Financing the Entrepreneurial Venture

Abstract

This paper is about financial contracting choices for the entrepreneur. In an incomplete contracts model, the entrepreneur can design contracts contingent on three possible control right allocations: entrepreneur-control, investor-control, and joint control, with each allocation inducing different effort levels by both the entrepreneur and the investor. Several contracts resembling financial instruments commonly used in practice, such as common stock, straight and convertible preferred equity, and secured and unsecured debt, emerge as potentially optimal. Contractual optimality is shown to depend on entrepreneur/investor input complementarity, and investors' opportunity cost of capital. The results of the model are consistent with, and propose an explanations for, empirical regularities such as a) the prevalence of equity-type contracts in high-growth ventures and of debt-type contracts in lifestyle ventures; b) geographical and temporal differences in equity-type instruments used to finance high-growth ventures.