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yearsofnegativeearningsbeforetheystarttoseeprofits.AccordingtoBergemannandHege(1998),thefractionofsuchprojectsforwhichinvestorscansuccessfullycashout,mostlythroughIPOs,is20%orless.Giventhissituation,banksandotherintermediariesarereluctanttoorevenprohibitedfromlendingmoneytosuchfirms.Furthermore,thesefinancialinstitutionsusuallylackexpertiseininvestinginyoungandhigh-riskcompanies.Consequently,thesestartupsoftenseekventurecapitaliststobeinvolvedintheiractivitiesbyofferingrevenuesharingintheformofequityjointventuresinordertoobtainnecessaryfundingandtobenefitfromtheventurecapitalists’experienceinmanagementandfinance.

Keycharacteristicsinventurecapitalfinancingarestagingthecommitmentofcapitalandpreservingtheoptiontoabandontheproject.Insteadofprovidingallthenecessarycapitalupfront,venturecapitalistsinvestinstagestokeeptheprojectundercontrol.Stagedinvestmentallowsventurecapitaliststomonitorthefirmbeforetheymakerefinancingdecisions.Theinformationabouttheviabilityofaprojectacquiredthroughsuchmonitoringhelpsventurecapitaliststoavoidthrowingmoneyatbadprojects.Itreduceslossesfrominefficientcontinuationandcreatesanexitoptionforventurecapitalists.Thehighertheriskintheproject,thehigherthevaluethisoptionhastoventurecapitalists.Thisoptiontoquitissimilartodebtinthatitlimitspotentialfinanciallosses.

Further,bymonitoringandcrediblythreateningtermination,venturecapitalistsalsohavebettercontroloverpotentialmoralhazards.Theremaybeseveralagencycostsinajointventure.Ifcashflowsarenotcompletelyverifiable,entrepreneursmayappropriateinvestments.Ifeffortisnotverifiable,entrepreneursmayshirkjobresponsibilities.Inaddition,ifthereareprivatebenefitsfromcontinuingaproject,entrepreneursmaykeeptheprojectgoingevenifithasnegativeexpectedprofits.Gompers(1995)providesanempiricalstudyonthefactorsaffectingthestructureofstagedfinancingwhenmoralhazardexists.Heshowsthatinfinancinghigh-riskcompanieswithpervasivemoralhazards,stagedfinancingallowsventurecapitaliststogatherinformationandtomonitortheprogressofprojectswhilemaintainingtheoptiontoquit.

Ourpaperisamongafewrecentpaperstoofferaformalmodelforstagedfinancingincontrollingrisksandmoralhazardinventurecapital.Wefindaclosed-formsolution,bywhichanalysisofthecomplementaryrolesofstagedfinancingandcontractingcanbemade.Wefocusontheproblemsofmoralhazardanduncertaintyinvolvedinfinancingnewstartups.Specifically,weconsiderafinanciallyconstrainedentrepreneur(EN)andaventurecapitalist(VC)whoisinterestedininvestingintheEN’sproject.TheprojectisriskyandtheEN’seffortisunverifiable.TheENfacesanimperfectcapitalmarketandtheVCistheonlypotentialinvestorwhounderstandstheproject(i.e.,theVCknowsthedistributionfunctionoftheoutput).TheVCoffersasharingcontractandfinancestheprojectstrategicallyinstages.Usingparametricfunctions,weareabletoderivesomeinterestingpropertiesofstagedfinancing.Ourresultsclearlyshowthat,inadditiontocontracting,stagedfinancingisaneffectivemechanismforventurecapitaliststoreduceagencycostsandtocontrolrisks.

Withtheflexibilityofstagedfinancing,manyprojects,whichmayotherwisebeabandonedunderupfrontfinancing,becomeprofitable.Weshowthattheefficiencyofstagedfinancingapproachesthefirstbestforhighlypromisingfirms.However,stagedfinancingisnotalwaysdominantoverupfrontfinancingintermsofsocialwelfare.When