Reciprocal Fairness, Strategic Behavior & Venture Survival: A Theory of Venture Capital-Financed Firms

Abstract

This article starts from the premise that contract parties care about fairness and argues that reciprocal fairness concerns can lead parties to engage in wasteful retaliation. In particular it analyzes reciprocal fairness issues in the context of venture capital contracts. The bargaining power of venture capitalists and the (well-documented) over-optimism of entrepreneurs can lead entrepreneurs to enter into one-sided contracts. In fact, standard venture capital contracts transfer effective control over the venture to the venture capitalist.

As high-powered incentive mechanisms and one-sided contract provisions are triggered, entrepreneurs will begin to revise their initial (over-optimistic) beliefs. This belief-revision will increase the likelihood that an entrepreneur will retaliate. Entrepreneurs control an important firm asset - their human-capital. This control over the production and dissemination of innovation-specific knowledge will given an entrepreneur the power: (1) to protect her contractual interests; and (2) to retaliate against venture capitalist actions deemed unfair. The article develops various theoretical and doctrinal implications.

Keywords: negative reciprocity, retaliation, venture capital finance, incomplete contracting

JEL Classification: A 12, A 13, G24, G30, G32, K12