LAWYERS IN VENTURE CAPITAL CONTRACTING: THEORY AND EVIDENCE

Ola Bengtsson and Dan Bernhardt

Economic Inquiry, 2014, vol. 52, issue 3, 1080-1102

Abstract: type="main" xml:id="ecin12088-abs-0001"> Real-world financial contracts are sometimes so complex that it can be difficult to understand their exact payoff consequences. We develop and test a theoretical model of a venture capitalist (VC) negotiating with an entrepreneur who may overweigh or underweigh the payoff consequences of contractual downside protection (DP). A lawyer with expertise in venture capital can inform the entrepreneur about these consequences, but less expert (but otherwise high quality) lawyers cannot. We determine how a VC's decision to include DP is affected by the expected quality of the entrepreneur's project, the entrepreneur's experience, and the VC expertise of his/her legal counsel. We show that the VC's incentive to include unnecessary DP declines in expected project quality. Indeed, for inexperienced entrepreneurs involved with high-quality projects, VCs prefer that the entrepreneur's counsel has VC expertise. This implies that, when negotiating with inexperienced entrepreneurs, VCs who invest in high-quality companies should be more likely to negotiate with entrepreneurs who employ lawyers with VC expertise. We document broad empirical support for the model, and provide evidence against competing explanations. ( JEL L24, G24, K12, L14, L24)

Date: 2014
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