We use agency theory to model equity division in venture capital financing with three complementary value-creation factors-the entrepreneur's effort, the venture capitalist's advising/monitoring service, and the investment amount. While considering that investors often base their funding decisions on gut feeling, even as they employ rational decision-making processes, we derive closed-form expressions for optimal ownership sharing. Our findings provide theoretical explanation to support the recent call for practitioners to allocate ownership equity based on the relative potential contributions of the entrepreneur and the venture capitalist to generate value for the new investment prospect.

We use a principal-agent model to examine how venture capitalists can determine the ownership division when fund-seeking entrepreneurs possess private information on their disutility of effort. This situation is especially applicable to earlystage first-time entrepreneurs seeking funding, since no history exists on their potential performance. The venture capitalist must thus consider this private information by forming a belief on the entrepreneur's effort level toward the proposed investment opportunity. Formal modeling enables us to describe how the deal process unfolds and to build a simulation. We then identify a unique investor's belief and resulting ownership sharing that maximizes the return to the entrepreneur, one that maximizes the return to the venture capitalist, as well as one that maximizes the deal welfare. We also conjecture an ordering relationship between these critical beliefs and between their resulting ownership allocations. Furthermore, we identify conditions under which the venture capitalist should choose to revise the investment offer if rejected by the entrepreneur. This paper thus moves us closer to a comprehensive theory of venture investment decisions. 1 We interchangeably use "VC" to denote both venture capital and venture capitalist, depending on the context. 0018-9391

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