Private Information and Bargaining Power in Venture Capital Financing

• Author: Michael J. Rebello,Yrjö Koskinen,Jun Wang
• Published date: 01 December 2014
• Date: 01 December 2014
• DOI: http://doi.org/10.1111/jems.12072

Private Information and Bargaining Power in

Venture Capital Financing

YRJ ¨

OKOSKINEN

The Wharton School

University of Pennsylvania

Philadelphia, PA19104

yrjo@wharton.upenn.edu

MICHAEL J. REBELLO

Naveen Jindal School of Management

University of Texas at Dallas

Richardson, TX 75080

mrebello@utdallas.edu

JUN WANG

Department of Economics and Finance

Baruch College

New York,NY 10010

Jun_Wang@baruch.cuny.edu

We model the natural evolution of private information over the life of a venture capitalist financed

project. In the early stages, the entrepreneur is better informed regarding the project, and when

the project matures, the venture capitalist has an informational advantage over the entrepreneur.

Within this framework, we examine how the venture capitalist’srelative bargaining power affects

cash flow rights and investment. When the bargaining advantage lies with the entrepreneur,

the project may not be screened, and the venture capitalist may acquiesce to excessive initial

investment but subsequently terminate the project. Increased venture capitalist bargainingpower

encourages project screening, attenuates the incentive to overinvest, and reduces the incidence

of project termination subsequent to the initial investment. The payoff sensitivity of venture

capitalist’s financing contract also increases as his bargaining power improves.

1. Introduction

Entrepreneurs are likely to be better informed than venture capitalists about some as-

pects of their projects whereas venture capitalists are likely to be better informed about

others.1Therefore, both venture capitalists and entrepreneurs have to contend with

adverse selection during their negotiations. Although adverse selection is a constant

The authors thank the coeditor, two anonymous referees, Mike Fishman, Thomas Telemann, Mark Johnson,

Josh Lerner, Tom Noe, Merih Sevilir, Masako Ueda, and seminar participants at Boston University, Georgia

Tech,Helsinki School of Economics, Louisiana State University, Simon Fraser University, Southern Methodist

University,University of Minnesota, University of South Carolina, University of Texas at Dallas, University of

Wisconsin - Madison, WakeForest University, University of Colorado at Boulder,the 17th Annual Conference

on Financial Economics and Accounting in Atlanta, and Searle Center Symposium on Economics and Law of

the Entrepreneur in Chicago for their comments. Michael Rebello thanks SIFR for its hospitality during his

visit to Stockholm when he started working on this paper.The authors are responsible for all remaining errors.

1. The evidence in Kaplan and Str ¨

omberg (2003, 2004) suggests that control structures in ventures

are engineered to limit problems arising from both the informational advantage of entrepreneurs and the

C2014 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume23, Number 4, Winter 2014, 743–775

744 Journal of Economics & Management Strategy

feature of the environment in which venture financing is contracted, other features of

the environment fluctuate. One important feature of the contracting environment that

fluctuates significantly is the flow of capital into venture funds.2This variation in the

flow of capital has been linked to dramatic fluctuations in the generosity of the terms of

venture financing contracts. For example, Gompers and Lerner (2000, 2004) document

that, when a lot of capital flows into venture funds, venture capitalists appear to be un-

der intense pressure to invest in projects: they tend to supply capital at generous terms,

giving rise to the “money chasing deals” phenomenon that leads to increased cash flow

shares for the entrepreneurs.

Recognizing the important influence of adverse selection on venture financing,

researchers have devoted considerable attention to understanding its influence on the

cash flow rights and other features of venture capital contracts. Some have focused

on the optimal design of venture financing contracts when the entrepreneur is better

informed than the venture capitalist while others have examined the effect of reversing

this situation.3However, regardless of their approach to capturing adverse selection

between the entrepreneur and venture capitalist, all these models share a common

feature: they are all built on the assumption that the entrepreneur has an absolute

bargaining advantage vis-`

a-vis the venture capitalist. Therefore, these models are unable

to help us to understand how fluctuations in the pressure on venture capitalists to invest,

by changing the strength of their bargaining position in negotiations over the division

of a project’s surplus, will alter both entrepreneurs’ and venture capitalists’ incentives

to exploit their informational advantages.

To fill this void, we build a model where the outcome of venture financing is

shaped by both the bargaining positions of venture capitalists and entrepreneurs and

adverse selection between them. In our model, the entrepreneur has an informational

advantage regarding the technology employed in the venture and her project’s likeli-

hood of successful scalability from a technological perspective. The venture capitalist,

in contrast, is better informed about factors that are of great importance in later stages of

projects: the management, marketing, and financial know-how needed to successfully

commercialize a venture. Thus, the locus of information asymmetry switches over the

life of a project.4The allocation of bargaining power between the venture capitalist and

the entrepreneur varies independently of their private information and is determined

by the relative scarcity of venture financing. Following the evidence of Gompers and

Lerner (2000, 2004), inflow of capital to venture funds could be an empirical proxy for

informational advantage of venture capitalists regarding [external] risks. The intense screening of projectsby

venture capitalists is consistent with the view that entrepreneurs have an information advantage over venture

capitalists regarding some aspects of their projects. The idea that venture capitalists are informed investors

is consistent both with Sahlman’s (1990) evidence that venture capitalists specialize in a small number of

industries and thus gain a deep understanding of those industries, and Lerner’s (1995) claim that venture

capitalists work closely with the companies they are financing. Hellmann and Puri (2000) and Bottazzi et al.

(2008) provide evidence supporting the claim that venture capitalists are informed investors.

2. In its survey “Venture capital: Money to burn,” The Economist (May 27, 2000) stated “It is clear that

venture capital has been prone to periods of extreme boom and bust.” In its next survey on the venturecapital

industry (April 3, 2004), “After the drought – Venturecapital,” The Economist claimed that “the money available

for investments in start-up companies slowed to a trickle after the bubble burst.”

3. Dessein (2005) and Trester(1998) develop models where entrepreneurs are better informed than the ven-

ture capitalists, whereas Admati and Pfleiderer (1994) and Ueda (2004) develop models where entrepreneurs

are only better informed than a subset of financiers. Garmaise (2007) develops a model in which the venture

capitalist has an informational advantage over the entrepreneur.

4. Yung (2009) also develops a model where both the entrepreneur and the venture capitalist possess

private information, but does not examine the effects of changes in bargaining power between the venture

capitalist and entrepreneur.

Private Information and Bargaining Power in Venture Capital Financing 745

the relative scarcity of venture financing: when the inflow of capital to venture funds is

large, we would expect the entrepreneur to possess the bargaining power. Alternatively,

venture capitalist experience, proxied by the number of entrepreneurs venture capital-

ists have financed (see, e.g., Bengtsson and Sensoy, 2011), can measure their bargaining

power: venture capitalists that have financed many entrepreneurs will have the upper

hand in bargaining.

We show that many features of optimal venture financing contracts vary greatly

with the allocation of bargaining power. When a venture capitalist has an absolute bar-

gaining advantage over an entrepreneur, the optimal contract minimizes the sensitivity

of the entrepreneur’s claim to project profitability.Granting the venture capitalist equity

or convertible claims that can be exchanged for a greater ownership share of the project

is one way to generate this sort of cash flow pattern. In contrast, when the bargain-

ing advantage shifts to the entrepreneur, the optimal contract ensures that the venture

capitalist’s claim is relatively insensitive to the project’s performance whereas the en-

trepreneur’s claim is very performance sensitive. This can be achieved by giving the

entrepreneur a claim resembling levered equity and the venture capitalist a debt-like

claim that can be converted into relatively modest share of equity.

The optimal investment in the project tends to be distorted in response to the

adverse selection problems. The timing and nature of these distortions varies with the

allocation of bargaining power. When the bargaining advantage lies with the venture

capitalist, investment is distorted only during the later stages of the project, at which

point he is privately informed. In this situation, the venture capitalist typically over-

invests. In contrast, when the bargaining advantage switches to the entrepreneur, both

early and late stage investments may be distorted. In this case, the venture capitalist

typically overinvests during the early stages and underinvests in the later stages.5

Another feature of venture financing that is quite sensitive to shifts in bargaining

power is project screening. When the bargaining advantage lies with the venture capi-

talist, the optimal contract always screens out the entrepreneur if her project is of poor

quality. When the bargaining advantage switches to the entrepreneur, she is often able

to obtain financing even for a poor quality project.6To compensate for this lax screen-

ing, the venture capitalist is more likely to terminate the project at a later stage. This

result explains why venture capitalists are less selective and make relatively large initial

investments in projects during venture financing booms.7

These dramatic variations in the venture financing contracts are the result of

changes in the relative importance of venture capitalist’s and entrepreneur’s adverse

selection problems arising from alterations in their bargaining power. When the ven-

ture capitalist has an absolute bargaining advantage, he can exploit it to limit the en-

trepreneur’s share of the project’s rents. Because the entrepreneur can only receive a

relatively small payout from the project, her potential gain from misrepresenting her

private information is also relatively small. Therefore, the primary force shaping the

venture financing contract is the need to limit the venture capitalist’s incentive to exploit

his private information to capture even more of the project’s value than he can based on

his bargaining advantage alone. In contrast, when the bargaining advantage switches to

5. The intuition behind overinvestment during the early stage of the project is similar to De Meza and

Webb’s (1987)result that borrowers who have good prospects may signal their type by overinvesting.

6. Manove et al. (2001) find similar results in their study of banking contracts.

7. For example, during the Internet boom, The Economist (May 27, 2000) reported that the venture capital

industry “has become less cautious about valuations and has financed too many competing companies with

dubious business plans.”