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We develop a dynamic principal-agent model to examine the effects of the interplay among risk, imperfect information, agency conflicts, and asymmetric beliefs on the characteristics of venture capital (VC) relationships---the economic value that they generate, the durations of relationships, the structures of long-term contracts between VCs and entrepreneurs (ENs), and the manner in which VC investment is staged over time. We show that the presence of asymmetric beliefs about project quality has a substantial beneficial impact on firm value and the expected payoff to the VC implying that VCs have significant incentives to encourage or "feed" entrepreneur optimism.
We analytically characterize the effects of the project's characteristics---its systematic and technical risk, and the degree of asymmetry in beliefs about its quality---on the path of staged investments by the VC and the structure of the long-term contract between the VC and the EN. Consistent with empirical evidence, we predict that varying project characteristics lead to significant heterogeneity in contractual structures and investment schedules. The systematic and technical risks of projects have opposite effects on the durations and economic values of VC relationships. The duration, firm value, and the expected payoff to the VC decrease with the project's systematic risk but increase with its technical risk, which leads to the striking implication that the value of the firm and the expected payoff to the VC are actually enhanced when there is greater noise in the perception of project quality.
Broadly, our study not only demonstrates that the interactions among agency conflicts, imperfect information, and asymmetric beliefs have a major impact on the VC-EN relationship, but also precisely describes the manner in which they affect this relationship.
