We consider the provision of venture capital in a dynamic model with multiple research
stages, where time and investment needed to meet each benchmark are unknown. The
allocation of funds is subject moral hazard. The optimal contract provides for incentive
payments linked to attaining the next benchmark, which must be increasing in the funding
horizon of each stage. Benchmarking reduces agency costs, directly by shortening the
agent's guaranteed funding horizon, and indirectly via an implicit incentive effect of
information rents in future financing rounds.
The ex ante need to provide incentives and the venture capitalist's desire to cut
information rents ex post create a hold-up conflict, which can be overcome by providing
all funds in every stage in a single up-front payment. Empirical patterns of the evolution
of financing rounds and research intensity over the lifetime of a project are explained as
optimal choices: the optimal capital allocated and the funding horizon are increasing from
one stage to the next. This emphasizes the notion that early stages are the riskiest in an
innovative venture.
Keywords: Venture financing, Optimal stopping, Benchmarking, Stage financing,
Abandonment option
JEL Classification: D83, D92, G24, G31
