Distributing Start‐Up Equity: A Theoretical Foundation for an Emerging Practice

Abstract

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.

What drives the valuation of entrepreneurial ventures? A map to navigate the literature and research directions

“…Due to this duality, the positive effect on the valuation of being VC-backed may be undermined by investors' needs to exit fast (e.g., Batt & Appelbaum, 2020). The same mechanism could apply to other types of external equity investors •Signaling theory explains the inverted U-shaped relationship between valuations and trademarks, whose positive marginal effects become null beyond a certain number of trademarks as VC investors do not gain any additional information on a firm's quality (Block et al, 2014) •When different theoretical lenses lead to opposed predictions on the effects on venture valuations of a specific driver, we need to further explore the boundary conditions that make one effect prevail over another •Agency theory and resource dependence theory explain the double-edged sword effect of entrepreneurs with firm-specific human capital, whose positive impact, undermined by the threat of cash flow appropriations, prevails if the founder-CEO is replaced with a professional CEO (Chahine & Zhang, 2020) •Signaling theory and principal-principal agency theory explain the double-edged sword effect of a high retained ownership by entrepreneurs, whose positive impact prevails under the condition that minority investors' interests are protected •Signaling theory and agency theory explain the double-edged sword effect of being VC-backed by a foreign VC with a positive signaling effect, undermined by high monitoring costs, that prevails if the VC investors replace the CEO with a manager with a higher level of human capital, to implement indirect monitoring (Chahine & Zhang, 2020) •When the effect on venture valuations of a focal driver is compatible with theoretical arguments that rely on different behavioral assumptions, we need to further explore the boundary conditions that allow us to disentangle the predictions of the different theories •The mimicking behavior of investors can be explained either through the theories of herd behavior and information cascade, according to which investors rely on their gut feelings (Narayanan & Lévesque, 2019), or through theories based on full rationality, according to which investors rationally follow their peers to maintain a certain level of reputation…”

“…Scholars questioned the ability of professional and crowd investors to effectively process the abundant and sometimes contradictory information provided by different sources (Butticè et al, 2021;Meoli et al, 2020). If investors, suffering from information overload, select investment targets based on cognitive shortcuts (as reported in a highly cited paper by Busenitz et al (2005)) and gut feelings (Narayanan & Lévesque, 2019), it can impact the drivers of venture valuations.…”

Initial coin offerings, information disclosure, and fraud

“…A more thorough analysis of the white papers is therefore needed. This could be done by institutional investors (Momtaz 2020a), in line with the notion that it is often optimal to share ownership (Narayanan and Lévesque 2019). Alternatively, specialized platforms might be in a comparatively better position to run background checks and analyze the truthfulness of the information in the white papers, because unlike one-time investors and issuers, they can specialize in conducting such a due diligence (Coffee 2006).…”

Initial Coin Offerings, Information Disclosure, and Fraud

“…This could be done by institutional investors, in line with the notion that it is often optimal to share ownership (Narayanan and Lévesque, 2019). Alternatively, specialized platforms might be in a comparatively better position to run background checks and analyze the truthfulness of the information in the whitepapers, because unlike one-time investors and issuers they can specialize in conducting such a due diligence (Coffee, 2006).…”