Pengfei Han

The importance of venture capital in the U.S. economy has skyrocketed over the last 50 years. To address the importance of venture capital in the U.S. economy, an endogenous growth model is developed. At the heart of the growth model is a dynamic contract between an entrepreneur and a venture capitalist. The venture capitalist invests in the entrepreneur's startup as an active participant. He evaluates the worthiness of the project stage by stage and provides funding for the next stage if the project is assessed to be viable. The success of a project depends on the amount of funding. The contract is designed so that it is not in the entrepreneur's interest to divert funds away from their intended purpose. The venture capitalist can imperfectly monitor at a cost the entrepreneur's use of funds and this helps to ensure incentive compatibility. The contract specifies by funding round the amount of investment that the venture capitalist will do, the evaluation strategy to gauge the project's worthiness, the level of monitoring to avoid malfeasance, and the shares of each party's equity in a potential IPO. The predicted features of the contract are compared with some stylized facts about venture capital: (i) the average cash-on-cash multiple, (ii) the success and failure rates by funding round, (iii) investment by funding round, (iv) the value of an IPO by the duration of the project, and (v) the venture capitalist's share of equity by funding round. The key participants in a venture capital partnership receive the majority of their compensation in the form of stock options and convertible equity. As such, they are subject primarily to capital gains taxation. The analysis indicates raising capital gains taxation reduces growth and welfare.