Week 4 - Venture Capital Contracts

Question 1

Financial Contracting

Answer 1

Deals with the allocation of risks and rewards between the entrepreneur and investors

Question 2

Proportional vs. Non-Proportional Sharing of Risk and Return

Answer 2

Proportional: The decision of the entrepreneur involves maximizing NPV by choosing his ownership share and financing the remainder outside

Non-Proportional: Each party will try to increase NPV by shifting as much risk the the other party as possible, which retaining as much of the expected return as possible

Investors are well-diversified, but entrepreneur is not -> comparative advantage in risk-bearing

Question 3

Types of Contracting

Answer 3

Risk-allocation Contracting: parties use clauses and securities to allocate risk
Return-allocation Contracting: parties use clauses and securities to allocate return

Question 4

Differences with an Active Investor

Answer 4

Demand higher ownership stake in the venture to compensate the time and effort they have to put in the business
Involvement increases expected return and may lower risk

Question 4

Differences with an Active Investor

Answer 4

Demand higher ownership stake in the venture to compensate the time and effort they have to put in the business
Involvement increases expected return and may lower risk