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A Cross-Functional Model Proposal for Valuing Venture Capital Investment:

Intersection of Real Options, Game Theory and Asymmetric Information

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International Research Journal of Finance and Economics
ISSN 1450-2887 Issue 9 (2007)
@ EuroJournals Publishing, Inc. 2007
http ://www.euroj ournals.com/fi nance.htm

A Cross-Functional Model Proposal for Valuing Venture

Capital Investment: Intersection of Real Options, Game Theory
and Asym metric Information

Sofia Alexandraki
23 lpirou str. Vrilissia, Athens, 152 35, Greece
E-mai I : sofi a. alexan dr aki@gmai l.com

John Mylonakis
l0 Nikifurou str. Glyfada, Athens, 166 75, Greece
E-mai I : imylonakis@panafonet. gr

Abstract

This paper prices the options of both the entrepreneur and the venture capitalist to
participate in venture capital investment. It concentrates on the strategic aspect of the
relationship between the parties as regards their optimal choice of effort in order to
maximise their option values, applying an adjusted Black and Scholes formula. The
association of effort and option value is demonstrated through implementation of the model
numerically. The results, restricted by the model's assumptions (required return, constant
effort, liquidation value, financing), provide some guidance on contract negotiations and on
the designing of the optimal contract for both parties; for the entrepreneur non-zero effort
exerted improves his option value and prefers the venture capitalist exerting full effort; for
the venture capitalist zero effort level is optimal if his share of profits and the liquidation
value are very high, diminishing the robustness of the entrepreneur's advantage, while at
the same time, he prefers the entrepreneur exefting low effort.

Keywords: Venture Capital Contracting, Options Theory, Asymmetric Information,

Stochastic Process, Game Theory, Black and Scholes formula
JEL Classifications: G24, G1l, G72
i'
l. Introduction
One of the most interesting features of venture capital investments, and the main reason for the
difficulty in assessing its value, is the immense information problems. Venture capitalists and
entrepreneurs cannot clearly predict the future states of the world in order to value the worth of the
venture when its nature is more tangible. In addition, principal-agent theory is applicable in the
entrepreneur - venture capitalist relationship where informational asymmetry regarding the
entrepreneur's effort level creates the need for sophisticated contracts. At the same time, the venture
capitalist, except for financing the project, can also add value to the venture through advising,
managing and creating superior prospects through its wide experience and network of contacts.
Therefore, the ability and effon level of the venture capitalist is another source of information problem
for the part of the entrepreneur creating a double moral hazard environment in the entrepreneur -
venture capitalist setting.
International Research Journal of Finance and Economics - Issue 9 (2007) 8

This paper, contrary to academic premise, claims that the optimality of non-zero effort exerted
by the venture capitalist is vulnerable with implications in the designing of venture capital contracts.
The dynamics of the relationship between the value of the option to invest in a venture and effort show
that for the venture capitalist it is optimal to exert zero effort when profit share is low and liquidation
value is high and full effort otherwise. The venture capitalist optimises his option value when the
entrepreneur exerts low effort. For the entrepreneur it is optimal to exert an intermediate level of effort
while the venture capitalist exerts full effort. Moreover, the equilibrium combination of effort levels is
always reached at the point where the entrepreneur achieves his maximum option value, while the
venture capitalist can only choose whether it is better to exert full or zero effort. Therefore, it is better
for the entrepreneur to set his profit share and the liquidation value not high in order for the venture
capitalist to exert full effort.
The present study analyses venture capital financing from a real options perspective, both from
the point of view of the entrepreneur and from the venture capitalist. It is a quantitative study,
integrating in one dual model both economics (agency and game theory) and finance (real options
theory). Using the models already presented by several authors in the field we focus on the asymmetric
information aspect of the entrepreneur - venture capitalist relationship and assess the value of the
option to invest in the project from both principal (venture capitalist) and agent (entrepreneur) views.
In order to discover the optimal strategies of the players, game theory is also employed

2. Literature Review Influences

Empirical evidence on venture capital industry and venture capital contracts
Gompers and Lerner (1999) argue that venture capitalists are not purely passive financiers of
entrepreneurial firms, but that they can and do add value through other services to the entrepreneur.
Venture capitalists can, by intensively scrutinising firms before providing capital and then monitoring
them afterwards, alleviate some of the information gaps and reduce capital constraints. Gompers and
Lerner also emphasise the negative effect on investors' willingness to invest if returns on venture
capital investments are low and in the presence of asymmetric information. Kaplan and Stromberg
(2001) find that the venture capitalists play an important role in shaping and recruiting the senior
management team and in providing strategic advice and customer introductions. Furthermore, they find
that greater asymmetric information risk is associated with more contingent compensation for the
entrepreneur and more venture capitalist control. In the present model control takes the form only of a
share in the firm. Kaplan and Strdmberg also examine liquidation cash flow rights. In liquidation
venture capitalists have claims senior to the common stock claims of the founders and these claims are
typically at least as large as the original investments. This feature has been incorporated in the model.
Finally, they find that convertible securities are most frequently used in venture capital financings. The
model presented in this study also makes this assumption.

Literature on asymmetric information in venture capital contracts

i. Moral hazard papers
Trester (1998) and Bergemann and Hege (1998) develop models of asymmetric information in venture
capital contracting. The compensation of the entrepreneur (the only source of moral hazard) is similar
to an option contract. They show that the optimal (arm's length) contract is a time-varying share of
equity contract. They also prove that the optimal contract is a mixture of debt and common equity or a
convertible preferred stock held by the investor. Except for the traditional financing role, Bergemann
and Hege also model two control instruments used by venture capitalists, namely monitoring and
changing the management in order to reduce the inefficiencies produced by moral hazard. They do not
however, specifically model effort exerted by either parry or their disutility of effort
 International Research Journal of Finance and Economics - Issue 9 (2007)

ii. Double moral hazard papers

Cooper and Ross (1985) model double moral hazard in the context of product warranties. Cooper and
Ross look at the issue of moral hazard using a game theoretic perspective and provide many insights on
how to deal with it. Nonetheless, they use discrete probability theory to take into account the
probability of the product not functioning. Casamatta (2000) models the relationship between the
venture capitalist and the entrepreneur in a double moral hazard seffing where both the manager and
the VC investor must exert an unobservable effort to increase the project's profitability. The
entrepreneur's effort is more efficient, namely less costly, a notion also adopted by the current model
in the function of the required retum demanded by each party. The main difference is that Casamatta is
using discrete probabilities for the states of nature while this model is using a continuous stochastic
process. Other papers using similar frameworks include Repullo & Suarez (1999) and Schmidt (1999)

iii. Game theory models

Martzoukos andZacharias (2001) provide a game theoretic approach on real options. The idea of the
two parties as two players who wish to maximise their option value with respect to their effort levels
and given the effort of the other is similar to those set out in Martzoukos and Zacharias. However, the
stochastic process they use is different, the model presented here applies the adjusted Black and
Scholes formula for continuous dividend yield and the options considered consist of a portfolio of two
call options (one long and the other short) due to the payoff structure ofthe two parties. In addition, the
solution method used in both papers is based on simulation over effort levels in order to locate an
equilibrium combination of effort levels

Real options literature and application on venture capital investment

There are not many models directly representing venture capital investment using the real options
approach. My research focused on three of these: the first such model is by Willner (1995). The
Willner model demonstrates sorne similarities with the model at hand in the basic notion of
representing it as a call option. On the other hand, the present model does not focus only on the value
of the option for the venture capitalist and does not include discrete jumps in the stochastic process of
the underlying value of the venture that is considered continuous and hence reflects market
uncertainties rather than technological uncertainty. Furthermore, in the present model the drift term
represents different influences on the underlying and emphasises effort exerted.
The second model is by Hsu (2002).In this model, however, the venture's riskiness changes
over time and the entrepreneur is assumed to maximise the probability of getting funded in the next
financing round. Hsu also places emphasis on the different results found between employing lump sum
and staged financing. The present study does not incorporate staged financing.
The third model is by Cossin, Leleux and Saliasi (2002) that examines individual features of
venture capital contracts with real options. It considers venture capital investment contracts as baskets
of real options instead of linear payoff functions. The present model also follows Cossin et al. in that
the effort put by the venture capitalist is taken"as deterministic and constantat each stage. However,
this model allows for the possibility of not exerting effort. Extending this idea of incorporating effort,
the present model also incorporates the entrepreneur effort in order to account for the agency issues
that lead to the contract features Cossin et al. analyse in their paper. The most interesting result from
their model was the interaction of liquidation preferences and convertibility also employed in the
model at hand. A contract with high liquidation value will be converted later than a contract at low
liquidation value

3. The Model Proposal

This section presents the model designed to evaluate venture capital investment from both the venture
capitalist and the entrepreneur point of view.
International Research Journal of Finance and Economics - Issue 9 (2007) 10

Assumptions
o ln a world of perfect competition among venture capitalists, where venture capitalists have to
break even, an entrepreneur endowed only with an idea seeks financing. His only way of
financing is a venture capitalist due to his lack of experience in the banking industry and the
increased risk associated with the venture. Without the venture capitalist the project cannot go
on.
o The entrepreneur has no initial financial endowment or is not willing to invest financially in his
venture (the latter is assumed not to be a negative impact on the expectation regarding the
venture's value).
r On the contrary the entrepreneur exerts effort in order for the venture to survive and become a
viable company with tangible assets in order for the venture capitalist to exit her investment
and attain a satisfactory return. This return is higher than just a compensation for her financial
investment because the venture capitalist also exerts effort. This effort takes the form of
advising the entrepreneur in terms of administrative tasks, by her large network of clients and
by her expertise in the industry the entrepreneur is entering (venture capitalists usually
specialise by industry/ies).
o Effort exerted by the entrepreneur (e) or the venture capitalist (fl is unobservable and costly. In
this model they are assumed deterministic andconstant. This can be explained due to the high
cost associated with monitoring; none of the parties is thus able to monitor value because they
cannot observe it.
o Moreover, at maturity, if the value of the project is too small, the venture capitalist takes over
the company and decides on the liquidation of its assets.
o It is also assumed that the venture capitalist holds convertible securities and hence she can turn
them into common shares and claim her share (1-s) of the venture after a predetermined value
level reached (zero conversion cost is assumed for simplicity).
o The model regards the venture capital investment as a European style option for both the
venture capitalist and the entrepreneur. The entrepreneur's payoff is what is left from what the
venture capitalist receives and as a result the horizon is determined by the venture capitalist's
option. The options thus assume a finite horizon with regard to when the venture capitalist can
exit. Staging is not incorporated in the model and therefore it may be argued that the model
represents lump sum financing.

Underlying stochastic process

Consider that the stochastic process of the possible values of the venture follow a geometric Brownian
motion as follows
4V = (ae + 9f + y)Vdr + oVdl{
Where:
dV is the instantaneous change in tire value of the venture V
(ae + ff :
+ y) the drift parameter or the expected rate of return per unit of time from the
venture, as affected by the entrepreneur's (e) and the venture capitalist's (fi effort and by any other
factors influencing value (y)
:
e the effort put forward by the entrepreneur
:
f the effort put forward by the venture capitalist
:
o the instantaneous standard deviation of the value of the venture
dW -N(|dt) is the classical increment for a Wiener process
The first term on the right hand side describes the deterministic portion of the change in
venture's value over time. The second term describes the random component.
Note that because of the assumption that the entrepreneur's and the venture capitalist's effort
add value to the venture, coefficients u and B must be positive, namely o, B > 0.
 ll International Research Journar of Finance
and Economics - Issue g (2007)
The Real Options

指麟愴 ざ綿Tw惹島∬島造
i錨 lili驚 棚::祖 ξ
¨
漁肥鮒i‰ 譜盤‖ :ξ
some cffOrt/in Ordcr tO add valuc tO the prtteco.DuetOthenaturi:][tち

.wi脇
11魔 扁 需脇∬le腑‰1:胤 』
terminaltimc T. Itt.e“.we祠 Ю lξ
me
irttll::』 II思 [『
l htte tt
):!h:羅

『 Their disutiliけ _Of― Cfbrt inctiOns are nOt cOnsidered here as in mOst asymmetric inf0111lation

Sl爺器 rT犯
麗
器よ ‰押篇∬
Ⅷ瑠庸糧彙
∬淵t鷹諸
∬日常[器唆
lλ

e2
ρ
E r+Ψ tt「
f2
where: θ
,/∈ [0,1]
pF=′ +9丁

and /: risk free rate

V,9>0
. It is important to note that the entrepreneur', #a1r*,, more effective. For this same reason the
required return for each parry's investmeni
is different. it ,.rtr.e capitarist wilr require
return because it is more costly for her
to exert effort. " a greater
The difference of this model to casamatta
(2000) is that is uses a continuous stochastic
for the underlying value of the venture process
uno ,otr"r;h. using the real options
and it does "pil;ion
an adjusted Black and Scholes formula approach and
venture capitalist' They are both considered
ntt oirrerentiate between th-e .advisor, and the
as tt. ra*" pu"y, irr. venture capitalist.
The value function for each party represents
the present value of their prospective payoff
terminal point T' The cost of effort of at the
t"he parties'actions has an impact
this way on the value function. This is the on the required return and in
strategic aspect of the model. Til u[
required to find the optimal strategy regarding of game theory is
flr.""rro.t1"uli"rror.n by each parw.The level
of effort
irnction, eiu",i,ut the other p,n; *iriact
f;"'J'[,,,,|l'rl1"oi# ilH'#:'ili:l";Ju. optimary. rhe

TF(//θ ) and maxE(θ //)

The maximisation above involves solving
the following first order conditions:
alrVr
df
,)l
=, and ;l;Giili:;""''
---du- =u
The first order conditions are necessary
for the existence of an interior maximum;
these conditions may also mean ttrougtritre satisfying
value will occur
rocatiori
at either zero or.iuri*urn effort. unlike
;i;;;tr"rm
point, in which case the maximum
(2001)' from where the game theoretic this model, Martzoukos and, Zacharias
urp"", of the model is influenced; ;; ;;;t
not relate it to the required rate of return). of effort (and did
of effort for each party given the effort ofJhe uruty.i.t"iow wil endeavourto nno the optimal level
the otrr".. g".uuse of the quadratic relation
required rate of return and effort, the between the
mathematical appliu"t"*il be to optimise
each value function

Taking into consideration the participation

and incentive compatibility constraints
of the two
::fi,?'ffiS;'iJ#ff,ff ::'[:ff','#4rffi,-'i;;,.Io,#'i,u".t inthe u",tu." nnanciary;h; ;;
 つ４
International Research Journal of Finance and Economics - Issue 9 (2007)

E(s)-C(e) > 0
F(s)-c(f)> I
Where: C(e) and C(fl represent the cost of effort of the entrepreneur and the venture capitalist
respectively and 1is the initial investment by the venture capitalist.
The payoff structure of the parties' investments at some terminal time T is the following:

Venture Capitalist
Payoffo =Yr. +0-⇒ mば 為―
∴9-mX為 ム
の .―

Entrepreneur
Payoff, -Vr - Payoff, =max(V, - L,0)-(1-s)max (V,' -:L
l-s-,0)
V: value of the venture
s: share the entrepreneur can claim
F: the value function of the venture capitalist
E : the value function of the entrepreneur
L: the predefined liquidation preference value, i.e. the value below which the venture capitalist
is entitled to liquidate the venture, taking control over its assets.

Derivation
Each party's payoff is represented by two call options (one long and the other short). The two value
functions illustrated above are replicating the payoff from investing in the venture. The venture
capitalist receives the full value of the venture (n if value is less than L. If L is smaller than V but
greater than (l-s)V,namely the sharepf the venture capitalist on the venture in case she converts her
share into common stock, the venture capitalist receives Z. Finally, if (1-9V is greater than L then the
venture capitalist converts her share into common stock and receives this amount. For the entrepreneur
the thinking behind his payoff is similar, thinking that he receives whatever is left from the venture
value after the venture capitalist has received her claim. Note that the venture capitalist's payoff is
similar to the payoff to a convertible bond with face value L.

Additional assumptions:
o V is the current spot value of the project. In order to use the market based real options
framework (namely, dynamic hedging that enables the use of risk neutral valuation) as opposed
to the dynamic programming framework, it is needed to assume that the uncertainty in the
evolution ofVis at least spanned by existing traded assets.
e It is assumed L<Ie" (and more specifically it is assumed that L=Ie" +C(f) so that the
participation constraint is satisfied, where 1is the initial investment by the venture capitalist).
However, the solution below simplifies the model, assuming that the parameter making L a
function of/is zero, so that L equals the initial cost (one could also add some constant). The
reason behind this assumption is that only with this simplification a relationship between the
optimal effort levels (e* andf) can be found
The payoffs are similar to the ones presented by Cossin, Leleux and Saliasi (2002) in their
model of liquidation preference and convertibility feature of the venture capital contract. The only
difference is that the conversion cost in this model is assumed to be 0 for simplicity. Moreover, the
solution below is very different since the study at hand considers only the finite horizon and uses the
Black and Scholes formula.
13 International ResearchJournal ofFinance and Economics - Issue 9 (2007)

Solving the model

For option pricing, the instantaneous change in the option price defined using Ito's lemma is (using as
an example one of the call options incorporated in the parties' options to invest in the venture called
P):
O'l^
dpy.t\=Ld, *Laf,
0t AV
*'2 AV' o,r,d,
Given that the venture's value follows the Geometric Brownian Motion given in (l) above:

dp(v.t) =
To,
*
fflt , +Ff + y)rtat + ovdwl+)ffo'r'a, =

u' * Lfu, !a' l- rror)ar + Lcvdtl

=( + Bf + r\r, *
(at AV' 2AV' ) AV
The change in the option price consists of a deterministic component, the first term, and a
second uncertain or risky component.
We first derive the equation satisfied by the value functions using contingent claims analysis. In
this case, we seek to form a riskless hedge portfolio by combining P with a number, the hedge ratio
(A), of units of the underlying value of the venture, V. We shall see that the first derivative of the
option price with respect to the underlying value of the venture , + , that captures the first order
,AV
impact of a change in the underlying on the call option price, provides a suitable hedge ratio. A riskless
hedge portfolio consisting of the underlying asset and the option can be created using this ratio that
hence earns the risk free rate ofreturn.
The change in the value of the portfolio of the underlying asset and option, g, is thus defined as:
dg: dP(v,t)- Ldv
,r + * * ff {o" + pf + i". o')a, + L ovdw- A(oe + pf + y)rat + ovdla\
\d/ dy )#rr'
Choosing L = * eliminates the stochastic component of the change in the value of the
AV
portfolio, resulting in:
js. =l
(ap 1a2P--",).
" [a, 2av'
-+--V'o'
ldl
)
This portfolio return is certain, or non-stochastic, thus the appropriate retum on the hedged
portfolio is the risk free rate of return. Therefore:

=( t. !
gllv'o')a,
!r),ar
ar =( p -
\ AV ,l [ar zAV' )

- rt, L v'o' o'

oP
-l
P-^

= rP (2)
0r AV 2 AV'
This final equation is the partial differential equation underlying the Black Scholes option
pricing formula. The appropriate equation is solved subject to appropriate boundary conditions. For
call options the boundary conditions are:
P(V,O):V-L for V>L
P(V,O) :0 for V<L
Where: Z is the exercise price of each call option for the portfolio of each of the parties, as
found in the payoffequations above.
Note however that the Black Scholes equation, and hence the resulting value function, does not
explicitly include the drift rate of V,which incorporates the effort levels into the model. If we wish to
International Research Journal of Finance and Economics - Issue 9 (2007) 14

take the effort into account, and also to consider the case when the dynamics of V are not spanned by
existing assets, so the hedging argument above cannot be used, we need to use dynamic programming,
and proceed as follows:
P(V,t) = e-Pd' E,ff(fi + dtt,t + dt)]
Expanding using Ito's Lemma and taking expectations:

p(v.t): tr- oarl[r (.t) +ffa, *

#r*, +gf + y)vdr + \ff"'r'r,)
and omitting terms that go to zero faster that dt as dt -+ 0

: p(v,t).l+# *v2 + (ae + Ff + r>,

# * ff - oror,,tfa,
We therefore have:

# = r, -(ae +Bf +YYt

L-t o','
#
Note that this equation has the same form as (2), the Black and Scholes partial differential
equation (PDE), so the solution is also ofthe same form with p =r and p-6 = ae+$f +y
Given the parties' payoffs and using the Black and Scholes formula adjusted for continuous
dividend yield, we therefore obtain the value function of each party as:
F, = v, + (1 - s)v,e- 5 " ItJ (d rr,) - Le- po' N (d r o) - v,e-' o' N (d r.) + Le- p" N (d r r)
r

and
p"
E, = v,e- 6 " N (d r) + Le- 0"
r
1t7 (d rr)- (1 - s)v,e-'il N (d r r,) + Le- N (d,n,)
Where:

d,,.,=frlP
olr
*(P,-a,*ig')'li
o
d,,,:d,,,-o.li
, tn(L),b,-60+)o')rl; , ln(l-s)
utF=----- dro=clro-oJi
=arFr- t-
o",l T o oir
d,,,:4P
olr
*(P'-a'*+o')'li
6
d,,,=d,,,-oJi
, _rn(f)
utE:-i , rn(l-s)
,(r,-6,+)o'),1;=orEr- drr=drr'-oJ'
olr o o4r-
p is the required rate of retur fli pa = , * r+ and 6o = pr -(* * Bf + y)
Po-5e = Pr-dE =a.e+9f +y
6p, 5s represent effective dividend yield and
6r = pr-(** tr *y), ^",0 6r = pr-(** frf *y)
1 "i- _x,
,\(4): PIX <d,1:1; 'ax
_)e
N(d) denotes the cumulative standard normal density evaluated at d
t:T-t
Note that:
dr, = dru drr, = drr,
drn = d* dro, = drr,
The optimal effort levels chosen by the venture capitalist and the entrepreneur can be found by
differentiating F and E with respect to f and e respectively:
15 ル たrη α′
わ刀α′Rι α′θ力■)ν ″4α ′(√ Fiη ακθθα刀グEθ Oη ο たs― 力 sν θ 9 ρ θθη
“ “
For the venture capitalist:

F=〆 十(1-5)И 9 (9/2ル _ぽ ι γハ グ

_α ttr
く9/2ル 十 Ⅳ
て 1角 )一 二θ
)τ r)τ
(グ 2Fs)

_ル く9/2ル ぽ ′―
→τ _α +″
Ⅳ(グ lF)十 /2ゎ 十
二θく゛ ″》Ⅳ
(グ 2F)
and given the equations ofthe relationship above betweenの ―
F9の 角,J2■・
and i2Fs,
∂
4F_∂ 4R_∂ 4F_∂ 4R_β マτ
σ

炒 ―
γ γ γ γ

ぢ却→(<向
和わ 砦呵
+ぽ Щ伽セツ子守 守 崎
″
ｒ特ｋレ
／

生
劃

浚
噂 抑

プ 
喝 加
＋

衝 
灯  颯

ヽ︲
 
 
︲

︲ ︲︲ ︲ ︲︲
メ    Ⅳ
、″

 
 

 
］

け
訓

ぽ
計
．
一

ノ
√

ーδ S)θ …/_ι -4Fウ イ ―

ρ戸― グウ
/_ι ′
ィ ― ウ
十
″
フ
2ハ 2′
Fτ

モ
li:;了 ￨ン ((1-― )_zθ (θ `/)]
And for the entrepreneur:
E=乃 く
Ψθげ¨ い
τ 2ル
+″
w(グ L)― (1-s)Ⅳ (グ 1ぷ )]― Zθ
イ
Ψ°τ
2ル

ド +→
(グ 2f) Ⅳ (グ 23)]
and given
∂4E_∂ 43_∂ tf_"23_α マ写
γ γ γ γ σ
メ つメτ θ
降 ―め Ⅳ 013)一 Ⅳ σ E月 十二θ Ψ Wo2F) Ⅳ
化
θ―の τが υ 23月

メ
轟[ダ 鰤 ア τ
‐ ζ
#=帥
― ザ イ4-ル
うψづ [・

/1=τ 乃くにぽ τ lF)― (1-S)Ⅳ (″

+″ →
w(″ l.)]
/2=己 θれ
・
)]
ド(″ 2■ ) Ⅳ (グ
旬τ一
⇒ルア
ー作 れ む
ど
2′

1/al中 ←
4=― :源 /)_z〆 /】
r87-√
and given 4″ =4F etC・ ■Om above:

チ θ ― =0⇒ <τ kげ
D4_ψ 2+障 3]=0

―
二 =0⇒ θΨ θ
RΨ
_α
)4-Ψ ″2+C4]=0
ttτ
International Research Journal of Finance and Economics - Issue 9 (2007) 16

τ―
θ子
°

Since ≠0 ,θ
vttτ

1t must mean that:

RcP/― β)И l― qμ 2+β ∠3]=O and kΨ θ―α)И l― Ψ″ 2+α ∠3]=0
Solving thc above equation the foHo、 ving optilnal results are found:

/*=型 ■θ or
9α
ど=冊 /*
Note, however, that these values may be either related to maximum option values or minimum.
It is possible to investigate this by considering the sign of the second derivatives. However, these are
complicated formulae whose sign cannot be determined unambiguously. Therefore, the possibility of
any or both of these values representing a minimum will be examined numerically in the next chapter
by considering all combinations of effort level in order to find the optimal response for each party.

4. Model Dynamics Analysis

The rest of this study involves simulation of the model using various different combinations of effort in
order to identifu the nature of the relationship of effort with the parties' value functions. At the same
time, the relationship between the value of each of the value functions and all the parameters of the
model is found and compared with logical and theoretical argumentation and (where possible) with
empirical evidence

Calculation Assumptions
o The range ofvalues chosen for e andf
As noted earlier, e (the entrepreneur's effort) andf (the venture capitalist's effort) can take
values from 0 to I (inclusive)l and are constant for both parties. Simulation was undertaken for all
possible combinations of e and from 0 to 1 with a 0.01 interval. Consequently, a set of 10,201
f
possible combinations of effort (and thus option values) was examined in order to explore the
iorrelation with the value functions2.
. The values ofu, B and y
According to the model, the entrepreneur's effort is more effective than the venture capitalist's.
This makes sense since the entrepreneur has the idea and knows how to realise it, while the venture
capitalist can only offer advice and customer base. This means that a, the coefficient of the
entrepreneur's effort relating it to the change in value, should be greater than B, the respective
coefficient of the venture capitalist's effort. The assumed values are 0.071 and 0.054 for u and B
respectively3.
In addition, y is small (assumed to be 0.01) because the net effect of all other influences (new
discoveries by the entrepreneur while materialising his idea or possible entry by competitors, or any
other environmental and project specific factors) niay not be very large since y is a net effect.
Moreover, the value of y has also been chosen due to the calculation of (pe,e - 6r,E)* discussed below.
. V,s,T, I,rando
The base case value Zis assumed to equal 100.
The share of profits given to the entrepreneur, s, is assumed to be 0.7. Gompers and Lerner
(1999) find that the vast majority of venture capital contracts fall into the range between 20 andZl

'l
his assurrption is very sinrplrstic. Neverlheless. restrictillg the valucs in this snrall range does allow sorrc fbrm ol- testing the model. Furtlier research
can examine a larger set ofpossibJe values lor etlbrt
The srmulation Lrndertaken proved that the equation betrveen e and ltbund in the Model section related the minimum value olF'and marimum ofE and
therelore tlie u,hole range ofcombinations oloptron values is examined in order to locate an optlmal combination.
Note that lor high values of n and p (summing to) the venture capitalist optron vaiue is lound to be negatile and the venture does not materialise unless
the entrepreneur credibl-v commits to low efTort level (thc game becomes similar to a prisoner's drlemma). The reason for tlie requirement of a and B to
be small must be the choice of the range (namely lrom 0 to 1 ) 1br the elfort level olthe panies.
(p 5) is equal to (ue+|3f+T)
17 International Research Journal of Finance and Economics - Issue 9 (2007)

percent, or else are greater thanZl percent. This paper argues that the entrepreneur only provides effort
and no financial investment to the venture and therefore the share given to the venture capitalist is
assumed to be as high as 0.3.
T, tirne to maturity or time that the venfure's assets are assumed to be able to become tangible
is considered to be 4 years. Due to the fact that simulation is undertaken for the value of the options at
time t4, r is equal to 7 (since r:
T - t).
1, the initial investment by the venture capitalist, is assumed to be 30 (the result of multiplying
the venture value with the share of the venture capitalist into profit)5
r, the risk less interest rate, is assumed to be equal to 0.08
o, the standard deviation of the value of the venture is assumed to be equal to 0.6
d, the dividend yield
In the model the most appropriate interpretation of 5 is the view of McDonald and Siegel
(1984) suggesting that 6 is a deviation from the equilibrium required rate of return. Using the
relationship between p and 6 whereby, (pr - 6B) : (pr'- 6p) : (oe+B/+y), all possible values that 6 takes
(since it is equal to p - ae - gf - y) have been calculated, with different combinations of e andf.
. Calculation of po, pr
e'
Pe=t*V,
pp :t *q, f2
Casamatta (2000) has put forward the idea of the difference in effort effectiveness between the
two parties. In a similar manner, although not as restrictive, it is assumed here that the effectiveness of
effort exerted by each pa(y, a and B is associated with the size of the constant coefficients y and g
respectively. Given that it is more difficult (costly) for the venture capitalist to add value to the
venture, she will require higher return for the same level of effort as the entrepreneur and thus y is
smaller than <p. The values assumed for ry and <p are 0.1 and 0.13 respectively.
Having assumed the above values for the parameters q and y, the values of puu and ps are
calculated for each value of effort considered and in this way the different values that F (the value
function of the venture capitalist) and E (the value function of the entrepreneur) take for different
combinations of e andf.

Table l: Assumptions Summary

Parameter Assumed Value Parameter Assumed Value

イ αβ γΦ Ψ

[0,1] 0.7
Ｉ

0.071 30
Ｖ

0.054 100
Ｔ

0.01 4
06
６

0.13
ｒ

0.1 0.08

Model Dynamics
i.The effect effort on the value functions
Simulation undertaken demonstrates that the value of dFldf and dElde asf and e* change, using the
relationship between f and e* found earlier, is not constant. In addition it is found that the
combination where dFldf becomes zero represents the minimum for F and hence the equation found
cannot be used to locate the optimal combination of effort levels.

t Notethatthevalueof/rs usedrn calculatingl.

" Note that rn the caiculation of pE one mal argue that r does not need to be included since the entrepreneur is assurned to onll off-er his etTort on the
project, and theretbre hts required retlLrn must onlv be dependent on his eflfort. Hos,ever. such an assumption is not made here considering that the
entrepreneur has other sources ofincome ifhe does not choose to run the venture.
International Research Journal of Finance and Economics - Issue 9 (2007) 18

As f increases, dF/df is at first negative, implying a negative association between F andf and
shortly after 0,4 it becomes positive, implying a positive association between F andf then after (for the
set considered in this study). This finding means that when dFldf :0, F is at its minimum. This finding
implies that there are two possible levels of effort where F is at its maximum, namely when/: 0 and
when/: l. Similarly, as e increases, dElde is at first positive, implying a positive association between
E and e and shortly after 0,8 it becomes negative, implying a negative association between E and e then
after (for the set considered in this study). This finding means that at dElde = 0, E is at its maximum
also implying that there is a single maximum for E atthe specifred range.
Having solved the model numerically, the way to locate an optimal effort level combination for
both parties is to discover common points where given the other party's effort level, one party
maximises its value function. This is similar to Cooper and Ross's (1985) and Martzoukos and
Zacharias' (2001) technique of locating locally unique equilibria.
Given the assumed values for the model parameters, the equilibrium combination of effort
levels was found at f : I and. e : 0.707 . At this point the value function of the venture capitalist F :
35.08 (while over all combinations maximum F : 46.65) and E : 76.39 (namely, maximum ,O).
Therefore, at the equilibrium effort level combination, E is maximised while the venture capitalist
compromises at a lower value than her maximum.
The simulation undertaken, given the assumed parameter values, demonstrates that the venture
capitalist is better off exerting full effort, a clear advantage for the entrepreneur and his bargaining
power. However, the venture capitalist prefers the entrepreneur to exert zero effort. This seems not to
be consistent with academic premise and logical argumentation. However, the way the present model
was constructed (namely the higher effectiveness of the entrepreneur's effort and the impact of
effective effort on the drift term and on the required retum) is the possible cause of such a finding.
Further investigation on these aspects of the model and perhaps other assumptions concerning the
value of the parameters may derive more realistic results.
Note, though, that the optimality offull effort (and therefore the robustness of the entrepreneur's
advantage) is invalid when the liquiddtion value (L) and the share claimed by the entrepreneur (s) are
high relative to the assumed current value V.
In addition, if it could be assumed that the venture capitalist has the power to set the terms of
the contract and since (for the parameter values chosen) she prefers lower effort exerted by the
entrepreneur, she would ask for low s (and therefore Z will be large). For example, if s : 0.6 and L:
55, then the equilibrium point is/: I and e: 0.66 at F: 41.79 (while maximum F: 51.15) and E:
69.19 (maximum D.In the latter case, the venture capitalist's investment value is much higher and
closer to her maximum F.
Consequently, there are different ranges and combinations of optimal effort levels that affect
option values differently. At equilibrium it is optimal for the venture capitalist to exert full effort and
for the entrepreneur to exert high effort as long as the share claimed by the entrepreneur and the
liquidation value are not high. The analysis demonstrates that the entrepreneur is in an advantageous
position (contrary to Cossin, Leleux and Saliasi, N02, who assume that the venture capitalist has all
the bargaining power) because of his effort effectiveness and that equilibrium is reached at his optimal
option value irrespective of his effort level because the venture capitalist exerts full effort.

ii. The effect of model parameters on the value functions

A preliminary comparative static analysis was undertaken to find the change in the optimal effort level
combination with different parameter values (holding all other parameters constant). The results are
presented below:

7 Note that given other assumptions for the parameter values, such equilibrium may not be possible to be found
19 International Research Journal of Finance and Economics - Issue 9 (2007)

Table 2:

Model Parameter Effect on e* Effect on ρ

s: claim on profits by the entrepreneur Increaseswith s No effect,ノ =1
Decreases with L <20 No effect,ノ =1
Z : liquidation value 8

Increases with L> 20

For vcry low%<30,′ =0
V: spot value ofthe venture Decreases in Z
For,/≧ 30′ =1
T : time when assets become tangible Increases with T
′=O fOr T=1
ノ=l fOr T>1
o: standard deviation of Z Decreases with o No effect,ノ =1
r: risk free interest rate Increases with r No ettct,′ =1
0: entrepreneur's effort effect on Z Increases with o, No effect,ノ =1

p: effect ofventure capitalist's effort on Z ノ=110W β

Increases with B
ノ=O fOr β>o.054
T: effect ofall other factors on Z Decreases with y No effcct,ォ =1

Table 2 shows that e* is influenced positively by the entrepreneur's claim on profits, the
liquidation value as long as it is relatively high, the time to maturity, the risk free interest rate and
coefficients u and B. Increasing the share on profits means that the entrepreneur has a greater stake in
the venture and therefore needs to exert more effort to succeed. Increasing the liquidation value means
that the entrepreneur needs to exert more effort since he needs to give back to the venture capitalist a
larger fixed value in case of default. As time to maturity increases, the effort level chosen must
increase and if the interest rate increases the entrepreneur must exert more effort since his and the
venture capitalist's required return increase. Increases in the effectiveness of both parties' effort
increases the level of e* exerted by the entrepreneur since if o increases it is cheaper for him to exert
effort and ifB increases, the venture capitalist's effort decreases.
As Z increases optimal entrepreneur effort decreases since he receives more gross return at the
same effort level. Finally as o' increases, e* decreases. This can be explained theoretically since moral
hazard theory argues that the agent will act opportunistically especially when the volatility increases.
The entrepreneur usually knows the risk of the venture and exerts appropriate effort.
The behaviour off is more or less constant: the venture capitalist prefers full to zero effort. It
is worth noting, however, the case of changing T and Z. When the venture is closer to maturity (for
given V, L and s), and for values of Z (given Z, s and T), the venture capitalist will exert zero effort.
Finally, if the effectiveness of the venture capitalist's effort is high (close or higher than that of the
entrepreneur), then the venture capitalist prefers to exert zero effort. This probably means that the
required rate of return becomes too high when the venture capitalist exerts maximum effort.

ii.The effect of model parameters on the option values

Due to the fact that each of the value functions described above consist of two options (one long and
the other short), the net effect of the model pirameters may not be as clear as when examining the
'Greeks' of the Black and Scholes formula. The effect may thus be ambiguous or even reverse for
some model parameters.

Note that changlng 1- and holding s constant or changing t'and holding L constant and vice versa is somewhat unrealistic since Z depcnds on 1 that in
turn d rcclh depends on s rnd t.
International Research Journal of Finance and Economics - Issue 9 (2007) 20

Table 3:

Model Parameter Effect on option value F (venture Effect on option value E

caoitalist) (entrenreneur)
Drift term : 0e + Bf + y) Positive effect Negative effect'u
V: spot value ofthe venture Positive effect Positive effect
1: initial investment in the ventureby the Positive effect (reverse for low 1 levels) Negative effect
venture capitalist
s: claim on profits by the entrepreneur Positive effect (lower magnitude) Negative effect (greater effect
than I
o: standard deviation of Z Negative effect Positive effect
r : risk free interest rate Positive effect Negative effect
T : time when assets become tansible Positive effect (greater magnitude) I 1
Positive effect

In the comparat市 e statistics analysis the mttor differences with academic literature(namely the
`Grccks'in Black and Scholes forlnula)occur Only in the relationship of E(the Cntrepreneur's valuc
hnction)and the parameters since such an option has not been exalnined before.In the case ofF the
only contradictow flnding、 vith otller research is the relationship with the drift term parameters and
with the standard de宙 ation(fOr high levels of σ).In the case of the drift terln,the opposite inding
could be the rcsult ofthc nct cffcct ofthc drill tcrln due to thc fact that each ofthe h″ o value functions
consists of加 o options(One 10ng and one short)themselves.Looking at the implication of thc results
for the parties'strategies,、 ve can see that it is optilnal for the venture capitalist that both partics cffort
effectiveness decreases,while the opposite holds for the entrepreneur.This lnay be due to the fact that
the venture capitalist's effolt is less effective than the entrepreneur's orlllay bc duc to thc design Ofthe
current model and more speciflcaHy of the assumptions regarding the valuc of thc drili tcllll and the
required rate of retum,and consequently of the effective dividend yield.Further work could exalnine
different forlnulations ofthe required return to invcstigatc diffcrcnt cffects on the value functions.
The effect on F of σis opposite tO academic premise stating that the venture capitalist prefers
the variance to bc high. It may be the casc ho、 vever that the venture capitalist prefers low variance
since shc stands to lose in the do、 vnside if she docs not receive at least a valuc equalto Z.The effect on
E is posit市e dcmonstrating that the entrepreneur prcfcrs the volatiliサ to bc largc,This may be the case
becausc he is not investing flnancially in the venture and therefore stands only to gain in the upside.
Looking at the result on the effect of s on F and E, the valuc of s chosen must be a
compromised solution.At the same tilne note that according to acadenlic premise,the value of s also
affccts the amount the venture capitalist will be willing to invest(thiS iS also incorporated in thc
model).The Venture capitalist is thus in a dilemma regarding the factor that chiefly increases her value
function;clailn on proflts or the investincnt icvel.The present sillllulation found that E is tFl10re scnsitive
to challges in s thanム while the effect of the two parameters on F is similar.Hence,keeping s at a
relatively average level while incrcasing rwould be a satisfactory strategy for thc venture capitalist and
the entreprcneur(for the irst F increases and for the sccond f decreases slightly)。 Note,howcvcr,that
such a strategy(high s andの mり
lead the optimal ettrt for the venture capitalist to equal zero(as
found abovc)and suggcst that the venturc capitalist should only providc flnancial investment in the
venture and thus the entrepreneur's value fLInCtion will fall dramaticaHy.

" Note that the moclel rvas also examined with a dilferent driti tenn in the stochastic process that the value ofthe venture follows, namely y(l+oe)(l+1]0
Houever. the results rvcre difl-erent In that there rvas a straight positir.e and negative relationship betrveen Fand./and E and e respectivell. irrespective
atf
of rvhat the other parl-v-'s et-tort level choice rsll The optrmal cflbrt level combination rvas located I and e = 0.01. One could undertake a deepcr
eramination on this lersion olthe model.
"' , is found to be mostil sensitive to changes in a out ofthe parameters ofthe drift term due to the direct relationship between the entrepreneur,s eflort
elltctiveness and his required return
rr The positive relationship rs in line with acaduric prenrise. Cossin. Leleux and Saliasi (2002) find that the liquidation right optron ls not as sensitive to
I
(related negatively) and thus the present study demonstrates that the positive ef'fect of lon the other option is more prevalent.
つ４
International Research Journal of Finance and Economics - Issue 9 (2007)

5. Sullllllary and Conclusions

Thc prcsent study uses the real option theory in combination with economic thco7(aSymmetric
infollllation and gal■ e theory)in Order to dcvclop a modcl for valuing venture capital investmcnt.The
model is an applicttion ofthe(attuSted for continuous di宙 dend yield)Black and Scholes follllula a■ er
having represented the payoff of the venture capitalist and the entrcprcncur in tclllls Of Call options.
The resulting value functions consist ofa portfolio of憫 Ⅳo can options,one long and the other short.
Thc modcl emphasises thc importance ofeffort exertcd by the venture capitalist,as this cffolt is
crucid according to emp■ ical alld theoredc Hterature(Kaplan and Strё mberg,2000 and 2002,
Gompers and Lerner,1999 and Casamatta,2000).The main differcncc with other modcls is that it
combincs the continuous stochastic process feature of advanccd venture capital models and thc
asyllllllletriC inforIInation feature of sillllpler double llloral hazard inodels.At the same tilne it rnodels an
option of investlnent not only for the venture capitalist,but also for the entreprcncur.In such a setting,
a game theoretic approach is adopted in order to locate an optilnal combination of effort lcvels that
maximisc thc椰 √
o value inctions in a similar manner to Marztoukos and Zacharias(2001),eVen
though for a different environment.
Thc vcriflcation ofthc model involvcs flrstly thc analysis ofthe association beiⅣ cen effort and
option value for both thc entrepreneur and the venture capitalist by illllplementing the model
numerically. The results show that non‐ zcro effort exertcd by the entrepreneur improves his option
valuc. Howcvcr,zero cffort icvel is optiinal for the venture capitalist if his share of proflts and the
liquidation valuc arc vcty high・ At the sal■ e tilne, the venture capitalist prefers the entrepreneur
cxcrting low effort,、vhile the entrepreneur prefcrs the venture capitalist exerting full effort.The double
moral hazard problem therefore is not how to make both exe■ high cffort,but how(from the venture
capitalist's view)the entrepreneur will exert low effort and(fOr bOth parties or from thc cntrepreneur's
view point ifliquidation valuc and share on proflts arc high)the Venture capitalist high cffo■ .

These flndings were the result oftaking into account the liquidation preference contract feature
for the venture capitalist and the association be● veen the required rate of return and the cost of effort.
The flrst was bascd on thc modcl by Cossin,Leleux and Saliasi(2002)and the second on thc argumcnt
of Casamatta(2000)that the entrepreneur's effect市 eness on valuc is higher than the venttlre
capitalist's and therefore the cost of effort is lowcr than thc lattcr's.Extcnding Casamatta,this study
assumes a nlrther positive association bet、 veen the costs of effort ofthe parties、 vith their required rate
ofretum from their invcstmcnt.
The most interesting and surprising flnding is that the double moral hazard problem discussed
in acadernia involving venture capital flnancing settings entails opportunistic behaviour that lnakes the
venture capitalist excrt low effort(even thOugh this is not optimal for both parties ifthe share on proflts
ofthe entrcprcneur and the liquidation valuc is not high)but the entrepreneur exert力 igh effort.Furthcr
work can exanline the features of the modcl that are driving this result.Thcsc flndings provide some
guidance on contract negotiations and on the designing of the optilllal contract for both partieso Whcn
negotiating on contract fcatures,it is optimal for the entreprcncur to acccpt a low liquidation valuc(and
high share on proflt)so that it is optimal for the venture capitalist to exert ibll cffort and since the
latter's option valuc is not particularly scnsitive to changes in liquidation valuc. In addition, thc
sensiti宙 サ of the Optimaliサ of fuH effort for the venture capitalist is less sensitive to changes in the
clailn by the entrepreneur as long as the liquidation valuc is kept low.
A mttor drawback ofthe model prcsented in this study is the lilnited application by investors
,even ex‐ post.The entreprencur and the venture capitalist can
due to the difflculty of rnonitoring effol■
use this IInodel as a tool for choosing their optilnal effort level given their belief ofthe level chosen by
the other p的・HOWever, it is difflcult to use this model as a tool for predicting the retum on their
investment.Duc to the difflculサ in monitOring effort and mainly for analメ ic traCtabiliり ,it has been
assumed that effort is constant(namely that the parties choOse one level ofeffort for the wh01e period),
cvcn though this lnay not be rcalistic.
ヽ4oreover, it has been assumed that the liquidation valuc is independent of effort. This
assumptiOn was based on the argumentthatthe liquidation value and thc expectcd(requircd)rcturn can
International Research Journal of Finance and Economics - Issue 9 (2007) 22

be at least partial substitutes as a way of compensating the venture capitalist for her exerted effort.
Therefore, we only consider one of these when calculating a solution for the model in terms of optimal
effort levels. A more complicated version however can include both kinds of compensation
mathematically and determine whether the means by which effort is compensated makes a difference.
Finally, it is important to note that the present model does not account for a common feature
among venture capital investment contracts, namely staged financing. Hsu (2002) models venture
capital investment staging applying a generalised Geske compound-option formula. Such an extension
of the present model would be particularly complex mathematically and for reasons of time and space
it has not been undertaken. Future research could endeavour such an extension or maybe represent
payoffs through backward induction and apply Geske-type formulae to value each period's options
consecutively.

Acknowledgment
The authors are most grateful to Dr Elizabeth Whalley for her helpful contribution in the designing and
suggested solutions of the model proposal in this paper.
23 International Research Journal of Finance and Economics - Issue 9 (2007)

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