital finance

Abstract

Venture capitalists (VCs) not only finance but also add value to start-up companies. Advising firms is time consuming and creates a trade-off between intensity of advice and portfolio size. We jointly determine the optimal number of portfolio companies and the intensity of managerial advice. Diminishing returns to advice per firm call for a larger portfolio. With progressively increasing managerial effort cost, however, a larger number crowds out advice to each individual firm. As they receive less support, entrepreneurs request a larger profit share, making further portfolio expansion eventually unprofitable. Comparative static analysis shows how optimal portfolio size responds to venture returns and other parameters.

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.…”

Size and Focus of a Venture Capitalist's Portfolio

“…Since the reaction functions of the two entrepreneurs are symmetric, the Nash-equilibrium of the e¤ort choice subgame is obtained by setting p j p i in the …rst-order condition (10), and then solving for p i ; giving (11). Substituting the Nash-equilibrium level of e¤ort (11) into the entrepreneurs'objective function, (8), and in the VC's objective function, (9), gives the VC's pro…ts (12) and the entrepreneurs'pro…ts (13). …”

“…Our paper is also related to the work by Kanniainen and Keuschnigg (2003), further extended by Bernile and Lyandres (2003). In these papers a VC has limited resources that he can devote to his start-ups, and adding an additional start-up to the portfolio always weakens both the VC's and the entrepreneurs'incentives.…”

“…In addition, a key feature of our analysis is to recognize that VC 1 Inderst, Mueller and Muennich (2006), Kanniainen and Keuschnigg (2003) and Bernile and Lyandres (2003) provide notable exceptions. 2 For anecdotal evidence on the relevance of fund size see The Economist, which wrote on April 2, 2005 that "some venture capital funds say they have turned away money from investors in order to keep fund sizes down to an amount that can be managed responsibly".…”

“…In addition, in our paper, the VC's ability to extract surplus depends on the degree of relatedness of the start-ups, and thus portfolio focus. Di¤erently from Kanniainen and Keuschnigg (2003) and Bernile and Lyandres (2003) we derive the optimal size of a VC's portfolio by analyzing the combined impact of portfolio size and focus on incentives.…”