Abstract
In recent years, venture capitalists (VCs) have retreated from active governance and monitoring of their portfolio companies. This trend raises doubts about the conventional model of VC behavior, which explains VCs’ active governance as a solution to moral hazard and adverse selection. We propose an alternative model in which VCs aim to persuade risk-averse founders to pursue high-risk strategies. VCs are motivated to encourage each of their portfolio companies to take risks because most of the gains in successful VC funds come from one or two outlier companies that grow exponentially. By contrast, founders are reluctant to gamble because their equity stakes come with firm-specific risk that cannot be diversified away. To compensate founders for their risk exposure, VCs offer an implicit bargain in which the founders agree to pursue high-risk strategies and in exchange the VCs promise them private benefits. VCs can promise to let founders cash out their shares early in secondary sales, to not replace them when the startup struggles, and to soften the landing if the startup fails. In our model, VCs who develop a founder-friendly reputation have a competitive advantage in ex ante pricing when contracting with a riskverse founder, but at the same time are more exposed to poor performance ex post due to suboptimal monitoring. Our risk-seeking model can explain recent developments in VC markets and has implications for doctrinal debates in corporate law.
PaperLink (coming soon)
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