Venture capital investors have developed an extensive set of tools to help address financing frictions for startups stemming from adverse selection and moral hazard. These include a focus on rigorous due diligence, complex security design, staged financing and active investment through extensive control rights, such as board seats. However, despite the importance of VC-backed firms and the wealth of information on these many solutions, little is known about the compensation contracts of founder-CEOs in private, venture capital-backed firms.
This gap is important for two reasons. First, exploring when professionalized CEO contracts emerge in the firm’s lifecycle reveals important features of how VCs implement dynamic contracts. Theory suggests that, at least initially, venture capital contracts have to leave founders bearing substantial non-diversifiable risk at the birth of firms in order to screen entrepreneurs. However, the value of screening is likely to fall as firm performance becomes publicly observed, suggesting that incentive alignment should increasingly dominate screening motives as firms mature.