Equity Contracts and Incentive Design in Start-Up Teams

Evgeny Kagan (), Stephen Leider () and William S. Lovejoy ()
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Evgeny Kagan: Carey Business School, Johns Hopkins University, Baltimore, Maryland 21202;
Stephen Leider: Ross School of Business, University of Michigan, Ann Arbor, Michigan 48109
William S. Lovejoy: Ross School of Business, University of Michigan, Ann Arbor, Michigan 48109

Management Science, 2020, vol. 66, issue 10, 4879-4898

Abstract: Entrepreneurial teams assign equity positions in their start-ups using a term sheet that details equity splits and the conditions for being granted those splits. The design of equity split agreements has attracted considerable attention in the entrepreneurial community, with no convergence on a single preferred contract form. This paper experimentally examines the effectiveness of different contractual arrangements, focusing in particular on the effects of contract form and contracting timing on founder effort and on the value of the venture. Our results suggest that performance improves with the incentive strength of the contract, but they question the conventional logic that this effect is causal. Instead, we suggest a novel causal sequence. Rather than the contract form being the primitive and the behavior the derived consequence, our results suggest the reverse. The differences in contract performance are driven primarily by the sorting of high contributors into nonequal contracts and of low contributors into equal contracts; that is, equal contracts are bad for team performance not because of their incentive strength but because of the founder types that adopt them. Taken together, these results suggest that both investors and founders should pay as much (or more) attention to personality type as they do to contract form.

Keywords: entrepreneurial operations; contracting; start-ups; behavioral operations; innovation (search for similar items in EconPapers)
Date: 2020
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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