Venture Capital Deals: Beliefs and Ownership

We use a principal-agent model to examine how venture capitalists can determine the ownership division when fund-seeking entrepreneurs possess private information on their disutility of effort. This situation is especially applicable to early-stage first-time entrepreneurs seeking funding, since no history exists on their potential performance. The venture capitalist must thus consider this private information by forming a belief on the entrepreneur´s effort level toward the proposed investment opportunity. Formal modeling enables us to describe how the deal process unfolds and to build a simulation. We then identify a unique investor´s belief and resulting ownership sharing that maximizes the return to the entrepreneur, one that maximizes the return to the venture capitalist, as well as one that maximizes the deal welfare. We also conjecture an ordering relationship between these critical beliefs and between their resulting ownership allocations. Furthermore, we identify conditions under which the venture capitalist should choose to revise the investment offer if rejected by the entrepreneur. This paper thus moves us closer to a comprehensive theory of venture investment decisions.