Pay for Performance, Partnership Success, and the Internal Organization of Venture Capital Firms

Abstract

We show how the structure of partner incentives and the decision processes within a venture capital firm contribute to fund performance, partner retention and partnership success. Optimal capital allocation during staged financing requires that partner incentives encourage cooperation by linking a partner’s compensation to the return on the entire fund rather than return on the investment sponsored by an individual partner. Incentives for individual performance of senior partners are optimally provisioned by a higher profit share in a subsequent fund. For junior partners with lower profit shares, partner pay may be linked to performance of current individually sponsored deals. Our paper provides an economic underpinning to empirical observations about the internal organization of venture capital firms.