Vesting and Control in Venture Capital Contracts
45 Pages Posted: 28 Feb 2005
There are 2 versions of this paper
Vesting and Control in Venture Capital Contracts
Vesting and Control in Venture Capital Contracts
Date Written: June 2004
Abstract
Vesting of equity payments to an entrepreneur, which is time contingent compensation, is ubiquitous in venture capital contracts and has been shown empirically to be of economic importance. We show that vesting equity to an entrepreneur over a longer period of time, late vesting, acts as a screening device against bad entrepreneur types. But if contracts are incomplete such that payments and vesting cannot initially be contracted upon later outcomes, then late vesting gives lower effort incentives than early (short time-period) vesting since it is subject to holdup by the venture capitalist. Comparative statics show how equilibrium outcomes of screening, effort and assignment of control rights vary based on the ex-ante probability and the ex-interim signal of the entrepreneur's type. Control rights are a substitute for early vesting and allow for the largest effort incentives by fully protecting the entrepreneur from holdup. We also find that a new explanation for the link between equity control rights and equity cash flow claims is that residual equity control rights over the firm are necessary to protect residual equity claims from holdup.
Keywords: Venture capital, vesting, control rights, contingent compensation, incentives, adverse selection, incomplete contracts, hold-up problem
JEL Classification: G24, D23, D82, J33, M52, M13, G32
Suggested Citation: Suggested Citation
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