Double-sided Moral Hazard Research Articles

Contracting with cost synergies: Continuous-time double-sided moral hazard

We study optimal effort and compensation in two continuous-time double-sided models with cost synergies. In the co-work synergy model, cost synergies exist between two agents with ongoing effort: each agent's effort reduces his colleague's marginal cost of effort. The agents completely divide the project's cash flow. In the optimal contract, the agent with higher productivity and a bigger cost-reduction influence claims a larger fraction of the cash flow. In the chain synergy model, one agent exerts initial effort to start the project, and her colleague exerts ongoing effort to manage it. The upfront effort reduces the marginal cost of her colleague's ongoing effort. The timing of optimal payments reflects cost synergies across agents and the timing of efforts: Upfront effort corresponds to early payments. We show that the introduction of cost synergies not only alters the allocation of the cash flow but also improves the expected social surplus. This study suggests that cost synergies increase efficiency for a broad set of contracting problems involving teams.

Simple contracts with double-sided moral hazard and adverse selection

We examine a linear contract model involving a risk-neutral venture capitalist (VC) hiring a risk-averse manager to run a project. The project output is determined by the joint efforts of both parties, the manager’s private ability and a random shock. We explicitly derive a truth-telling menu of contracts, which explain that the incentives provided by VC increase with the manager’s ability, under the widely-recognized monotone hazard rate condition. The fixed compensation would be negative; thus, the manager provides a portion of the financial investment and shares risks with VC. VC’s contracts can not distinguish the types of managers in a range of low-ability managers, leading to a partially pooling equilibrium. Conversely, within a range of high-ability managers, VC’s contracts identify the types of managers, resulting in convex information rents that increase with abilities. We explicitly provide ability thresholds specifying partially or completely pooling and separating equilibrium.

Simple contracts with double-sided moral hazard and adverse selection

Simple contracts with double-sided moral hazard and adverse selection

Startup Fundraising and Equity Split Under Double-Sided Moral Hazard With a Two-Stage Investment

Startup Fundraising and Equity Split Under Double-Sided Moral Hazard With a Two-Stage Investment

Venture Capital Finance – Eliminating Double Sided Moral Hazards Through Trade-off Between Economic and Behavioural Economic Aspects – A Case Analysis

Venture capital finance has two aspects, the economic aspect and the behavioural economic aspect. The economic aspect includes issues such as conflict of interest between the entrepreneur and the venture capitalist (VC), asymmetric information, moral hazard, and compensation issues for both the parties. The behavioural economic aspect is related to relational factors such as empathy and a feeling of fairness and trust shown by both the parties.Therefore, while deciding the financer, entrepreneur should consider both relation aspect and value add services of the financier and strike optimal trade-off. The ensuing case analysis has been carried out focusing on elimination of double sided moral hazards through a proper trade-off between economy and behavioural economic theories (aspects).The performance of the venture can be enhanced by balancing both of these theories in practice. An equity distribution that represents economic reward is a source of motivation for both the parties to put optimal efforts towards the success of the venture. This was seen in the case analysis, when the parties perceived the initial equity distribution agreement as fair, the satisfaction level of all the parties increased, leading to the reduction in the possibility of double-sided moral hazard and ensuring the success of the venture. Moreover, the analysis shows that information sharing and two-way communication increases trust and improves decision quality. It further focusses on how feedback and proper work distribution results in efficiency of performance for each of the stakeholders, leading to reduced probability of double-sided moral hazards.

Optimal design of venture capital financing contracts: the case of Portuguese, Spanish and German markets

PurposeThis study aims to investigate the use of convertible securities and control rights covenants for a sample of 53 Portuguese, Spanish and German venture capital (VC) firms.Design/methodology/approachA relatively new methodology in business sciences – a fuzzy set qualitative comparative analysis – that considers both quantitative and qualitative factors is used for obtaining a solution that best fits the empirical data.FindingsThe results show that the use of convertible securities is affected by agency predictions, namely, the anticipated severity of double-sided moral hazard problems. On the other hand, a mixed support is provided to the agency predictions regarding the use of control right covenants. The results seem to suggest that control right covenants tend to play a different role from convertible securities in the optimization of contract design for VC-backed investments.Originality/valueExisting literature on VC contract design is extended by providing a cross-border analysis to VC financing decision.

Venture Capital and the Use of Convertible Securities and Control Rights Covenants: A Fuzzy Set Approach

Although venture capital is considered crucial for promoting economic development and innovation, not much has been done regarding the use of complex financing contracts in venture capital backed investments. In this study we investigate the use of convertible securities and control rights covenants for a sample of 15 Portuguese venture capital firms. We use an innovative methodology - a fuzzy set Qualitative Comparative Analysis - that considers both quantitative and qualitative factors for obtaining a solution that best fits the empirical data. Our results show that the use of convertible securities is affected by the anticipated severity of double-sided moral hazard problems. On the other hand, only a weak support is provided to the agency predictions regarding the use of control right covenants. Interestingly, the results reveal that convertible securities, unlike control rights covenants, are the most apt instruments to reduce costly double-sided incentive problems of a venture capital relationship

What Goes Around, Comes Around: Reciprocal Effects and Double-Sided Moral Hazard in the Choice of Brand Licensing

Extending a brand beyond its original product category is a major strategy for long-term profitability. A brand owner can internalize the development of the extension product, or license the brand to an external partner in order to exploit the licensee’s better capabilities and higher efficiency on the targeted market. Brand extension is characterized by the presence of the socalled reciprocal effect, whereby the effort exerted to develop and market the extension has a feedback effect – either positive or negative – on the value of the parent brand. Under licensing, this effect is an externality from the standpoint of the brand owner. The licensing relationship is characterized by double-sided moral hazard, requiring an incentivizing contract; the reciprocal effect adds a further element that should be governed by the contract. Indeed, a positive effect can boost the attractiveness of licensing relative to internal development, whereas a negative one can have the opposite effect. Drawing from extant literature, we build a game-theoretical model and show how reciprocal effect, (dis)similarity between the extension product and the parent brand, and (in)efficiency of the brand owner relative to the licensee in developing the extension shape the optimal licensing contract and affect the choice between internal development and licensing.

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

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.

Revisiting the financial performance – corporate social performance link

PurposeThe existing literature has focused heavily on investigating the effect of corporate social performance (CSP) on financial performance (FP) but has not paid sufficient attention to an inverse causation of the relationship. Moreover, while some of the literature argues that FP positively affects CSP, based on the slack resources theory, others have found negative effects of FP on CSP, supporting the managerial opportunism perspective. Thus, this paper aims to address the impact of FP on CSP. Further, this study examines the moderating role of franchising to better understand the relationship.Design/methodology/approachThis study uses and expands the models derived from the CSP literature to confirm the effects of FP on CSP with the moderating role of franchising within the restaurant industry. Using two-way fixed effects models, it effectively addresses important problems embedded in the panel data.FindingsThe findings show a positive effect of FP on CSP, which is inconsistent with Park and Lee’s (2009) findings and supports the slack resources theory. Further, the interesting results show that the impact of FP on CSP diminishes as a firm franchises more, supporting the double-sided moral hazard framework of the agency theory.Originality/valueThis paper fills the lacuna in both the existing literature on the relationship between CSP and FP and the franchising. This study contributes to enhancing restaurant practitioners’ understanding of the double-sided moral hazard of agency theory unique to franchising context.

Made for each other: Perfect matching in venture capital markets

Abstract This paper studies bargaining power allocation and stable matching between venture capitalists and entrepreneurs with double-sided moral hazard in venture capital markets. We find that the optimal bargaining power allocation is determined by the output elasticities of effort by the two parties; the higher the output elasticity for one's effort, the greater her bargaining power. We show that efficient and stable matching follows the principle of positive assortative matching, suggesting that strong entrepreneurs/VCs match with strong partners, and weak ones match with weak counterparts. Using a large sample from the Chinese venture capital market, we empirically confirm that entrepreneurs and VCs with similar standing in their peer groups are more likely to match.

Bargaining over crowdfunding benefits

Purpose Crowdfunding creates multifaceted benefits for different agents who all desire to extract some of these benefits. The purpose of this paper is to analyze the allocation of crowdfunding benefits among crowdfunders, entrepreneurs, and venture capitalists. Design/methodology/approach The present paper develops a multi-stage bargaining model with a double-sided moral hazard. Findings It is demonstrated that higher entrepreneurial bargaining power vis-à-vis the crowd may not always be beneficial for the venture. Most importantly, this is due to the reduced success probability of crowdfunding resulting from higher bargaining power of the entrepreneur. Bargaining power and the value of outside options determine the equilibrium allocation of crowdfunding benefits, expected venture value, and thus expected wealth of all agents. Practical implications Entrepreneurs face a tradeoff between venture quality gains and worse outcomes from crowdfunding campaigns. Crowdfunding success and thus venture quality gains are the ultimate goal of policy makers if they aim to enhance the overall social welfare. Originality/value This paper is the first to investigate how multifaceted crowdfunding benefits are allocated between the crowd, entrepreneurs, and venture capitalists. The paper furthers the development of an appropriate regulatory framework for crowdfunding by depicting new and original effects related to crowdfunding.

Contracts for venture capital financing with double-sided moral hazard

Using a Nash bargaining approach, we analyze the financing contract between the entrepreneur and the venture capitalist with double-sided moral hazard in a start-up enterprise. Our results show that there exists an optimal contract set between the entrepreneur and the venture capitalist, in which all contracts achieve an identical second-best social state. Within the optimal contract set, there exists continuum of joint debt-equity financing. The pure equity financing contract exists in the optimal contract set when the ratio of total social surplus to the amount of investment is greater than a threshold.

Overburdened judges

We develop a double-sided moral hazard model in which the production of justice depends on two tasks (jurisdictional and administrative). The jurisdictional task can be provided only by a judge (the agent) while the administrative task can be provided either by the government (the principal) and/or by the judge. However, the judge performs the administrative task at a higher unit cost. First, we show that the first-best situation is such that the judge exerts no effort to provide the administrative task. Second, we show that two forms of (second-best) optimal contract can emerge when neither the government's effort nor the judge's effort is contractible: either the incentives are shared between the government and the judge and the judge exerts no effort to provide the administrative task, or the judge faces high-powered incentives which induce her to exert effort to provide both tasks. Our model proposes a rationale for judges work overload observed in many countries.

Incentive mechanism on customer knowledge collaborative acquisition with relational contract under double-sided moral hazard in big data context

In the big data context, the customer data are distributed out of the enterprise boundary. It’s the key to maintain competitive advantage that applying the customer knowledge acquisition to the enterprise innovation. From the perspective of the supply chain, there is complementarity of customer knowledge for the manufacturer and the retailer. Sharing the collaborative acquisition of customer knowledge can improve the efficiency of both sides, and even of the whole system. However, since the imbalance of the information between both sides and the imbalance aggravated because of the pending verification of customer big data value, result in speculation behaviors that called bilateral moral hazard. Reasonable design of synergy incentive contract is an important way to solve bilateral moral hazard in customer knowledge collaborative acquisition. As the big data customer knowledge needs to be examined, the relational contract model of customer acquisition knowledge is established and contract analysis of the incentive effects between the formal contract and relational contract is made. Consequently, the incentive of formal contract will result in system profit loss, while relational contract incentive has positive inspiration for collaboration between the manufacturer and the retailer, which can improve the efficiency of the acquisition. In the process, when the discount rate is large enough to reach a certain threshold, the optimal system revenue can be achieved through the relational contract.

Double-sided moral hazard, information screening and the optimal contract

Purpose In the practice of venture capital investment, the venture capital will not only claim the share of the enterprise’s future output, but also a certain amount of fixed income. The purpose of this paper is to examine the optimal contract which blends the variable ownership income and the fixed income theoretically so as to provide a keen insight into the venture capital practice. Design/methodology/approach This paper establishes an extended principal-agent model and researches on the design of optimal contract dominated by venture capital with double-sided moral hazard and information screening. Findings By establishing theoretical models, the main findings are: first, high-quality enterprise tends to relinquish less ownership but give more fixed return to the venture capital as compensation in order to obtain the venture capital financing; second, low-quality enterprise is willing to relinquish more ownership but give less fixed return to the venture capital for financing; third, due to the existence of double-sided moral hazard, neither of the venture capital and the enterprise will exert their best effort. Originality/value This paper furthers the application of principal-agent model in the field of venture capital investment and researches on the optimal contract, considering double-sided moral hazard and adverse selection at the same time originally.

The complementarity effect: Effort and sharing in the entrepreneur and venture capital contract

This paper focuses on the relationship between the venture capitalist and the entrepreneur. In particular, it analyses how both players’ unobservable effort levels affect the equity share that the entrepreneur is willing to cede to the venture capitalist. We solve the entrepreneur’s maximization problem in the presence of double-sided moral hazard. In this scenario, we show that the venture capitalist’s share is binding and, therefore, there is no efficiency wage. We simulate the model and show that the entrepreneur’s effort does not monotonically decrease in the share allocated to the venture capital, while the venture capitalist’s effort does not monotonically increase in his share. We show that as efforts tend to be more complementary, the project cash flows are distributed nearly equally, at approximately 50% for each partner. This theoretical finding is actually observed in real contracts between entrepreneurs and venture capitalists.

Investor competition and project risk in Venture Capital investments

In a double-sided moral hazard framework we model the effect of competition between Venture Capitalists on the risk profile of the investees. We show that as competition increases, investors are willing to finance risky projects that would otherwise be infeasible.

Enabling versus Controlling

Revenue sharing between principals and agents is commonly used to balance double-sided moral hazard. We provide a theory of how, when such revenue-sharing is optimal, a principal allocates control rights over decisions that either party could make. We show that the principal either keeps control over all such decisions, or gives up control entirely, and that this choice is aligned with whether the principal chooses to keep more or less than 50% of variable revenues. We explore how moral hazard, contractibility, and spillovers affect this choice. The theory helps explain whether professionals operate as employees or as independent contractors.The appendices for this paper are available at the following URL: http://ssrn.com/abstract=2628128

A Comparison of Milestone-Based and Buyout Options Contracts for Coordinating R&D Partnerships

We analyze optimal contractual arrangements in a bilateral research and development (R&D) partnership between a risk-averse provider that conducts early-stage research followed by a regulatory verification stage and a risk-neutral client that performs late-stage development activities, including production, distribution, and marketing. The problem is formulated as a sequential investment game with the client as the principal, where the investments are observable but not verifiable. The model captures the inherent incentive alignment problems of double-sided moral hazard, risk aversion, and holdup. We compare the efficacy of milestone-based options contracts and buyout options contracts from the client's perspective and identify conditions under which they attain the first-best outcome for the client. We find that milestone-based options contracts always attain the first-best outcome for the client when the provider has some bargaining power in renegotiation and identify their applicability to different R&D partnerships. This paper was accepted by Yossi Aviv, operations management.