Venture capital (VC) firms are pools of private capital that typically invest in
ID: 1198575 • Letter: V
Question
Venture capital (VC) firms are pools of private capital that typically invest in small, fast-growing companies, which usually can’t raise funds through other means. In exchange for this financing, the VCs receive a share of the company’s equity, and the founders of the firm typically stay on and continue to manage the company. 1 a. Describe the nature of the incentive conflict between VCs and the managers, identifying the principal and the agent. b. VC investments have two typical components: (1) managers maintain some ownership in the company and often earn additional equity if the company performs well; (2) VCs demand seats on the company’s board. Discuss how these two components help address the incentive conflict.
Explanation / Answer
a. The Venture Capitalists invest in the business organisation, while the founder of the company stays in the management of the company. If Venture capitalisms do not take part in management, then the principle-agent problem of moral hazard arises. This happens because the salaried managers do not have much interest in the company's long term problems. If the company makes profits, managers do not gain from it. If the company loses, the managers do not lose much while the VCs surely do. This may lead the management work with negligence. In fact, the founders of the organisation may be tempted to take risky decisions, where the company either makes big bucks or breaks to pieces. This they might do because if the decision turns out to be successful, they gain fame, and if the decision turns out to be a failure, the financial burden falls more on the VCs. So for the agent, the situation is effectively: "Tails I win, Heads they lose."
b. These two components do held in addressing the principal-agent problem.
The contracts wherein the managers get a greater equity stake if the company does well, managers do have a greater incentive to work efficiently.
If the VCs take part in the management board (say by getting for themselves a right to veto any decision), then they can make sure that unwanted decisions are not taken by the company's management.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.