The complementarity effect: Effort and sharing in the entrepreneur and venture capital contract

Abstract

This paper focuses on the relationship between the venture capitalist and the entrepreneur. In particular, it analyses how both players' unobservable effort levels affect the equity share that the entrepreneur is willing to cede to the venture capitalist. We solve the entrepreneur's maximization problem in the presence of double-sided moral hazard. In this scenario, we show that the venture capitalist's share is binding and, therefore, there is no efficiency wage. We simulate the model and show that the entrepreneur's effort does not monotonically decrease in the share allocated to the venture capital, while the venture capitalist's effort does not monotonically increase in his share. We show that as efforts tend to be more complementary, the project cash flows are distributed nearly equally, at approximately 50% for each partner. This theoretical finding is actually observed in real contracts between entrepreneurs and venture capitalists. (C) 2016 Elsevier B.V. All rights reserve

How Feasible a Convertible Ijarah Contract for Sme’s Financing: A Simulation Approach

“…VC-backed firms have significantly higher revenues, employment growth rates, and higher operating efficiency due to better screening and monitoring. Vergara et al (2016) highlighted the importance of VC in the entrepreneurship and economic growth process. They stated that VC industry has played a key role in provide financing for entrepreneurs in United States.…”

“…A venture capital firm usually aims to reach the harvest time for selling the venture at the initial public offering (IPO); in many cases, ventures are even sold to investors prior to the IPO. In sum, venture capital financing has a positive impact on entrepreneurship, innovation (Ueda, 2004), job creation (Schmidt, 2003;Paglia &Harjoto, 2014), and thus the growth and development of the economy (Vergara et al, 2016).…”

Venture Capital Contracting with Ambiguity Sharing and Effort Complementarity Effect

“…The cumulative cash flow generated by the risk project is affected by the efforts of VC and EN. Vergara et al [18] studied an optimal contract design problem and analyzed how the complementarity of efforts between an EN and a VC affects the equity share that the EN is willing to allocate to the VC. Chang and Hu [19] explored the combined impact of double-sided moral hazard and the EN's fairness concerns on venture capital contracting.…”

“…Following [14,19,20], we assumed the VC's investment in the project is endogenous, and the VC plays a leadership role in the game relationship. Our model took a similar angle with [18] on considering the complementarity effect but departed from it in three ways. First, we established the model and solved the optimization problem, where the VC holds bargaining power.…”

“…Second, we extended the contract analysis to a continuous-time situation, in which cash flow and the compensation awarded to the EN are dynamic. Third, we used a project revenue function proposed by [17] to simulate the model, instead of the constant elasticity of production function in [18].…”