Venture Capitalists as Benevolents Vultures: The Role of Network Externalities in Financing Choice by Dima Leshchinskii :: SSRN

This paper studies how externalities between projects affect investment decisions and investor involvement with the companies they invest in. Entrepreneurs select investors for their projects, choosing between venture capitalists and individual "angel" investors. In industries with high externalities, venture capitalists can increase social welfare by coordinating their investments into portfolio companies and by intensively monitoring their progress to an endogenously determined higher degree. However, entrepreneurs are indifferent to the total effect of venture capital investment and simply choose venture capital finance only if it increases their project's NPV. When the network externalities are positive, coordinated investment by VCs guarantees profitable investment into some projects that would otherwise have ex-ante negative NPV and fail to attract funding When the network externalities are negative, coordinated investment allows early termination of some projects. Some positive NPV projects may even be sacrificed, to the total benefit of overall value of the VC portfolio. The entrepreneurs know that there is a probability that it is their project that will be terminated, yet they are willing to allow for this eventuality because, if their project continues the payoff will be much higher, than with non-coordinated individual investment.