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Compensation Schemes and Investment Behavior of Venture Capital Firms(Vol.7 No.2)

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Compensation Schemes and Investment Behavior of Venture Capital Firms(Vol.7 No.2)

Kyoungwon Rhee

Professor, Department of Economics krhee@dongguk.edu

Korean venture capital firms in general possess two different sources of funds for investments; one is their own capital (=internal funds) and the other limited partnership fund raised with outside investors (=external funds). Recent empirical findings by Lee, Kim, and Yoon (2003) tell us that Korean venture capital firms tend to supply external funds to relatively riskier startups. This article provides theoretical predictions about such investment behavior on the part of venture capital firms. In particular, it argues that investment behavior of venture capital firms depends crucially on the compensation contract between the owners and their employees, the venture capitalists who actually manage the investment process. More importantly, it shows that when the invested companies are risky, the owners of venture capital firms set the success fee rate for external capital sufficiently high so as to induce the venture capitalists to use external capital instead of internal funds. This arrangement allows the owners of venture capital firms to transfer the risks associated with investments to outside investors. Furthermore, the article finds that through the compensation contract with its employees, a venture firm will cause the external capital to be invested in riskier companies than would otherwise be the case when the outside investors stipulate clauses to protect their ex post payoff.

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