Financial Contract Design in the World of Venture Capital

Abstract

Recent scholarship has described a venture capital cycle which finances start-up technology companies. This cycle, however, bears striking similarities with its counterpart in the old economy under which banks financed young firms. Indeed, with one notable exception, venture capital has introduced little innovation in financial contract design between financial intermediaries and entrepreneurs. The same approaches to information problems are used by banks and venture capital partnerships alike. The significant exception is the frequent use in venture capital finance of convertible instruments in the place of secured debt financing by banks. This paper explains (i) the functional similarity between venture capital and bank contracts with entrepreneurs and (ii) the valuable role played by convertible debt or preferred stock in technology start-ups.