Risk, Uncertainty and Optimism in Venture Capital Relationships

We develop a dynamic, structural model to quantitatively assess the effects of risk, uncertainty and asymmetric beliefs about project quality on the characteristics of venture capital relationships. We estimate the model parameters with data about the distributions of total investments, payoffs, risks and returns of venture capital projects. Entrepreneurial optimism mitigates the agency costs of risk-sharing between venture capitalists (VCs) and entrepreneurs (ENs) by over 20% and significantly enhances the VC’s expected payoffs. The EN optimism premium implied by the data explains the huge discrepancy between the discount rates used by VCs (∼ 40%), which adjust for optimistic payoff projections by ENs, and the average expected return of VC projects (∼ 15%). Consistent with observed contractual structures, the equilibrium dynamic contracts feature both equity-like and debt-like components for the VC and progressive vesting of the EN’s stake. The duration, project value and the VC’s expected payoff all increase with the project’s transient risk but decrease with its intrinsic risk. JEL Classification Codes: G24, D92, D80, G12 ∗We thank Anastasia Kartashevea, Zhiyong Liu, Dan Peled, Haim Reisman, Antoine Renucci, Alex Shapiro, Adam Speight, Eric Ulm, Jun Yang, Yongsheng Xu, and seminar participants at the Fields Institute for Mathematical Sciences (Toronto, Canada), ESSEC (Paris, France), the University of Paris-Dauphine (Paris, France), the Georgia Institute of Technology (Atlanta, USA), and Georgia State University (Atlanta, USA) for valuable comments and suggestions. The usual disclaimers apply. †Department of Industrial Engineering and Management, Jerusalem College of Technology, Jerusalem, Israel ‡School of Industrial and Systems Engineering, Georgia Institute of Technology, Atlanta, GA 30332 §Department of Risk Management and Insurance, J. Mack Robinson College of Business, Georgia State University, Atlanta, GA 30303