Journal of Applied Business and Economics

Venture Capital Financing : A Theoretical Model

Mondher Cherif
University of Reims OMI-LAME
Sana Elouaer
ISG Sousse

This paper investigates venture capital financing in an environment where a manager faces an
imperfect capital market and a venture capitalist faces a moral hazard and uncertainty. Active
monitoring, staged funding and syndication can alleviate moral hazard and reduce risk. At first
stage, we compare the social welfare in case of up-front funding with monitoring, and in case of
staged funding without monitoring. We find that up-front funding can provide greater benefits
than in case of staged funding. Moreover, under given conditions, we find that staged funding
acts as a successful device in controlling information asymmetries. At a second stage, we find
that syndicated investments used with active monitoring gives the higher profit to the start-up
due to the VCs free-riding problem in monitoring.
INTRODUCTION
Venture capital is often the source of financing in the essential stages of the early
development of many firms. The fundamental need for funding in start-up firms comes from the
entrepreneurs wealth constraints. One important characteristic of many start-ups is the high risk
due to the great uncertainty about returns, the lack of substantial tangible assets and the lack of a
track record in operations. Many start-ups may face many years of negative earnings before they
start to see profits. Given this situation, banks and other intermediaries are averse to or even
prohibited from lending money to such firms. Moreover, these financial intermediaries usually
lack expertise in investing in young and high-risk companies. Consequently, these start-ups often
seek venture capitalists to be involved in their activities by offering revenue sharing in the form
of equity joint ventures in order to obtain necessary funding and to benefit from the venture
capitalists experience in management and finance (Wang and Zhou, 2004).
Venture capital firms are financial intermediaries focused on providing capital to small, fastgrowth start-up companies that are typically high risk and not amenable to more traditional
financing alternatives. In comparison with traditional sources of funds, venture capital firms have
some particular characteristics. According to Gompers (1995), venture capitals investments
entail higher intensities of uncertainty, asymmetric information and in general higher intangible

assets and development opportunities. Sapienza and Gupta (1994) assert that venture capitalists
obtain an equity position in the corporation and play an active role in the corporate governance.
In other words, they sit in the board of directors and regularly monitor performance (Shalman,
1990). Key characteristics in venture capital financing are staging the commitment of capital and
preserving the option to abandon the project. Instead of providing all the necessary capital
upfront, venture capitalists invest in stages to keep the project under control. Staged investment
allows venture capitalists to monitor the firm before they make refinancing decisions. The
information about the viability of a project acquired through such monitoring helps venture
capitalists to avoid throwing money at bad projects. It reduces losses from inefficient
continuation and creates an exit option for venture capitalists.
In this paper, we investigate venture capital financing in an environment where an
entrepreneur faces an imperfect capital market and an investor faces moral hazard and
uncertainty. We consider an up-front funding, and then we consider a stage funding and
syndication, to compare the effects of these financing strategies on the managers behavior.
Staged financing can play two roles in this model: to control risk and to alleviate moral hazard.
Staged financing has been widely used in venture capital, especially in the United States.
Can staged financing be used by venture capitalists to reduce problems of asymmetry
information? To answer this question, we present a comprehensive, two stages model of the
venture capital contracting process, incorporating moral hazard and asymmetric information
problems. The structure of the model involving managerial effort, staged investment reproduces
what we know of venture capital financing. Using parametric functions, we discover a few
interesting properties of staged financing. In particular, we show that when used together with a
sharing contract, staged financing acts as an effective complementary mechanism to contracting
in controlling agency problems. Moreover, venture capitalists often band together in groups to
invest in companies. Conventional wisdom says they engage in this practice, called syndication,
to better screen potential investments. More eyes the thinking goes yield better investments
(Amit, 2003).
From the lead venture capitalists point of view, the benefit of seeking syndication is that the
value of the project rises if other venture capitalists become involved. Syndication, for example,
lets them to share risk and diversify their portfolios, Amit found some evidence of that. Banding
together might also give them a stronger bargaining position vis--vis the companies in which
they invest. Formally, we consider a financially constrained manager and a venture capitalist
who is interested in investing in the managers project. The project is risky and the managers
effort is not verifiable. We assume that the manager faces an imperfect capital market and the
venture capital is the only potential investor who accepts to finance the project. The venture
capital offers a sharing contract and finances the project strategically in stages in one hand, and
syndicated the investment on the other hand. Using parametric functions, we are able to derive
some interesting properties of venture capital financing. Our results show that, in addition to
contracting, staged financing is an effective mechanism for venture capitalists to reduce
problems of asymmetry information and to control risks resulting from the managers behavior.
By taking into account the active monitoring role of the venture capitalist we show that up-front
funding provides a higher profit than in case of staged funding, or syndication.

LITERATURE REVIEW
An important source of financing for the entrepreneurial sector is the venture capital industry.
Indeed, venture capital activity is usually defined as the provision of equity financing to young
firms. In addition, they often provide managerial advice to their investees. The venture capital
industry is characterized by great uncertainty about returns and information asymmetries
between principals and agents. The structure of this section applies some aspects of the theory of
asymmetric information to a financial contracting setting in which an entrepreneur may obtain
funding from a venture capitalist. Moral hazard problems are particularly important in situations
where one party acts as an agent for another party: the principal. In these situations, the principal
cant perfectly observe the effort (or other actions) of the agent. Jensen and Meckling [1976]
argued that agency analysis was the key to understanding the modern firm. Other classic papers
on the agency problem include Holmstrom [1979] and Grossman and Hart [1983].
The role of asymmetry of information in financial contracting in venture capital is commonly
recognizable.
Shalman [1990] postulated that contracting practices in the venture capital industry reveal
uncertainty about payoffs and information asymmetries between venture capitalists and
managers. He precisely argued that the lack of operational history intensifies the adverse
selection dilemma. During the screening stage, venture capitalist reviews business plans of startups and proposes to the manager contracts that reduce agency costs. Shalman [1990] considers
venture capital as control mechanisms used to alleviate agency costs.
Gompers [1995] asserts that three control mechanisms are common to nearly all venture capital
financing:
- The use of convertible securities;
- The syndication of investment;
- The staging of capital infusions.
Some researchers suggested solutions engineered by the venture capital industry to overcome
problems arising from the asymmetry of information include the use of convertible preferred
stock (Bary, 1994), Trester (1998) control rights (Hellmann, 1998) which may include
representation on the boards of start-ups (Lerner, 1995) and syndication (Lerner, 1994), Brander,
Amit and Antweiler (1995). The syndication may be a mechanism through which venture
capitalists determine informational uncertainties about potential investments. Admati and
Pfleiderer (1994) develop a rationale for syndication in later venture rounds that is based on
informational asymmetries between the initial venture investor and other potential investors. A
venture capitalist who is involved in the firms operations may utilize this informational
advantage, overstating the appropriate price for the securities in the next financing round. The
only way to avoid this opportunistic behavior is when the lead venture capitalist maintains a
constant share of the firms equity. Syndication may also be a mechanism through which venture
capitalists exploit informational asymmetries and collude to overstate their performance to
potential investors.
Venture capitalists prefer syndicating most deals for a simple reason; it means they have a
chance to check out their own thinking against other knowledgeable. If two or three other funds
whose thinking you respect agree to go along, that is a double check to your own thinking. Most
financing involves a syndicate of two or more venture groups, providing more capital availability

for current and follow-on cash needs. Syndication also spreads the risk and brings together more
expertise and support. These benefits pertain only to start-up financing requiring the venture
capitalists first investment decision. There are different strategies and motivations for
syndication in follow-on financing. Lead venture capitalists who become involved in the firms
operations can solve this information problem. Other less well-informed investors will invest if
this lead one does. Venture capitalists, however, may exploit their informational advantage and
overstate the proper price for the securities in the firms financing. Staged investment, which
creates the option to abandon a venture, is an important mean for venture capitalists to minimize
the present value of agency costs. The active involvement of venture capitalists in the operations
of their invested companies may also mitigate the moral hazard problem.
Staging capital allows the venture capitalist to gather information and monitor the progress of
the firms with maintaining the option to periodically abandon projects. The role of staged
funding is similar to that of debt in highly leveraged transactions, keeping the owner/manager on
a tight leash and reducing potential losses from bad decisions. Total venture financing and the
number of financing rounds should also be higher for successful projects than for failures if
venture capitalist uses information in investment decisions. In other words, venture capitalists
monitor firms progress and discontinue funding the project if they learn negative information
about future prospects. Amit, Glosten and Muller (1990a) related the venture capital financing
decision to the entrepreneurs skill level and predicted which entrepreneurs would decide to enter
into an agreement with venture capitalists. They also considered moral hazard problems, but
treated adverse selection only in the situation where the entrepreneurs type becomes common
knowledge between hiding and contracting. Hirao (1993) assumed that the agents (the
managers) unobservable actions affect the learning process. She found that because of the
interaction between learning and moral hazard, a long-term contract is not equivalent to a series
of short term contracts. Bergemann and Hege (1998) analyzed a similar situation in which there
is a link between moral hazard and gradual learning about project quality. They assumed that an
entrepreneur cant affect the up-side potential of her venture; she can only prevent intrinsically
good projects from failing. Withholding effort (moral hazard) not only endangers the success of
the venture but also causes the entrepreneurs and the venture capitalist (initially symmetric)
learning about project quality to diverge. Bergemann and Hege (1998) found that the optimal
contract in this situation is a time varying share contract. Amit, Glosten and Muller (1990b)
considered the role of different mechanisms for matching entrepreneurs and venture capitalists in
mitigating adverse selection problems. In their work, entrepreneurs are assumed to have private
information about their types and venture capitalists can participate in the management of
invested firms (at some cost) and thus contribute directly to the ventures success.
Managers may stop around or venture capitalists may actively seek out attractive
investment opportunities. With a three-stage game, the authors examined possible pooling and
separating equilibrium. To characterize the contract that allows optimal continuation decisions
with a staged finance, Admati and Pfleiderer (1994) found that venture capitalists should prefer a
fixed fraction contract. This contract stipulates that the venture capitalist owns a certain fraction
of the final payoffs, and finances the same fraction of any future investment (if the continuation
of the project is desirable). This result explains why later stages are not fully financed by the lead
venture capitalist. It also attributes a positive role to the venture capitalist as a financial
intermediary between the manager and outside investors.
On the same direction, Hellmann (1994) built a multi-stage model involving staged
investment. He explained certain institutional features that distinguish venture capital from more

traditional methods of finance. For example, he explained that only when the venture capitalist
has a concentrated stake in invested companies will there be a sufficiently high incentive for
active monitoring. The monitoring goes beyond what a traditional financing institution would do
and includes spending time at the companies, frequent meetings with managers, and being
involved in the definition of the companies strategies, hiring decisions (Hellmann and Puri,
2001), and top management compensation (Kaplan and Stromberg, 2000). In addition, venture
capitalists bring their experience in evaluating the prospects of start-ups through their screening
of potential investments (Hall and Hofer, 1993), their collaboration with other start-ups, their
understanding of the solutions to the problems that these firms may face, and when stat-ups are
best positioned to raise money (Gompers and Lerner, 1999). Finally they provide access to a
strategic network including potential clients and suppliers, management talent (Bygrave and
Timmons, 1992), strategic partners (Baum, Calabrese et.al; 2000). Our model tries to explore, at
a first stage, the arbitrage between up-front funding and staged funding for the venture capitalist.
Second, we analyze venture capitalists choice between financing the project individually and
splitting financing with other venture capitalists: syndicating venture investments.
THE MODEL
Consider an entrepreneur endowed with an innovative investment project. The project
requires an initial investment, denoted I, and yields an outcome R. The entrepreneur is wealthconstrained. To implement the project, he must raise funds from outside investors. Some of those
investors have special expertise in financing innovative projects. We call them venture
capitalists. The innovative manager (denoted by M) relies on a venture capitalist (denoted by
VC) for investment. We assume that the project requires a minimum amount I of capital
investment. Thus, I is a given constant. The project lasts two periods. The venture capitalist
provides a total investment I. The venture capitalist requires that the manager exerts an effort in
exchange for financing the project. The managers effort, e is applied during the two periods.
The cost of effort for the manager is c (e). The expected return of the project is function of the
effort e of the manager during the two periods, and the monitoring intensity of the venture
capitalist if monitoring occur. We suppose that the expected return is subject to a random effect z
such that the realized return is r = z.R. At the beginning of the first period, the venture capitalist
knows the distribution function of z, and the random effect is realized and publicly revealed at
the beginning of the second period. The investment can be made in one amount, or in two stages
I0 and I1. Although I is fixed, the venture capitalist can divide, in case of staged funding, the
required amount into two parts,I0 and I1 for the two periods, and the venture capitalist also has
the option to abandon the project ex post by not providing the remaining investment I1.
In our model, staged financing dominates the alternative of giving the manager all the money
at the same time, since staged financing enables the venture capitalist to cut his losses and to shut
down underperforming projects early. Thus, the venture capitalist proposes to supply a total of I0
in resources at the beginning of the first period. After the random effect is realized at the start of
the second period, the venture capitalist thinks about supplying a total of I1 in resources. If the
project is neglected in the middle by either the manager or the venture capitalist, the project fails
without any output and the initial investment is lost. If it is not the case, the project continues. To
realize the return by the end of the second period, the necessary amount, I of investment must be
made, i.e., I = I0 + I1. If both investments are made, the start-up continues to date 2 and the

entrepreneur and the venture capitalist can split the final return of the project. The split depends
on their ownership percentages, which are assumed, fixed on the existing contract.
THE CONTRACT
In a typical agency model, contracts are typically based on some well-known aggregate
measures. We assume that only the return of the project is contractible at the beginning of the
first period (ex ante). We will concentrate on a certain type of informational asymmetry, having
to do with the behavior of the manager during the investment. We shall assume that the agents
behavior is observable by the principal, but it is not verifiable. This asymmetric information
problem is known as moral hazard. That effort is not verifiable means that it cannot be included
in the terms of the contract. Then, the managers effort is not verifiable. Concerning the venture
capitalists investment strategy, its not contractible in the contract. The manager is steady with
the reality that the VC normally has the option of abandoning the project in the future. Typically,
venture capital investors provide capital unsecured by assets to young, private companies with
the potential for rapid growth. Such investing covers most industries and is appropriate for
businesses through the range of developmental stages. Investing in new or very early companies
inherently carries a high degree of risk. But venture capital is long term or patient capital that
allows companies the time to mature into profitable organizations. Venture capital financing
consists in an equity financing, which is represented by funds that are raised by a business, in
exchange for a share of ownership in the company. Equity financing allows a business to obtain
funds without incurring debt, or without having to repay a specific amount of money at a
particular time.
Taking into account the managers effort e, and the random effect z, the venture capitalist
proposes a sharing contract and finances the project strategically in two stages. As consequence,
the contract proposed by the venture capitalist is a sharing contract (, 1 ) where is the
return share for the venture capitalist, and the remaining part (1 ) is the return share for the
manager. At the end of the project, we will seek for the social optimum. The determination of a
feasible social optimum amounts to maximize the collective utility function that is the individual
utility combination.
We defined the optimal social welfare by:
*
SW = *M + VC
Where:
SW : is the Social Welfare;
*M : is the optimal profit level of the manager;
*
VC
: is the optimal profit level of the Venture Capitalist.

The variables e, I0, I1and are determined endogenously in equilibrium.

Timing

The model has three periods: t = 0, 1, 2. All agents are risk neutral. There is no discounting.
The timing of the actions is given below:
At t = 0, the venture capitalist decides on an investment plan (I0, I1) (in case of up-front
funding I1 = 0 and I0 = I). But first, the venture capitalist proposes a sharing contract (,

1 ) to the manager; then if the manager accepts the sharing contract, the venture
capitalist invests I0, and the manager applies effort e and incurs cost c (e). The venture
capitalist may benefit from the resolution of uncertainty by investing ex post. However,
ex post investment will impose a risk on the manager (from the venture capitalists option
to quit and to renegotiate), which may lead to a higher effort.
At t = 1, the venture capitalist thinks about the decision to leave the project, to
renegotiate the contract1, or to provide the remaining investment. The uncertainty is
resolved; then, if the project is good, the venture capitalist continues to invest in the
project and offers the necessary investment I1. If the project is average, the venture
capitalist will ask for renegotiating a new contract. And if the project is bad, the venture
capitalist will abandon the project without investing I1.
At t = 2, the project is finished, and the venture capitalist and the manager split the return
based on the existing contract.

Assumptions

We suppose that venture capitalist will exert monitoring in case of up-front funding, and in
case of staged financing, monitoring will not occur. In case of syndicated venture investments,
venture capitalists will monitor the project.
Venture capitalist can ameliorate managers moral hazard problem through monitoring. Venture
capitalist chooses to monitor the project with an intensity m which has an impact on the
managers behavior. Monitoring is costly, an intensity m costs C (m) = cm with m [ 0, 1]
1
and c 0, .
2
We suppose that the expected return is a linear function of the manager effort and the
monitoring intensity. If the managers effort is increasing, the expected return of the project is
increasing, and if the monitoring intensity of the venture capitalist is high, the output expected of
the project is high.
We assume that:
R
R
0 and
0
e
m
Thus, the realized return with z an observable random effect is:
zR(e, m)
r=
zR(e)
For simplicity, we consider the identity function for the expected return of the project.

We will not consider the case of renegotiation in this paper.

We assume that the random effect is distributed according to the Uniform2 distribution on
interval [0,1] .
Moreover we assume that the effort cost function c (e) of the manager is such that:
c ' (e ) 0 and c '' (e ) 0
For example, we assume that:
1
c(e) = e where 1

Venture Capital Funding

The basic need for funding in start-up firms comes from the entrepreneurs wealth constraints.
The entrepreneur needs funds to finance the firm from beginning until it gives positive returns.
Venture capitalists provide the funds required to overcome cash limitations during the initial
stages of a firms life, before the uncertainty of the venture is reduced and alternative sources of
funding become available. Staged funding is a main characteristic of venture capital financing.
Rather than providing their funding upfront, stage funding allows venture capitalists to
periodically update their information about the firm, monitor its progress, review its prospects,
and evaluate whether to provide additional funding or abandon the project. Staged financing
provides venture capital with a real option. This option can be exercised or abandoned over time
as the uncertainty about the start-up firm is reduced.
Staged financing is also advocated as a control mechanism. Theoretical models explain this
financing structure as a governance mechanism to reduce the agency costs implicit in venturebacked start-ups. These theoretical models are important to understand the unique nature of
venture financing. Neher (1999) studies the superiority of staged funding over up-front funding
in a perfect certainty, full information setting (thus without a real option). A wealth-constrained
entrepreneur establishes an agency relationship with an investor who provides the funds required
to start the business. The investment that the entrepreneur makes is partly sunk, thus the
relationship is open to the hold-up problem associated with the entrepreneur renegotiating the
contract after the investment has been made. Staging the investment can reduce this hold-up
problem if the value of the ventures assets without the entrepreneur increases over time as the
entrepreneurs specific knowledge is embedded in the assets of the firm. The cash constraints
associated with follow-up rounds, while never binding in equilibrium, provide the bargaining
power that the investor needs to reduce the costs associated with the hold-up problem.
Kockensen and Ozerturk (2002) adopt an incomplete contracting structure to endogenously
derive the optimality of staged venture capital funding. Their model assumes a wealthconstrained entrepreneur and an initial investor who provides a first round of funding, but does
not commit to further funding. Before the second round funding decision, new information
becomes available. This information is available to both the entrepreneur and the inside investor
but not to potential outside investors. Consequently, the inside investor has an informational
advantage that allows him to offer better terms if the project remains attractive as well as capture

A uniform distribution is one for which the probability of occurrence is the same for all values z Z.

a surplus associated with the private information. Staged funding provides the inside investor
with a surplus that otherwise he would not capture. As in previous models, the first round
removes the initial cash constraint and allows the entrepreneur to grow its venture. The second
round gives the venture capitalist bargaining power to extract additional rents. The cash
constraint implicit in the second round is the threat that strengthens the venture capitalist
bargaining position even if rational expectations ensure that it is never carried out. In Canada,
syndicated investments yielded significantly higher returns than those by a single venture
capitalist. Amit found that "unconnected investments had average annual rates of return on the
order of 15% to 20% whereas the syndicated investments had average returns of about 35% to
39%". Wang and Zhou (2004) derive the advantage of staged financing over up-front financing
in a situation where there is information asymmetry between the venture capital and the
entrepreneur. The entrepreneur provides effort, new information becomes available over time
and only the final output is contractible. In the staged funding solution, the venture capitalist
keeps the option of abandoning the project if the new information is not attractive. Staged
funding provides two benefits. First, it reduces the cost associated with the risk of bad
information becoming available. And second, it decreases the costs of the moral hazard problem
that emerges from the agency relationship established when the first investment occurs. The
initial funding provides the resources that the wealth constrained entrepreneur needs. In contrast,
follow up funding relies on the threat that the entrepreneur runs out of resources to curve down
moral hazard, even if in equilibrium this threat is never carried out. These models separate an
initial stage where the cash-constrained entrepreneur receives funding and where an agency
relationship is established from follow-up rounds. These follow-up rounds rely on the threat to
the entrepreneur of hitting his cash constraint to reduce agency costs.
Up-front Funding

In this paragraph, we study the alternative where the venture capitalist provides the funds
required by the manager in one amount I. At the beginning of the first period, the venture
capitalist has the choice between two possibilities: financing or not the project. In case of upfront
funding the venture capitalist loses the option to abondon the project. Since the effort is not
verifiable, the sharing contract and active monitoring serves as means of control of moral hazard
problem to the venture capitalist.
The venture capitalist should choose the contract ( * , (1 * )) that maximizes his expected profit
and taking into account the consequences of this contract on the managers decisions.
Definition 1: Let the managers expected profit from the project be:
M = (1 )zR (e, m)h( z ).dz c(e)
1

(1)

Where z is the random effect distributed according to the uniform density distribution
1
1
h( z ) = 1 with mean and variance
. We assume that the managers reservation utility is
2
12
equal to zero ( = 0) .
The managers will accept the contract if and only if it gives him a profit no smaller than that
represents the utility the manager can obtain by breaking his relationship with the venture
capitalist.

The participation constraint (the Individual Rationality constraint) thus can be written:
M 0
1

(1 )zR(e, m)h( z ).dz c(e)

(IR)

When the venture capitalist offers him a contract (, (1 )), the manager chooses his effort
by solving the following program:

1
Max (1 )zR(e, m)h( z ).dz c(e)
eE

0
The FOC gives us the second constraint that the venture capitalist has to take into account: it is
the Incentive Constraint. Thus the incentive compatibility constraint can be written:
1

(1 )zR(e, m)h( z )dz = c' (e)

(IC)
e 0
Definition 2: Let the venture capitalists expected profit from the project in case of upfront
funding be:
1

UVC = .zR (e, m)h( z ).dz C (m)

0

Then, the venture capitalist will choose the contract which resolves the following program:
1

Max .zR (e, m)h( z ).dz C (m)

, m[0 ,1]
0

(P.1)
Subject to :
(IC )

(IR )
From the (IC) constraint we obtain:
= 1 2e 1
(2)
The FOCs conditions are:
UVC
1
=0
e 1 c = 0

m
2

U
VC = 0
1 e 1 m( 1)e 2 = 0
2
e
The FOCs conditions of the program above imply that the venture capitalist will exert
monitoring (which means m 0 ) if and only if the manager will exert an effort level smaller than

1
e =
2

1
1 2e 1
since m =
.
( 1)e 2

Another conclusion is that the optimal effort level which makes the profit level of the venture
capitalist optimal is:
1

1
1
e* = c

2
*
By substituting e in we obtain:
* = 2c
And:

(3)

2 1

1 2
m =
2
c
1 2 1 2c

1
1 2c
In case of upfront funding, the second best solution is:

m* is positive if and only if: 1

1
1
e = c
2

2 1
1 2

2
m* =
c
1 2 1 2c

* = 2c

( )
( )

2 2
1
1 1

= c
+
2

1 1 2c
2

U
M

1
1
1
= * e * + m * cm * = ce * = c c
2
2

U *
VC

SW = UM

) + ( )
*

U *
VC

2 2
1
1 1

= c
+
2 + c

1 1 2c
2


Proof. See Appendix 1
Staged Funding in Venture Capital

In this section we consider stage funding in venture capital. We assume that the venture
capitalist will not exert monitoring, and that the managers effort is not verifiable.A prominent
characteristic of venture capital investing is its staging structure through sequential financing
rounds. At each round of financing, a venture capital firm supplies new financial resources to the
start-up. These rounds of financing are discrete events staged over the life of the company as a
private entity. Rounds of funding are critical in the relationship between venture capitalists and
the start-ups that they invest in. They are not a simple transfer of financial resources; they also
involve the redefinition of the governance structure of the firm and provide a signal about its

prospects. This new ownership structure affects the control structure of the company as well as
the payoffs of a future liquidity event.
At the beginning of the first period, the venture capitalist invests I0, the manager applies effort
e. At the beginning of the second period, the uncertainty is resolved. Given the investment I0, the
managers effort e, and the resolved uncertainty z, the venture capitalist decides whether to
continue investing in the project or to abandon it. We assume that the venture capitalist will
accept to provide the remaining amount to the manager if and only if the random effect value is
such that:
( zR(e) ) I 1
This means that the venture capitalist will accept to continue financing the project if her expected
return is at least equal to I1. Let assume that:
I
z= 1
R(e)
If z z , the venture capitalist will provide the refinancing; otherwise the venture capitalist will
stop investing in the project. Thus:
z z The project continues

z z The project is abandonned

Definition 3: Let the venture capitalists expected profit from the project be:
1

VC = ( .z.R(e ) I 1 )h( z ).dz I 0

(4)

Formally, the venture capitalists program to resolve is given by:

1

Max VC = ( .zR(e) I 1 )h( z ).dz I 0

, eE

Subject to :
M 0
1
(1 )zR(e)h( z ).dz = c' (e)

e z
I + I = I
0 1
I 0 0, I 1 0 and [0,1]

(IR)
(IC)
(RC)

(PC)
This problem establishes that the venture capitalist maximizes the profit that she obtains from
investing in the project, under the restriction that the manager is willing to accept the sharing
contract. This condition is known as the participation condition (I.R). Moreover, the venture
capitalist maximizes its profit subject to its individual participation condition z z , the
managers incentive compatibility constraint (I.C) and the resources constraint (R.C). Positivity
constraint (P.C) must be taken into account. The following solution characterizes the equilibrium
in the situation of staged financing.

In the case of stage funding, the second best solution is:

e * =
+ 1
1
* = 1

2 1 1 1 1

I 1* =
+1
+ 1

( ) = ( 1) 1+ 1
SB *
VC

( )

SB *
M

=0

S
SW = VC

1 1
I
= ( 1)
+ 1

Proof. See Appendix 2.

Now assume that the managers effort is verifiable. We suppose that the venture capitalist
demand an effort level in the contract. The problem to resolve is:
1

Max VC = ( .zR(e) I 1 )h( z ).dz I 0

, eE

(P.3)
Subject to :

M 0

I 0 + I1 = I

(IR)
(RC)

In case of staged funding and a verifiable effort, the first best solution is:

 * = 1

1 1
e * =

1 1
2
I 1* = ( 1)
1

( )
( ) = 0

1 1 1
=
I
2

FB *
VC
FB *
M

SW =

S *
VC

1 1 1
=
I
2

Proof. See Appendix 3.

We will use this solution to find the optimal strategy for the venture capitalist: up-front funding
with active monitoring, staged funding with a not verifiable effort, and syndicated investments.
Syndicated Venture Investments

We now turn to the equilibrium with multiple venture financing: syndicated venture funding.
Syndication is the process whereby a group of venture capitalists will each put in a proportion of
the amount of money needed to finance a small business. Two main competing sights exist as to
why venture capitalists syndicate investments. The traditional side developed from finance
theory considers syndication as a means of risk sharing via portfolio diversification (Bygrave,
1987, 1988) and Smith & Kiholm Smith, 2000). In contrast the resource based side views
syndication as a means to share resources such as information in the selection (before the
investment is made) and management (after the investment is made) of investments. Related to
the resource based view, syndication is considered as a mean to assure, increase or reciprocate
transaction flow of the venture capitalist. Consider now that we have numerous firms and
venture capitalists. As before firms have access to an investment project each and need external
funds to finance them. Only venture financing is available. Venture capitalists can decide either
to finance firms on their own individual venture financing or to share financing with other
venture capitalist: multiple venture financing (syndicated investments).
Managers behavioral choices are not observable: there is a moral hazard problem. Firms
receive financing only if venture capitalists expect non-negative profits .i.e. if they expect a
return at least equal to the income from an alternative investment. Suppose that we have n
venture capitalists (henceforth indexed by j = 1...n), each venture capitalist finances k projects
(henceforth indexed by i = 1...k). The difference with the up-front funding depends on how
I
unit
venture capitalists share financing with other (n 1) venture capitalists so that it invests
n
in each of the k projects. We assume that all the projects have the same distribution function of
uncertainty. We can have free-riding problem because monitoring is privately costly and not

observable, each venture capitalist has an incentive to reduce its own effort and benefits from the
other venture capitalists monitoring. Moreover, there is a duplication of efforts because venture
capitalists dont coordinate in the choice of their monitoring intensities. The idea is that
monitoring delivers a public good, and all venture capitalists financing a start-up benefit from the
higher return of the project.
The expected return of the project i is:
n

R (ei , M i ) = ei + M i = ei + mij
j =1

Where ei is the effort level exerted by the manager of the project i and Mi is the total monitoring
intensities that all n venture capitalists exert on the project i. Since venture capitalists (VCs)
financing the same project will act as only one VC, they will propose i to the manager in case of
success. Then they will split i equally between them. Then:

ij =

n
The venture capitalist j will demand ij to the manager i in case of success of the project. Thus
the proportion of the manager i from the project is (1 nij). Venture capitalist js expected
profit from a project i is given by:
1

i
VC j = ij .z.R(ei , M i ).h( z ).dz cmij
0

1
= ij ei + mij cmij
2
j =1

Venture capitalist js expected profit from the k projects is given by:

k 1

k
VC j = ij .z.R(ei , M i ).h( z ).dz cmij

i =1 0

(5)
n
i

= ei + mij cmij
i =1
j =1

2n
Where the first term represents the expected return from the k projects venture capitalist j
finances, and the second term is the total cost of monitoring k projects. Venture capitalist
chooses mij and i to maximize (5).
Venture capitalists can finance more projects and reach a greater degree of diversification
than with individual venture financing. Each venture capitalist can finance k projects instead of
one.
The expected return of each project depends on the monitoring of all k venture capitalists.
Venture capitalists will demand the same share of return in case of success of the project i.
The program to resolve is:
k

k
n
k

Max VC
e
m
cm

=
+

i
ij
ij
j

i , mij
i =1
j =1

2n

Subject to :
n
i
1

M = (1 i ) ei + mij (ei ) 0
2
j =1

i
1
M
1
= 0 (1 i ) = (ei )

2
ei

1
i
VC

e
mij cmij 0
=
+

ij i
j
2

j =1

iM
1
From
= 0 , we obtain i = 1 2(ei ) . Taking into account this result into the objective
ei
function, we find:
k
n
k

11
1

(
)
Max VC
e
e
m
cm

+
=

i
i
ij
ij
j
j ,m j

i =1
j =1

n 2

The third constraint means that the venture capitalist j will monitor the project i if its expected
profit is positive, which gives us:
n

1
mij ij ei + mij
2c
j =1

The total monitoring intensities that VCs exert for the project i they finance is:
n

M i = mij
j =1

1
1
The FOCs Conditions give ei = c . The average monitoring intensity exerted by the VCs
2

1
1 2ei
on the project i is M i =
. Venture capitalists will exert monitoring if the managers
2n( 1)ei 2
1

1 1
effort is lower than ei = , which maximizes their expected profit. We notice that the
2
necessary total monitoring intensity to control managers misbehavior is lower in case of
syndication than in case of single venture funding (here up-front funding) since monitoring is
dispersed through n venture capitalists providing finance to the manager. The following
proposition characterizes the equilibrium of the syndicated investment. The unique symmetric
equilibrium of the syndicated venture investment, in which each venture capital monitors the
project with intensity mij and demands the share of return ij is given by:

 ij* =

2c
n
1

1
1
e = c
2

*
i

1
1
1 c

M i* = c
2
n( 1) 2n
1

1
1
1 c
+
mij = c
2
n( 1) 2n
0 if mij* = m ij
SyF *
VC =
*
0 if mij m ij

( )

SyF *
M

1 c 2n 1
c 1 c 1 c 1

+
=
n( 1) 2 2 k
2 n 2n

SyF
SW = VC

) + ( )
*

SyF *
M
1

1 c 2n 1
c 1 c 1 c 1

=
+

n( 1) 2 2 k
2 n 2n
If the Venture capitalist will choose to monitor the project closely and with a high monitoring
1

intensity

1
1
1 c
that mij = c
+ her
2
n( 1) 2n

such

expected

profit

will

1 c 1 c 1
1 0 . The VCs objective is to maximize its expected
be =
2 k n( 1) n
profit, she will choose to provide a lower monitoring level since the lead venture capitalist will
monitor the project closely (Free-riding problem), thus:
SyF
VC

1
1
1 c
mij* c
+
2
n( 1) 2n
Since VCs dont operate cooperatively, all VCs will provide a monitoring intensity such
that: mij* = m ij , and the only agent who will profit from the free-riding problem is the manager.
Proposition 1: Even when the number of venture capitalists financing many projects
simultaneously is high, the net profit of the manager is positive.

lim

n + , k +

( )

SyF *
M

c 1 1 1

= 1 +
2 2

In syndicated venture investments with active monitoring, the venture capitalist does not obtain
positive returns. This is due to the problem of free-riding. The net profit of the manager in case
of syndicated investments with active monitoring is lower than in case of up-front funding.
Analysis

To appreciate the role of venture capitalist financing strategy in alleviating moral hazard, we
consider the following cases: up-front funding, staged funding and syndicated investments. We
will use UF, SF and Syn for up-front funding, staged funding and syndication, respectively.
If we compare the social welfare when the cost of monitoring goes to 0 and when the cost of
1
monitoring is high, and goes to . We find:
2
SW (c0)
1
SW (c )
2

Up-front funding
1
1 1 1 1

+
1

2

2 2

Staged funding (FB)

2 1 1 1
2 1 1 1

2
2

Staged funding (SB)

1
( 1) 1
( 1) 1
+ 1
+ 1

1
Syndication
n 1
1 1
n 1 k 1 1
1 1

1
2n + 2

4n ( 1) 2k
2 2n

Proposition 2: When goes to infinity, the Social Welfare in case of up-front funding is higher
then in case of syndication, when the cost of monitoring is high, and when the cost of monitoring
is low, syndicated investments increase the social welfare of the agents.

The proposition above suggests that in case of syndicated venture investments the social
profit of the agents is higher than in case of a single venture funding (up-front funding) when
monitoring is not costly. VCs will monitor closely the project. Otherwise, syndication is not the
optimal strategy for the venture capital investor when monitoring is costly, since monitoring is
not an observable action between the VCs; they will free-ride to maximize their expected profit.
Thus, when monitoring is costly, up-front funding with active monitoring is an optimal strategy.
Monitoring intensities are higher when there is only one venture capitalist that finances the
project, this is the direct result of the numerous venture capitalist that provide funding to the
start-up. As in up-front funding, the manager of the project i must provide an effort level lower
1

1 1
than e i = to give incentives for the VCs to monitor the project.
2

The comparison of four social welfare curves when the cost of monitoring is low is shown in
Figure 1.
Figure 1

The figure above indicates that the social welfare in case of up-front funding with active
monitoring when is low, which means that the cost of the effort provided by the manager is
higher than the social welfare for the first best solution. The syndicated investments provide the
lower social welfare; this is the direct result of free-riding problem. We conclude that when
providing effort is costly for the manager, up-front funding with active monitoring is the optimal
strategy to obtain higher results. In the other case, when supplying effort isnt costly ( ),
staged funding with verifiable effort is the optimal strategy.
The comparison of four social welfare curves when the cost of monitoring is high is shown in
Figure 2.

Figure 2

The social welfare in case of up-front funding with active monitoring is higher than the social
welfare in case of staged funding for given value of (the cost of effort converges to zero as
+).
In fact active monitoring will have an impact on the managers behavior which gives an
increasing in the net profit of the agents. Staged funding can reduce uncertainty and alleviate
moral hazard. In our model, the monitoring in up-front funding increase the net profit of the
venture capitalist and the start-up. For lower value of , which means a high cost of effort for the
manager, the VC must monitor the project closely to control the managers misbehavior. In other
words, the manager will not provide a higher effort since it is costly. Monitoring will be a good
mechanism to control this problem. But when is high, the cost of the effort is low, and the
manager will provide a higher effort to increase the expected return of the project and then there
is no reason for the VC to monitor closely the project. For that reason, the social welfare in case
of staged funding (FB) is higher than the social welfare in case of up-front funding with active
monitoring. When the cost of monitoring is high, the social welfare in case of syndicated
investments approaches the social welfare in case of up-front funding: venture capitalists will
operate as one "financier".
CONCLUSION

This study has extended the venture capital literature by analyzing the role of asymmetric
information conditions, which may arise subsequent to the time of contracting, can play in the
choice of contract type. However, the entrepreneur has an incentive to behave opportunistically
under asymmetric information. In our model we consider an entrepreneur facing an imperfect
capital market and a venture capital investor facing uncertainty and moral hazard. We study how

active monitoring can increase the expected net profit of these two agents, and thus the social
welfare. Under certain assumptions, we obtain some unique results on the performance and role
of the monitoring that the venture capitalist uses to mitigate moral hazard problem and to reduce
uncertainty. We find that up-front funding may be socially better choice when the cost of the
effort is high. In particular monitoring in up-front funding can eliminate the incentives of the
manager to misbehave since providing effort is costly. Moreover, this paper analyzes VCs
incentives to enter in syndicated investments with other VCs in a context where both start-ups
and VCs are subject to moral hazard, and monitoring is essential. VCs choose syndicated venture
investments whenever the benefit of a greater diversification in terms of higher overall
monitoring dominates the drawbacks of free-riding problem. We find that when the number of
VCs financing the same project is high the social welfare in case of syndication is lower than in
case of up-front funding.
We develop the analysis under the assumption that all VCs share financing equally when they
syndicate the investment and receive the same share of benefits in case of success of the project.
Allowing for asymmetric shares would lead to different results. How the VCs split the
investment amount between them? Using a bargaining model, we can have an answer to this
idea. This analysis constitutes an interesting avenue for future research.
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Appendix
Proof. Solution 1
For z U [0,1], we have h( z ) = 1
Problem (P.1) to resolve is:
1

Max UVC = (e + m ) cm
,m
2

Subject to :

1
1
2 (1 ) = e
1
(1 )(e + m ) 1 e
2

The (IC) constraint implies the (IR) condition; we can consider the following program:
1

Max UVC = (e + m ) cm
,m
2

Subject to :
1
(1 ) = e 1
2
Which is equivalent to:
1

Max UVC = (e + m ) me 1 e cm
,m
2

The FOCs conditions are :

1
1
2 e c = 0

1 e 1 m( 1)e 2 = 0
2

Which gives e*,m*, then * and UVC in solution 1.

Proof. Solution 2

We know that: z =

I1
R (e)

M = (1 )zR (e)h( z )dz c(e)

z

2
1
(1 )e (1 2)I 1
2
2 e
(
1 )I 12
M 1
= (1 ) +
2
e
2 2 e 2
And:

VC = zR(e)h( z )dz I 0
z

I2
1
= e 1 I
2
2e
The problem (P.2) to resolve is:

I2
1
Max VC = .e 1 I
, eE
2
2 .e

Subject to :

1
(
1 )I 12
(
)
= e 1
1 +
2 2
2 e
2

2
1 (1 )e (1 )I 1 1 e
2

2 2 e
The two first constraints give us:
1 + 1
e
= 1

And:

+1 1
I 1 = e
e

+1

Thus,

Max VC =
e e I
, eE
+1

The FOC for e implies:

1

VC
1 1

= 0 e * =
e
+ 1

SB
Which immediately implies * , I 1* , and VC
in solution 2.

Proof. Solution 3
The problem (P.3) to resolve is:

I2
1
Max UVC = .e 1 I
, eE
2
2 .e

Subject to :
1
(1 )I 12 1
(
)

e
e

2 2 e
2
I = I + I
0
1

Considering that:
2
1
(1 )e (1 2)I1 = 1 e
2

2 e
We obtain:
I 12
2
= e2
e +1
2
(1 )

And:
2
I1 = e 2
e +1
(1 )
The program to resolve is:

Max VC = .e
e I
, eE
(1 )

FOCs are :

VC

e =0

0
=

1
e
VC = 0
=0
e
(1 )2
Which gives:
1
* = 1

FB
in solution 3.
Which immediately implies e * , I 1* , and VC

Proof. Solution 4
The problem (P.4) to resolve is:

k
n
k

Max VC
e
m
cm

=
+

ij
i
ij
j

i , mij
i =1
j =1

2n

Subject to :
n
i

1
1

M = (1 i ) ei + mij (ei ) 0
2
j =1

i
1
M
1
= 0 (1 i ) = (ei )

2
ei

1
i
VC

e
mij cmij 0
=
+

ij i
j
2

j =1

The second constraint provides us:

i = 1 2(ei ) 1
Considering that VC will choose the monitoring intensity which gives him a profit at least equal
to zero. Then:
n

1
mij = ij ei + mij
2c
j =1

The FOCs conditions are:

SyF
n k
VC
=0
2 ij c = 0

m
ij
i =1

1
SyF
VC = 0
1 1 n 1 1 ij 1 1 n + nm = 0
ij
ij
2 2 ij 1 2 2 ij

From the FOCs for mij and ei we obtain:

SyF
VC
1
1
=0

(ei ) c = 0

m
ij

SyF
1 1 (e ) 1 M i ( 1)(e ) 2 = 0
VC = 0
i
i
2n n
ij

This gives:
1

(ei )

1 2 (ei )
1
1
= c and M i =
2
2n( 1)(ei )
2

This immediately implies ( i ) and ( ij ) .

*