Venture capital contracting under asymmetric

information
Jerey J. Trester
*
Financial Institutions Center, The Wharton School, University of Pennsylvania, 3301 Steinberg Hall-
Deitrich Hall, Philadelphia, PA 19103, USA
Abstract
A model is developed wherein entrepreneurs and venture capitalists contract under
symmetric information. Asymmetric information may arise following rst contracting.
It is shown this can lead to debt infeasibility and preferred equity usage. Control is
linked to choice between common and preferred. Results are robust to multiperiod ex-
tensions. Roles of convertible preferred, retained equity, and debt in IPOs are consid-
ered. An empirical survey of venture capital rms is presented demonstrating
preferred dominates in early nancing. Debt and common are used far less generally
at later stages under lower probability of asymmetric information. These results agree
with the theory's implications. 1998 Elsevier Science B.V. All rights reserved.
JEL classication: G3; G2; D4; D8; L2
Keywords: Venture capital; Entrepreneurship; Preferred stock; Debt; Corporate nance
1. Introduction
Venture capital is often the source of nancing in the crucial stages of the
early development of many rms. Despite its critical role, a relatively small
Journal of Banking & Finance 22 (1998) 675699
*
Tel.: 1 215 898 9555; fax: 1 215 573 8084.
0378-4266/98/$19.00 1998 Elsevier Science B.V. All rights reserved.
PII S 0 3 7 8 - 4 2 6 6 ( 9 8 ) 0 0 0 1 3 - 2
amount of attention has been paid to this form of nancing in the academic
literature. Much of what does exist has been written only in the last few years.
Much of the theoretical literature has been concerned with the staged process
by which project information is revealed and venture capital is invested. Ques-
tions related to this area have been explored in the rmformation and labor eco-
nomics literature, for example Kihlstrom and Laont (1979) and Allen (1985).
Others have explicitly tied asymmetric information to capital structure in corpo-
rate nance, e.g., Boot and Thakor (1993). This concept has also been a frequent
theme in the banking literature; a review may be found in Santomero (1984) or
Allen and Santomero (1997). In the venture capital area, work generally focuses
on the project continuation decision, and often on debt optimality along the
lines of Jensen and Meckling (1976). For example, Cooper and Carleton
(1979) study a model in which both the entrepreneur and the venture capitalist
learn information about project quality at stages of rm development, and each
must make continuation decisions, contracting with debt. Gompers (1992) ties
stage timing to agency cost and the creation and value of a strategic option,
using an equity contract. Hansen (1992) derives another model of debt optimal-
ity in venture nance, and explores issues of conversion and stopping. Chan et
al. (1990) create a model where entrepreneur skill is revealed to a venture capi-
talist making equity investments, and that skill level determines who ultimately
controls the rm. Admati and Peiderer (1991) create a two-period asymmetric
information model in which they examine the dual role of the venture capitalist
as a provider of nancing and a sender of project quality signals. They determine
that a constant fractional holding of equity sends an incentive compatible signal
to the markets regarding project quality. Boot and Thakor (1993) present a
model in which splitting rm capital structure into debt and equity increases
rm value. The split increases the volatility of the risky security and the prots
of informed investors, encouraging investors to become informed.
Discussions of the relation between venture capital and capital structure are
rare. Sahlman (1991) considers the importance of the staged structure of ven-
ture capital nance. He mentions the choice between preferred and common
equity, and conjectures that preferred stock may serve to shift more risk away
from venture capitalists and to entrepreneurs. He suggests this greater risk
might have the eect of ``smoking out'' poorer projects and giving the entrepre-
neur an incentive to perform well. But as discussed below, debt would seem to
perform a similar function, casting doubt on this explanation of the role of pre-
ferred stock.
Given this paper's consideration of the preferred versus debt choice under
asymmetric information, it is natural to also consider the literature on debt
contract optimality with costly state verication. Example of this literature in-
clude Townsend (1979), Diamond (1984) and Gale and Hellwig (1985). In these
models a nancier pays a costly auditor (such as a banker) to verify the ex-post
state of the project. Debt optimality arises from the minimization of auditing
676 J.J. Trester / Journal of Banking & Finance 22 (1998) 675699
costs under such contracts. This suggests the optimality of preferred might
arise from the impossibility of auditing and/or a market failure associated with
inecient liquidation. In the model presented here, there exists the possibility
of information asymmetries which cannot be lifted by costly auditing, the na-
ture of the projects being such that auditing is either prohibitively costly or im-
possible. This creates the possibility of opportunistic behavior by the
entrepreneur, a mode of behavior encouraged by the venture capitalist's fore-
closure option. This leads to inecient liquidation and a market failure under
debt which preferred is not subject to.
This paper expands the literature by addressing the role asymmetric infor-
mation plays in determining why venture capitalists use equity, and preferred
equity in particular, rather then debt, to nance entrepreneurial projects. It
is suggested that the risk of the entrepreneur observing information about
the project type before the venture capitalist may play a role in the contract
type selection, as well as the project quality uncertainty itself.
The paper develops a multiperiod framework in which optimal contract
choice is driven by considerations of monitoring diculty in an environment
of potentially asymmetric information with moral hazard. Conditions of asym-
metric information may arise between the venture capitalist and the entrepre-
neur. That is, at various stages of rm development there is a positive
probability of a condition of asymmetric information. As a result, it is shown
that the foreclosure option embedded in a debt contract may actually create an
incentive for the entrepreneur to ``behave opportunistically'', taking whatever
project payos are available and defaulting on the debt. As a result, for su-
ciently high probabilities of asymmetric information, debt contracting may be
neither feasible nor desirable. Under these circumstances, equity contracting
may be a feasible alternative precisely because of the lack of foreclosure rights.
In particular, preferred or convertible preferred stock may be the dominating
contract, because this contract eliminates the foreclosure option while preserv-
ing some seniority in the event of bankruptcy due to current liabilities should
information turn out to be symmetric. It is argued that this asymmetric infor-
mation mechanism may be responsible for the predominance of preferred stock
in venture capital contracting. That predominance is demonstrated in an em-
pirical study which extends the previous empirical literature.
Empirical inquiries into the nature of venture capital contracts have also
been limited in number. The approach of Sahlman (1991) is of the case-study
type, with emphasis on the importance of the option to abandon the project in
a state of distress, or alternatively to re-nance. Specic examples analyzed are
MCI and Federal Express. Lerner (1992a) analyzes venture capital nancings
in two industries: biotechnology and Winchester hard drives. He nds that
the likelihood of later round venture capital nancing increases with the ``tech-
nological progress'' (i.e. patents) obtained by the rm, and with rising liquidity
in the IPO market through which venture capitalists often ``cash out''. In a
J.J. Trester / Journal of Banking & Finance 22 (1998) 675699 677
second paper, Lerner (1992b) examines the venture capitalist role in the IPO
process, and determines that rms backed by ``seasoned'' venture capitalists
are more likely to successfully ``time'' the market, going public when valuations
are highest. He also nds only such experienced venture capitalists consider in-
tangible assets in the IPO decision, and that they tend to retain the most ``rep-
utable'' underwriters. Nowhere, however, has there been any study which
documents the types of nancing seen in venture capital. In particular, the
presence of preferred stock in such nancings has not been discussed except
in passing. For example, Lerner (1992a) mentions in a footnote that the biotech
and disk drive rms he examines were nanced with either equity or convertible
debt, and most of the equity was preferred. No mention of the relative amounts
of preferred versus debt is made.
It would appear that there exists a need for investigation of the evolution of
venture capital contracts through the life of the rm, particularly to comple-
ment dynamic capital structure models like the one developed here. To con-
struct a database which demonstrates the stylized facts which this theory
implies, a survey of venture capital rms is conducted whose results indicate
that preferred stock is by far the most common contract type used in early-
stage nancings. Debt and common equity are used far less frequently. Where
they do appear it is usually in later stage nancings and/or in industries where
monitoring is less dicult, and hence the probability of asymmetric informa-
tion is much lower. These results are in accord with the theoretical structure
I present.
The plan of the remainder of this paper is as follows. In Section 2 the model
is developed. It is a four-period model of venture capital contracting in which
the entrepreneur and venture capitalist contract under symmetric information.
However, a condition of asymmetric information may arise subsequent to the
rst contract. It is shown that this can lead to infeasibility of debt contracts and
the use of preferred equity contracts. Issues of control and ownership percent-
ages are linked to a similar choice between common and preferred equity. In
Section 3 issues of multiperiod extension and risk aversion are explored. In
Section 4 empirical evidence is presented which supports the theory's assertion
that preferred equity is more likely to be used in instances where conditions of
information asymmetry are more probable. Section 5 oers some concluding
remarks.
2. The model
2.1. Agents, projects and endowments
I consider a world with risk-neutral venture capitalists and entrepreneurs.
The world has four periods t
0
` t
1
` t
2
` t
3
Y (Fig. 1). All agents seek to
678 J.J. Trester / Journal of Banking & Finance 22 (1998) 675699
maximize their expected wealth at t
3
. There is free entry into the venture capital
business, which exhibits perfect competition. Each venture capitalist is en-
dowed with capital at t
0
. At t
0
a project is owned by the entrepreneur who
has no other assets. The project may be one of three types S=L, M, or H rep-
resenting low, medium and high value projects. However, the type is not
known to the entrepreneur or the venture capitalists at t
0
. Only the probabili-
ties of the project being of each type, denoted P
L
, P
M
, P
H
(P
L
P
M
P
H
= 1),
are known in the t
0
information set (dashed line). While the entrepreneur has
no other assets, at t
0
he does have an employment opportunity paying wages w
1
at t
1
and w
3
at t
3
which will constitute reservation wages.
To move forward the project requires an initial infusion of capital I
0
at t
0
.
The only sources for this capital are the venture capitalists. The entrepreneurs
use the funds obtained in the following way. A fraction q of the initial capital I
0
is used as xed capital qI
0
at t
0
(e.g. plant and equipment) the rest is used as
operating capital. It is also assumed that in the course of operations the project
takes on current liabilities d payable at t
2
(these can be phone bills, rent, pay-
roll etc.).
If the project is funded by a venture capitalist at t
0
(see below) then the rst
payout from the project is R
1
(S) where R
1
(H) PqI
0
dY R
1
(M) = qI
0
dY
qI
0
TR
1
(L) ` qI
0
d. It is assumed that R
1
(S) is generated by the project at
t
1
. However, while the entrepreneur observes this payo at t
1
the venture cap-
Fig. 1. The four period model: Game form. t
0
: venture capitalist can invest I
0
; entrepreneur learns S
at t
1
, venture capitalist learns S at t
l
; t
1
: venture capitalist can foreclose under debt if l=1, entre-
preneur can behave opportunistically if l =2; t
2
: if no opportunism at t
1
, venture capitalist may
invest I
2
or foreclose if debt used; t
3
: nal payos if any.
J.J. Trester / Journal of Banking & Finance 22 (1998) 675699 679
italist observes the payo at t
l
where l=1 with probability 1 A p and l=2
with probability p. It is also assumed that the entrepreneur observes S at t
1
while the venture capitalist observes S at t
l
. Thus there is a probability p of
a state of asymmetric information existing between the venture capitalist and
the entrepreneur. Note S is assumed here to be learned by some mechanism
other than receiving R
1
(S). If R
1
(H) R
1
(M) then R
1
(S) could conceivably
serve as a signal itself, but in practice the signal is more likely the result of fac-
tors like lab tests. A signaling mechanism distinct from the t
1
payo allows for
R
1
(S) to be aected by factors other then S, which will permit the possibility of
default under a debt contract even in the H state. It is assumed that
R
1
(L) ` R
1
(M) TR
1
(H) to permit the existence of a project type or state of
the world L in which current liabilities d cannot be serviced at t
2
. This will give
value to contract seniority during project development, and, as will be seen,
have a role in the selection of preferred over common equity.
To continue the project until t
3
, when a second payo R
3
(S) is made, it
is necessary for the project to have capital k qI
0
available at t
2
; that is, the
xed capital must be preserved and an added amount of working capital is re-
quired. As in the previous period, it is assumed current liabilities d must be paid
at t
3
.
The venture capitalist learns S at t
l
through a costless auditing process
which cannot be completed until then. On the other hand, the entrepreneur
learns S at t
1
. Therefore, if l=2 the entrepreneur learns S before the venture
capitalist and has operating control of the project. In this case the entrepreneur
may choose to pay himself any amount C
e1
TR
l
(S) at t
1
, regardless of any con-
tractual obligations at t
2
, and abandon the project. In practice this may be
done by legally increasing the project's ``burn rate''. That is, by t
2
, when the
venture capitalist learns S, the entrepreneur is no longer accessible. Alternative-
ly he may choose to stay with the project because of the payo C
e3
which he
now knows he will receive at t
3
. If l =1 then the entrepreneur and the venture
capitalist observe S and the payo R
1
(S) simultaneously. Then it is assumed
the venture capitalist has at his disposal the legal enforcement mechanism nec-
essary to assure compliance with any contractual obligations. The payment the
venture capitalist receives at t
1
is labeled C
v1
.
If the project is to continue until t
3
, the venture capitalist must make a sec-
ond-round investment I
2
where
I
2
= k qI
0
[R
1
(S) d C
e1
C
v2
[X (1)
Note that if the endowment of the venture capitalist is restricted to I
0
k then
the quantity R
1
(S) d C
e1
C
v2
must exceed qI
0
for venture capital to be
able to fund the second stage. In the scenarios examined the entrepreneur will
not have the ability to nd a replacement venture capitalist between t
1
and t
2
.
In the scenario we will consider a ``no-exit'' clause arises endogenously to pre-
vent such a move by the entrepreneur, because the possibility of such an action
680 J.J. Trester / Journal of Banking & Finance 22 (1998) 675699
would reduce the venture capitalist's expected return at t
0
below the level of
feasibility. Hence participation by the initial venture capitalist at t
2
is necessary
to continue the project if added external capital is needed. In essence the infor-
mation conveyed in the valuation process that the venture capitalist performed
at t
0
gives him a ``lock'' on the second-stage nancing option at t
2
. Further, it is
assumed that if the entrepreneur behaves opportunistically at t
1
the project is
necessarily terminated.
2.2. Contracts
In this study I seek to compare three types of contracts with varying embed-
ded options and legal rights: debt, preferred equity and common equity. I pro-
pose to explore the conditions under which these securities, particularly
preferred equity, may be feasible and dominating among the three contracts.
It is worth noting that the stronger claim of a particular contract being optimal
over all possible contracts, including but not exclusively the three considered
here, is far more dicult, if not impossible, to show. This is because such an
optimization must be performed over all possible project types and legal ar-
rangements between parties, and it is dicult to know all of these. Therefore
I conne my attention to the three contracts stated above, and assume that
their widespread usage is some demonstration of the likely superiority of the
group.
I dene the rights associated with the three contracts as follows: Under a
debt contract the venture capitalist loans the entrepreneur I
0
and receives a
xed payment C
v2
= C
d
v2
at t
2
if there is no default. A covenant exists allowing
the venture capitalist to foreclose at t
1
if under symmetric information (l =1)
he learns the entrepreneur will default at t
2
. Thus, here the right of foreclosure
is the right of the venture capitalist, under symmetric information, to seize the
entire t
1
payo in any state other than the best (H) state. The venture capitalist
then takes whatever assets are available less the current liabilities, which are as-
sumed for the moment to be senior to all contracts between the venture capi-
talist and the entrepreneur. If information is asymmetric (l =2) the
entrepreneur may choose to ``behave opportunistically'', taking all the assets
available. On the other hand, he may choose to remain committed to the pro-
ject through t
3
. Should the project be continued until t
3
, a second debt contract
is created in which the venture capitalist loans the entrepreneur I
2
and receives
total payment (for both debt contracts) C
v3
= C
d
v3
at t
3
. Note since informa-
tion is always symmetric at t
3
, the venture capitalists right of foreclosure is en-
forceable with certainty at that time.
A preferred equity contract is essentially equivalent to a debt contract but
without the right of foreclosure. The venture capitalist loans the entrepreneur
I
0
and receives a xed payment C
v2
= C
p
v2
at t
2
if there is no default. In the
event of default under symmetric information, the venture capitalist may not
J.J. Trester / Journal of Banking & Finance 22 (1998) 675699 681
foreclose, but the entrepreneur may not take any payment for himself unless
the amount due the venture capitalist is paid in full. Under asymmetric
information the entrepreneur may or may not choose to behave opportunisti-
cally as in the debt contract. Should the project be continued until t
3
, the ven-
ture capitalist invests I
2
and is to receive total payment (for both contracts) C
p
v3
at t
3
. Note that although preferred has no foreclosure right, because its divi-
dend must be paid before the entrepreneur if information is symmetric, under
the always symmetric information of t
3
the preferred stock payo structure is
identical to that of debt.
Lastly, in a common equity contract the venture capitalist pays the entrepre-
neur I
0
and receives a fraction of equity f
0
at t
0
. It is assumed that control of
the rm rests with whoever owns more then Z% of the common equity. With-
out loss of generality, it can be assumed that Z =
1
2
. If the venture capitalist and
the entrepreneur each own
1
2
of common stock the rm is jointly controlled so
that both parties must agree on payout decisions. In the case where the entre-
preneur does not behave opportunistically the payment to the venture capitalist
at t
2
is C
v2
= C
e
v2
P0. If the entrepreneur does behave opportunistically
then C
v2
=0. Should the project be continued until t
3
the venture capitalist in-
vests I
2
and, if this second contract is an equity contract, receives additional
equity ownership f
2
at t
2
. The payment he receives at t
3
is again labeled
C
v3
= C
e
v3
.
It is assumed there exists free entry and perfect competition among the ven-
ture capitalists, and that the entrepreneur circulates his business plan among all
of them. Further, a zero risk-free rate is assumed. Under risk neutrality this has
the eect of driving the venture capitalist's expected return down to zero. That
is, if W
v0
and W
v3
are the wealth of the venture capitalist at t
0
and t
3
, respec-
tively, then the t
0
expectation of the return at t
3
is E
0
W
v3
A W
v0
=0.
This expected value of the venture capitalist's return at t
3
may be calculated
as follows: for the debt contract
E
0
W
v3
W
v0
= X
t0
I
0

S=LYMYH
P(S)[min[C
d
v2
Y max[R
1
(S)
@
dY 0[[(1 p) Z
t1
min[C
d
v2
Y max[R
1
(S) dY 0[[p[
Z
t2
Z
t1
X
t1
[I
2
min[C
d
v3
Y max[R
3
(S) dY 0[[[
A
Y (2)
where X
t0
= 1 if the venture capitalist invests at t
0
and zero otherwise; if l=2
and the entrepreneur behaves opportunistically then Z
t1
= 0, otherwise Z
t1
=1;
X
t2
=1 if the venture capitalist does not foreclose at t
1
and invests at t
2
and zero
otherwise; Z
t2
=1 if the entrepreneur continues with the project at t
2
and zero
otherwise, and again I
2
= k qI
0
[R
1
(S) d C
e1
C
d
v2
[X
682 J.J. Trester / Journal of Banking & Finance 22 (1998) 675699
Under a preferred equity contract,
E
0
W
v3
W
v0
=X
t0
I
0

S=LYMYH
P(S)[C
v2
(1 p) Z
t1
C
v2
p[
@
Z
t2
Z
t1
X
t2
[I
2
min[C
p
v3
Y max[R
3
(S) dY 0[[[
A
Y (3)
where C
v2
T C
p
v2
, and
if l = 2 then C
e1
TR
1
(S) Z
t1
[d C
v2
[Y
if l = 1 then C
e1
TR
1
(S) [d C
v2
[X
Here X
t0
Y Z
t1
Y Z
t2
and X
t2
are dependent on S and each other in chronological
order. Note again that under a preferred contract with symmetric information
at t
1
the entrepreneur can pay C
v2
Y 0 ` C
v2
TC
p
v2
Y so long as C
e1
=0 if
C
v1
` C
p
v1
. This is to say that the entrepreneur can choose to pay the venture
capitalist any amount between zero and the preferred coupon so long as
he pays himself nothing if the full coupon is not met. Of course if l=1
and the project is not continued, (Z
t1
and/or X
t2
equal zero) then
C
v2
= min[C
p
v2
Y max[R
2
(S) dY 0[ and therefore the entrepreneur receives
C
e2
= max[R
2
(S) d C
p
v2
Y 0[. That is, after debt service, the venture capitalist
receives all funds up to the preferred coupon, and the entrepreneur receives
whatever remains or zero, whichever is larger.
In the case of common equity, the form of E
0
W
v3
A W
v0
is dependent upon
the equity ownership percentages f
0
and f
2
. For the moment I will consider the
case where )
0
T
1
2
; I do not wish to treat buyouts at this point. It may be that
entrepreneurial control is necessary in the rst stage for development to be suc-
cessful, or it may be impossible to construct an equity contract with )
0
b
1
2
which gives the entrepreneur an expected return greater than the sum of his res-
ervation wages w
1
+ w
3
(these variables are exogenous so they can always be
set so that this is the case). Further, there may be some non-pecuniary benet
to the freedom of control which the entrepreneur seeks, alternatively this may
be factored in as a higher set of reservation wages.
Further for both parties to get paid at t
3
it may be necessary for each to have
an equity ownership interest equal to
1
2
(this restriction will be lifted in a sub-
sequent analysis of a multiperiod extension with an IPO cash-out).
If the above assumptions hold then under a two period common equity con-
tract the venture capitalist's expected t
3
return is
E
0
W
v3
W
v0
= X
t0
I
0
Z
t1

S=LYMYH
P(S)[[C
e
v2
X
t2
Z
t2
[
@
I
2

1
2
max[R
3
(S) dY 0[[[[
A
Y (4)
J.J. Trester / Journal of Banking & Finance 22 (1998) 675699 683
where C
e
v2
TR
1
(S) d C
e1
Y C
e1
TR
1
(S) d if l=2 and C
e1
TR
1
(S) if l=1.
Of course if l =1 and the entrepreneur chooses to behave opportunistically,
then C
e1
TR
1
(S) and C
e
v1
=0.
2.3. Feasible and dominant contracting
For a given type of contract to be feasible here means it is possible to de-
sign a contract of the type that the relation E
0
W
v3
A W
v0
=0 holds. I am
now in a position to compare the feasibility of the above contracts under var-
ious projects as parameterized by (I
0
Y I
2
Y kY qY dY pY P(S)Y R
1
(S)Y R
3
(S)Y l = 1Y 2Y
S = LY MY H). In particular, I analyze the parameter subspace in which the pre-
ferred contract is feasible while the common stock and debt contracts are infea-
sible.
What will be illustrated here is the following point. States may exist in which
the venture capitalist would prefer to foreclose as opposed to continuing the
project, but under asymmetric information such foreclosure will not be possible
because the entrepreneur will anticipate the foreclosure and act opportunisti-
cally. Without the foreclosure option the entrepreneur might choose to contin-
ue the project if the venture capitalist makes another investment. For the
venture capitalist, this might be preferable to getting nothing, which is what
he receives under asymmetric information with debt and its foreclosure option.
If the probability of a condition of asymmetric information is suciently high,
the foreclosure option's existence reduces the value of the debt contract to the
venture capitalist, making it inferior to preferred equity contract and indeed
not even feasible.
To further illuminate this point, consider the following two propositions.
Proposition 1. For any set of parameter values I
0
, I
2
, k, q, d, P(S), R
1
(S),
R
3
(S); l=1, 2; S=L, M, H there exists some value of p = p
+
Y 0 Tp T1, above
which the debt contract's option to foreclose is worthless.
Proof. First note that if p =1 the foreclosure option is always worthless to the
lender, because the entrepreneur has the R
1
(S) payo in his possession at t
1
with certainty and may behave opportunistically if debt service is not possible,
making the foreclosure right unenforceable eectively the entrepreneur now
has a put on the project with a strike price of zero. Also note that if p =0 then
information is symmetric and the entrepreneur is certain not to be able to
behave opportunistically, making the foreclosure option always enforceable
and hence of positive value. Therefore there must exist p
+
Y 0 Tp
+
T1, such that
the foreclosure option is worthless.
Corollary 1. If it can be shown that at p=1 the existence of the foreclosure
option is actually of negative value to the venture capitalist, then 0 Tp
+
` 1, the
684 J.J. Trester / Journal of Banking & Finance 22 (1998) 675699
critical asymmetric information probability is strictly less than 1, by the
intermediate value theorem.
Proposition 2. For p=1, there exist projects for which the existence of the debt
foreclosure option makes a debt contract infeasible, while a preferred contract is
feasible. In such cases the foreclosure option is of negative value.
The proof of this is given in Appendix A. Essentially, a project is construct-
ed so that a preferred equity contract is just feasible, only because it receives
some payo in the M state. Then since the debt contract receives no payo
in the M or L states, and can receive no more payo than the preferred con-
tract in the H state due to the entrepreneur's reservation wage, the debt con-
tract is not feasible. It should be noted that since the contract is just feasible,
an endogenous ``no exit'' clause arises at t
2
; otherwise the opportunity to fully
participate in the project's upside state H could be lost to the venture capitalist,
and the relation E
0
W
v3
A W
v0
=0 could not be satised.
The point here is that there can exist states where under symmetric informa-
tion the venture capitalist would prefer to foreclose, but if information is asym-
metric the existence of the foreclosure option causes the entrepreneur to behave
opportunistically, leaving the venture capitalist with nothing. It may also be the
case that in such states the venture capitalist would prefer to make another in-
vestment than receive nothing, and the entrepreneur would rather continue
with the project than behave opportunistically, given that he will not be fore-
closed on. Then the foreclosure option's existence will, under asymmetric infor-
mation, drive the entrepreneur to behave opportunistically when he would
rather continue the project. This leaves the venture capitalist with nothing
when he would rather have made another investment. When the probability
of such states under asymmetric information is high enough, the foreclosure
option actually serves to reduce the expected return to the venture capitalist
to the point where it is below that of a preferred equity contract. Indeed under
such conditions a debt contract may not be feasible or desirable, while a pre-
ferred contract may oer an acceptable rate of return.
What has been demonstrated here is that the existence of the foreclosure op-
tion embedded in the debt contracts can create a condition of intertemporal in-
centive incompatibility under asymmetric information. This may result in the
entrepreneur taking actions which reduce the expected return to the venture
capitalist to the point that debt is no longer a feasible form of contracting.
Note that this is in contrast to Sahlman's ``smoking out'' or downside limita-
tion suggestions for the role of preferred versus common equity. In the case of
the preferred versus debt choice the decision is driven by a state of asymmetric
information which may occur subsequent to the time of contracting, rather
than before.
J.J. Trester / Journal of Banking & Finance 22 (1998) 675699 685
It is interesting to look at the above result in the context of the costly state
verication/debt optimality literature. In models like those of Townsend
(1979), Diamond (1984) and Gale and Hellwig (1985), the nancier can verify
the ex-post project state through a costly auditing process. Debt optimality
arises from the minimization of the auditing cost. In the model presented here,
it is assumed that there is a possibility of an information asymmetry which can-
not be eliminated through auditing. We may think of such auditing as either
prohibitively expensive or impossible. This possibility makes venture capital
projects distinct from those funded by banks and the bond market, and drives
the contracting choice toward preferred. It is a severe diculty in monitoring
intrinsic to the sort of projects nanced through venture capital, a point ex-
plored in the following empirical section. Without auditing, the possibility of
asymmetric information and the foreclosure option of debt gives rise to the po-
tential for opportunistic behavior on the part of the entrepreneur. Indeed, the
foreclosure option incentivises the entrepreneur to such behavior in a debt con-
tract. The result is inecient liquidation and a ``market failure'' under debt.
With no foreclosure option, the preferred contract is not aicted with this in-
tertemporal incentive incompatibility.
In the context of this model, consideration of the choice of preferred equity
versus common equity is necessarily somewhat qualitative, with some features
beyond the scope of this paper. However, the forms of Eqs. (3) and (4) certain-
ly suggest a role for downside protection, in that as current liabilities d rise it
will take a greater fraction f
0
of the rm's equity to compensate the venture
capitalist for giving up his priority position in a bankruptcy liquidation. This
would be necessary as noted above: because in the L state under symmetric in-
formation liquidation is certain, and therefore opportunistic behavior is certain
under asymmetric information. Either way the venture capitalist is left with
nothing here since under opportunistic behavior the entrepreneur takes the en-
tire payo.
It may be that the amount of equity required by the venture capitalist to
compensate him for this zero payo in the L state leaves the entrepreneur with
a fractional interest such that his expected return is less than the sum of his res-
ervation wages w
2
+ w
3
. It may also be the case that there is some non-pecu-
niary benet to the entrepreneur from having common equity fractional
ownership above some critical point, notably the control level
1
2
, which results
in a substantially higher ``eective'' reservation wage. Finally entrepreneurial
control may be necessary to facilitate the advancement of the project through
the development process. Any of these factors or some combination of them
may be responsible for a common stock contract's infeasibility for a given pro-
ject and, in conjunction with the argument against debt given above, the choice
of a preferred equity contract becomes the dominating one.
A convertible preferred contract will allow the venture capitalist to partici-
pate in any cash-out via an IPO. Therefore under the above framework there is
686 J.J. Trester / Journal of Banking & Finance 22 (1998) 675699
no reason why the venture capitalist need give up the downside protection of
the preferred for common (nor the entrepreneur give up necessary control).
3. Extensions of the model
In this section two extensions of the basic model are considered to investi-
gate the robustness of its results. In the rst extension, the basic framework
is extended to N periods and in the second the introduction of risk aversion
is considered. Let us examine each of these in turn.
The above model has been formulated in a four period setting. However, it
is relatively straightforward to extend the model into more periods.
Proposition 3. The above model may be extended to N periods while preserving
subgame perfection.
Proof. Replace the t
3
terminal payos R
3
(S), S=L, M, H, with games of the
same structure as the t
0
t
3
game presented above whose expected payos are
equal to those previously terminal values. This self-similar extension procedure
may be repeated for an arbitrary n iterations to produce a 4n period model. So
long as the assumption of risk neutrality hold the agent will view the new
extensions exactly as they viewed the original t
3
terminal payos (by the law of
iterated expectations). Then the solution discussed in Proposition 1 will be a
sub-game perfect Nash equilibrium.
What does alter the analysis somewhat is the introduction of risk aversion
on the part of the agents. Such curvature of preferences may give rise to some
mixing of contracts, which is to say the use of some debt in addition to pre-
ferred or common equity. A way to see the intuition behind this point is to con-
sider the above treatment in the larger context of standard (von Neuman
Morgenstern) expected utility theory. The venture capitalist's preferences con-
sidered above correspond to a risk-neutral utility function of consumption U
with U
/
b 0 and U
//
= 0; in this case U=C. Under risk neutrality only the
overall expected consumption matters without regard to a projects risk, which
is to say any hedge against the risk of a state M under symmetric information
has no value if it reduces the overall expected consumption, which we have seen
it does.
If some risk aversion is introduced, U
/
b 0 and U
//
` 0, then a hedge
against the risk of an M state under symmetric information acquires value.
If p=1 then there is no possibility of such a state, and therefore there is no
such risk to hedge against. However, as p is reduced from 1 by some value
D b 0, so that 0 ` p ` 1, then there exists the possibility of such a state, and
by the standard result the value of debt as a hedge against this possibility
J.J. Trester / Journal of Banking & Finance 22 (1998) 675699 687
may result in some contract mixing, with both debt and equity used. A more
formal analysis of this mixing could be performed with the specication of a
particular utility function, but this would introduce unnecessary mathematical
complexity the intuition remains as presented above. As is shown in the fol-
lowing empirical section, there seems to be in practice very little such contract
mixing. This result is consistent with the risk neutral model presented above
under a high probability of asymmetric information, p ~ 1. To the extent that
risk aversion exists, this would seem to imply that there is an even higher prob-
ability of asymmetric information in the projects funded by venture capitalists.
There are three other points that bear mentioning:
There may be reasons for the use of preferred stock even under certain
symmetric information (p=1 = l=2). If for example the entrepreneur
has customers expecting delivery of some good or service at t
2
, the poten-
tial for foreclosure by the venture capitalist at that time may make those
customers reticent to do business with the entrepreneur if debt is used.
A similar argument could be used for current liability holders unsure of
the seniority of their claim or concerned that the venture capitalist foreclo-
sure option will, under asymmetric information, cause the entrepreneur to
behave opportunistically and leave them with nothing. If however the rm
has no customers in the initial development stage the former argument is
not valid, of course.
Just as debt may provide a poor incentive structure in a venture capital -
nancing under high probabilities of asymmetric information, so a similar in-
centive inconsistency may develop if equity is later sold to the public by the
venture capitalist in an IPO, if that high probability of asymmetric informa-
tion persists. This would tend to make high debt levels undesirable in such
situations, if an IPO is desired. Conversely, under the above framework
the existence of debt may indicate a low probability of asymmetric informa-
tion, and might even serve as a signal of this to the market.
A logical question in the context of this model is what distinguishes ven-
ture capital rms from other intermediaries, i.e. banks, which use debt.
In terms of contracting, the key dierence is the diculty of monitoring,
which is to say the likelihood of asymmetric information, p in the model.
It is the high likelihood of asymmetric information in the projects venture
capitalists nance which causes them to use preferred equity. Banks and
other institutions contracting with debt are nancing projects where mon-
itoring is easier and the probability of asymmetric information is smaller.
Should banks choose to become involved in nancing the sort of projects
funded by venture capitalists, they would presumably switch to preferred
equity (anecdotally, one of the rms responding to the survey described be-
low is the venture capital arm of a money center bank, and its investments
were made along the same pattern as the other rms, that is, with preferred
stock).
688 J.J. Trester / Journal of Banking & Finance 22 (1998) 675699
4. Empirical evidence
The above model gives us a context under which to examine patterns in ven-
ture capital nance. This context is dierent from that previously presented in
the literature in that prior studies have focused on the ``cash-out'' IPO end
stage of the venture capital process. Previously the availability of IPO data mo-
tivated the theoretical focus (e.g. questions of signals to the market) to the ex-
clusion of the initial investment issues considered here. This analysis deals with
the ``cash-in'' initial investment stages of venture capital. Therefore I will in-
vestigate the contracts oered by these rms to seek support for the above
model. This study will center on the nature of these contracts and how they
vary with diering probabilities of asymmetric information.
The theory presented makes the following predictions, which constitute null
hypotheses here. In situations where monitoring is dicult and hence the prob-
ability of a state of asymmetric information is high, preferred equity should
tend to be the dominant form of contracting. The use of debt should become
more pronounced in situations where monitoring is easier and the probability
of information asymmetries is lower.
Not surprisingly, venture capital rms tend to be unwilling to reveal detailed
information on the nancings on a deal by deal basis. Therefore, data was ob-
tained through a direct survey of rm principals asked to provide information
on the aggregate nancing patterns of their rms. Such a method is necessarily
cruder than direct examination of nancial records, but at present may be the
only hope for acquiring any meaningful data on the crucial initial stages of the
venture capital process.
A survey of eight venture-capital rms was performed, the sample having
been provided by partners leading venture rms directly. All of the rms had
at least 250 million dollars under management and had done in excess of
~100 deals. Firms were asked the following questions:
1. In nancing companies in initial product development phases (dened as
rms with no current customers) what is the estimated percentage of deals
in which the following are used: (a) preferred stock (b) common stock (c)
debt?
2. In nancing companies in later phases (dened as rms with current custom-
ers) what is the estimated percentage of deals in which the following are used
(a) preferred stock (b) common stock (c) debt?
3. What percentage of early stage nancings are of rms with pre-existing debt
(including and excluding current liabilities)?
4. What percentage of later stage nancings are of rms with pre-existing debt
(including and excluding current liabilities)?
Questions 14 were then each repeated for specic industries: biotech, soft-
ware, retailing and manufacturing. These industries were chosen for their dif-
ferent developmental processes and hence variations in the probability of
J.J. Trester / Journal of Banking & Finance 22 (1998) 675699 689
asymmetric information (see below). Lastly, venture capitalist were asked what
percentage of preferred-nanced deals utilized convertible preferred, and in
what percentage of venture capital nanced deals control was shifted from
the entrepreneur to the venture capitalist.
Turning to the industry groups considered, note that biotech rms go
through a product development process in which the initial stages, consisting
of in-house lab tests, are non-public and extremely dicult for anyone but
the researchers involved to interpret. By contrast, later stages of testing, e.g.
the FDAs Phase IIII tests, have results which are generally made public, mak-
ing monitoring easier and reducing the likelihood of asymmetric information.
Similarly, software rms have an initial product development stage known
as ``alpha'' testing, in which the software is tested in-house and the results
are known only to the programmers. A later phase of testing, known as the
``beta'' phase, involves sending software out to user groups and industry peri-
odicals for review. The results of this phase are widely observed by industry
participants, lowering the probability of asymmetric information.
In the case of retailing, no high-tech barrier exists to determining the state of
the project in early phases of development, although some practical diculties
may remain in monitoring sales or the reliability of suppliers, etc. Once reve-
nues exist, however, they may be used as a monitoring device.
As would be expected under the above theory with a high probability of
asymmetric information, the data demonstrates that preferred stock represents
the dominant mode of contracting. In early stage nancings, the means and
standard deviations of the contract types are (Table 1) 95.4% (1.3%) for pre-
ferred, 2.0% (1.0%) for common, and 2.1% (1.0%) for debt. No venture
rms indicated any signicant change in their estimated percentage use of these
contracts for the four industry groups (Tables 25), although two rms indicat-
ed that as a matter of policy they do not invest in retail rms, which accounts
for a slight dierence in the breakdown for this category: (Table 4) 95.5%
(1.7%), 2.5% (1.3%), 2.0% (1.1%).
The 95% condence intervals are calculated assuming a sample size of 800
entrepreneurial nancings (600 in retail) with each venture rm representing
100 of these transactions. In fact it was only possible to determine that each
venture rm had done at least 100 deals, so the condence intervals given here
are for a lower bound on the sample size, and may be somewhat distorted by
the assumption of equal weights for the venture rms. However, given the sim-
Table 1
All deals Early stage, # venture rms =8
Mean (95%) C.I. (n =800) Min Max
% Preferred 96.4 1.3 90 100
% Common 2.0 1.0 0 10
% Debt 2.1 1.0 0 10
690 J.J. Trester / Journal of Banking & Finance 22 (1998) 675699
ilarity in responses among the venture capital rms, the weighting assumption
is of very limited importance. Condence intervals are therefore calculated as
follows. For sample size n and fraction of armative responses p, i.e. fraction
of deals in which a given contract type is used, the 95% C.I. is
Z
0X025
_
[p(1 p)an[. Here Z
0X025
=1.96 is the standard normal, and note here
the central limit theorem has been applied so that in the large sample limit
Z
0X025
equals and replaces t
0X025
, the student t at 0.025.
In later stage nancings, there appears to be some increase in the use of debt
and common, although the great majority of deals still utilize preferred. The
percentage use breakdown is (Table 6) 87.8% (2.3%) for preferred, 3.9%
(1.3%) for common, and 10.1% (2.1%) for debt. As can be seen from Ta-
bles 710, there is little variation from this pattern for the four industry groups,
Table 2
Biotech Early stage, # venture rms =8
Mean (5%) C.I. (n =800) Min Max
% Preferred 96.4 1.3 90 100
% Common 2.0 1.0 0 10
% Debt 2.1 1.0 0 10
Table 3
Software Early stage, # venture rms =8
Mean (95%) C.I. (n =800) Min Max
% Preferred 96.4 1.3 90 100
% Common 2.0 1.0 0 10
% Debt 2.1 1.0 0 10
Table 4
Retail Early stage, # venture rms =6
Mean (95%) C.I. (n =600) Min Max
% Preferred 95.5 1.7 90 100
% Common 2.5 1.3 0 10
% Debt 2.0 1.1 0 10
Table 5
Manufacturing Early stage, # venture rms =8
Mean (95%) C.I. (n =800) Min Max
% Preferred 96.4 1.3 90 100
% Common 2.0 1.0 0 10
% Debt 2.1 1.0 0 10
J.J. Trester / Journal of Banking & Finance 22 (1998) 675699 691
with only retailing indicating any meaningful deviation, the breakdown being
(Table 9) 83.2.8% (3.0%), 5.0% (1.7%), 13.2% (2.7%).
Under the theoretical framework presented here such a shift would be con-
sistent with easier monitoring, and hence a lower probability of asymmetric in-
Table 6
All deals Later stage, # venture rms =8
Mean 95% C.I. (n =800) Min Max
% Preferred 87.8 2.3 50 100
% Common 3.9 1.3 0 10
% Debt 10.1 2.1 0 50
Table 7
Biotech Later stage, # venture rms =8
Mean (95%) C.I. (n =800) Min Max
% Preferred 88.4 2.2 50 100
% Common 3.9 1.3 0 10
% Debt 9.5 2.0 0 50
Table 8
Software Later stage, # venture rms =8
Mean (95%) C.I. (n =800) Min Max
% Preferred 88.4 2.2 50 100
% Common 3.9 1.3 0 10
% Debt 9.5 2.0 0 50
Table 9
Retail Later stage, # venture rms =6
Mean (95%) C.I. (n =600) Min Max
% Preferred 83.2 3.0 50 100
% Common 5.0 1.7 0 10
% Debt 13.5 2.7 0 50
Table 10
Manufacturing Later stage, # venture rms =8
Mean (95%) C.I. (n =800) Min Max
% Preferred 88.4 2.2 50 100
% Common 3.9 1.3 0 10
% Debt 9.5 2.0 0 50
692 J.J. Trester / Journal of Banking & Finance 22 (1998) 675699
formation, in retail. However, given the smaller sample size and large standard
deviations here, this slightly lower use of preferred, in favor of debt, in retail
deals may not be meaningful. Nonetheless, retailing does not involve advanced
technologies which may be tested in-house, and thus out of the view of the ven-
ture capitalist. While elds like biotech, software and manufacturing involve
advanced technologies which only experts (e.g., the entrepreneur) may be in
a position to evaluate, the evaluation of a retail operations health is a simpler
matter, largely involving the monitoring of inventory, sales and the like. Thus it
seems plausible to argue that a higher percentage of retail rms would present a
low enough probability of asymmetric information to make debt nancing fea-
sible.
Of course it is possible that entrepreneurial rms are receiving debt nancing
from sources other than venture capital rms. Questions 3 and 4 are designed
to address this issue. In the case of early stage nancing and excluding current
liabilities (which virtually all rms have e.g., utility bills, rent etc.) the mean
percentage of deals in which some debt existed on the books of the rm at
the time of venture capital nancing is (Table 11) 8.2% (1.9%). This gure
is constant across the four industry groups with the exception of retail, which
is slightly higher at 10.8% (2.5%). For later stage nancings (Table 12), the
percentage of deals with debt is considerably higher, at a mean of 41.9%
(3.4%). Note that the mean for biotech software and manufacturing are
40.0.3% (3.4%), 43.1% (3.4%) and 46.9% (3.5%), respectively. Only retail
is signicantly higher, at 69.2% (4.0%).
The higher instance of debt usage in later stage rms may be indicative
of easier monitoring; for example the health of a rm with revenues may be
Table 11
% Deals with some debt on books Early stage
Mean (95%) C.I. Min Max # venture rms
% All deals 8.2 1.9 0 35 8
% Biotech 8.1 1.9 0 35 8
% Software 8.1 1.9 0 35 8
% Retail 10.8 2.5 0 35 6
% Manufacturing 8.1 1.9 0 35 8
Table 12
% Deals with some debt on books Later stage
Mean (95%) C.I Min Max # venture rms
% All deals 41.9 3.4 0 75 8
% Biotech 40.0 3.4 0 80 8
% Software 43.1 3.4 0 75 8
% Retail 69.2 4.0 20 100 6
% Manufacturing 46.9 3.5 0 80 8
J.J. Trester / Journal of Banking & Finance 22 (1998) 675699 693
partially evaluated through examination of those revenues. As noted above,
more mature high-tech rms go through more public product testing, e.g.,
FDA tests that biotech rms go through, and the beta testing of software. De-
pending on the product, manufactured items may also have to go through gov-
ernment safety tests with public results (e.g., in the defense or auto industries).
All of these factors would tend to lower the probability of asymmetric informa-
tion in later stage rms and make the use of debt more attractive under the
probability of asymmetric information-driven framework constructed above.
Likewise the higher instance of debt tolerated in retail rms may be a function
of the greater ease of monitoring, and hence lower probability of asymmetric
information, associated with this industry. Under the theory presented, this
lower probability of asymmetric information would make the use of debt more
attractive.
Lastly, it is argued that the use of a conversion option in a preferred con-
tract should cause that contract to dominate common in the pre-IPO period,
eliminating any argument for the use of common to make possible a cash-
out in an IPO. Indeed, the mean of the surveyed rms' estimates of the percent-
age of preferred deals which used convertible preferred is (Table 13) 88.8%
(2.2%). These options generally do not result in a transfer of control (dened
as eective control, or the ability to convert to voting shares capable of seizing
control) from entrepreneurs to the venture capitalists the mean percentage of
deals in which such a transfer occurred was (Table 14) 28.0% (3.1%). Thus it
seems plausible that these options are simply facilitating the cash-out process.
Certain caveats are in order in drawing interpretations from the estimates
garnered in a survey of the type performed here. The precision which can be
reasonably hoped for in the estimates made by the venture capitalists may be
lower than would be indicated by the standard deviations given. However,
the overall pattern revealed here, that being the dominance of the use of pre-
ferred in deals where the potential for asymmetric information is high, seems
so pronounced that it is unlikely to be in any sense spurious.
The data presented here is of particular value because, despite its necessarily
rough quality, it is the only data on the aggregate percentages of contract types
Table 13
% Preferred deals where preferred convertible
Mean (95%) C.I. Min Max # venture rms
% Pref./conv. pref. 88.8 2.2 30 100 8
Table 14
% Deals where venture syndicate could take control
Mean (95%) C.I. Min Max # venture rms
% All deals 28.0 3.1 1 100 8
694 J.J. Trester / Journal of Banking & Finance 22 (1998) 675699
used in venture capital which has ever been obtained. Further, the massive
dominance of preferred equity as the contract type, not only as compared to
common equity but to debt as well, is of particular importance given that
the previous venture capital models have centered on the use of common stock,
e.g. Admati and Peiderer (1991), Chan et al. (1990), or debt e.g. Hansen
(1992). As illustrated in the model presented here, the use of preferred stock
in venture capital is crucial. It is driven not only by the risk inherent in the en-
trepreneurial projects themselves but by the diculty in monitoring those pro-
ject which the venture capitalist is likely to encounter.
Venture capital is not just a matter of making a risky loan or purchasing a
portion of a risky project. It involves extraordinary monitoring problems lead-
ing to a high probability of asymmetric information, particularly in the high
tech elds which venture capital has nanced in recent years. It is this high
probability of asymmetric information which appears to account for the choice
of preferred stock as a nancing tool, and renders the foreclosure option of
debt a hindrance. Analysis of venture capital nancing without consideration
of this point is fundamentally incomplete.
5. Conclusions
This study has extended the venture capital literature by analyzing the role
of asymmetric information conditions. Such conditions may arise subsequent
to the time of contracting, can play in the choice of contract type. In particular,
the choice of preferred equity over debt has been explored and shown to be po-
tentially motivated by intertemporal incentive inconsistencies due to the possi-
bility of information asymmetries in certain states of intermediate return. The
venture capitalist would foreclose under symmetric information. However, the
entrepreneur has an incentive to behave opportunistically under asymmetric in-
formation. If the probability of asymmetric information is high, this eect may
make the foreclosure feature of debt a large enough drag on the expected re-
turn of the venture capitalist as to make debt contracting infeasible. Under
such circumstances preferred equity may be desirable, because without foreclo-
sure the entrepreneur is not pushed into behaving opportunistically and the
venture capitalist may receive some positive return, rather then a total loss.
This feature of my model may help to explain the widespread use of pre-
ferred stock in venture capital contracting, particularly in high-tech elds like
software and biotech. In these elds, the initial phases of development often in-
volve tests which only the entrepreneur and his sta can observe and evaluate
(in-house ``alpha'' testing in software, private lab tests in biotech) while later
phases are more easily observed by outside parties (computer journal ``beta''
tests in software, FDA drug tests or EPA/Dept. of Agriculture eld tests in bio-
tech).
J.J. Trester / Journal of Banking & Finance 22 (1998) 675699 695
In the empirical results presented, the high instance of preferred stock usage
is documented and shown to be consistent with the model presented. This is
due to the fact that the industries funded by venture capitalists tend to exhibit
by their nature high probabilities of asymmetric information. The greater usage
of debt in retail, which presents less of a monitoring challenge and presumably
exhibits a lower probability of asymmetric information, is also consistent with
a framework in which a lower probability of asymmetric information makes
the use of debt more attractive. Finally, it is found that in later rounds of -
nancing the instance of debt use rises, although preferred is still the dominant
contract. This is consistent with a higher percentage of more developed rms
having a lower probability of asymmetric information, making a debt contract
feasible.
These results suggest policy makers wishing to encourage the formation and
deployment of venture capital might consider actions conducive to preferred
stock investment. For example, these might include elimination of the double
taxation of dividends on preferred stock used in venture capital, and the place-
ment of such securities on at least an equal tax footing with debt. A cut in the
capital gains tax on such securities would also be helpful.
This paper also suggests future directions of inquiry. Among these are
the pursuit of a better understanding of the role of capital structure in the ven-
ture capitalist's exit strategy, e.g. IPOs and earn-outs. Also of interest is the
role of capital structure in markets with a less developed venture capital sector,
e.g. the European market with its universal banks. The ability of such banks to
make equity investments may allow them to substitute for venture capital rms
to some degree, although other institutional features (size, conict of interest,
bias toward debt, etc.) may limit the eectiveness of such banks in funding ven-
tures.
In summary, this study has demonstrated that the dominant contract in ven-
ture capital nancing is preferred stock. This is supportive of a model in which
the contract choice is driven by the high probability of information asymme-
tries between the entrepreneur and the venture capitalist. Venture capital -
nancing is not simply a matter of making a high-risk loan or equity
investment. It involves extreme monitoring diculties, and preferred equity
represents the method by which these can be dealt with in an incentive-compat-
ible manner. An understanding of the venture capital process without consid-
eration of this point in necessarily incomplete.
Acknowledgements
The author wishes to thank Anthony M. Santomero, Franklin Allen, Rich-
ard Herring, Richard E. Kihlstrom, and Donald F. Morrison for help and sup-
port. This paper was presented at N.Y.U. Stern School's Conference on the
696 J.J. Trester / Journal of Banking & Finance 22 (1998) 675699
Economics of Small Business Finance, and the author gratefully acknowledges
the discussant, Anjan V. Thakor, as well as those of Gregory F. Udell, Allen N.
Berger, an anonymous referee, and the conference participants. I also thank
Matthew Richardson, Michael Goldstein, Michel Habib, Jim Mahoney and
Mark Roomans for very useful discussions. This work was supported in part
by a Dean and a Unisys Fellowships. All errors are the responsibility of the au-
thor.
Appendix A. Proofs
A.1. Proof of Proposition 2
First, set p=1 and construct a project such that R
1
(S) ` w
1
Y
S = MY L and R
3
(L) ` w
3
. I further adjust P(S)Y R
1
(S) and R
1
(S) so that un-
der a preferred equity contract
E
0
W
v3
W
v0
= 0 iff C
p
v2
= R
1
(H) d (w
1
d
1
) set at t
0
Y (5)
C
p
v3
= R
3
(H) d (w
3
d
3
) if S is revealed to be H at t
l
Y (6)
C
p
v3
= R
3
(M) d w
3
if S is revealed to be M at t
l
X (7)
Here d
1
and d
3
are premia over the reservation wages w
1
and w
3
necessary to
make the expected return to the entrepreneur at least as high as w
1
+ w
3
, given
R
1
(S) ` w
1
Y S = MY L and R
3
(L) ` w
3
, as well as the probabilities P(S)Y
S = LY MY HX
Such a project may be constructed if, in the L state R
3
(L) ` I
2
dX Then if
S=L it will not be possible for the venture capitalist to make a positive return
on his investment of I
2
Tk necessary to continue the project. Suppose this is the
case. Then since the project requires total capital of qI
0
k to continue at t
2
(including the xed asset and the new working capital) the forced liquidation
of the project by the current liability creditors is certain in the L state if there
is symmetric information or if the entrepreneur does not behave opportunisti-
cally. Therefore the entrepreneur is certain to behave opportunistically under
asymmetric information (which will be the case here since p =1), but he will
receive less than his reservation wage in both the L and M states by the above
assumptions. Therefore he must receive more than that wage in the H state to
make his expected return equal that reservation wage. As for the venture cap-
italist, his payos in the H and M states must be high enough to make up for
the certain zero payo in the L state in order for E
0
W
v3
A W
v0
=0 to hold and
the contract to be feasible.
It is possible to construct such a project simply by adjusting P(S), raising
R
1
(H) and R
3
(H) suciently above R
1
(M) and R
3
(M), and adjusting the
J.J. Trester / Journal of Banking & Finance 22 (1998) 675699 697
capital requirements I
0
and K appropriately. This is possible since these are all
free parameters in an underdetermined system of equations (the system of
Eqs. (2), (3), (5)(7)) plus the normalization

S=LYMYH
P(S) = 1 represents six
equations with 15 unknowns, admitting a nine dimensional free parameter sub-
space in which the desired project solution may be found). Note the w
3
term in
Eq. (7) arises form the fact that unless the entrepreneur knows he will be paid
that amount at t
3
there is no reason to continue with the project. Any new con-
tract at t
2
in M must then promise such a wage at t
3
.
Now consider: for Eqs. (6) and (7) to play a necessary role in making
E
0
W
v3
A W
v0
=0, the entrepreneur must not behave opportunistically in either
the M or H states, despite the certainty of asymmetric information at t
1
. There-
fore w
3
b R
1
(H) b R
1
(M) must hold. This is to say that if the project is contin-
ued, the entrepreneur stands to make more at t
3
then he would by behaving
opportunistically at t
1
, l=2. So long as this is the case the preferred equity
contract above may be feasible.
This scenario can be adjusted so that the preferred equity cannot be replaced
with a feasible debt contract. If debt were used, Eq. (5) would have to hold for
E
0
W
v3
A W
v0
=0. But since debt carries a foreclosure right, the venture capi-
talist would have the right to foreclose on the rm's assets in state M, because
the entrepreneur would be unable to pay C
v2
= R
1
(H) d (w
1
d
1
) in state
M. Indeed, if the condition
R
1
(M) d b R
3
(M) d w
3
(8)
the venture capitalist will prefer to foreclose should the entrepreneur not be-
have opportunistically at t
1
. Knowing this, however, given that p =1 and hence
l=2, the entrepreneur will be certain to behave opportunistically, setting
C
e1
=R
1
(M) and leaving the venture capitalist (and the current liability credi-
tors) with nothing. Thus the venture capitalist is left with nothing in state M
under a debt contract. But by construction the venture capitalist must have
a non-zero payo in state M for E
0
W
v3
A W
v0
=0. Therefore the debt contract
is not feasible for this project while the preferred equity contract is feasible, and
given the proper values of d
1
and d
3
, the preferred represents a Nash equilib-
rium. It should be noted that under the preferred contract, for the venture cap-
italist to wish to fund the second stage the relation
0 R
3
(M) d w
3
(9)
must hold. Substitution of this into Eq. (8) yields, R
1
(M) d P0 which of
course is consistent.
Thus, a project is constructed so that a preferred equity contract is just fea-
sible, and only because it receives some payo in the M state. Then since the
debt contract receives no payo in the M or L states, and con receive no more
payo then the preferred contract in the H state due to the entrepreneur's res-
ervation wage, the debt contract is not feasible. h
698 J.J. Trester / Journal of Banking & Finance 22 (1998) 675699
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