Real-world financial contracts are sometimes so complex that it can be difficult to understand their exact payoff consequences. We develop and test a theoretical model of a venture capitalist (VC) negotiating with an entrepreneur who may overweigh or underweigh the payoff consequences of contractual downside protection (DP). A lawyer with expertise in venture capital can inform the entrepreneur about these consequences, but less expert (but otherwise high quality) lawyers cannot. We determine how a VC's decision to include DP is affected by the expected quality of the entrepreneur's project, the entrepreneur's experience, and the VC expertise of his/her legal counsel. We show that the VC's incentive to include unnecessary DP declines in expected project quality. Indeed, for inexperienced entrepreneurs involved with high-quality projects, VCs prefer that the entrepreneur's counsel has VC expertise. This implies that, when negotiating with inexperienced entrepreneurs, VCs who invest in high-quality companies should be more likely to negotiate with entrepreneurs who employ lawyers with VC expertise. We document broad empirical support for the model, and provide evidence against competing explanations.
ASJC Scopus subject areas
- Business, Management and Accounting(all)
- Economics and Econometrics