Ch. 9: Venture Capital 491
Table 4provides a summary of investments in the ten states with the most venture cap-
ital activity over the past three decades.
Before considering the mechanisms employed by venture capitalists, it is worth high-
lighting that a lengthy literature has discussed the financing of young firms. Uncertainty
and informational asymmetries often characterize young firms, particularly in high-
technology industries. These information problems make it difficult to assess these
firms, and permit opportunistic behavior by entrepreneurs after financing is received.
This literature has also highlighted the role of financial intermediaries in alleviating
these information problems.
To briefly review the types of conflicts that can emerge in these settings,Jensen and
Meckling (1976)demonstrate that conflicts between managers and investors (“agency
problems”) can affect the willingness of both debt and equity holders to provide capital.
If the firm raises equity from outside investors, the manager has an incentive to engage
in wasteful expenditures (e.g., lavish offices) because he may benefit disproportionately
from these but does not bear their entire cost. Similarly, if the firm raises debt, the
manager may increase risk to undesirable levels. Because providers of capital recognize
these problems, outside investors demand a higher rate of return than would be the case
if the funds were internally generated.
More generally, the inability to verify outcomes makes it difficult to write contracts
that are contingent upon particular events. This inability makes external financing costly.
Many of the models of ownership (e.g.,Grossman and Hart, 1986, andHart and Moore,
1990 ) and financing choice (e.g.,Hart and Moore, 1998) depend on the inability of in-
vestors to verify that certain actions have been taken or certain outcomes have occurred.
While actions or outcomes might be observable, meaning that investors know what the
entrepreneur did, they are assumed not to be verifiable: i.e., investors could not convince
a court of the action or outcome. Start-up firms are likely to face exactly these types of
problems, making external financing costly or difficult to obtain.
If the information asymmetries could be eliminated, financing constraints would dis-
appear. Financial economists argue that specialized financial intermediaries, such as
venture capital organizations, can address these problems. By intensively scrutinizing
firms before providing capital and then monitoring them afterwards, they can alleviate
some of the information gaps and reduce capital constraints. Thus, it is important to un-
derstand the tools employed by venture investors discussed below as responses to this
difficult environment, which enable firms to ultimately receive the financing that they
cannot raise from other sources. It is the nonmonetary aspects of venture capital that are
critical to its success.
One of the most common features of venture capital is the meting out of financing in
discrete stages over time.Sahlman (1990)notes that staged capital infusion is the most
potent control mechanism a venture capitalist can employ. Prospects for the firm are
periodically reevaluated. The shorter the duration of an individual round of financing,
the more frequently the venture capitalist monitors the entrepreneur’s progress and the
greater the need to gather information. Staged capital infusion keeps the owner/manager