Funding new ventures: some strategies for raising early finance

Abstract

This research provides formal insights into how new firms facing a number of potential investors might effectively raise funds at early stages, especially when a firm is small and/or a marketable product has not yet been developed. In the principal–agent framework, the firm can be seen as the principal, maximizing its revenues, and the potential investors aim to minimize payment for a share in ownership. The firm auctions incentive contracts to investors to secure seed money, while parting with a (minority) share of ownership. The effects of increased competition among investors on project size (research spending) and contractual design (incentive, fixed-price or cost-plus contracts) are examined and policy implications discussed.

Acknowledgements

Eric Cochran provided useful research assistance.

Notes

There is some evidence that initial public offerings (IPOs) are powerful determinants of venture capital investments (Jeng and Wells, 2000). Gompers and Lerner (2001, p. 159) report that while in recent years the proportion of IPO's backed by venture capital has increased, the majority of IPOs still are not backed by venture capitalists. However, there is considerable variance across industries. For instance, venture capital funding for Internet and technology companies in 1999 was 56% of all venture capital investment in the USA (NUA Internet Surveys).

Later on the principal–agent relationship is likely to end when the investor becomes a part owner. However, contracts can be written to limit the rights of the new owners.

This implicitly assumes that the firm would only like to part with partial ownership in exchange for funding and is not interested in outright sale. Moreover, potential investors might not have the technical know-how to carry out the project on their own.

Other inputs can be incorporated into this analysis. However, R&D is treated as a single composite input. This might not be a too restrictive assumption in light of the fact that a lot of ventures at the startup stage own mainly intangible assets like intellectual property. Kortum and Lerner (2000) have found a positive relation between venture capital investments and innovation rates.

One could, alternatively, have these rewards dependent on R&D such that P(x) and P ′ > 0, where x denotes R&D spending.

There might be other types of risks associated with investing in new ventures and these risks might vary across different project stages (Ruhnka and Young, 1991). We do not address the other types of risks in this paper.

This uncertainty can alternatively be viewed as uncertainty regarding the outcome of the regulatory process. A(n) drug (energy) company might already have invented a promising new drug (nuclear reactor) but regulatory approval might be uncertain. In such cases x may be viewed as the effort devoted towards overcoming regulatory barriers.

This setup is a departure from models of contractual R&D where moral hazard issues with respect to costs can arise (Goel, 1999; also see Rogerson, 1989).

This is obviously a simplifying assumption. In practice, it is likely that the parties have different risk attitudes.

It is assumed that both parties prefer an exclusive relationship. In the real world, however, there are examples of many investors holding equity stakes in the same firm. A consortium of investors can alternatively be treated as a single financier.

The investor pays [B + α(c − B)] or [(1 − α)B  + αc]. Note that with α = 1, the contract is cost-plus, while α = 0 makes the contract fixed price. With α between zero and one, the contract is an incentive contract. Incentive contracts provide incentives for cost containment. For example, say the highest bid is $100 million, project costs are $120 million and α = 0.4. Under a cost-plus contract the investor pays $120 million, under a fixed-price contract it pays $100 million, while under an incentive contract it pays $108 million.

In particular, these conditions imply Z, M ₂ < 0, and M ₁ > 0. Note, however, that B _n will be negative when bidders are able to collude and lower the bid. The results in this case are less clear.

Specifically, with B _Pα B _{α n}  < 0, and B _Rn  > 0.

Determination of how bids respond to changes in contractual parameters is perhaps an empirical matter and must await availability of appropriate data.