ANTI-COMPETITIVE FINANCIAL CONTRACTING: THE DESIGN OF FINANCIAL CLAIMS.



former. The entrepreneur’s ”outside option” lies not in competing offers from
other venture capitalists (who, if interested, will very likely join the same
syndicate once the deal is struck), but in finding other sources of funds (see
e.g. Silver 1984, p.87).

A second feature of the venture capital environment makes them worthy
of separate consideration. The venture capitalist is typically involved in close
monitoring of the entrepreneur. As the relationship continues, the venture
capitalist has access to marketing studies, the results of product testing and
other short term performance measures, and so learns more about how to
avoid pitfalls and problems in the industry. It is almost inevitable that through
financing an innovating firm, the venture capitalist learns something about the
likely profitability of the whole industry. He is then in a much better position
to fund potential entrants, and is naturally tempted to make further use of his
knowledge and exploit his comparative advantage in choosing and monitoring
projects in this industry by funding a competing firm. Indeed, other venture
capital partnerships will often try to persuade him to do so by offering very
attractive deals to join their syndicate in order that they can benefit from his
expertise.

Therefore, it is not very surprising that venture capitalists do sometimes
succumb to the temptation to fund competing firms.24 For example, amongst
the syndicate funding Osborne Computer Corporation were Sevin, Rosen Part-
ners, and First Century Partnership. Sevin, Rosen Partners was the lead in-
vestor in Compaq Computer Corporation, a competitor to Osborne. First
Century Partnership was an investor in Gavilan Computer Corporation, a
portable computer manufacturer (Silver, 1984 p.58). In a particularly severe
case of over-funding (probably from a social as well as an industry point of
view), Sahlman and Stevenson (1985) document “the six year long parade of
venture capital investors into an emerging segment of the computer data stor-
age industry. In all, 43 start-ups were funded in an industry segment that
could be expected in the long run to support perhaps four.”

Given the practical importance of the Coase problem for the venture capital
industry, one might expect from the simple model of section 4 that they would
hold common equity claims in their investments. This is indeed the case for late
stage investments. For early stage investments, venture capitalists prefer to use
convertible debt or convertible preferred stock (Sahlman 1990, Gompers 1996).
In addition, the conversion often occurs automatically upon the attainment of

24As mentioned in section 5.3 above, it is simple to extend the model of section 4 to
allow for cases where over-funding occurs probabilistically in equilibrium. If the investor
does not know the value of V2 in advance of contracting with Firm 1, he trades off the
certain reduction in Firm 1’s incentives, against the chance that Firm 2 will be sufficiently
profitable that he will be tempted to fund Firm 2 ex post. The optimal probability of entry
will generally be strictly positive (see Cestone-White 2000 for more detail).

22



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