EXECUTIVE SUMMARY

This paper investigates the role of venture capitalists. We view their ªraison d'eÃtreº as their ability to reduce the cost of informational asymmetries. Our theoretical framework focuses on two major forms of asymmetric informa-tion: ªhidden informationº (leading to adverse selection) and ªhidden ac-tionº (leading to moral hazard). Our theoretical analysis suggests four em-pirical predictions. 1. Venture capitalists operate in environments where their relative ef®ciency in selecting and monitoring investments gives them a comparative advantage over other investors. This suggests strong industry effects in venture capital investments. Venture capitalists should be prominent in industries where infor-mational concerns are important, such as biotechnology, computer software, etc., rather than in ªrou-tineº start-ups such as restaurants, retail outlets, etc. The latter are risky, in that returns show high variance, but they are relatively easy to monitor by conventional ®nancial intermediaries. 2. Within the class of projects where venture capitalists have an advantage, they will still prefer projects where monitoring and selection costs are relatively low or where the costs of informational asymmetry are less severe. Thus, within a given industry where venture capitalists would be expected to focus, we would also expect venture capitalists to favor ®rms with some track records over pure start-ups