We develop a theory and empirical test of how the legal system affects the relationship
between a venture investor and an entrepreneur. The theory uses a double moral
hazard framework to show how optimal contracts and investor actions depend on the
quality of the legal system. The empirical evidence is based on a sample of European
venture capital deals. The main results are that with better legal protection, investors
give more non-contractible support and demand more downside protection, and they
develop more value-adding skills. These predictions are stongly supported by the
empirical analysis. We also find that the investor’s legal system is more important
that of the company in determining these effects, and that legal system effects persist
within civil law countries