A Portfolio Approach to Venture Capital Financing

This paper offers an analysis of the contracting agreement between entrepreneurs and
venture capitalists from the perspective of portfolio allocation. We demonstrate that the opportunity to transfer risk provides a sufficient incentive for a wealth-constrained and risk-averse entrepreneur to engage in the transaction with a venture capital investor. The allocation of investment and cash flow rights is then contingent on the entrepreneur's risk aversion and bargaining power. The portfolio approach also yields a novel partition of venture capitalists, where the entrepreneur's risk aversion is instrumental in the choice of investor type. We validate these predictions in an empirical investigation of 1,315 European venture capital investment rounds that occurred between 2010 and 2019.