TAILIEUCHUNG - Financing and Advising: Optimal Financial Contracts withVenture Capitalists

THE VENTURE CAPITAL INDUSTRY has grown dramatically over the last decade. In the United States, venture capital (hereafterVC) investments grew from $ billion in 1990 to $100 billion in 2000. In Europe, funds invested in VC grew from $ billion in 1998 to more than $10 billion in success of VC is largely due to the active involvement of the venture so-called hands-on investors carefully select the investment projects they are proposed (Sahlman (1988, 1990)) and remain deeply involved in those projects after investment is realized. Their most recognized roles include the extraction of information on the quality of the projects (Gompers (1995)), the monitoring of. | THE JOURNAL OF FINANCE VOL. LVIII NO. 5 OCTOBER 2003 Financing and Advising Optimal Financial Contracts withVenture Capitalists CATHERINE CASAMATTA ABSTRACT This paper analyses the joint provision of effort by an entrepreneur and by an advisor to improve the productivity of an investment project. Without moral hazard it is optimal that both exert moral hazard if the entrepreneur s effort is more efficient less costly than the advisor s effort the latter is not hired if she does not provide funds. Outside financing arises endogenously. This explains why investors like venture capitalists are value enhancing. The level of outside financing determines whether common stocks or convertible bonds should be issued in response to incentives. The VENTURE CAPITAL INDUSTRY has grown dramatically over the last decade. In the United States venture capital hereafter VC investments grew from billion in 1990 to 100 billion in 2000. In Europe funds invested in VC grew from billion in 1998 to more than 10 billion in 1999. The success of VC is largely due to the active involvement of the venture capitalists. These so-called hands-on investors carefully select the investment projects they are proposed Sahlman 1988 1990 and remain deeply involved in those projects after investment is realized. Their most recognized roles include the extraction of information on the quality of the projects Gompers 1995 the monitoring of the firms Lerner 1995 Hellmann and Puri 2002 and also the provision of managerial advice to entrepreneurs. This advising role has been extensively documented empirically by Gorman and Sahlman 1989 Sahlman 1990 Bygrave and Timmons 1992 Gompers and Lerner 1999 and more recently Hellmann and Puri 2002 . Venture capitalists contribute to the definition of the firm s strategy and financial University of Toulouse CRG and CEPR. This paper is a revised version of chapter 3 of my . dissertation University of Toulouse. Bruno Biais has provided invaluable .

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