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Fairness Norms and Self-Interest in Venture Capital/Entrepreneur Contracting: A Game-Theoretic Model

This paper explores the interplay between fairness norms and self-interest in venture capital (VC) and entrepreneur (E) contracting. Existing models assume narrow self-interest, overlooking the significance of procedural justice and trust. Our behavioral game-theoretic model integrates double-sided moral hazard, where both VCs and Es exert value-adding efforts. We propose a two-stage negotiation process, illustrating how fairness norms influence equity offers and effort levels. The findings reveal insights into optimal equity proposals and venture performance, paving the way for future research into dynamic fairness and trust dynamics.

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Fairness Norms and Self-Interest in Venture Capital/Entrepreneur Contracting: A Game-Theoretic Model

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  1. Fairness Norms and Self-interest in VC/E Contracting: A Behavioral Game-theoretic Approach • Existing VC/E Financial Contracting Models assume narrow self-interest. • Double-sided Agency problems (both E and VC exert Value-adding Effort) (Casamatta JF 2003, Repullo and Suarez 2004, Fairchild JFR 2004). • Procedural Justice Theory: Fairness and Trust important. • No existing behavioral Game theoretic models of VC/E contracting.

  2. My Model: • VC/E Financial Contracting, combining double-sided Moral Hazard (VC and E shirking incentives) and fairness norms. • 2 stages: VC and E negotiate financial contract. • Then both exert value-adding efforts.

  3. How to model fairness? Fairness Norms. • Fair VCs and Es in society. • self-interested VCs and Es in society. • Matching process: one E emerges with a business plan. Approaches one VC at random for finance. • Players cannot observe each other’s type.

  4. Timeline • Date 0: VC makes ultimatum offer of equity stake to E; • Date 1: VC and E exert value-adding effort in running the business • Date 2 Success Probability • => income R. • Failure probability • =>income zero

  5. Expected Value of Project • Represents VCs relative ability (to E).

  6. Fairness Norms • Fair VC makes fair (payoff equalising) equity offer • Self-interested VC makes self-interested ultimatum offer • E observes equity offer. Fair E compares equity offer to social norm. Self-interested E does not, then exerts effort.

  7. Expected Payoffs If VC is fair, by definition,

  8. Solve by backward induction: • If VC is fair; • Since • for both E types. • => • =>

  9. VC is fair; continued. • Given Optimal Effort Levels: Fair VC’s equity proposal (equity norm):

  10. VC is self-interested: • From Equation (1), fair E’s optimal effort;

  11. Self-interested VC’s optimal Equity proposal • Substitute players’ optimal efforts into V= PR, and then into (1) and (2). Then, optimal equity proposal maximises VC’s indirect payoff =>

  12. Examples; • VC has no value-adding ability (dumb money) => • => • r =0 => • r => 1 ,

  13. Example 2 • VC has equal ability to E; => • r =0 => • r => 1 , • We show that as r => 1

  14. Table 1.

  15. Graph

  16. Table of venture performance

  17. Graph of Venture Performance.

  18. Future Research. • Dynamic Fairness Game:ex post opportunism (Utset 2002). • Complementary Efforts. • Trust Games. • Experiments. • Control Rights.

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