Requirements for Creating a Venture Capital Market: Lessons from the American Model

Abstract:  In working with the Tanzanian Government and Investment Community, this paper seeks to to help the parties to understand the core of the U.S. venture capital contracting model, and develops the extent to which the model provides guidance in engineering a venture capital market and,in particular, in identifying a viable role for government in assisting that project. All financial contracts respond to three central contracting problems:  uncertainty, information asymmetry and opportunism in the form of agency costs. The special character of venture capital contracting is shaped by the fact that investing in early stage, high technology companies presents these problems in extreme. The genius of venture capital contracting lies in the use of powerful incentives coupled with powerful monitoring for all participants in the process, the braiding of the investor/venture capital fund and venture capital fund/portfolio company contracts, especially with respect to the role of exit and reputation, and the critical role of implicit contracts, especially through the reputation market, to support the dense set of explicit contracts comprising the structure of venture capital contracting. Finally by illustrating the implications of this analysis through consideration of three different government programs - a remarkably unsuccessful early effort in Germany; a more recent, more successful program in Israel; and a newer program in Chile. This is designed to give a serious overview of the effects of political favoritism and corruption, as well as the needs of an independent intermediary to monitor the investments and contracts for all parties, from investment in the funds to investment in the entrepreneurial contracts.