Banks in the Venture Capital Market

Abstract

This paper analyzes bank lending in the venture capital market. I develop a principal-agent model in which startup firms have a growth opportunity and need funds to invest. The realization of non-verifiable returns depends on the fund invested and the managers/entrepreneurs' effort, which is unobservable to the banks. I show that convertible debt contracts can mitigate ex-post inefficiency arising from firms' strategic default due to non-verifiability of returns. I further generalize the model by considering moral hazard of the managers/entrepreneurs. In this case, the optimality of convertible debt contracts for startup firms is shown. Finally, I develop a dynamic model in which I take into account the relationship values of the startup firms and their banks. I show that in this case convertible debt contracts are optimal as well, which is consistent with the empirical evidence (Kaplan and Stroemberg, 2000). In addition, when firms' relationship value is low and banks' relationship value is high, banks do not convert and thus the lending relationship between banks and firms is maintained. This result is also consistent with the evidence that banks participate in venture capital finance in order to build the lending relationship early on with potential clients (Hellman et. al., 2008).