Abstract
This paper demonstrates how the principal-agent problem between venture capitalists and their investors (limited partners) causes limited partner returns to depend on diversifiable risk. Our theory shows why the need for investors to motivate VCs alters the negotiations between VCs and entrepreneurs and changes how new firms are priced. The three-way interaction rationalizes the use of high discount rates by VCs and predicts a correlation between total risk and net of fee investor returns. We take our theory to a unique data set and find empirical support for the effect of the principal-agent problem on equilibrium private equity asset prices. The Author 2013. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.
Highlights
The trade-off between risk and incentives is a classic feature of contracts
In the venture capital arena, the principal-agent problem between an investor and a venture capitalist alters the interaction between the venture capitalist and the entrepreneur. We show that it is the entrepreneur who must compensate the venture capitalist for the extra risk that the investor requires the VCs to hold, even though the entrepreneur holds all of the market power in the model
The VC market is the ideal arena to examine the economic significance of the principal-agent problem, because the investing principals do not have the time or skill to become overly involved in fund management
Summary
The trade-off between risk and incentives is a classic issue between a principal and an agent. If the principalagent problem were due to costly effort, VCs would exert too little of it Said another way, the principal-agent problem remains regardless of how VC investments are aggregated into funds, so removing risk from the VC is not optimal. Since VCs correctly use a higher discount rate to evaluate projects, some projects are not taken that are positive NPV based on factor risk alone This is in line with earlier work, as the principalagent problem has consistently been shown to distort investment. The principal-agent problem leads to a contract that may cause a competitive VC and an entrepreneur to be unable to find a price to fund an otherwise profitable project. The prediction from our model is not explained by other potential theories, and its presence in the data gives us some confidence that the principal-agent problem does affect prices and returns
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