Throwing Good Money After Bad

Dan Bernhardt (), Burton Hollifield () and Eric Hughson

No 1999-E15, GSIA Working Papers from Carnegie Mellon University, Tepper School of Business

Abstract: Typically, venture capital contracts feature stage financing where both parties commit to prohibiting {\em de novo} financing at each stage. The objective of this paper is to explain how these long--term contracts deal with entrepreneurial short--termism. We study an environment where entrepreneurs can manipulate early cash flows in a costly manner. In equilibrium, a certain amount of window dressing is optimal --- such window dressing improves the quality of ventures that are allowed to continue. In addition, the optimal contract features credit rationing. Were the financing hurdle reduced, more positive NPV projects would be funded. In contrast, when de novo lending is permitted, window dressing is merely dissipative --- it does not improve the quality of projects that are continued.

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