Economic Annals 2010 Volume 55, Issue 187, Pages: 61-86
https://doi.org/10.2298/EKA1087061O
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Venture financing of start-ups: A model of contract between VC fund and entrepreneur
Osintsev Yury (ICEF, Higher School of Economics, Moscow, Russian Federation)
Venture capital has become one of the main sources of innovation in the
modern, global economy. It is not just a substitute for bank loans: it has
proven to be a more efficient way of financing projects at different stages.
On one hand, venture financing allows for projects with higher risk, which
leads to the possibility of higher returns on investment. On the other hand,
venture investors who usually have managerial experience often participate in
governing the business, which certainly adds value to the enterprise. In this
paper we establish the model of contract between the venture capital fund and
the entrepreneur, focusing on probably the most important issue of this
contract: the shares of the parties in the business. The shares in the
company determine the distribution of the joint surplus. The expected joint
profits are not just exogenously specified in the contract but are dependent
on the behavioral variables of both parties at the stage of fulfilling the
contract. We call the behavioral variable of the entrepreneur ‘effort’ and
the one of the venture fund ‘advice’. The probability of the project’s
success, and hence the expected joint revenues, are increased by these two.
However, both kinds of effort are costly to the respective parties that have
made them. Based on this fact we can elaborate the profit functions of both
sides of the contract. Our model can be considered as a basis for specifying
contracts concerning venture financing. It can provide the logic for how the
equilibrium shares of entrepreneur and venture fund are obtained.
Keywords: venture capital, entrepreneur, venture fund, value added, contract shares, costly effort, profit functions