Venture capital (VC) firms are pools of private capital that typically invest in small, fast-growing companies, which usually can’t raise funds through other means. In exchange for this financing, the VCs receive a share of the company’s equity, and the founders of the firm typically stay on and continue to manage the company.
a. Describe the nature of the incentive conflict between VCs and the managers, identifying the principal and the agent. VC investments have two typical components:
(1) Managers maintain some ownership in the company and often earn additional equity if the company performs well;
(2) VCs demand seats on the company’s board.
b. Discuss how these two components help address the incentive conflict.