Venture Capital Contracts

We estimate the impact of venture capital (VC) contract terms on startup outcomes and the split of value between the entrepreneur and investor, accounting for endogenous selection via a novel dynamic search and matching model. The estimation uses a new, large data set of first financing rounds of startup companies. Consistent with efficient contracting theories, there is an optimal equity split between agents that maximizes the probability of success. However, VCs use their bargaining power to receive more investor-friendly terms compared to the contract that maximizes startup values. Better VCs still benefit the startup and the entrepreneur, due to their positive value creation. Counterfactual exercises show that eliminating certain contract terms benefits entrepreneurs and enables low-quality entrepreneurs to finance their startups more quickly, increasing the number of deals in the market. Lowering search frictions shifts the bargaining power to VCs and benefits them at the expense of entrepreneurs. The results show that selection of agents into deals is a first-order factor to take into account in studies of contracting.