Venture Capital Contracting with Double-Sided Moral Hazard and Fairness Concerns

Abstract

The development of new venture enterprise is the result of joint efforts of entrepreneurs and venture capitalists who collaborate based on complementary resources. In this paper, we analyze a venture capital incentive contracting model in which a venture capitalist interacts with an entrepreneur who is risk neutral and fairness concerned, offering him an equity contract. We solve the venture capitalist’s maximization problem in the presence of double-sided moral hazard. Our results show that fairness concerns change the structure of the optimal contract. More importantly, we show that the solution to the contract regarding the optimal share given to the entrepreneur is nonlinear and is a fixed point between 0 and 1. Further, we simulate the model under the assumption that venture project’s revenue is a Constant Elasticity of Substitution (CES) function and obtain the following results. (1) When the two efforts are complementary, the venture capitalist’s effort does not monotonically decrease in the share allocated to the entrepreneur, while the entrepreneur’s effort does not monotonically increase in his share. (2) Relative to the benchmark case where the entrepreneur is fairness neutral, the optimal equity share allocated to the fair-minded entrepreneur is larger than 1/2, and as the degree of efforts complementarity increases, the optimal equity share tends to 60%. In this scenario, for a given efforts substitution parameter, the fair-minded entrepreneur provides a higher effort level than the venture capitalist.

On the Study of a Single-Period Principal-Agent Model with Taxation

“…Proposition 1. Suppose that the cost function c(a) satisfies Assumption 1. e unique equilibrium (δ * , β * , a * ) of problem (6) exists and is demonstrated by the following statements.…”

“…e complementarity shows a universality in various circumstances. Chang and Hu [6] consider a venture capitalist's optimal contracting model of double-sided moral hazard. eir results show that fairness concerns change the optimal contract.…”

Venture Capital Contracting with Ambiguity Sharing and Effort Complementarity Effect

“…The EN chooses to shirk, then a t = 0, while to work, a t = 1. Based on (3) and (19), the continuation value of the EN evolves as…”

“…Vergara et al [18] studied an optimal contract design problem and analyzed how the complementarity of efforts between an EN and a VC affects the equity share that the EN is willing to allocate to the VC. Chang and Hu [19] explored the combined impact of double-sided moral hazard and the EN's fairness concerns on venture capital contracting. However, these pieces of literature assume that VC knows the true probability distribution of project cash flow; hence there is no ambiguity uncertainty.…”

“…The novelty of this paper focused on the effect of the efforts complementarity and the optimal pay-performance sensitivity that the VC would allocate to the EN. Following [14,19,20], we assumed the VC's investment in the project is endogenous, and the VC plays a leadership role in the game relationship. Our model took a similar angle with [18] on considering the complementarity effect but departed from it in three ways.…”