COWLES FOUNDATION FOR RESEARCH IN ECONOMICS
AT YALE UNIVERSITY

Box 208281
New Haven, CT 06520-8281

COWLES FOUNDATION DISCUSSION PAPER NO. 1682RR

Venture Capital and Sequential Investments

Dirk Bergemann, Ulrich Hege and Liang Peng

November 2008
Revised October 2009

We present a dynamic model of venture capital financing, described as a sequential investment problem with uncertain outcome. Each venture has a critical, but unknown threshold beyond which it cannot progress. If the threshold is reached before the completion of the project, then the project fails, otherwise it succeeds. The investors decide sequentially about the speed of the investment and the optimal path of staged investments. We derive the dynamically optimal funding policy in response to the arrival of information during the development of the venture. We develop three types of predictions from our theoretical model and test these predictions in a large sample of venture capital investments in the U.S. for the period of 1987-2002.

First, the investment flow starts low if the failure risk is high and accelerates as the projects mature. Second, the investment flow reacts positively to information that arrives while the project is developed. We find that the investment decisions are more sensitive to the information received during the development than to the information held prior to the project launch. Third, investors distribute their investments over more funding rounds if the failure risk is larger.

Keywords: Venture capital, Sequential investment, Stage financing, Intertemporal returns

JEL Classification: D83, D92, G11, G24