Vesting and Control in Venture Capital Contracts

Vesting of equity payments to an entrepreneur, which is time contingent compensation, is ubiquitous in venture capital contracts and has been shown empirically to be of economic importance. We show that vesting equity to an entrepreneur over a longer period of time, late vesting, acts as a screening device against bad entrepreneur types. But if contracts are incomplete such that payments and vesting cannot initially be contracted upon later outcomes, then late vesting gives lower e¤ort incentives than early (short time-period) vesting since it is subject to holdup by the venture capitalist. Comparative statics show how equilibrium outcomes of screening, e¤ort and assignment of control rights vary based on the ex-ante probability and the ex-interim signal of the entrepreneurs type. Control rights are a substitute for early vesting and allow for the largest e¤ort incentives by fully protecting the entrepreneur from holdup. We also \u85nd that a new explanation for the link between equity control rights and equity cash ow claims is that residual equity control rights over the \u85rm are necessary to protect residual equity claims from holdup