Bilateral Incentive Problems and the Financing of Start-Ups

41 Pages Posted: 13 Feb 2007

See all articles by Stanley Baiman

Stanley Baiman

University of Pennsylvania - Accounting Department

Sasson Bar-Yosef

Hebrew University

Bharat Sarath

Rutgers University

Date Written: February 2007

Abstract

We analyzed two distinct but related issues - (i) the role of different contracting instruments in mitigating bilateral incentive problems and (ii) the role of a public report in affecting the inferences drawn from the structure of private contracts and the efficiency of those contracting instruments. We showed that in a setting where a venture capitalist (VC) with private information about a project's future cash flows contracts with an entrepreneur (E) who provides services under conditions of moral hazard, the VC prefers equity instruments to debt instruments and equity contracts with option and debt features (including convertible debt instruments) to both. This finding is consistent with observations from actual practice where convertible contracts are quite commonly employed as a financing vehicle. In addition, we show that a public report about the probability of success of a project released after the project has proved successful, has informational value in that it allows more information to be extracted (by public investors) from the form of the venture financing contract. This, in turn, makes the earlier contracting between the VC and E more efficient. Consequently, the historical information emphasized in many audited financial reports may be of greater indirect value than is apparent by their ability to predict current (or future) prices.

Keywords: Efficient Contracting, Venture Capital, Incentive problems, IPO

JEL Classification: G24, G32, D82, M41

Suggested Citation

Baiman, Stanley and Bar-Yosef, Sasson and Sarath, Bharat Sarrukai, Bilateral Incentive Problems and the Financing of Start-Ups (February 2007). EFA 2007 Ljubljana Meetings Paper, Available at SSRN: https://ssrn.com/abstract=962634 or http://dx.doi.org/10.2139/ssrn.962634

Stanley Baiman

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States
215-898-6782 (Phone)
215-573-2054 (Fax)

Sasson Bar-Yosef (Contact Author)

Hebrew University ( email )

Mount Scopus
Jerusalem, Jerusalem 91905
Israel

Bharat Sarrukai Sarath

Rutgers University ( email )

94 Rockafeller Road
Piscataway, NJ 08854
United States
8484453447 (Phone)

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