The complementarity effect: Effort and sharing in the entrepreneur and venture capital contract

• Allocation of equity share depends upon the level of complementarity of efforts.
• Model is solved as a double-sided moral hazard problem.
• Optimal share allocated to the venture capitalist, is non-linear.
• Participants will tend to divide in equal parts the equity of the new firm.
• Theoretical results are observed empirically.

This paper focuses on the relationship between the venture capitalist and the entrepreneur. In particular, it analyses how both players’ unobservable effort levels affect the equity share that the entrepreneur is willing to cede to the venture capitalist. We solve the entrepreneur’s maximization problem in the presence of double-sided moral hazard. In this scenario, we show that the venture capitalist’s share is binding and, therefore, there is no efficiency wage. We simulate the model and show that the entrepreneur’s effort does not monotonically decrease in the share allocated to the venture capital, while the venture capitalist’s effort does not monotonically increase in his share. We show that as efforts tend to be more complementary, the project cash flows are distributed nearly equally, at approximately 50% for each partner. This theoretical finding is actually observed in real contracts between entrepreneurs and venture capitalists.