The view that contracting has its limits and that often reputation serves as a disciplining device is well understood and accepted in finance and economics (see Fama, 1980; Crocker and Reynolds, 1993; and Banerjee and Duflo, 2000). Yet, there is relatively little empirical evidence on whether parties which behave opportunistically in a repeated game setting with incomplete contracts (where reputation matters the most) suffer negative reputational consequences, and how big the negative effects are. There are several studies that attempt to measure the reputational loss from changes in product or service quality.
Other studies document a decline in the market value of publicly traded firms resulting from involvement in litigation (Cutler and Sumers, 1988; Karpoff and Lott, 1993; Bhagat, Brickley, and Coles, 1994; and Bizjak and Coles, 1995). In a recent study of Indian business groups, Gopalan, Nanda, and Seru (2007) find that the first bankruptcy in a business group leads to a loss in reputation as evidenced by the drop in the amount of external finance raised, investments and profits, and an increased likelihood of bankruptcy of other healthy members of the group.
Our paper contributes to empirical literature on reputation by investigating whether opportunistic behavior leads to reputational losses in the US venture capital (VC) industry. We choose the VC industry because in our opinion it represents an excellent example of a setting with repeated interaction and incomplete contracts. The repeat players are the VCs and the pool of entrepreneurs. Venture capitalists invest in startup companies and entrepreneurs with limited track records and lack of proven products or technologies. VC investments are thus plagued by uncertainty and information asymmetries.
The pervasive uncertainty and informational asymmetries between the VC and their investors, and between VCs and entrepreneurs, are managed with complex contracts and incentive structures, but contracts set in such an environment are necessarily incomplete (Williamson, 1985). Incomplete contracts could lead to ex post opportunism (Williamson, 1985; Goldberg, 1985; Masten, 1988) and/or ex ante investment distortions (Tirole, 1986; Hart and Moore, 1988).
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The Effect of Litigation on Venture Capitalist Reputation
