Abstract
We develop a principal agent model to determine the optimal ownership division in venture capital investment where there are three factors of production—the entrepreneur’s effort, the VC’s service, and the investment amount—and the VC takes on a belief about the entrepreneur’s disutility of effort. Our results show that, for the VC to receive maximal economic rents, the VC should only offer to the entrepreneur an ownership share equaling the entrepreneur’s output elasticity—namely, the importance of the entrepreneur’s effort to the success of the venture—and demand all the rest. On the other hand, if the entrepreneur is to receive maximal economic rent, the VC can only demand an ownership share equaling the VC’s output elasticity with all the rest allocated to the entrepreneur. Furthermore, the information asymmetry about the entrepreneur’s disutility of effort only affects whether the VC should make an offer and not the ownership division. We also develop closed-form expressions for important deal outcomes.
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