Venture Capital Deals: Beliefs and Ownership

Abstract

We use a principal-agent model to examine how venture capitalists can determine the ownership division when fund-seeking entrepreneurs possess private information on their disutility of effort. This situation is especially applicable to earlystage first-time entrepreneurs seeking funding, since no history exists on their potential performance. The venture capitalist must thus consider this private information by forming a belief on the entrepreneur's effort level toward the proposed investment opportunity. Formal modeling enables us to describe how the deal process unfolds and to build a simulation. We then identify a unique investor's belief and resulting ownership sharing that maximizes the return to the entrepreneur, one that maximizes the return to the venture capitalist, as well as one that maximizes the deal welfare. We also conjecture an ordering relationship between these critical beliefs and between their resulting ownership allocations. Furthermore, we identify conditions under which the venture capitalist should choose to revise the investment offer if rejected by the entrepreneur. This paper thus moves us closer to a comprehensive theory of venture investment decisions. 1 We interchangeably use "VC" to denote both venture capital and venture capitalist, depending on the context. 0018-9391

Distributing Start‐Up Equity: A Theoretical Foundation for an Emerging Practice

“…Since the VC expects the entrepreneur to work full‐time in the venture (Metrick and Yasuda ), the VC agrees to such exogenously determined, nonincentive‐compatible base salary. Consistent with practice (WSJ ), we refine Narayanan and Lévesque's () work by allocating the entrepreneur's salary to the venture's operating expenses rather than to the VC firm. The second term in Equation is the entrepreneur's share of the venture's value .…”

“…Narayanan and Lévesque () develop a model that considers the VC's use of gut feelings and as such differs from our approach in only one main aspect. Their model captures both the VC's management of an investment portfolio and his/her gut feelings, but they focus on conditions under which a VC should revise an investment offer that is rejected by the entrepreneur.…”

“…For that equity, the VC's advisory service is offered after investing, with a unit cost (i.e., representing the cost for the VC's time) accrued at the end of the contract. Following the lead of Narayanan and Lévesque (), this service level cannot be included explicitly in the contract because it cannot be observed (ex‐ante) by the entrepreneur, just as the entrepreneur's level of effort to be allocated to the funded venture cannot be observed (ex‐ante) by the VC. Nevertheless, this effort , advisory service , and the agreed upon investment all produce value for the new business venture.…”

“…We therefore chose Narayanan and Lévesque's () multiplicative functional form to formally model the venture's value. Parameter in Equation represents the collective productivity of these three value‐creating factors and can vary based on, for instance, economic or industry conditions.…”

“…A mathematical analysis also achieves our goals as its results can help illuminate the logic (or lack thereof) behind today's equity division practices. Our principal‐agent model is inspired by Narayanan and Lévesque () who formally model the VC's “gut feeling” to investigate the conditions under which a VC should revise an investment offer rejected by an entrepreneur. They associate the VC's gut feeling with the entrepreneur's level of effort exerted toward the new business prospect.…”