Cannibalization & Incentives in Venture Financing

Abstract

This paper develops a financial contracting setting to explore the effects of strategic substitutabilities in venture capital financing. Strategic substitutabilities between a VC’s portfolio firms may induce a VC to provide soft entrepreneurial incentive schemes in order to limit cannibalization. At the same time, however, they strengthen the credibility of termination threats imposed on poorly performing ventures. Strategic substitutabilities can thus be employed to incentivize entrepreneurs to perform (and compete) more aggressively. We demonstrate that the latter effect prevails when strategic substitutabilities are neither too small nor too large. We discuss our findings in light of case study evidence from the venture capital industry.