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Series/Report no.: 
IEHAS Discussion Papers No. MT-DP - 2002/15
Hungarian Academy of Sciences, Institute of Economics, Budapest
The paper focuses on the financing possibilities for capital constrained entrepreneurs when venture financiers perform two tasks, monitoring and advice. We model advice as effort that results in an increase in the probability of success. In turn, we consider monitoring as an activity exerted to control entrepreneurial project choice, which results in an increase in the returns in the less successful state. Thus entrepreneurs favor advice and dislike monitoring. Through the financial claim offered, an entrepreneur can affect the financier’s effort exertion on the two tasks. The primary result is that highly capital constrained entrepreneurs can get financing only with intense monitoring and limited advice. The optimal financial claim resembles to a convertible debt contract. Entrepreneurs endowed with more self-financing can restrain the level of monitoring, thus induce more advice, and can offer an equity contract. The results may shed light on contracting practices observed in the venture capital industry, namely the unusual negative correlation between control and cash-flow rights and the use of a variety of securities.
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Working Paper

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