Abstract:

We develop and conduct a classroom experimental analysis of venture capital/entrepreneurial (VC/E) financial contracting and performance. We motivate our experiment by developing a theoretical model in which the VC first makes an ultimatum equity offer to the E (since the VC has the bargaining power), and the VC and the E then exert simultaneous unobservable effort (thus, double-sided moral hazard problems exist in the form of effort-shirking). Our normative model demonstrates a unique equity offer from the rational VC, followed by optimal effort levels from the VC and the E. In an extension to our model, we incorporate social preferences and behavioural feelings of fairness, empathy and engagement in the VC/E dyad. This mitigates double-sided moral hazard, and enhances the players’ effort levels for ‘balanced’ equity offers.

Our experimental analysis demonstrates large heterogeneity between VCs’ equity offers, and subsequent VC’s and E’s effort levels, in contrast to the normative theory. We surmise that this wide variation in results may be due to bounded rationality and feelings of fairness. Nevertheless, our regression analyses demonstrate that the relationship between the VC’s equity offer to the E, and our variables of interest (the players’ effort levels, the venture value, and players’ payoffs) is consistent with our theoretical model. We run our experiment with both postgraduate (Masters) students, who are studying venture capital/entrepreneur financing, and undergraduate students, who are studying behavioural economics and venture financing. Our experiment is didactic, in that it helps the students to understand both the theoretical and practical aspects of venture capital contracting and performance: furthermore, it helps prepare the students, many of whom aim to be venture capitalists or entrepreneurs, for the real-world aspects of financial contracting and negotiations.

Keywords:

Classroom experiment, venture capital financial contracting, double-sided moral hazard, behavioural economics, theory and practice.