This paper provides a new explanation for the use of convertible securities in venture capital. A key property of convertible preferred equity is that it allocates different cash flow rights, depending on whether exit occurs by acquisition or IPO. The paper builds a model with double moral hazard, where both the entrepreneur and the venture capitalist provide value-adding effort. The optimal contract gives the venture capitalist more cash flow rights in acquisitions than IPOs. This explains the use of convertible preferred equity, including automatic conversion at IPO. Contingent control rights are also important for achieving efficient exit decisions.

Some venture capital investors seek purely financial gains while others, such as corporations, also pursue strategic objectives. The paper examines a model where a strategic investor can achieve synergies, but can also face a conflict of interest with the entrepreneur. If the start-up is a complement to the strategic partner, it is optimal to obtain funding from the strategic investor. If the start-up is a mild substitute, the entrepreneur prefers an independent venture capitalist. With a strong substitute, syndication becomes optimal, such that the independent venture capitalist is the active lead investor and the strategic partner a passive co-investor. The expected returns for the entrepreneur are nonmonotonic, lowest for a mild substitute, and higher for a strong substitute as well as for a complement. The paper also explains why a strategic investor often pays a higher valuation than an independent venture capitalist.

This paper develops a theory of how angel and venture capital markets interact. Entrepreneurs first receive angel then venture capital funding. The two investor types are ‘friends’ in that they rely upon each other׳s investments. However, they are also ‘foes,’ because at the later stage the venture capitalists no longer need the angels. Using a costly search model we derive the equilibrium deal flows across the two markets, endogenously deriving market sizes, competitive structures, valuation levels, and exit rates. We also examine the role of legal protection for angel investments.

We analyze the funding of start-up companies across financing rounds, focusing on the dynamic interactions between angel investors and venture capitalists. Using unique data from British Columbia, Canada, we show that angels and venture capitalists are dynamic substitutes. This substitutes pattern applies across the performance range of companies. It is less pronounced for serial angels. An instrumental variable analysis, based on available investor tax credits, suggests that the substitutes pattern is driven by company characteristics. Overall, the evidence points to the existence of parallel streams of angel and venture capital funding, with fewer transitions between streams than is traditionally assumed.