The Effect of Capital Market Characteristics on the Value of Start-Up Firms

Abstract

We show that the pricing, contractual structure, and efficiency of venture capital deals depends on characteristics of the capital market in which the start-up raises finance. Market characteristics such as the expected return on investments, entry costs, and capital market transparency all affect the relative supply and demand for capital, and thus the relative bargaining power of entrepreneurs and venture capitalists. Relative bargaining power, in turn, affects equity shares and incentives. This finally affects the success probability, value, and valuation of start-ups. Moreover, we show that relative supply and demand conditions also determine the incentives of venture capitalists to screen projects ex ante. By characterizing both the short- and long-run dynamics of the venture capital industry, our model sheds light on the Internet boom and bust periods. The model is consistent with available empirical evidence and provides many novel empirical predictions.