Abstract
We examine the relationship between a society's legal system, a society's culture of empathy, the strength of venture capital contracts and venture performance. We develop a double-sided moral hazard model in which an entrepreneur and a venture capitalist exert value-adding efforts in a venture. The venture capitalist can select a strong contract, containing a punishment threat for entrepreneurial poor performance, or a weak contract which contains no such threat. However, the ability to punish the entrepreneur depends on the effectiveness of the legal system. Furthermore, selection of the strong contract destroys trust and empathy between the parties, adversely affecting performance. A strong contract is optimal if the legal system is strong and empathy is low, while a weak contract is optimal if the legal system is weak and empathy is high. We discuss international policy implications, and present results from our survey of Chinese venture capitalists that supports our model.
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