The Benefits of Shallow Pockets∗

This paper argues that a commitment to ‘shallow pockets’, namely by limiting the size of funds raised initially, may improve an investor’s ability to deal with entrepreneurial agency problems. Shallow pockets allow the investor to create competition for continuation finance between her portfolio entrepreneurs. Although this increases the investor’s ex post bargaining power vis-à-vis entrepreneurs financed by her, we show that it can nevertheless improve ex ante effort incentives as well as allow sorting across entrepreneurial types, when neither of which can be achieved through contractual means. As a result, our paper provides an endogenization of a widespread phenomenon in venture capital finance, namely provisions that limit a venture capital fund’s size and make it more difficult to attract further investors after the fund has been raised.