Financing and Advising: Optimal Financial Contracts withVenture Capitalists

28 Pages·2003·0.219 MB·English

by  Casamatta C.

THEJOURNALOFFINANCE(cid:1)VOL.LVIII,NO.5(cid:1)OCTOBER2003
Financingand Advising: Optimal Financial
ContractswithVenture Capitalists
CATHERINECASAMATTAn
ABSTRACT
Thispaperanalysesthejointprovisionofe¡ortbyanentrepreneurandbyan
advisortoimprovetheproductivityofaninvestmentproject.Withoutmoral
hazard,itisoptimalthatbothexerte¡ort.Withmoralhazard,iftheentrepre-
neur’se¡ortismoree⁄cient(lesscostly)thantheadvisor’se¡ort,thelatteris
nothiredifshedoesnotprovidefunds.Outside¢nancingarisesendogenously.
Thisexplainswhyinvestorslikeventurecapitalistsarevalueenhancing.The
levelofoutside¢nancingdetermineswhethercommonstocksorconvertible
bondsshouldbeissuedinresponsetoincentives.
THEVENTURECAPITALINDUSTRYhasgrowndramaticallyoverthelastdecade.Inthe
UnitedStates,venturecapital(hereafterVC)investmentsgrewfrom$3.3billion
in1990 to $100 billion in 2000. In Europe, funds invested inVC grew from $6.4
billionin1998tomorethan$10billionin1999.ThesuccessofVCislargelydue
totheactiveinvolvementoftheventurecapitalists.Theseso-calledhands-onin-
vestors carefully select the investment projects they are proposed (Sahlman
(1988,1990))andremaindeeplyinvolvedinthoseprojectsafterinvestmentisrea-
lized.Their most recognized roles include the extraction of informationon the
quality of the projects (Gompers (1995)), the monitoring of the ¢rms (Lerner
(1995), Hellmann and Puri (2002)), and also the provision of managerial advice
to entrepreneurs.This advising role has been extensively documented empiri-
cally by Gorman and Sahlman (1989), Sahlman (1990), Bygrave and Timmons
(1992),GompersandLerner(1999),andmorerecentlyHellmannandPuri(2002).
Venturecapitalistscontributetothede¢nitionofthe¢rm’sstrategyand¢nancial
nUniversityofToulouse,CRG,andCEPR.Thispaperisarevisedversionofchapter3ofmy
Ph.D. dissertation, University of Toulouse. Bruno Biais has provided invaluable advice at
everystageofthepaper:Specialthankstohim.Iamindebtedtoananonymousrefereeand
especiallytoRickGreen(theeditor)forveryusefulcommentsandadvice.Manythanksalso
forhelpfulsuggestionsanddiscussionstoSudiptoBhattacharya,AlexGˇmbel,MichelHabib,
AntoineRenucci,NathalieRossiensky,JavierSuarez,andWilfriedZantman,aswellasparti-
cipantsatthe1999EEAmeeting,the1999AFFIinternationalmeeting,the1999workshopon
corporate ¢nance at the University of Toulouse, the 1999 conference on Entrepreneurship,
Bankingand the Public Policyat the Universityof Helsinky, the 2000 EFMA meeting, and
the 2000 ESSFMat Gerzensee. Ialsobene¢ted fromcommentsat seminars at SITE(Stock-
holmSchoolofEconomics),ESSEC,andHECLausanne.
2059
2060 TheJournalofFinance
policy, to the professionalization of their internal organization, and to the
recruitmentofkeyemployees.
Thispaperprovidesatheoryforthedual(i.e.,¢nancingandadvising)roleof
venture capitalists. Entrepreneurs endowed with the creativity and technical
skills neededto developinnovativeideas maylackbusiness expertise and need
managerialadvice.Ianalyzeamodelwhere,inthe¢rstbest,somee¡ortshould
beprovidedbothbyanentrepreneurandbyanadvisor.Inlinewiththeviewthat
entrepreneurialvisionisreallykeytothesuccessoftheventure,Iassumethat
theentrepreneur’se¡ortismoree⁄cient(lesscostly)thantheadvisor’s.Iconsid-
erthecasewhereadvicecanbeprovidedbyconsultantsorbyventurecapitalists.
Quiteplausibly,Iassumethatthelevelofe¡ortexertedbytheadvisor,aswellas
by the entrepreneur, to develop the project is not observable. Consequently the
entrepreneur and the advisor face a double moral-hazard problem.To induce
themtoprovidee¡ort,boththeentrepreneurandtheadvisormustbegivenprop-
er incentives throughthe cash-£ow rights they receive over the outcome of the
project.Inadditiontoe¡ort,theprojectrequires¢nancialinvestment.Thiscan
beprovidedbytheentrepreneur,theadvisor,orpure¢nanciers.
The¢rstquestionraisedinthepaperis:Whyshouldtheentrepreneuraskfor
advice fromventure capitalists rather than from consultants? What makesVC
advisingdi¡erentfromconsultantadvising?Ishowthat,eveniftheentrepreneur
is not wealthconstrained andcould himself fund all the initial investment, he
chooses to obtain funding fromthe advisor, thus relyingonVCadvising rather
thanonconsultants.1Tounderstandtheintuitionoftheresult,considertheex-
tremecasewheretheadvisorcouldnotprovidefunds.Inthiscase,althoughthe
projectwouldbemorepro¢tablewithexternaladvice,theentrepreneurchooses
nottohireaconsultant.Thisisbecausetherenttheentrepreneurwouldneedto
leavetotheconsultant(tomotivateher)istoohigh.If,incontrastwiththemain-
tained hypothesis, the advisor’s e¡ort was more e⁄cient than the manager’s,
(pure)consultantscouldbehiredinequilibrium.Thissuggeststhattherelative
rolesofconsultantsandventurecapitalistsdependonhowcrucialtheiradviceis
tothesuccessoftheventures.Moredrasticinnovationsthatrelyontheentrepre-
neur’shumancapitalaremorelikely torelyonVCadvising ratherthanconsul-
tantadvising.
Themodelconcludesthatventurecapitalists,throughtheir¢nancialpartici-
pation,canprovideadvicethatcouldnototherwisebeprovidedbyconsultants.
Thesecondobjective of thepaperistoinvestigatetherelativerolesofexternal
¢nancing (venture capital) and internal ¢nancing (entrepreneurial ¢nancial
participation).Theresultoftheanalysisisthat someamountofexternal ¢nan-
cingguarantees anoptimalprovisionofe¡ortby theventurecapitalistand in-
creases the value of the ¢rm. Projects requiring a small initial investment
comparedtotheirexpectedcash£owsareoptimally¢nancedbyoutsidecapital
only.Inthatcase,outside¢nancingcomesasacompensationfortheagencyrent
lefttotheventurecapitalistforincentivemotive.The¢nancialparticipationof
1Ofcourse,whentheentrepreneuriswealthconstrained,VC¢nancingisallthemorede-
sirable.
FinancingandAdvising 2061
theentrepreneurisshowntobevaluableforthoseprojectswheretheinitialin-
vestmentislargecomparedtotheexpectedcash£ows.Inthatcase,pureoutside
¢nancingwouldproducetoomuchadvisinge¡ortandnotenoughentrepreneur-
iale¡ort.This e¡ect is corrected by the entrepreneur’s ¢nancial participation.
Thisimpliesapositivecorrelationbetweenthelevelofentrepreneurial¢nancial
investmentandthepro¢tabilityofstart-up¢rms,forthelesspro¢tablestart-ups
only.
Thelastquestionraisedinthepaperconcernstheimplementationofthecon-
tractbetweentheentrepreneurandtheventurecapitalist.Thewaythe¢nancial
agreementisdesignedmusttakeintoaccountthetwoagents’incentives.Itmust
alsoprovidethemanexpectedreturnatleastequaltotheirinvestment.Conse-
quently, two regimes arise depending on the amount invested by the investor.
Whentheamountinvestedbytheventurecapitalistislow,hereceivescommon
stocks, while the entrepreneur is given preferred equity.When the amount in-
vestedbytheventurecapitalistishigh,heisgivenconvertiblebondsorpreferred
equity.Theintuitionofthisresultisthatwhentheinvestmentofoneagentislow,
she gets a small share of outcome. In order to motivate her, she must be given
higher-poweredincentives.Inthe¢rstregime,theinvestorisgivenmorepower-
ful incentives to exert e¡ort because her investment is low.The second regime
correspondstothesymmetriccase,wheretheentrepreneurmustbegivenhigher-
poweredincentives,sincehisinvestmentislower.
These results areconsistent withtheway venture capitalists structuretheir
¢nancialcontracts.Fenn,Liang,andProwse(1998)observethatbusinessangels
invest smalleramountsof money thanventurecapitalistsandacquirecommon
stocks. In contrast, venture capitalists acquire convertible bonds (see also
Kaplan and Str˛mberg (2003)). The two regimes identi¢ed in my theoretical
model can be interpreted respectivelyas business angel ¢nancingand venture
capitalist ¢nancing.The present analysis can thus be viewed as a ¢rst step to-
wardsunderstandingthedi¡erencesbetweenbusinessangelsandventurecapi-
talists. While both types of investors play a signi¢cant role in early stage
¢nancing, the analysis of their di¡erences has not received, to my knowledge,
muchattentionintheliteraturesofar.
Thepresentmodelo¡ersarationalefortheuseofconvertiblebondsoroutside
equityinthe¢nancingofstart-upstomotivatetheinvestorandadvisor.2Other
papersexplaintheuse ofconvertible claims inVC¢nancingbyfocusingonthe
incentivesconvertibleclaimsprovidetomanagers.Forexample,Green(1984)and
BiaisandCasamatta(1999)showthatconvertiblebondsinducemanagerstoex-
ert e¡ort while precluding ine⁄cient risk taking.To the extent that the model
derivestheoptimalityofamixofoutsidedebtandoutsideequity,itisalsorelated
totheliteratureonoptimaloutsideequity¢nancingthatincludesChang(1993),
DewatripontandTirole(1994),orFluck(1998,1999)andthatdoesnotspeci¢cally
focusonventurecapital¢nance.
2AnoriginalapproachisdevelopedinCestoneandWhite(1998),who¢ndthatoutsideequi-
tyactsasacommitmentdevicefortheventurecapitalistnottofundcompeting¢rms.
2062 TheJournalofFinance
WhilethecurrentpaperfocusesonhowVCcontractsdealwithmoralhazard
issues,CornelliandYosha(1997),BergemannandHege(1998),HabibandJohnsen
(2000),andDessi(2001)analyzehow¢nancialcontractselicitinformationrevela-
tion,andareusefulindiscriminatingacrossprojectsandtakinge⁄cientconti-
nuationorliquidationdecisions.3
Thespecialfocusofthepresentmodelonthee⁄ciencyofthejointe¡ortsofthe
managerandtheinvestorissharedbyacoupleofrecentpapers.4InRepulloand
Suarez (1999), unlike in the present paper, the entrepreneur does not have the
option to implement the project alone.This makes my ¢rst question irrelevant
intheirsetting.Schmidt(1999)also considersadouble moral-hazard settingto
explaintheuseofconvertiblebondsinVC¢nancing.However,investmentinhis
model is an unobservable variable, while the present model distinguishes be-
tween¢nancialinvestmentande¡ort.Incontrasttothesepapers,Iendogenize
thelevelof¢nancialinvestmentbytheventurecapitalist,andstudyunderwhich
conditionsconsultantsarenotvaluablefortheentrepreneur.
The paper is organized as follows.The model and the assumptions are pre-
sented in Section I.The optimal contract is solved in Section II. Here I study
whyentrepreneursareunwillingtohirepureconsultantsandanalyzetheopti-
malprovisionofe¡ortandlevelofoutside¢nancing.SectionIIIdiscusseshowto
implement the contracts between theVC and the entrepreneur with ¢nancial
claimssuchasconvertiblebondsorstocks.ConcludingremarksaremadeinSec-
tionIV.AllproofsareintheAppendix.
I. TheModel
Consideranentrepreneurendowedwithaninnovativeinvestmentproject.The
project requires three types of inputs: One contractible initial investment I
(money) and two unobservable (and a fortiori noncontractible) investments de-
notedeanda,whereerepresentstheinnovativee¡ortputintotheprojectanda
themanagemente¡orttoruntheprojectproperly.Theprojectisriskyandgen-
eratesaveri¢ablerandomoutcomeR(cid:1) .Tokeepthingssimple,assumethatitcan
eithersucceedorfail.R(cid:1) takesthevalueRuincaseofsuccessandRd(oRu)incase
of failure.The probabilityof success is denoted p .The probabilityof failure is
u
denoted(1(cid:2)p ).
u
Theproductiontechnologyisthefollowing:IfIisnotinvested,p isequalto0;
u
ifIisinvested,p ¼min[eþa;1]5whereeandaarecontinuousvariablesthattake
u
valuesbetween0and1.
3AdmatiandP£eiderer(1994)¢rststudiedtheproblemofacquisitionofinformationinthe
context ofstage ¢nancing.Theyarguethat assigninga ¢xedclaimtotheventurecapitalist
preventshimfromstrategictradingandinducesoptimalcontinuationdecisions.
4While notfocusingondouble moral-hazard problems, Renucci(2000) and Cestone (2001)
analyzesituationswheretheinterventionofaventurecapitalistmayalsobevaluable.
5Theassumptionthatunobservablee¡ortincreasestheprobabilityofsuccessoftheproject
is in line with Holmstr˛m andTirole (1997).The additive speci¢cation implies that the two
e¡orts arenotcomplementary:Their joint realizationisnotrequired toimplement the pro-
ject.Instead,eache¡ortcontributesseparatelytoimprovethepro¢tabilityoftheproject.
FinancingandAdvising 2063
Thereisalsoacontinuumofrisk-neutraladvisorsandpure¢nanciers.Thedif-
ferenttypesofagentsdi¡erintheirabilitytoprovidethenonobservablee¡ortse
and a. Speci¢cally, ecanonlybeprovidedby the entrepreneur whilea mustbe
providedbyanoutsideadvisor.Althoughtheentrepreneurisendowedwiththe
technicalskillsandcreativityrequiredtodevelophisidea,helacksmanagement
expertise.Pure¢nancierscannotprovideaore.
Bothe¡ortsarecostly.Letc ((cid:3))denotetheentrepreneur’sdisutilityofe¡ort,
E
andc ((cid:3))theadvisor’sdisutilityofe¡ort.Assume
A
e2
c ðeÞ¼b ; ð1aÞ
E 2
and
a2
c ðaÞ¼g : ð1bÞ
A 2
Assumethatforagivenlevelofe¡ort,thecostislowerfortheentrepreneurthan
for the advisor: g4b, that is, the e¡ort of the entrepreneur is more e⁄cient. It
wouldbeequivalenttoconsiderthatthetwoagentshavethesamecostfunction,
andthattheimpactofeache¡ortonp isweightedby1,and1respectively.This
u b g
assumptioncapturestheideathattheentrepreneur’scontributionismoreimpor-
tantforsuccessthanthemanagerialexpertiseoftheadvisor.Theconsequences
ofrelaxingthisassumptionarediscussedlater.
Agentsarenotaprioriwealthconstrained.Anyofthemcanprovidetheinitial
investment I. However, I assume that once the ¢rm is created, agents are pro-
tectedbylimited liability.The only thing that canbe shared is the outcome of
theproject.6Allagentsareriskneutral.Theiropportunitycostofputtingmoney
into the ¢rm is the riskless interest rate r, normalized to zero. DenoteA the
VC
amount of money provided by the advisor, A the money provided by the pure
F
¢nancier,andI(cid:2)A (cid:2)A themoneyprovidedbytheentrepreneur.7IfA ¼0,
VC F VC
the advisor who exerts e¡ort awillbe called aconsultant,whileifA 40,she
VC
willbecalledaventurecapitalist.
Thesocialvalueoftheprojectis
e2 a2
Vðe;aÞ¼min½eþa;1(cid:4)Ruþmax½0;1(cid:2)ðeþaÞ(cid:4)Rd(cid:2)b (cid:2)g (cid:2)I: ð2Þ
2 2
Asabenchmark,letusdeterminetheoptimallevelsofe¡ortswhenallinputsare
contractible(i.e.,whene¡ortsareobservable).Thiscorrespondstothe¢rst-best
solutionthat maximizes the socialvalue of the project. It is straightforward to
seethatitisoptimaltohaveboththeentrepreneurandtheadvisorexertstrictly
positivelevels ofe¡ort.When both e¡orts are observable, the optimal levels of
6ThisassumptionisinthelineofInnes(1990)andismeanttomaketheprobleminterest-
ingunderriskneutrality.
7Note that the amount of money the entrepreneur puts into the ¢rm may be negative if
A þA 4I,inwhichcasehereceivesastrictlypositivetransferwheninvestmentismade.
VC F
2064 TheJournalofFinance
e¡ortaregivenbythe¢rst-orderconditionsofthemaximizationofV:
1
eFB ¼ ðRu(cid:2)RdÞ ð3Þ
b
and
1
aFB ¼ ðRu(cid:2)RdÞ: ð4Þ
g
(cid:1) (cid:2)
Assume 1þ1 ðRu(cid:2)RdÞo1, so that the constraint min[eþa;1](cid:5)1is notbind-
b g
ingatthe¢rstbest.Notethatasthee¡ortoftheentrepreneurismoree⁄cient
thanthee¡ortoftheadvisor,theoptimallevelofe¡orteFBislargerthanaFB.The
¢rst-bestvalueoftheprojectisthengivenby
1(cid:3)1 1(cid:4)
VFB ¼ þ ðRu(cid:2)RdÞ2þRd(cid:2)I: ð5Þ
2 b g
Assumethat
1(cid:3)1 1(cid:4)
I (cid:5) þ ðRu(cid:2)RdÞ2þRd (cid:6)II(cid:1) ð6Þ
2 b g
sothat,whenthe¢rst-bestlevelsofe¡ortareprovided,theprojectispro¢table.
This¢rst-bestsolutioncanbeimplementedinanumberofways.E¡ortseanda
must be provided by the entrepreneur and by the advisor, respectively, but the
identityoftheagentprovidingthe¢nancialinvestmentIisirrelevant.Thus,the
ModiglianiandMillertheoremholdsinthe¢rstbest.Financialstructureisin-
determinateand realdecisions donotdependon ¢nancialdecisions.Participa-
tion is ensured as capital suppliers receive an expected income equal to the
opportunitycostoftheirinvestment.Thisisalwaysfeasiblesince,byassumption,
theNPVoftheprojectispositiveinthe¢rstbest.
Whenthereisnomoral-hazardproblem,itisalwaysoptimalfortheentrepre-
neurtoaskfortheservicesofanadvisor.Whethertheadvisorisaconsultantora
venture capitalist is irrelevant:The same social value can be attained when a
¢nancier,anadvisor,or theentrepreneurhimself providesthe¢nancialinvest-
mentI.Wewillseelaterthatthiscontrastssharplywiththeconclusionsderived
undermoralhazard.
II. OptimalContractwithMoralHazard
Thetimingof thegameisas follows.First,thecontractissignedand Iisin-
vested.Second,agentschoosetheirlevelofe¡ort.Third,theoutcomeofthepro-
ject is realized. The two agents choose their e¡ort level to maximize their
expected utility, given the contract and given their rationalexpectation of the
equilibriumlevelofe¡ortoftheother.Thisisasimultaneousmovegame.Assum-
ingsimultaneous movesisnatural,sincee¡ortlevelsarenotobservable.Asall
agentsareriskneutral,theirexpectedutilityisperfectlyidenti¢edbytheirnet
expectedpayo¡s.Those payo¡s dependonthe ¢nancialcontracttheyagree on,
FinancingandAdvising 2065
whichspeci¢esthe¢nancialcontributionofeachpartyandtheshareoftherev-
enueallocatedtoeachpartyineachstateofnature.
Denote ay (resp. ay) the share of the revenue accruing to the entrepreneur
E A
(resp.theadvisor)instateyA{u,d}.Ifapure¢nancierisincludedinthecontract,
shereceivesashare:1(cid:2)(ay þay)instatey.
E A
Contrarytothe¢rst-bestcase,thewaythecash£owisshareddetermineshow
muche¡ortwillbeprovided.Thelevelofe¡ortchosenbytheentrepreneurisgi-
venbyhisincentivecompatibilitycondition,denoted(IC) :
E
^ee2
e2argmaxð^eeþaÞauRuþð1(cid:2)ð^eeþaÞÞadRd(cid:2)b (cid:2)ðI(cid:2)ðA þA ÞÞ; ð7Þ
^ee E E 2 VC F
whichmeansthathechoosesthelevelofe¡ortthatmaximizeshisexpectedprof-
it,giventhecontractestablished,hisrationalexpectationofthee¡ortlevelofthe
otheragent,andgivenhiscostofe¡ort.
Equivalently, the incentive compatibility condition of the advisor, denoted
(IC) ,isgivenby:
VC
aa^2
a2argmaxðeþaa^ÞauRuþð1(cid:2)ðeþaa^ÞÞadRd(cid:2)g (cid:2)A : ð8Þ
aa^ A A 2 VC
Assume1Ruo1(A.1).Assumption(A.1)simplyensuresthatwegetaninteriorso-
b
lutionwhenoneagentisgivenmaximalincentives.Intheremainderoftheana-
lysis, (A.1) will be assumed to hold.The following lemma states what levels of
e¡ortarechosenbytheentrepreneurandbytheadvisorasafunctionofthepara-
metersofthecontract.
LEMMA1:Thelevelsofe¡orteandaaregivenbythe¢rstorderconditionsoftheincen-
tivecompatibilityconstraints(IC) and :
E (IC)VC
1
e¼ ðauRu(cid:2)adRdÞ ð9Þ
b E E
and
1
a¼ ðauRu(cid:2)adRdÞ: ð10Þ
g A A
Foreachagent,thelevelofe¡ortincreasesinthedi¡erencebetweenhispro¢t
instateuandhispro¢tinstated.Indeed,e(resp.a)isincreasinginau(resp.au),
E A
anddecreasinginad(resp.ad).Increasingtheshareofthe¢naloutcomegivento
E A
oneagentincaseofsuccessreducesthesharelefttotheotheragentandcorre-
spondinglyhisincentives.Theoptimalcontractwillre£ectthistrade-o¡.
The¢nancialcontractischosentomaximizetheexpectedutilityoftheentre-
preneur.Theunderlyingassumptionisthattheentrepreneurhasaunique,inno-
vativeidea, andcanask forbusiness advice and moneyfrom a largenumberof
agents.Theparticipationconstraintsoftheadvisorandofthe¢nancier,ensuring
that they recoup their investment in expectations, must be included in the
entrepreneur’s program. The participation constraint of the advisor, denoted
2066 TheJournalofFinance
(PC) ,is
VC
a2
ðeþaÞauRuþð1(cid:2)ðeþaÞÞadRd(cid:2)g (cid:7)A : ð11Þ
A A 2 VC
Theparticipationconstraintofthe¢nancier,denoted(PC) ,is
F
ðeþaÞð1(cid:2)ðau þauÞÞRuþð1(cid:2)ðeþaÞÞð1(cid:2)ðad þadÞÞRd (cid:7)A : ð12Þ
E A E A F
Hencetheprogramtobemaximizedis
e2
max ðeþaÞauRuþð1(cid:2)ðeþaÞÞadRd(cid:2)b (cid:2)ðI(cid:2)ðA þA ÞÞ;
ayE;ayA;AVC;AF E E 2 VC F
s:t: ðPCÞ ;
VC ð13Þ
ðPCÞ ;
F
ðICÞ ;
VC
ðICÞ ;
E
ðau;ad;au;adÞ(cid:7)0 ð14Þ
E E A A
au þau (cid:5)1 ð15Þ
E A
ad þad (cid:5)1; ð16Þ
E A
whereyA{u,d}andthelastthreeconditionsarefeasibilityconstraintsensuring
limitedliabilityholdsforallagents.
A. ProvisionofE¡ortsandExternalFinancingwhentheAdvisorIsaConsultant
Theprevioussectionestablishedthatwithoutmoral-hazardproblems,theen-
trepreneur wasindi¡erenttowhetherhehiresaconsultantorcontractswitha
venturecapitalist.Undermoralhazard,however,theentrepreneurneverchooses
tohireapureconsultant,asstatedinthenextproposition.
PROPOSITION1:IfAVC¼0,theentrepreneurmaximizeshisexpectedutilitybynothiring
aconsultant.Theentrepreneurexertshis¢rst-bestlevelofe¡orteFBiftheamountof
outside¢nancingisnottoolarge(A (cid:5)Rd).
F
TheintuitionofProposition1isthefollowing.Toinducetheconsultanttoexert
e¡ort,theentrepreneurneedstogiveherastrictlypositiveshareofthe¢nalin-
comeincaseofsuccess.Thisa¡ectstheentrepreneur’sownpro¢tinthreeways.
The¢rstoneisadirectrevenuee¡ect:Theentrepreneur’sshareofincomeislow-
er.Thesecondoneisanincentivee¡ect:Havingalowershareofincome,theef-
fort providedby the entrepreneur decreasesand isnot fullyo¡setby thee¡ort
exertedbytheconsultant,becausetheconsultant’se¡ortislesse⁄cient.Overall,
the probability of success decreases. The third e¡ect is a reduction in the
FinancingandAdvising 2067
entrepreneur’scostofe¡ort,sincehise¡ortislower.The¢rsttwoe¡ectsa¡ect
negativelytheentrepreneur’spro¢twhilethethirde¡ectispositive.Howeverthe
coste¡ectisnothighenoughtocompensatethe¢rsttwo,andtheentrepreneur
maximizeshispro¢tbynothiringaconsultant.Thisis,however,onlyasecond-
best optimum: Because the cost ofe¡ort is convex, it wouldbe technologically
e⁄cienttosplittheprovisionofe¡ortbetweenthetwoagents,butthisissubop-
timal because of incentive considerations. Starting from the case presented in
Proposition1wherethe entrepreneurdoesnothireanadvisor,a smallamount
of business advice would increasethevalue of the project.The entrepreneur is
notabletorecoupthecostofthisenhancementinsocialvalue,however.Therent
hewouldhavetosurrendertotheconsultantwouldbetoolargecomparedtothe
increaseinvaluetheconsultant’sadvicewouldinduce.
The main result of Proposition 1comes from the combination of two condi-
tions.First,theconsultantislesse⁄cient,andsecond,hedoesnotinvestmoney
intotheproject.Ifoneoftheseassumptionsisrelaxed,itbecomesoptimaltohire
anadvisor.Considerthecasewheretheentrepreneur’se¡ortislesse⁄cient.He
would then ¢nd it optimal to hire a consultant. In the venture capital setting,
however,theentrepreneur’sspeci¢cexpertiseiskeytothesuccessoftheventure.
Thispreventshimfromhiringaconsultant.Inthefollowingsection,wewillsee
thatonewaytoovercomethisine⁄ciencyistoasktheadvisortoparticipate¢-
nanciallyintheproject,inthe spiritof venturecapital ¢nancingand advising.
Intuitively, asking the advisor to contribute ¢nanciallycompensates the entre-
preneurforgrantingtheadvisorashareoftheproceedsandreducesthecostof
gettingbusinessadvice.Thissuggeststhattherelativerolesofconsultantsand
venture capitalists depend on how crucial their advice is to the success of the
ventures.Pureconsultantscanbehirediftheire¡ortismoree⁄cientthanthat
ofentrepreneurs.Moredrasticinnovationsthatpresumablyrelyontheentrepre-
neur’shumancapitalaremorelikelytoneedVCadvising.
ThelastpartofProposition1simplystateswhenthe¢rst-bestlevelofentrepre-
neuriale¡ort is achieved.If A islower than Rd, the revenue promised tothe
VC
¢nancierisaconstant,andtheentrepreneurcapturesanyincreaseinvaluein-
ducedbyhise¡ort.Thisgivesrisetostrongincentivestoexerte¡ort.Thisisre-
miniscentoftheclassicalHarrisandRaviv(1979)result.However,duetolimited
liability,ifoutside¢nancingishigherthanRd,the¢rst-bestlevelofe¡ortisin-
feasible because the di¡erence between the revenue of the entrepreneur in the
goodandbadstatesisnotlargeenough.
B. ProvisionofE¡ortsandExternalFinancingwhenAllAgentsCanInvest
Letus now turntothe casewhere allagents can invest moneyintothe ¢rm,
that is, whenA and A canbothbepositive.WhenA and A arechosento
VC F VC F
maximizetheentrepreneur’s expectedpayo¡,thetwoparticipationconstraints
PC and PC are obviouslybinding.8 The program boils down to maximizing
VC F
8Iftheywerenot,increasingthe¢nancialparticipationoftheadvisorandofthe¢nancier
wouldmaketheentrepreneurbettero¡withouta¡ectingincentives.
2068 TheJournalofFinance
theNPVoftheprojectsubjecttotheincentivecompatibilityconditionsandthe
feasibilityconditions described at thebeginningof this section.Fromthis sec-
tionon,Irestricttheanalysistothecasewheretherevenueofthepure¢nancier
does notdecreasewiththeproject’s income. As arguedby Innes (1990), thisas-
sumptiondeterssecretinfusionofcashintothe¢rm’saccountsbyinsiders.9The
nondecreasingconditionthus generates morerobustcontracts.10 Tore£ectthis
assumption,thecondition
ð1(cid:2)ðau þauÞÞRu (cid:7)ð1(cid:2)ðad þadÞÞRd; ð17Þ
E A E A
is added to the program.The next proposition establishes that venture capital
¢nancingisdesirable.
PROPOSITION2:Whenallagentscaninvest,itisoptimaltoaskforventurecapital¢nan-
cing:An 40.Thelevelofe¡ortexertedbytheVCanisstrictlypositive.
VC
Proposition 2 states that the entrepreneur is willing to hire an advisor who
alsoinvestsastrictly positiveamountof moneyintotheproject.Combinedwith
Proposition1, it implies that ¢nancingand advising must go hand in hand.The
¢nancialparticipationoftheVCcompensatestheentrepreneurforconcedingpart
oftheproject’sincometomotivateher.Optimallychosen,theVC’s¢nancialinvest-
mentexactlyo¡setstheagencyrentheisgiventobeinducedtowork.Theentre-
preneur’s objective turns out to be aligned with NPV maximization, which
requires a positive e¡ort a.The entrepreneur strictly prefers to have a ¢nancial
partner investingintheproject,eventhoughheiswealthyenoughtoimplement
theprojectalone.Areal¢nancialpartnershipwiththeadvisorarisesendogenously.
ThisresultprovidesarationaleforthecommonlyobservedbehaviorofVCin-
vestors, or business angels. A distinctive feature is their personal involvement
along withtheir ¢nancial investment to develop the projects theyback. For in-
stance,GormanandSahlman(1989)reportthatventurecapitalistsspendagreat
deal of time in the ¢rms they invest in, providing advice and experience. Hell-
mann and Puri (2002) also document this ‘‘soft side’’of venture capital. Less
unanimityisfoundconcerningtheadvisingroleofbusinessangels.Althoughit
issometimesarguedthattheyarelessdeeplyinvolvedintheprojectsthey¢nance
(seeforinstanceEhrlichetal.(1994)),manyauthorsdo¢ndanimportantadvis-
ingroleinangels’¢nancing.11Prowse(1998,p.790)reportsfrominterviewswith
businessangelsthat‘‘Activeangelsalmostalwaysprovidemorethanmoney.An-
gels will often help companies arrange additional ¢nancing, hire top manage-
9Suchasituationmayoccurifthemonetaryoutcomeisperfectlyveri¢ablebutnottheori-
ginofthisoutcome.
10Thisisattheexpenseofe⁄ciencysincethosecontractsprovidelesspowerfulincentives
toexerte¡ort.Forthesakeofcompleteness,IpresentintheAppendixtheresultswhenthis
conditiondoesnothold.Themaininsightsofthissectionconcerningtheroleofventureca-
pital¢nancingarequalitativelyunchanged.
11OtherevidenceisfoundinFreear,Sohl,andWetzel(1994)orMasonandHarrison(2000).
SeealsoBergerandUdell(1998)andLerner(1998)foradiscussiononthedi¡erentcharacter-
isticsofangelinvestors.