Angels, venture capitalists, and entrepreneurs: A dynamic model of private equity financing. mimeo

We consider a setting in which an entrepreneur chooses between angel and venture capital financing to fund his investment project. The entrepreneur may raise the required external financing over several rounds, though a certain minimum amount needs to be raised initially. There are four key ingredients driving the entrepreneur’s choice between the above two sources of private equity financing in our model. First, venture capitalists are to able add value to some of the firms they finance, while angels are not able to add significant value. Second, the entrepreneur has private information regarding the nature of his own firm. Further, the extent of this private information evolves over time, since a financier who has financed the firm in prior rounds will know more about it than a new financier. Third, since the venture capitalist has to engage in privately costly effort to add value to the firm, the financial contract between the two has to provide him with the right incentives to maximize this value-addition. Finally, the entrepreneurs effort is also required to ensure project success. In the above setting, we derive: (i) The equilibrium financing path of the firm, including its choice between angel and venture capital financing over different financing rounds, and the amounts raised in these rounds; (ii) The equilibrium design of financial contracts between the entrepreneur and the angel or venture capitalist, with implications for the differences between angel and venture capital contracts; (iii) The dynamic evolution of venture capital contract