Post-IPO Governance: Venture Capitalists’ Role in Real Options Exercise Decisions

One important role of corporate governance is to ensure that real options are exercised in the interest of the shareholders. This paper explores whether and how this can be achieved in start-up firms by the venture capitalist retaining a post-IPO equity stake. Our setting is a firm whose future prospects are uncertain and strategic choices remain to be made. The payoff to entrepreneur and shareholders will be asymmetric across the different strategies, leading to the agency problem of suboptimal exercise of options. We derive VC’s optimal post-IPO stake under symmetric information and show that this mechanism can alleviate the agency issue. Specifically, VC should only retain a stake for firms with poor prospects and exit fully otherwise. Under asymmetric information, however, VC’s of the firms with good prospects have no other way to signal to the public than to retain the stake until the information is revealed. Conversely, VCs may fully exit firms with poor prospects, leading to adverse selection. Finally, although very large equity positions held by the entrepreneur can eliminate the conflict of interest, initial wealth constraints would prevent such situations. When the entrepreneur holds equity stakes insufficient to eliminate agency problem the agency problem is exacerbated.