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Startup Contracting and Entrepreneur-Investor Bargaining

Evgeny Kagan, Kyle Hyndman, Anyan Qi

Abstract

To grow their businesses, entrepreneurs often rely on equity funding. This paper focuses on two elements of entrepreneur-investor equity negotiations: the number of potential investors and the contractual complexity surrounding investor protection. Our approach involves a theoretical model and a series of laboratory experiments that analyze the effects of different bargaining conditions and contractual terms on the equity (ownership) split between entrepreneurs and their investors. We show that the conventional wisdom that entrepreneurs should seek to negotiate with as many investors as possible, while consistent with the theoretical model, is not true in the data. Indeed, negotiating with multiple investors reduces the entrepreneur's profits under most conditions. We also show that investor downside protections may disadvantage early-stage startups, but can be beneficial to later-stage startups. A refinement of belief modeling in multi-party bargaining, as well as a stylized risk allocation framework, reconcile these results with theory predictions. Our findings provide a decision framework for entrepreneurs to optimize their approach to investors and negotiate favorable contractual terms.

Startup Contracting and Entrepreneur-Investor Bargaining

Abstract

To grow their businesses, entrepreneurs often rely on equity funding. This paper focuses on two elements of entrepreneur-investor equity negotiations: the number of potential investors and the contractual complexity surrounding investor protection. Our approach involves a theoretical model and a series of laboratory experiments that analyze the effects of different bargaining conditions and contractual terms on the equity (ownership) split between entrepreneurs and their investors. We show that the conventional wisdom that entrepreneurs should seek to negotiate with as many investors as possible, while consistent with the theoretical model, is not true in the data. Indeed, negotiating with multiple investors reduces the entrepreneur's profits under most conditions. We also show that investor downside protections may disadvantage early-stage startups, but can be beneficial to later-stage startups. A refinement of belief modeling in multi-party bargaining, as well as a stylized risk allocation framework, reconcile these results with theory predictions. Our findings provide a decision framework for entrepreneurs to optimize their approach to investors and negotiate favorable contractual terms.
Paper Structure (43 sections, 11 theorems, 61 equations, 4 figures, 11 tables)

This paper contains 43 sections, 11 theorems, 61 equations, 4 figures, 11 tables.

Table of Contents

  1. Introduction
  2. Field Data
  3. Overview of Studies and Results
  4. Contributions
  5. Literature
  6. Finance and Entrepreneurship
  7. Bargaining in Economics and Operations Management
  8. Theory and Experiment Overview
  9. Theory Predictions
  10. Common Stock Contract
  11. Preferred Stock Contract
  12. Experiment Overview
  13. Experimental Design
  14. Experimental Parameters and Theory-Motivated Hypotheses
  15. How Does the Number of Investors Affect Bargaining?
  16. ...and 28 more sections

Key Result

proposition 1

The investor invests $I_0^{SI}= e$. The shares are as follows:

Figures (4)

  • Figure 1: Fairness vs. Negotiation Outcomes
  • Figure :
  • Figure EC1: Negotiation Interface: SI Treatment
  • Figure EC2: Negotiation Interface: TI Treatment

Theorems & Definitions (14)

  • proposition 1: Single investor
  • proposition 2: Two investors
  • corollary 1: Comparison of entrepreneur's share
  • remark 1: Bargaining Power
  • remark 2: Larger Investors
  • proposition 3: Single investor bargaining
  • proposition 4: Two investor bargaining
  • remark 3: Results with Larger Investors
  • proposition EC1: Single investor
  • proposition EC2: Two investors
  • ...and 4 more