Contracts for venture capital financing with double-sided moral hazard

  • Hui Fu
  • Jun Yang
  • Yunbi An


Using a Nash bargaining approach, we analyze the financing contract between the entrepreneur and the venture capitalist with double-sided moral hazard in a start-up enterprise. Our results show that there exists an optimal contract set between the entrepreneur and the venture capitalist, in which all contracts achieve an identical second-best social state. Within the optimal contract set, there exists continuum of joint debt-equity financing. The pure equity financing contract exists in the optimal contract set when the ratio of total social surplus to the amount of investment is greater than a threshold.


Optimal contract Venture capital Double-sided moral hazard Bargaining game 

JEL classification

C70 D82 G24 L26 



Hui Fu thanks his supervisor, Professor Tian Cunzhi, for his guidance, support, and continuing encouragement throughout his Ph.D. studies at Jinan University.


  1. Binmore, K., Rubinstein, A., & Wolinsky, A. (1986). The Nash bargaining solution in economic modelling. RAND Journal of Economics, 17(2), 176–188.CrossRefGoogle Scholar
  2. Bengtsson, O. (2012). Financial contracting in US venture capital: overview and empirical evidence. In D. Cumming (Ed.), The Oxford handbook of venture capital (pp. 478–508). New York: Oxford University Press.Google Scholar
  3. Bengtsson, O., & Sensoy, B. A. (2015). Changing the nexus: the evolution and renegotiation of venture capital contracts. Journal of Financial and Quantitative Analysis, 50(03), 349–375.CrossRefGoogle Scholar
  4. Boadway, R., O. Secrieru, M. Vigneault (2005). A search model of venture capital, entrepreneurship, and unemployment. SSRN Working Paper, available at
  5. Casamatta, C. (2003). Financing and advising: optimal financial contracts with venture capitalists. Journal of Finance, 58(5), 2059–2086.CrossRefGoogle Scholar
  6. Chemla, G., Habib, M. A., & Ljungqvist, A. (2007). An analysis of shareholder agreements. Journal of the European Economic Association, 5(1), 93–121.CrossRefGoogle Scholar
  7. Cheung, S. N. S. (1969). The theory of share tenancy. Chicago: University of Chicago Press reprinted in June 2000 by Arcadia Press.Google Scholar
  8. Coase, R. H. (1937). The nature of the firm. Economica, 4(16), 386–405.CrossRefGoogle Scholar
  9. Cumming, D. J. (2005). Capital structure in venture finance. Journal of Corporate Finance, 11(3), 550–585.CrossRefGoogle Scholar
  10. Cumming, D. J. (2007). United States venture capital financial contracting: foreign securities, in Hirschey, John, and Makhija (ed.) Issues in corporate governance and finance (Advances in financial economics, Volume 12), Emerald Group Publishing Ltd, 405–444.Google Scholar
  11. Cumming, D. (2008). Contracts and exits in venture capital finance. Review of Financial Studies, 21(5), 1947–1982.CrossRefGoogle Scholar
  12. Cumming, D., & binti Johan, S. A. (2008). Preplanned exit strategies in venture capital. European Economic Review, 52(7), 1209–1241.CrossRefGoogle Scholar
  13. Cumming, D., Schmidt, D., & Walz, U. (2010). Legality and venture capital governance around the world. Journal of Business Venturing, 25(1), 54–72.CrossRefGoogle Scholar
  14. De Bettignies, J. E. (2008). Financing the entrepreneurial venture. Management Science, 54(1), 151–166.CrossRefGoogle Scholar
  15. De Bettignies, J. E., & Brander, J. A. (2007). Financing entrepreneurship: bank finance versus venture capital. Journal of Business Venturing, 22(6), 808–832.CrossRefGoogle Scholar
  16. Fairchild, R. (2011a). An entrepreneur’s choice of venture capitalist or angel-financing: a behavioral game-theoretic approach. Journal of Business Venturing, 26(3), 359–374.CrossRefGoogle Scholar
  17. Fairchild, R. (2011b). Fairness norms and self-interest in venture capital/entrepreneur contracting and performance. International Journal of Behavioural Accounting and Finance, 2(1), 4–20.CrossRefGoogle Scholar
  18. Fenn, G., N. Liang, S. Prowse (1998). The role of angel investors in financing high-tech start-ups, Unpublished Manuscript, Federal Reserve Board.Google Scholar
  19. Gilson, R. J., & Schizer, D. M. (2003). Understanding venture capital structure: a tax explanation for convertible preferred stock. Harvard Law Review, 116(3), 874–916.CrossRefGoogle Scholar
  20. Hartmann-Wendels, T., Keienburg, G., & Sievers, S. (2011). Adverse selection, investor experience and security choice in venture capital finance: evidence from Germany. European Financial Management, 17(3), 464–499.CrossRefGoogle Scholar
  21. Hellmann, T. (1998). The allocation of control rights in venture capital contracts. RAND Journal of Economics, 29(1), 57–76.CrossRefGoogle Scholar
  22. Hellmann, T. (2002). A theory of strategic venture investing. Journal of Financial Economics, 64(2), 285–314.CrossRefGoogle Scholar
  23. Hellmann, T. (2006). IPOs, acquisitions, and the use of convertible securities in venture capital. Journal of Financial Economics, 81(3), 649–679.CrossRefGoogle Scholar
  24. Hirsch, J., & Walz, U. (2013). Why do contracts differ between venture capital types? Small Business Economics, 40(3), 511–525.CrossRefGoogle Scholar
  25. Inderst, R., & Muller, H. M. (2004). The effect of capital market characteristics on the value of start-up firms. Journal of Financial Economics, 72(2), 319–356.CrossRefGoogle Scholar
  26. Kaplan, S. N., Martel, F., & Strömberg, P. (2007). How do legal differences and experience affect financial contracts? Journal of Financial Intermediation, 16(3), 273–311.CrossRefGoogle Scholar
  27. Kaplan, S. N., & Strömberg, P. (2003). Financial contracting theory meets the real world: an empirical analysis of venture capital contracts. Review of Economic Studies, 70(2), 281–315.CrossRefGoogle Scholar
  28. Landier, A. (2002). Start-up financing: From banks to venture capitalists, Working Paper, University of Chicago.Google Scholar
  29. Lerner, J., & Schoar, A. (2005). Does legal enforcement affect financial transactions? The contractual channel in private equity. Quarterly Journal of Economics, 120(1), 223–246.Google Scholar
  30. Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. American Economic Review, 48(3), 261–297.Google Scholar
  31. Nahata, R., Hazarika, S., & Tandon, K. (2014). Success in global venture capital investing: do institutional and cultural differences matter? Journal of Financial and Quantitative Analysis, 49(04), 1039–1070.CrossRefGoogle Scholar
  32. Nash, J. (1950). The bargaining problem. Econometrica, 18(2), 155–162.CrossRefGoogle Scholar
  33. Nash, J. (1953). Two-person cooperative games. Econometrica, 21(1), 128–140.CrossRefGoogle Scholar
  34. Osintsev, Y. (2010). Venture financing of start-ups: a model of contract between VC fund and entrepreneur. Economic Annals, 55(187), 61–86.CrossRefGoogle Scholar
  35. Reid, G. C. (1996). Fast growing small entrepreneurial firms and their venture capital backers: an applied principal-agent analysis. Small Business Economics, 8(3), 235–248.CrossRefGoogle Scholar
  36. Repullo, R., & Suarez, J. (2004). Venture capital finance: a security design approach. Review of Finance, 8(1), 75–108.CrossRefGoogle Scholar
  37. Roth, A. E. (1979). Axiomatic models of bargaining. New York: Springer-Verlag.CrossRefGoogle Scholar
  38. Schmidt, K. M. (2003). Convertible securities and venture capital finance. Journal of Finance, 58(3), 1139–1166.CrossRefGoogle Scholar
  39. Tirole, J. (2001). Corporate governance. Econometrica, 69(1), 1–35.CrossRefGoogle Scholar
  40. Tirole, J. (2006). The theory of corporate finance. Princeton: Princeton University Press.Google Scholar
  41. Utset, M. A. (2002). Reciprocal fairness, strategic behavior and venture survival: a theory of venture capital-financed firms. Wisconsin Law Review, 2002(1), 45–168.Google Scholar
  42. Yousfi, O. (2013). Does PLS solve moral hazard problems? Journal of Islamic Economics, Banking and Finance, 9(3), 11–26.CrossRefGoogle Scholar

Copyright information

© Springer Science+Business Media, LLC, part of Springer Nature 2018

Authors and Affiliations

  1. 1.School of BusinessJiangnan UniversityWuxiChina
  2. 2.F.C. Manning School of Business AdministrationAcadia UniversityWolfvilleCanada
  3. 3.Odette School of BusinessUniversity of WindsorWindsorCanada

Personalised recommendations