Robust Financial Contracting and the Role of Venture Capitalists

Authors

  • ANAT R. ADMATI,

  • PAUL PFLEIDERER

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    • We would like to thank Bob Dammon, Bob Keeley, Alan Kraus, David Kreps, Eitan Müller, Roni Ofer, Motty Perry, Art Raviv, René Stulz, Jim Van Horne, Peter Wendell, Ingrid Werner, Mark Wolfson, Josef Zechner, an anonymous referee, and seminar participants at University of Chicago, Northwestern University, and the University of British Columbia for helpful comments. Support from the Robert M. and Anne T. Bass Fellowship, the Sloan Foundation, the National Science Foundation (through grant #SBR-9308238), and the Financial Services Initiative at Stanford Graduate School of Business is gratefully acknowledged.

ABSTRACT

We derive a role for inside investors, such as venture capitalists, in resolving various agency problems that arise in a multistage financial contracting problem. Absent an inside investor, the choice of securities is unlikely to reveal all private information, and overinvestment may occur. An inside investor, however, always makes optimal investment decisions if and only if he holds a fixed-fraction contract, where he always receives a fixed fraction of the project's payoff and finances that same fraction of future investments. This contract also eliminates any incentives of the venture capitalist to misprice securities issued in later financing rounds.

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