Staged financing: a trade-off theory of holdup and option value

Lei Gao ()
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Lei Gao: Shandong University

Journal of Economics, 2017, vol. 121, issue 3, No 1, 197-237

Abstract: Abstract This paper investigates financial contract design in venture capital investments and shows that staged financing is the implementation of optimal contracts. In designing contracts, venture capitalists consider the value of real options and the costs of holdup. This consideration boils down to contract rigidity and flexibility: rigid contracts mitigate the holdup problem of entrepreneurs, but have little option values, whereas flexible contracts create real options for venture capitalists in corporate decision-making, but yield weak bargaining power when ventures appear promising. In optimal contracts, venture capitalists choose flexibility by separating capital into stages and then strategically allocating control rights at each stage. This strategy creates option value in corporate governance, and can protect sunk investments in distress while capturing the potential benefits of good outcomes.

Keywords: Venture capital; Staged financing; Incomplete contracts; Holdup; Real options (search for similar items in EconPapers)
JEL-codes: G24 G31 G34 (search for similar items in EconPapers)
Date: 2017
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Persistent link: https://EconPapers.repec.org/RePEc:kap:jeczfn:v:121:y:2017:i:3:d:10.1007_s00712-017-0524-x

DOI: 10.1007/s00712-017-0524-x

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