Optimal contingent payment mechanisms and entrepreneurial financing decisions

Abstract

We explore Contingent Payment Mechanisms (also known as Contingent Earn-Outs) as a capital raising strategy surrounding Entrepreneurial Financing decisions. Unlike previous literature, which investigates how Contingent Payment Mechanisms are used within the context of mergers and acquisitions, we show how an optimum contingent payment might be designed so that one Entrepreneur and one external equity provider – taken as a Venture Capitalist – are simultaneously and jointly willing to support a given Entrepreneurial Firm and its growth strategy. We show that such optimum contingent payment might be designed for a range of different types of contingent payments, for which we present a novel taxonomy. As closed-form solutions underlay the terms of such optimum contingent payments, we provide a tractable analytical tool for Entrepreneurs and Venture Capitalists to easily contract these Contingent Payment Mechanisms.