A Soft Budget Constraint Explanation for the Venture Capital Cycle

Georg Gebhardt

Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems from Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich

Abstract: We explore why venture capital funds limit the amount of capital they raise and do not reinvest the proceeds. This structure is puzzling because it leads to a succession of several funds financing each new venture which multiplies the well known agency problems. We argue that an inside investor cannot provide a hard budget constraint while a less well informed outsider can. Therefore, the venture capitalist delegates the continuation decision to the outsider by ex ante restricting the amount of capital he has under management. The soft budget constraint problem becomes the more important the higher the entrepreneur’s private benefits are and the higher the probability of failure of a project is.

Keywords: Contract Theory; Corporate Finance; Venture Capital (search for similar items in EconPapers)
JEL-codes: D82 G24 G31 (search for similar items in EconPapers)
Date: 2006-10
New Economics Papers: this item is included in nep-ent
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