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Explores the financial contracts that can be entered into by the entrepreneur and the inside investor that permit optimal continuation and investment decisions. The inside investor is assumed to be a venture capitalist. The unique contract under examination is termed the fixed-fraction contract. It gives the venture capitalist an equity-like position in the firm. In addition to enlisting the funds of a venture capitalist, the entrepreneur can approach outside investors. Outside investors do not have the same information that inside investors do. The model presented consists of a three-period project. The analysis of the entrepreneur-led financing highlights the information asymmetry that exists in this type of relationship in addition to agency problems related to investment decisions. On the other hand, the fixed-fraction contract involving the venture capitalist induces optimal continuation because the venture capitalist owns a fixed fraction of the project for which he or she provides the capital. Since the venture capitalist payoff is independent of the pricing of later-issued securities, or she he has no reason to misprice these securities. While the benefits of the fixed-fraction contract are shown, consideration must be given to the venture capitalist's cost of monitoring the firm. (SRD)
Admati et al. (Wed,) studied this question.