Explores the financial contracts that can be entered into by the entrepreneur and the inside investor that permit optimal continuation and investment decisions. The inside investor is assumed to be a venture capitalist. The unique contract under examination is termed the fixed-fraction contract. It gives the venture capitalist an equity-like position in the firm. In addition to enlisting the funds of a venture capitalist, the entrepreneur can approach outside investors. Outside investors do not have the same information that inside investors do. The model presented consists of a three-period project. The analysis of the entrepreneur-led financing highlights the information asymmetry that exists in this type of relationship in addition to agency problems related to investment decisions. On the other hand, the fixed-fraction contract involving the venture capitalist induces optimal continuation because the venture capitalist owns a fixed fraction of the project for which he or she provides the capital. Since the venture capitalist payoff is independent of the pricing of later-issued securities, or she he has no reason to misprice these securities. While the benefits of the fixed-fraction contract are shown, consideration must be given to the venture capitalist's cost of monitoring the firm. (SRD)

We derive a role for inside investors, such as venture capitalists, in resolving various agency problems that arise in a multistage financial contracting problem. Absent an inside investor, the choice of securities is unlikely to reveal all private information, and overinvestment may occur. An inside investor, however, always makes optimal investment decisions if and only if he holds a fixed‐fraction contract, where he always receives a fixed fraction of the project's payoff and finances that same fraction of future investments. This contract also eliminates any incentives of the venture capitalist to misprice securities issued in later financing rounds.

The authors develop a model in which a large investor has access to a costly monitoring technology affecting securities' expected payoffs. Allocations of shares are determined through trading among risk-averse investors. Despite the free-rider problem associated with monitoring, risk-sharing considerations lead to equilibria in which monitoring takes place. Under certain conditions, the equilibrium allocation is Pareto efficient and all agents hold the market portfolio of risky assets independent of the specific monitoring technology. Otherwise, distortions in risk sharing may occur and monitoring activities that reduce the expected payoff on the market portfolio may be undertaken.