Engineering a Venture Capital Market: Lessons from the American Experience
Abstract
This paper seeks to identify the core of the U.S. venture capital contracting model, and then assess the extent to which the model provides guidance in engineering venture capital markets in other countries and, in particular, in identifying a viable role for government in assisting that project. All financial contracts respond to three central contracting problems: uncertainty, information asymmetry and opportunism in the form of agency costs. The special character of venture capital contracting is shaped by the fact that investing in early stage, high technology companies presents these problems in extreme form. The genius of U.S. venture capital contracting lies in the use of powerful incentives coupled with powerful monitoring for all participants in the process, the braiding of the investor/venture capital fund and venture capital fund/portfolio company contracts, especially with respect to the role of exit and reputation, and the critical role of implicit contracts, especially through the reputation market, to support the dense set of explicit contracts comprising the structure of venture capital contracting. The paper then illustrates the implications of this analysis through consideration of three different government programs – a remarkably unsuccessful early effort in Germany; a more recent, more successful program in Israel; and a newly launched program in Chile.