Legacy Events Room CBA 3 . 202 Thursday , August 29 , 2019 11 : 00 am

We estimate the impact of venture capital (VC) contract terms on startup outcomes and the split of value between the entrepreneur and investor, accounting for endogenous selection via a novel dynamic search and matching model. The estimation uses a new, large data set of first financing rounds of startup companies. Consistent with efficient contracting theories, there is an optimal equity split between agents that maximizes the probability of success. However, VCs use their bargaining power to receive more investor-friendly terms compared to the contract that maximizes startup values. Better VCs still benefit the startup and the entrepreneur, due to their positive value creation. Counterfactual exercises show that eliminating certain contract terms benefits entrepreneurs and enables low-quality entrepreneurs to finance their startups more quickly, increasing the number of deals in the market. Lowering search frictions shifts the bargaining power to VCs and benefits them at the expense of entrepreneurs. The results show that selection of agents into deals is a first-order factor to take into account in studies of contracting. ∗We are grateful to Ilona Babenko (discussant), Tania Babina (discussant), Vincent Glode (discussant), Will Gornall (discussant), Igor Makarov (discussant), Pavel Zryumov (discussant), Steven Kaplan, Gordon Phillips, seminar participants at Caltech, Northwestern University (Kellogg), Tulane, and USC, and participants at the 2019 American Finance Association meetings, the 2019 Midwest Finance Association meetings, the 2019 Financial Intermediation Research Society meetings, the 2018 NBER Entrepreneurship Summer Institute, the 2018 London Private Equity Symposium, the 2018 Financial Research Association conference, and the 2018 Stanford Financing of Innovation Summit. Jun Chen provided valuable research assistance. We thank the Linde Institute of Economic and Management Sciences for funding. Authors’ email addresses: mewens@caltech.edu, gorbenko@marshall.usc. edu, korteweg@marshall.usc. edu. Legacy Events Room CBA 3.202 Thursday, August 29, 2019 11:00 am A large body of academic work examines the problem of financial contracting, frequently within the context of an entrepreneur negotiating a financing deal with an investor (e.g., Bolton and Dewatripont, 2004; Salanie, 2005). Entrepreneurial firms are key drivers of innovation and employment growth, and the efficient allocation of capital to early stage firms is crucial to their success (Solow, 1957). 1 Financial contracting plays an important role at this stage, as information asymmetries and agency problems are severe (Hall and Lerner, 2010), and the observed contracts between entrepreneurs and venture capitalists (VCs) are quite complex. The predominant explanation in the theoretical literature is that the complex contractual features improve incentives and information sharing (e.g., Cornelli and Yosha, 2003; Kaplan and Strömberg, 2003; Schmidt, 2003; Repullo and Suarez, 2004; Hellmann, 2006). This result is usually derived under the assumption that investors are homogeneous and competitive, and thus earn zero rents. A contrasting view is that investors negotiate to include certain contract terms not to grow the size of the pie that is divided between the contracting parties, but to change the distribution of the pie in their favor. This is possible because VCs are not homogeneous, as evidenced by the persistence in VC returns (e.g., Kaplan and Schoar, 2005; Hochberg, Ljungqvist, and VissingJorgensen, 2014; Korteweg and Sorensen, 2017) and the positive relation between VC fees and performance (Robinson and Sensoy, 2013). Similar to models of economic superstars (Rosen, 1981), a VC of lesser quality (a shorthand for its experience, network, and other value-added activities) is usually a poor substitute for a greater quality investor. Moreover, VCs are repeat players in the market for startup financing, with a broader view of the market and the distribution of possible outcomes, and a better understanding of the implications of complicated contract terms than entrepreneurs. As a result, they have substantial bargaining power, while lawyers and regulators do not have strong incentives to correct this imbalance. The resulting contracts are favorable to the VC, even if they reduce the startup’s value. This comes at the expense of the entrepreneur, who experiences poor returns (e.g., Moskowitz and Vissing-Jørgensen, 2002; Hall and Woodward, 2010; Cestone, 2014). As of yet, there is little empirical evidence that quantifies in which direction, let alone how much, various contract terms impact outcomes and the distribution of value. This paper helps fill that gap. A key empirical problem is that contracts are related to the underlying qualities of the entrepreneur and investor, which are unobserved. To address the resulting omitted variables problem we specify a dynamic search and matching model. In broad strokes, the model works as follows. Penniless entrepreneurs search for investors in their startups, and vice versa. When two potential Successful entrepreneurial firms represent a sizable component of the economy. In 2015, public VC-backed firms in the US accounted for 21% of equity market capitalization, 44% of research and development expense, and 11% of employment (Gornall and Strebulaev, 2015).