Entrepreneurs and venture capitalists engage in team production. Inherent in team production is an incentive problem: team members have an incentive to shirk. The incentive to shirk derives from the inability to monitor team members perfectly and compensate them based on productivity. Economic models of team production teach that solutions to shirking must involve (1) a principal (2) with authority to break the budget by realigning the claims of team members through use of a penalty or a bonding arrangement (3) based only on observations of team output, not on monitoring of individual inputs. This paper analyzes the team production problem in venture capital investing using the rich set of facts provided by the book Startup: A Silicon Valley Adventure, which recounts how entrepreneur Jerry Kaplan and his venture capitalists at Kleiner Perkins Caufield & Byers, the most prominent venture capital firm in Silicon Valley, formed and operated GO Corporation. The paper argues that entrepreneurs and venture capitalists address the team production problem through staged financing, the practice of investing only enough money to allow the entrepreneur to progress to the next milestone in its business plan. Under the traditional view, the possibility of abandonment by the venture capitalist is the key virtue of staged financing. This insight is important but incomplete because it fails to accord full credit to the power of staged financing to provide incentives to both the entrepreneur and the venture capitalist. From the entrepreneur's perspective, the prospect of abandonment is not the only danger in staged financing, and it may not even be the most important. Another danger is that successive rounds of financing may substantially dilute the entrepreneur's interest in the company. This threat of dilution provides the entrepreneur with incentives to be diligent, thus effectively addressing the team production problem. Unlike the entrepreneur, the venture capitalist is not susceptible to dilution because the venture capitalist has a fixed claim, enforced by the right of first refusal in all additional financings. Nevertheless, the venture capitalist has incentives to maximize valuation at each stage of the financing process. Those incentives derive primarily from the reputational effects of high valuations.
Available at: http://works.bepress.com/gordon_smith/33/