Peer Monitoring, Syndication, and the Dynamics of Venture Capitalist Interactions

Abstract

We develop a new rationale for the formation of syndicates by financial intermediaries, theoretically analyze the dynamics of interactions by syndicate members, and test the implications of our theory. The specific context in which we develop our analysis is that of venture capital (VC) syndicates. In our model, an entrepreneur needs financing from a VC investor to implement his firm’s positive net present value project. In addition to financing, VCs can provide the firm with two inputs (each in a different area of activity), which can increase the probability of project success: these inputs can be provided either by a single VC, or by two different VCs, each operating in his own area of expertise. The effort exerted by a VC in providing the above inputs is unobservable to the entrepreneur but observable to other VCs who may form part of a syndicate with him. We analyze the firm’s equilibrium choice between financing the project by contracting with a single VC, by contracting individually with two VCs, or by contracting with a syndicate consisting of two VCs. Our analysis generates several testable predictions for the equilibrium choice of the structure of VC financing, for the evolution of this structure across financing rounds, and for the dynamics of the composition of VC syndicates. First, firms with more complex projects are more likely to seek financing from a VC syndicate. Second, while VC specialists are more likely to join in a VC syndicate to finance an entrepreneurial firm, VC generalists are more likely to finance the firm alone. Third, firms obtaining financing from a VC syndicate throughout various financing rounds are more likely to have a successful exit compared to those which have syndicate financing in earlier rounds but switch to financing from a single VC in later rounds. Fourth, firms financed by a syndicate consisting of the same set of VC investors throughout various financing rounds are more likely to have a successful exit compared to those which are financed by VC syndicates whose membership changes across financing rounds. Finally, VCs forming part of a syndicate which financed a successful firm are more likely to form a syndicate again financing future projects. We present empirical evidence consistent with the above predictions of our model.