Venture Capital Contracting with Double-Sided Moral Hazard and Fairness Concerns

Abstract

The development of new venture enterprise is the result of joint efforts of entrepreneurs and venture capitalists who collaborate based on complementary resources. In this paper, we analyze a venture capital incentive contracting model in which a venture capitalist interacts with an entrepreneur who is risk neutral and fairness concerned, offering him an equity contract. We solve the venture capitalist’s maximization problem in the presence of double-sided moral hazard. Our results show that fairness concerns change the structure of the optimal contract. More importantly, we show that the solution to the contract regarding the optimal share given to the entrepreneur is nonlinear and is a fixed point between 0 and 1. Further, we simulate the model under the assumption that venture project’s revenue is a Constant Elasticity of Substitution (CES) function and obtain the following results. (1) When the two efforts are complementary, the venture capitalist’s effort does not monotonically decrease in the share allocated to the entrepreneur, while the entrepreneur’s effort does not monotonically increase in his share. (2) Relative to the benchmark case where the entrepreneur is fairness neutral, the optimal equity share allocated to the fair-minded entrepreneur is larger than 1/2, and as the degree of efforts complementarity increases, the optimal equity share tends to 60%. In this scenario, for a given efforts substitution parameter, the fair-minded entrepreneur provides a higher effort level than the venture capitalist.