Competition, Contracting, and Value Creation in Venture Capital Finance∗

We embed venture capital contracting in a search market environment where venture capitalists and entrepreneurs meet and bargain over optimal contracts. We find that both the composition and type of financial claims held by the venture capitalist and entrepreneur depend critically on the underlying market structure. In some cases both parties hold a mix of debt and equity while in others only one party holds a mix and the other holds straigth equity. The link between optimal contracting and market structure yields several implications. For instance, we find that the total value created in ventures is a hump-shaped function of competition, and that both the success probability and the market (or IPO) value of ventures are either increasing (if efforts are perfect substitutes) or hump-shaped (if efforts are complements) functions of competition. Finally, we show that the entry by inexperienced portfolio investors may have a negative externality on the value created by venture capitalists. Business angels, i.e., advisors with limited wealth, may even be driven out of the market. ∗We are indebted to Per Strömberg for his insightful comments and advice. Moreover, we wish to thank Mike Burkart, Zsuzsanna Fluck, Thomas Hellmann, Martin Hellwig, Josh Lerner, Enrico Perotti, Elu von Thadden, Masako Ueda, Andrew Winton, and seminar participants at Amsterdam, Berlin (Humboldt), Mannheim, Tilburg, and the European Summer Symposium in Financial Markets (ESSFM) in Gerzensee (2001) for helpful comments and suggestions. †London School of Economics. Address: Department of Accounting and Finance, London School of Economics, Houghton Street, London WC2A 2AE. Email: [email protected]. ‡New York University & CEPR. Address: Department of Finance, Stern School of Business, New York University, 44 West Fourth Street, Suite 9-190, New York, NY 10012-1126. Email: [email protected]