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Casamatta C. Financing and Advising Optimal Financial Contracts withVenture Capitalists (2003)Casamatta C. The venture capital industry has grown dramatically over the last decade. In the United States, venture capital (hereafter VC) investments grew from $3.3 billion in 1990 to $100 billion in 2000. In Europe, funds invested in VC grew from $6.4 billion in 1998 to more than $10 billion in 1999. The success of VC is largely due to the active involvement of the venture capitalists. These so-called hands-on investors carefully select the investment projects they are proposed (sahlman (1988, 1990)) and remain deeply involved in those projects after investment is realized. Their most recognized roles include the extraction of information on the quality of the projects (Gompers (1995)), the monitoring of the firms (Lerner (1995), Hellmann and Puri (2002)), and also the provision of managerial advice to entrepreneurs. This advising role has been extensively documented empirically by Gorman and Sahlman (1989), Sahlman (1990), Bygrave and Timmons (1992), Gompers and Lerner (1999), and more recently Hellmann and puri (2002). Venture capitalists contribute to the definition of the firm's strategy and financial policy, to the professionalization of their internal organization, and to the recruitment of key employees. This paper provides a theory for the dual (i.e., financing and advising) role of venture capitalists. Entrepreneurs endowed with the creativity and technical skills needed to develop innovative ideas may lack business expertise and need managerial advice. I analyze a model where, in the first best, some effort should be provided both by an entrepreneur and by an advisor. In line with the view that entrepreneurial vision is really key to the success of the venture, I assume that the entrepreneur's effort is more efficient (less costly) than the advisor's. I consider the case where advice can be provided by consultants or by venture capitalists. Quite plausibly, I assume that the level of effort exerted by the advisor, as well as by the entrepreneur, to develop the project is not observable. Consequently the entrepreneur and the advisor face a double moral-hazard problem. To induce them to provide effort, both the entrepreneur and the advisor must be given proper incentives through the cash-flow rights they receive over the outcome of the project. In addition to effort, the project requires financial investment. This can be provided by the entrepreneur, the advisor, or pure inanciers. The first question raised in the paper is: Why should the entrepreneur ask for advice from venture capitalists rather than from consultants? What makes VC advising different from consultant advising? I show that, even if the entrepreneur is not wealth constrained and could himself fund all the initial investment, he chooses to obtain funding from the advisor, thus relying on VC advising rather than on consultants.1 To understand the intuition of the result, consider the extreme case where the advisor could not provide funds. In this case, although the project would be more proitable with external advice, the entrepreneur chooses not to hire a consultant. This is because the rent the entrepreneur would need to leave to the consultant (to motivate her) is too high. If, in contrast with the maintained hypothesis, the advisor s efort was more eicient than the manager s, (pure) consultants could be hired in equilibrium. This suggests that the relative roles of consultants and venture capitalists depend on how crucial their advice is to the success of the ventures. More drastic innovations that rely on the entrepreneur s human capital are more likely to rely on VC advising rather than consultant advising. The model concludes that venture capitalists, through their financial participation, can provide advice that could not otherwise be provided by consultants. The second objective of the paper is to investigate the relative roles of external inancing (venture capital) and internal inancing (entrepreneurial inancial participation). The result of the analysis is that some amount of external financing guarantees an optimal provision of efort by the venture capitalist and increases the value of the irm. projects requiring a small initial investment compared to their expected cash lows are optimally inanced by outside capital only. In that case, outside inancing comes as a compensation for the agency rent left to the venture capitalist for incentive motive. The financial participation of the entrepreneur is shown to be valuable for those projects where the initial investment is large compared to the expected cash lows. In that case, pure outside inancing would produce too much advising efort and not enough entrepreneurial effort. This effect is corrected by the entrepreneur's financial participation. This implies a positive correlation between the level of entrepreneurial financial investment and the profitability of start-up firms, for the less profitable start-ups only. The last question raised in the paper concerns the implementation of the contract between the entrepreneur and the venture capitalist. The way the financial agreement is designed must take into account the two agents incentives. It must also provide them an expected return at least equal to their investment. Consequently, two regimes arise depending on the amount invested by the investor. When the amount invested by the venture capitalist is low, he receives common stocks, while the entrepreneur is given preferred equity. When the amount invested by the venture capitalist is high, he is given convertible bonds or preferred equity. The intuition of this result is that when the investment of one agent is low, she gets a small share of outcome. In order to motivate her, she must be given higher-powered incentives. In the irst regime, the investor is given more powerful incentives to exert effort because her investment is low. The second regime corresponds to the symmetric case, where the entrepreneur must be given higher-powered incentives, since his investment is lower. These results are consistent with the way venture capitalists structure their financial contracts. Fenn, Liang, and Prowse (1998) observe that business angels invest smaller amounts of money than venture capitalists and acquire common stocks. In contrast, venture capitalists acquire convertible bonds (see also Kaplan and Stromberg (2003)). The two regimes identified in my theoretical model can be interpreted respectively as business angel inancing and venture capitalist financing. The present analysis can thus be viewed as a first step towards understanding the diferences between business angels and venture capitalists. While both types of investors play a signiicant role in early stage inancing, the analysis of their diferences has not received, to my knowledge, much attention in the literature so far. The present model offers a rationale for the use of convertible bonds or outside equity in the financing of start-ups to motivate the investor and advisor? Other papers explain the use of convertible claims in VC inancing by focusing on the incentives convertible claims provide to managers. For example, Green (1984) and Biais and Casamatta (1999) show that convertible bonds induce managers to exert effort while precluding inefficient risk taking. To the extent that the model derives the optimality ofa mix ofoutside debt and outside equity, it is also related to the literature on optimal outside equity inancing that includes Chang (1993), Dewatripont and Tirole (1994), or Fluck (1998,1999) and that does not specifically focus on venture capital inance.
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Financing and Advising Optimal Financial Contracts withVenture Capitalists (2003)