Bilateral Incentive Problems and the Financing of Start-Ups

Abstract

We analyzed two distinct but related issues - (i) the role of different contracting instruments in mitigating bilateral incentive problems and (ii) the role of a public report in affecting the inferences drawn from the structure of private contracts and the efficiency of those contracting instruments. We showed that in a setting where a venture capitalist (VC) with private information about a project's future cash flows contracts with an entrepreneur (E) who provides services under conditions of moral hazard, the VC prefers equity instruments to debt instruments and equity contracts with option and debt features (including convertible debt instruments) to both. This finding is consistent with observations from actual practice where convertible contracts are quite commonly employed as a financing vehicle. In addition, we show that a public report about the probability of success of a project released after the project has proved successful, has informational value in that it allows more information to be extracted (by public investors) from the form of the venture financing contract. This, in turn, makes the earlier contracting between the VC and E more efficient. Consequently, the historical information emphasized in many audited financial reports may be of greater indirect value than is apparent by their ability to predict current (or future) prices.