Survey_Dietz_2003

Abstract

Based on a model of venture capital investing with a focus on time investments, we will be able to look at market structures following shocks on the demand for venture capital. The paper has some similarities to Michelacci and Suarez (2002) who propose a search model of the market for venture capital. A venture capitalist monitors one project at a time and thereby guarantees effort provision by the entrepreneur. Given this interrelationship, the venture moves to a mature state with a constant hazard rate. A similar search approach is also used by Inderst and M¨uller (2003). These authors incorporate value adding services by the venture capitalist and consider implications of market structures on contracting. Finally, Kanniainen and Keuschnigg (2003) analyze the determinants of VC’s portfolio composition. In their model, venture capitalists expand or shrink the number of portfolio firms depending on the demand and supply for venture capital. All previous papers omit a direct view on the scarce time of a venture capitalist. In addition, the combination of a continuous decision between screening and advising has not been analyzed before and results in interesting implication for contracts and market structures. We consider a partial equilibrium model of an economy with a market rate of return of ? = 0 and a common wage rate w > 0. Time is continuous. Two players are introduced both of which are assumed risk neutral and maximizing their expected profit. The general setup follows the early literature on patent races2 similar to Michelacci and Suarez (2002). Entrepreneurs have an idea for a risky venture but are fundless and thus need external investments of I to develop their R&D results into a new product. Once the investment is done, the project moves into a development stage. Given commitment of the players (to be defined below), a final product ready for market introduction then arrives randomly at a hazard rate ?. Venture capitalists are specialized financial intermediaries. They have access to the capital market and can raise funds at the market rate of return. The time line of a single venture capital investment is as follows: Entrepreneurs are endowed with a business idea with unknown, but predetermined quality. Venture Capitalists announce a contract offer specifying all financial arrangements. Acceptance is however contingent on successful screening.4 Entrepreneurs with a business idea then apply for venture capital finance. During the following screening period, bad projects will drop out at the hazard rate µ. Once screening is completed, investment takes place and the period of advising starts. Productive input of both entrepreneur and venture capitalist are unobservable. If both comply, a marketable product appears at a hazard rate ?. Uncertainty is resolved after market introduction and payoffs are settled. At some point in time, remaining projects might be liquidated. Screening and advising period are consecutive. Advising only starts once screening is finished and investments are done.A venture capitalist is only able to either screen or advise one project at a point in time. Once he stops his involvement in a specific project, be it that the project fails in the screening stage, succeeds to bring a project to the market or fails to develop a product and is consequently terminated, the venture capitalist will start to look for a new investment opportunity so that the investment process starts afresh. Arranging individual investment projects back-to-back, the model thus describes a repeated, intertemporal venture capital cycle. We will renew this interpretation when discussing market structures and now continue to analyze a single project.