Contracts As Reference Points in Venture Capital

Richard Fairchild (University of Bath)
Maija Halonen-Akatwijuka (University of Bristol)
John Lewis (UPEC, IAE Gustave Eiffel and IRG)

Abstract: We apply contracts as reference points (Hart and Moore (2008) and Hart (2009)) in venture capital. We find that the venture capitalist, VC, chooses to leave some surplus for the entrepreneur, E, even when he has all ex ante bargaining power to guarantee a smoother ex post relationship. However, renegotiation can occur in equilibrium leading to souring of the relationship and deadweight losses. Therefore not all efficient projects will be funded. Contractual clauses such as vesting arrangements and noncompete clauses enable VC to lower the equity offer to E. Furthermore, VC benefits from costlier renegotiation as E will accept a lower equity share without triggering renegotiation.