Financing and Advising: Optimal Financial Contracts with Venture Capitalists

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 effort. With 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 paper thus provides a theory for why investors like venture capitalists are value enhancing. The optimal amount of outside financing is determined. Last, it is optimal to issue common stocks when the level of outside financing is not too large, while it is optimal to issue convertible bonds when the outside financing is large. These results are consistent with empirical evidence on venture capital.

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