Adverse selection plays an important role in venture financing. For example, Admati and Pfleiderer (1994) argue that syndication agreements in venture financing may be a response to adverse selection, Dessein (2005) posits that the allocation of control rights is influenced by adverse selection, and Kaplanand Strömberg (2004) assert that agency problems between the entrepreneur and venture capitalist, which are "directly related to asymmetric information," are very important determinants of venture financing contract designs.
While there is considerable support for the view that adverse selection is an important feature of the venture capital contracting environment, there is considerable divergence in opinions regarding the exact nature of this adverse selection. Some argue that entrepreneurs are better informed than venture capitalists (see, e.g., Dessein (2005) and Trester (1998)); others support the diametrically opposite view that venture capitalists have an informational advantage over entrepreneurs (see, e.g., Garmaise (2007)); some even argue that entrepreneurs only have an advantage over a subset of venture capitalists (see, e.g., Admati and Pfleiderer (1994)).
Despite the important role that both informational asymmetries and bargaining power play in venture financing, there is little theoretical analysis to help us understand their joint effects on the design of cash flow rights and project structures; researchers have either focused on explicating the role of bargaining power as the root of cycles and ignored the role of adverse selection in shaping cash flow rights and project structures (see, e.g., Inderst and Mueller (2004), and Michelacci and Suarez (2004)), or they have focused on the role of adverse selection in shaping cash flow rights and ignored the effects of variations in bargaining power (see, e.g., Admatiand Pfleiderer (1994), Trester (1998), Garmaise (2007), and Dessein (2005)).
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Private Information and Bargaining Power in Venture Capital Financing
