TY - JOUR
T1 - Entrepreneurial finance
T2 - Banks versus venture capital
AU - Winton, Andrew
AU - Yerramilli, Vijay
PY - 2008/4/1
Y1 - 2008/4/1
N2 - We analyze how entrepreneurial firms choose between two funding institution: banks, which monitor less intensively and face liquidity demands from their own investors, and venture capitalists, who can monitor more intensively but face a higher cost of capital because of the liquidity constraints that they impose on their own investors. Because the firm's manager prefers continuing the firm over liquidating it and aggressive (risky) continuation strategies over conservative (safe) continuation strategies, the institution must monitor the firm and exercise some control over its decisions. Bank finance takes the form of debt, whereas venture capital finance often resembles convertible debt. Venture capital finance is optimal only when the aggressive continuation strategy is not too profitable, ex ante; the uncertainty associated with the risky continuation strategy (strategic uncertainty) is high; and the firm's cash flow distribution is highly risky and positively skewed, with low probability of success, low liquidation value, and high returns if successful. A decrease in venture capitalists' cost of capital encourages firms to switch from safe strategies and bank finance to riskier strategies and venture capital finance, increasing the average risk of firms in the economy.
AB - We analyze how entrepreneurial firms choose between two funding institution: banks, which monitor less intensively and face liquidity demands from their own investors, and venture capitalists, who can monitor more intensively but face a higher cost of capital because of the liquidity constraints that they impose on their own investors. Because the firm's manager prefers continuing the firm over liquidating it and aggressive (risky) continuation strategies over conservative (safe) continuation strategies, the institution must monitor the firm and exercise some control over its decisions. Bank finance takes the form of debt, whereas venture capital finance often resembles convertible debt. Venture capital finance is optimal only when the aggressive continuation strategy is not too profitable, ex ante; the uncertainty associated with the risky continuation strategy (strategic uncertainty) is high; and the firm's cash flow distribution is highly risky and positively skewed, with low probability of success, low liquidation value, and high returns if successful. A decrease in venture capitalists' cost of capital encourages firms to switch from safe strategies and bank finance to riskier strategies and venture capital finance, increasing the average risk of firms in the economy.
KW - Banks
KW - Entrepreneurial finance
KW - Monitoring
KW - Strategic uncertainty
KW - Venture capital
UR - http://www.scopus.com/inward/record.url?scp=42049102403&partnerID=8YFLogxK
UR - http://www.scopus.com/inward/citedby.url?scp=42049102403&partnerID=8YFLogxK
U2 - 10.1016/j.jfineco.2007.05.004
DO - 10.1016/j.jfineco.2007.05.004
M3 - Article
AN - SCOPUS:42049102403
SN - 0304-405X
VL - 88
SP - 51
EP - 79
JO - Journal of Financial Economics
JF - Journal of Financial Economics
IS - 1
ER -