1 s2.0 S0883902606000814 Main

A theoretical analysis of optimal
financing strategies for different types

of capital-constrained entrepreneurs
Armin Schwienbacher

Universiteit van Amsterdam Business School, Finance Group, Roetersstraat 11,
1018 WB Amsterdam, The Netherlands
Universit catholique de Louvain, IAG - Louvain School of Management, Place des Doyens 1,
1348 Louvain-la-Neuve, Belgium
Received 1 July 2005; received in revised form 1 July 2006; accepted 1 July 2006
Abstract
In this paper, we compare two alternative financing strategies that capital-constrained entrepreneurs
can adopt: they can either wait until they raised enough money to complete their project (the more
conservative strategy) or use limited resources to achieve some intermediate milestone before contacting
large outside investors such as venture capitalists (the more adventurous strategy). We examine how the
choice of financing strategy is affected by entrepreneurial types (life-style, serial and pure profit-
maximizing entrepreneur). We show that specific entrepreneurial characteristics may ultimately affect
the shape of firms as they may pursue different strategies to achieve similar goals. The paper generates a
number of empirical predictions on security design, the interplay between angel and venture capital
finance, and the professionalization of the venture capital market.
2006 Elsevier Inc. All rights reserved.
Keywords: Entrepreneur; Financing strategy; Business angel; Venture capital; Start-up finance
Journal of Business Venturing 22 (2007) 753781
The author gratefully acknowledges comments received from Enrico Perotti, two anonymous referees and
seminar participants at the University of Amsterdam.
Tel.: +32 10 478440.

E-mail address: armin.schwienbacher@uclouvain.be.
0883-9026/$ - see front matter 2006 Elsevier Inc. All rights reserved.
doi:10.1016/j.jbusvent.2006.07.003
1. Executive summary
Before obtaining large amounts of capital from investors, a start-up company very often
first starts with the founder's money. Typically, the resources made available by the founder
are limited. Thus, at a later stage, the company needs to raise larger amounts of capital from
outside investors in order to secure growth.
This article endogenizes the decision on whether to start a firm and which strategy to
use in order to achieve the goals set by the entrepreneur. Within a theoretical framework
of agency theory, we compare two alternative financing strategies that capital-constrained
entrepreneurs can adopt: they can either wait until they have raised enough money to
complete their project (the more conservative wait-and-see strategy) or use their own
savings to achieve some intermediate milestone before contacting outside investors such
as venture capitalists (the more adventurous just-do-it strategy). We show that the latter
is better if the venture is highly profitable, the likelihood of achieving the milestone is
high, the venture capital market is large, and the amount needed to achieve the milestone
is small. When the entrepreneur has not enough savings to adopt the just-do-it strategy,
she will need to raise finance from smaller investors (here, business angels) before
attracting larger investment amounts from venture capitalists. She will do so more often
when the business angel is given senior claims on future cash flows, such as liquidation
preference, (convertible) preferred equity and debt. In this case, the entrepreneur has less
incentive to inefficiently postpone the investment by choosing the wait-and-see strategy
than under common equity finance. This is because common equity gives liquidation
value to the entrepreneur up to the fraction of her shareholding. With junior claims, the
entrepreneur's liquidation value under this strategy is reduced. Then, she pursues her
project without delay.
We further examine how the choice of financing strategy (wait-and-see versus just-do-it)
is affected by entrepreneurial types. Relative to a serial entrepreneur and a pure profit-
maximizing entrepreneur, a life-style entrepreneur is more likely to choose the more
adventurous strategy over the wait-and-see strategy. The outcome of a serial entrepreneur
relative to a pure profit-maximizing entrepreneur depends on the parameter values
assumed. While some wait until they control the essential resources, others prefer to go
ahead and in turn postpone the acquisition of outside resources so as to better capture
maximum gains (but at higher risk).
The analysis generates a number of new empirical predictions for security design, the
interplay between angel and venture capital finance, the professionalization of the venture
capital market, and the entry and exit of entrepreneurial firms.
2. Introduction
The creation of firms with innovative products and services has been identified as a
key driver for wealth creation and economic growth. Many of these new firms start
with their own resources before contacting outside investors such as banks and private
equity investors (Bhid, 1999; Baeyens and Manigart, 2005; Cosh et al., 2005).
However, we still know very little about what drives individuals to become an
entrepreneur and the strategies they adopt to achieve their goals. In addition, it has
754 A. Schwienbacher / Journal of Business Venturing 22 (2007) 753781
become clear that economic theory needs to adopt a more differentiated view of what
an entrepreneur is, in order to better understand the strategic choices of entrepreneurs.
There is not one type of entrepreneur populating the economy, but many (see Section 3
for references).
This article contributes to the emerging discussion regarding the need for distinct
theoretical developments in the field of entrepreneurial finance (for a discussion on this
issue, see, e.g., Phan, 2004; Dew et al., 2004; Alvarez and Barney, 2004). It builds on the
tradition of constructing theories in entrepreneurial finance by including several
entrepreneurial types into the more standard decision-making on financing. Among other
things, this article recognizes the fact that different types of entrepreneurs may coexist (as
evidenced by the large number of studies, such as Woo et al., 1991; Miner et al., 1992;
Wright et al., 1997; Westhead and Wright, 1998; Westhead et al., 2005), and shows howthey
may take different strategic and financial decisions in given situations. We specifically focus
on the need for securing seed capital fromventure capitalists for starting a newcompany. For
instance, a life-style entrepreneur may be very interested in keeping control of the venture
after early investors (business angels, venture capitalists) have exited. This contrasts with a
serial entrepreneur, who aims at renewing past successes by starting new companies, and
therefore is less concerned about control over the companies she currently nurtures. This
may ultimately affect the shape of firms, as they may pursue different strategies to achieve
similar goals.
In this article, we consider an entrepreneur who has some savings to start her project, but
not enough to complete it. From the entrepreneur's perspective, a trade-off arises: she can
either use her own money to achieve a certain milestone before raising additional funds (the
adventurous just-do-it strategy), or she can wait until she finds a large investor (here, a
venture capitalist) before even starting the project (the more conservative wait-and-see
strategy). When choosing the just-do-it strategy, she needs to invest her own savings up
front, but potentially secures better terms from venture capitalists if she successfully
achieves the milestone. Under the wait-and-see strategy, the entrepreneur will not lose her
savings in the case of failure, but will obtain poorer terms if she finds an interested venture
capitalist. The choice between these two strategies can be seen as the entrepreneur's choice
as to which type of uncertainty to resolve first: the technological or financial uncertainty of
the venture's start-up phase. The trade-off stems from the so-called equity gap, because
venture capitalists only invest in larger projects. Venture capitalists specialize in financing
larger amounts, and thus find business plans with relatively small, initial capital amounts
unattractive. This makes it difficult for entrepreneurs to secure venture capital finance in the
start-up stage, since they do not attract the attention of venture capitalists when sending out
their business plan.
An important reason for the presence of an equity gap is the fund size of venture capitalists
(see Cressy, 2002, for a more detailed discussion). Since they manage large funds, venture
capitalists need to invest in larger projects if they want to monitor them efficiently. In addition,
the fixed costs of project screening and monitoring make it uneconomical for venture
capitalists to make small investments (Van Osnabrugge and Robinson, 2000). Below a certain
threshold, venture capitalists rarely participate in deals. As pointed out by Bhid (1999),
venture capitalists are hesitant to pursue small opportunities where even high-percentage
returns will not cover their investment overhead. Part of this equity gap is filled by business
angels.
1
In addition, some entrepreneurs may have savings that reduce their need for outside
finance at the very beginning.
At the same time, entrepreneurs differ widely in several aspects. A large number of
entrepreneurs can be categorized into two types, the serial entrepreneur and the life-
style entrepreneur. While the first type aims to achieve one success story after the other
(and thus sells the newly created venture once its success becomes apparent), the latter
prefers to successfully start a single business and subsequently run it on her own. She is
therefore more concerned about the degree of independence vis-a-vis outside investors,
since this affects her likelihood of remaining in the firm. From a theoretical perspective,
very little is known about the difference between a serial and a life-style entrepreneur, and
whether this difference affects the choice of financing strategy remains an unexplored issue.
In our analysis, we introduce these two entrepreneurial types and compare their choice of
financing strategy with a pure profit-maximizing entrepreneur. In the case of a serial
entrepreneur, we model this by assuming that besides monetary gains, she obtains non-
monetary personal benefits (e.g., from glamour) each time she succeeds in setting up a new
profitable venture. As for the life-style entrepreneur, we assume that she aims to minimize
the claims issued to outside investors (i.e., her dependence on external finance).
This article therefore focuses on the very first steps of any entrepreneurial firm, namely
when the assets required still need to be assembled. We address the following research
questions: What is the optimal strategy for entrepreneurial firms to successfully raise
outside finance? Alternatively: what is the optimal timing for opening the firm to outside
investors? When an entrepreneur wealthless, does it deter her from choosing the more
adventurous just-do-it strategy? Which type of entrepreneur will first go to a business angel
before approaching venture capitalists, and which goes directly to venture capitalists? What
is the optimal contract? What are the possible sources of conflict between entrepreneurs and
business angels? How do different types of entrepreneurs (serial versus life-style
entrepreneur) affect this decision?
The analysis provides a number of key results. We show that the adventurous just-do-it
strategy is better if the venture is highly profitable, the likelihood of achieving the milestone
is high, the venture capital market is large, and the amount needed to achieve the milestone
is small. Relative to a serial entrepreneur and a pure profit-maximizing entrepreneur, a life-
style entrepreneur is more likely to choose the more adventurous strategy over the wait-and-
see strategy. The outcome for a serial entrepreneur relative to a pure profit-maximizing
entrepreneur depends on the parameter values assumed.
We also provide interesting results in terms of when the entrepreneur has to raise funds for
the very initial capital (e.g., because she does not have any savings to start the just-do-it
strategy). In this case, she will need to raise angel finance if she wants to adopt the just-do-it
strategy prior to contacting venture capitalists. Business angels traditionally fill part of the
equity gap, but only invest small amounts compared to venture capitalists. We show that
when a business angel obtains common equity, he potentially faces an agency problem.
1
In Europe (Source: EBAN), the number of active angel investors is estimated to be around 125,000, with
investment pools of available angel finance at EUR 1020 billion (extrapolations). In the US (Freear et al., 1994),
there are approximately 250,000 business angels investing in around 250,000 companies each year (a total of US
$1020 billion). In terms of the number of investments, this is much greater than the venture capital market.
While the business angel always wants the entrepreneur to choose the just-do-it strategy,
the entrepreneur may instead favor the alternative strategy. Issuing common equity to the
business angel gives the entrepreneur claims proportional to her equity stake in the case of
an unsuccessful wait-and-see strategy. This conflict can be mitigated by giving a
liquidation preference to the business angel. In this case, the entrepreneur does not expect
any gains under the wait-and-see strategy in the case of failure. Then, there are no longer
any gains from waiting. Such liquidation provisions are usually included in the share
purchase agreement of convertible preferred equity. This is a new possible explanation for
the widespread use of convertible preferred equity in entrepreneurial firms, especially at
the very early stage compared to later stage investments (see, e.g., Trester, 1998, for
empirical evidence). We also show that issuing senior claims to investors (e.g., preferred
equity or common debt) helps to solve the problem of inefficient strategy choice. In
equilibrium, the entrepreneur will therefore raise angel finance more often when the
business angel is given a liquidation preference or seniority rights, as the first-best
financing strategy can then be achieved.
More generically, the analysis shows that a liquidation preference (such as that typically
attached to convertible preferred equity) or senior claims should be given to early investors if
the entrepreneur has an option to postpone her investment. This has direct analogy to issues
in real options, since in the trade-off examined here the wait-and-see strategy corresponds to
an option to wait (along the lines of Mayers, 1998; Myers, 2000; Cosh et al., 2005). Under
common equity finance, she may inefficiently decide to wait instead of starting the project
immediately after investors have committed their funds. The analysis generates a number of
empirical predictions for security design, the interplay between angel and venture capital
finance, the creation of new firms, and the professionalization of the venture capital market.
This article is structured as follows. In the next section, we discuss the related literature.
In Section 4, the model is presented. Section 5 provides an analysis in the case where the
entrepreneur has enough savings to finance the milestone investment. In Section 6, we then
present a security design analysis in the event that the entrepreneur needs to raise angel
finance to pursue the milestone. The professionalization of the venture capital market is
considered in Section 7. Empirical implications are presented in Section 8. Lastly, we
conclude by discussing possible extensions for future research.
3. Literature
This research builds on several strands of the literature. First, a number of papers have
discussed the importance of early-stage investors such as business angels and venture
capitalists in the critical phase of start-up finance (e.g., Sapienza et al., 1996; Fenn et al.,
1998; Baeyens and Manigart, 2003; Cassar, 2004; Audretsch and Keilbach, 2005;
Audretsch and Thurik, 2004). Chemmanur and Chen (2002) provide a theoretical analysis
of the choice between business angels and venture capitalists. In their model, business
angels are considered as passive investors, while venture capital is considered as providing
added value to investees. Leshchinskii (2003) studies the increased benefits for venture
capitalists of using synergies between portfolio companies, given that they manage a large
portfolio of companies compared to business angels. Prowse (1998) provides an extensive
empirical analysis of angel investments. Other analyses of the angel market are provided by
Freear et al. (1994), Lerner (1998), Wong (2002). Moreover, Gompers and Lerner (1999)
provide an extensive study of venture capital finance.
From a more general perspective, other studies have focused on the decision of
individuals to become an entrepreneur. Lazear (2002) provides a general framework for
the analysis of this choice. Hellmann (2002) examines the entrepreneurial process of
obtaining resources and thereby identifies several strategies. Gromb and Scharfstein
(2002) compare entrepreneurship with intrapreneurship. Landier (2002) studies the effect
of the stigma of failure on entrepreneurial incentives. Finally, Kanniainen and
Keuschnigg (2003, 2004), Cumming (2005b) investigate the impact of taxation on
entrepreneurial incentives and the investment behavior of venture capitalists. All these
articles focus on a single type of entrepreneur, namely the pure profit-maximizing type
(some include personal benefits of control for the entrepreneur). Within this strand, our
study is most closely related to the work by Berglund and Johansson (1999), but they
focus on other aspects of our trade-off. An adverse selection approach is required to
analyze the decision of entrepreneurs to time when to approach a venture capitalist. The
authors show that entrepreneurs with the most valuable projects approach venture
capitalists later as a way of signaling the quality of their projects. Our article takes
another approach by analyzing a moral hazard rationale under angel finance. Moreover,
we contribute to this strand of the literature by evidencing links between the choice of
financing strategies and several entrepreneurial types.
Another strand of the literature focuses on contracting and the optimality of convertible
securities in entrepreneurial firms (for theoretical discussions, see, e.g., Berglf, 1994;
Bergemann and Hege, 1998; Hellmann, 2000a,b; Bascha and Walz, 2001; Casamatta, 2003;
Cornelli and Yosha, 2003; Schmidt, 2003). These papers show that optimal security design
is a response to agency problems, and that convertibles provide a solution to many of these
problems. An alternative explanation, suggested by Gilson and Schizer (2002), is the tax
advantages obtained by entrepreneurs in the US. Empirical evidence for the use of
convertibles around the world is provided by Trester (1998), Kaplan and Strmberg (2003),
Cumming (2005a,b), Bascha and Walz (2002), Schwienbacher (2003). They show that
convertibles are widely used in the US, but much less elsewhere. Wong (2002) shows that
such securities are also less common in business angel finance; however, the use of
preferred securities is very common (as well as common equity). As we will see, a solution
to the problem examined in this article is also the issuance of preferred shares, debt or
convertibles. They all give higher priority to investors.
Finally, our paper builds on studies evidencing the existence of several types of
entrepreneurs (see, among many others, Woo et al., 1991; Miner et al., 1992; Wright
et al., 1997; Westhead and Wright, 1998; Burke et al., 2003; Westhead et al., 2005).
Important types are life-style and serial entrepreneurs, novice and portfolio entrepre-
neurs, craftsman and opportunistic entrepreneurs, and the inventor-entrepreneur, as well
as an entrepreneur who mixes self-employment with waged work. This large variety
arises from the fact that the literature considers not only the financial aspects of
entrepreneurship, but also other issues such as social and educational aspects. None of
these studies have examined how different types of entrepreneurs may adopt different
strategies in pursuing similar goals, which is the objective of this paper. Here, we focus
on two specific types of entrepreneur: the life-style and the serial entrepreneur. When
only considering financial aspects (which is what we do here), the other types can
sometimes be viewed as variations of these two forms (e.g., portfolio entrepreneurs and
opportunistic entrepreneurs share some similarities with serial entrepreneurs, while
craftsman entrepreneurs and inventor entrepreneurs resemble life-style entrepreneurs).
So far, little has been done to incorporate various entrepreneurial types into theoretical
analyses. This paper contributes to filling this gap.
4. The model
4.1. Investment opportunity and capital requirements
For the sake of simplicity, all parties (entrepreneurs and investors) are assumed to be
risk-neutral. We consider an entrepreneur (E) who has an investment opportunity that is
worth VN0 if successfully completed before a pre-determined time TN0.
2
We can
interpret the parameter T as the time at which the option to invest in this project loses its
value (e.g., because at that time others may start the same project). We further suppose that
the entrepreneur has some savings up to the amount kN0 to start the project, but actually
needs a total of KNk to complete it. Once the full amount K is injected into the firm, the
project is certain of success. The initial amount k is just enough to possibly realize some
intermediate milestone, but not to fully complete the project. We may think of a project that
initially requires a small amount to start, but eventually needs a second, significantly larger
round of financing.
4.2. Venture capitalists and business angels
We consider two types of investors: venture capitalists (VCs) and business angels (BAs).
What distinguishes them is the amount of funding they provide to entrepreneurs. VCs only
invest larger amounts, such as K, given that they manage larger funds and thus seek to
invest in larger projects. They are therefore less interested in the kind of firms that require k
in the initial stage. On the other hand, we suppose BAs only invest small amounts of
approximately the size our entrepreneur requires to achieve her intermediate milestone.
This distinction between VCs and BAs is in line with the notion that business angels
partially fill the equity gap. For the sake of simplicity, suppose that there is a perfectly
competitive angel market and that the BA's reservation payoff is zero.
3
In the basic setting
(Section 5), business angels are irrelevant, since the entrepreneur has savings k. However,
they become essential in Section 6.
In the spirit of Hellmann (2002), we assume that the entrepreneur needs to attract the
attention of investors before having her project screened by them. While this is not a
problem when raising k from business angels, the entrepreneur faces a lack of interest in her
project from venture capitalists if the intermediate milestone has not been achieved yet. She
2
While V is considered constant and deterministic, we could also assume it to be stochastic with mean equal to
V. Given the assumption of risk-neutrality, the outcome would be exactly the same. Under risk-aversion, the
modeling would require some changes. However, the main intuitions would still hold.
3
Alternatively, suppose that there is a probability that the entrepreneur knows or has access to many business
angels. Here, we normalize this probability to 1 (but our results would also hold if it were less than 1).
therefore needs to convince them first. We motivate this by assuming that VCs prefer larger
investments, given the size of their managed funds and the limited number of companies
they can assist.
4
We consider a venture capital market that is not perfectly competitive, and
that is also subject to demand from projects with much larger capital needs. Finding an
interested VC before the expiration of the investment option is therefore uncertain. More
details on the probability distribution are provided in the next subsection.
4.3. Choice of financing strategy
The entrepreneur has two alternative strategies she can adopt:
1. The wait-and-see strategy (S1): The E can wait and see if she can find an interested
venture capitalist before spending much time and effort on the project. If she cannot find
a venture capitalist before time T, the project is no longer of any value to her. However,
if she finds a venture capitalist, her bargaining power is a function of the time remaining
before the option is lost (the idea is that an entrepreneur who is time-constrained has less
bargaining power than one who can wait another year or so before starting the project
the latter can then look around for additional investors in order to increase her
bargaining power).
2. The just-do-it strategy (S2): she can invest the amount k now in order to start the project,
knowing that this is not enough to complete it. However, it allows the entrepreneur to
accomplish (with some probability) a milestone that will make the project worthwhile
for large outside investors. If successful, VCs will compete for the project (since now
they all find the project sufficiently large) so that the entrepreneur will have all the
bargaining power vis-a-vis venture capitalists).
For simplicity, both strategies are assumed to be mutually exclusive, and the entrepreneur
only needs to inject the amount k into the firm if she chooses S2.
5
Moreover, once the E has
chosen a strategy, she can no longer change it. Under S2, the liquidation value is 0 if the E
has not raised the remaining amount of money required before time T. Another simplifying
assumption is that all venture capitalists in the market have enough funds to finance any
other valuable project they can find, so that there is no competition among entrepreneurs for
venture capital funding once a match is made. We also assume that both strategies are
profitable for the E at time t =0. The VC participation constraint must also be satisfied,
which we assume to be the case even at time 0 (to avoid an additional constraint). Lastly, as in
Myers (2000) and many other studies, we assume that the financing strategy of the E at time
t =0 is a non-contractible variable (and thus also the investment k). If both parties were able
to contract on it, the first-best outcome would always be achieved. This assumption is
irrelevant in the basic setting (Section 5), but is important in Section 6. This implies that the
costs k are at the discretion of the entrepreneur (e.g., she may be able to decide on the
4
In principle, the model allows for a broader interpretation. The amount k may come from a small VC, so
that K must be raised by a larger VC or a syndicate of VCs. Alternatively, it may come from friends and family
if k is particularly small.
5
The alternative setting in which this is also required under S1 to keep the option alive yields qualitatively
similar results.
company's burn rate) and hence a BAcannot force the E to undertake S2 (however, he can,
of course, force S1 by delaying the supply of capital k to the entrepreneur).
6
More specifically, regarding financing strategies, suppose the wait-and-see strategy
gives an instantaneous probability of N0 (constant hazard rate) for finding one investor.
7
The bargaining process is such that VC makes a take-it-or-leave-it offer to the entrepreneur.
The entrepreneur's expected bargaining power is denoted by
1
(T) and her probability of
finding an investor by w(T). This limited bargaining power stems from the fact that VCs are
ex post differentiated (although symmetric as long as no match is found).
As for the just-do-it strategy, suppose this strategy gives a constant hazard rate of N0 if
the amount k is invested at t =0 and this amount is then sunk. In this case, the entrepreneur's
bargaining power and the probability of achieving the intermediate milestone is denoted by
2
and p(T), respectively. Given the assumptions made,
2
=1 and p(T) =T. Let us only
consider cases for which p(T) b1, given that the E starts the project with limited resources.
This can also be motivated by the fact that the entrepreneur still needs to spend some time
and effort in raising funds, while at the same time working on her project. We further
assume that relative to the previous strategy, the entrepreneur needs to exert more effort
under the just-do-it strategy. Effort cost is denoted by cN0, while for S1 it is normalized to
zero.
8
Table 1 presents an overview of all the variables used throughout the article.
4.4. Entrepreneurial types
In the tradition of the entrepreneurial typology described in Section 3, we distinguish
between three different types of entrepreneur: the profit-maximizing entrepreneur (PME),
the life-style entrepreneur (LSE) and the serial entrepreneur (SE). The first type only
cares about expected profits, and we use this type in the analysis as a benchmark. The more
interesting types are the two others.
9
Let us define a life-style entrepreneur as one who aims to build her own company and
run it on her own in the future. In addition to maximizing her expected payoff, such an
entrepreneur may also decide to maximize her independence vis-a-vis outside investors
(as for European entrepreneurs, who put greater emphasis on retaining control than US
entrepreneurs; see Landier, 2002, for a related discussion). In the spirit of Vinturella and
Erickson (2004), for these businesses [life-style businesses], a good living and
independence is the goal and driving force behind the business. There is no plan to take
the business public or sell it to a larger company [] nor to grow the business faster than the
internal resources will allow. We model this by supposing that an independence-
7
While we assume constant hazard rates, our analysis allows for time-varying rates. This is because we only
concentrate on cumulative distributions.
8
The existence of the effort cost. is not essential in our analysis, as it does not drive our results.
9
In practice, we may think of SEs as being more professional than LSEs, given their accumulated experience (see,
e.g., Westhead and Wright, 1998; Westhead et al., 2005). Although we do not include this difference here (we believe
that this is not central to the issues studied in this paper), our framework allows this to be carried out very easily. For
instance, we can assume that firm value is greater from an SE (V
SE
) than an LSE (V
LSE
), i.e. V
SE
V
LSE
N 0, that this
difference increases with the SE's experience.
6
In reality, such discretion is limited, so that the E can only control a fraction of the costs. Here, we assume full
discretion purely for the sake of simplicity. However, the trade-off examined in this article would still arise as long
as a strictly positive fraction of the costs is at the discretion of the E.
maximizing entrepreneur will aim at maximizing expected bargaining power (i.e., ) to
avoid having to issue too large a fraction of the claims (equity and debt combined) to
outsiders. This is equivalent to maximizing the entrepreneur's fraction of free cash flow.
A serial entrepreneur is one who intends to move on to build up a new company once
the previous one is successfully completed. In line with Vinturella and Erickson (2004) on
this type, once the start-up reaches some sort of equilibrium or steady state, the thrill is
gone for many entrepreneurs and the next start-up beckons them to a fresh challenge. []
Many successful entrepreneurs insist that they are not motivated by the money, but by the
challenge. We may interpret this by saying that the entrepreneur obtains some personal
benefits (e.g., through fame) when successfully setting up a company, but no other personal
benefits thereafter. Such an entrepreneur prefers a financing strategy that is most likely to
lead to a successful ending. A pure SE therefore only cares about the relative probabilities
between the two strategies. If w(T) Np(T), she will prefer S1 and otherwise, S2. This
definition of a serial entrepreneur is broadly consistent with Wright et al. (1997), Westhead
and Wright (1998), Westhead et al. (2005).
Note that the literature on entrepreneurship has identified a much richer set of
entrepreneurial types, evidencing many more traits to describe different entrepreneurs.
These include education, blue-collar versus white-collar, social awareness and adaptability
(Woo et al., 1991; Miner et al., 1992; Burke et al., 2003). Froma financial perspective however,
the main differences between many of these types can be brought down to the two types
described above (for instance, Woo et al., 1991 define their craftsman type as someone aiming
to making a comfortable living, and their opportunist type as profit-oriented, which is close
to the types defined here). Unfortunately, there is little evidence on the relative importance of
the different types, and studies are difficult to compare, as they examine different categories of
types. However, overall the studies support the fact that the types considered in this article are
important (see, e.g., Westhead and Wright, 1998; Westhead et al., 2005).
5. Optimal financing choices for start-ups
Before examining the implications of the model for the choice of financing strategy and
creation of entrepreneurial firms, let us first derive the expected profits for each financing
strategy. Under S1, the entrepreneur's expected payoff is:
10
P
e
1
wTq
1
TVK: 1
10
The more complete equation is:
_
T
0
f xd
_
T
t
f xds
_ _
d VK
_ _
dt:
For f(x) = this gives:
_ _
T
0
f xd dTtd VKdt dT
1
2
dT
_ _
VK:
Thus, w(T ) =T and
1
(T ) =1/2 T. If the E were to inject her own savings under S1, it should be
1
e
=w(T )
[
1
(T )[V(Kk)] k].Note, however, that she has no incentive to do so, since
1
(T )[V(Kk)] kb
1
(T )
[VK] whenever
1
(T ) b1 (which is the case here). Intuitively, this is because the entrepreneur has to share
rents with the venture capitalist according to her bargaining power (i.e.,
1
). As long as
1
b1, she cannot
recover all the funds k injected.
Conditional on a match (which occurs with probability w(T)), the level of profits
1
(T)
[VK] corresponds to the level for which she is indifferent between obtaining financing
from the VC and waiting in the hope of finding a second VC before the option expires. If
she finds a second interested VC, both investors will compete for the project and thus drive
down their own expected return to zero. In other words, since the expected probability of
finding another investor is
1
(T), we obtain the following expression:
1
(T)[VK] +(1
1
(T))[0]. This exactly gives the level of profits used in Eq. (1).
11
As for the just-do-it strategy (S2), the entrepreneur's expected payoff is given by:
P
e
2
pTVKkkc: 2
Here, the entrepreneur needs to incur k and c up-front. The first term represents the
expected profits (gross of costs) accruing to her under this strategy. With probability p(T),
she attracts venture capital for the remaining amount (Kk). Given the allocation of
bargaining power, the entrepreneur obtains [V(Kk)].
5.1. The first-best
As the first-best outcome, we consider an entrepreneur who only aims to maximize
monetary payoffs for the venture. In our basic setting described in Section 4, the profit-
maximizing entrepreneur therefore always makes the first-best choice.
Lemma 1. (First-best) The first-best financing strategy is the just-do-it strategy (S2)
whenever
pTVKkkc zwTq
1
TVK: 3
This condition can be re-written as follows:
pTzwTq
1
T
VK
VKk

k c
VKk
: 4
Eq. (4) gives the threshold value of p(T) that induces the entrepreneur to choose S2.
Alternatively, the threshold (border) line for venture profits is:
VzK k
1pT
pTwTq
1
T
_ _

c
pTwTq
1
T
: 5
Note that achieving the first-best requires that p(T) Nw(T)
1
(T).
12
Eq. (5) states that
the most profitable projects (i.e., high V) are started by entrepreneurs under the S2 strategy.
11
There is a direct link between the shareholding of the E and the parameter . If we denote the fraction of
shares retained by the entrepreneur by, we obtain the following simple identity: V=[VK]. This leads to the
following relationship: a q 1
K
V
_
.
12
To see this, we simply need to re-write Eq. (3) as: (pw
1
)[VK] c+(1p)k. Since the right-hand side is
strictly positive, we require that (pw
1
) N0.
This is because an increase in profitability has a greater impact on S2 than S1.
13
In terms of
the probability of finding a venture capitalist, the threshold value is:
w V
pVKkck
qVK
: 6
The duration T ambiguously affects the trade-off. On the one hand, it improves the
bargaining power of the entrepreneur (
1
(T)) and her probability of resolving the venture's
financial uncertainty (w(T)) under S1. On the other hand, it leaves more time to possibly
achieve the required milestone (probability p(T)).
5.2. Choice of financing strategy and entrepreneurial type
In this subsection, we examine the effect of entrepreneurial type on the choice of
financing strategy and compare it with the first-best choice.
Let us start with the optimal financing strategy of a life-style entrepreneur. In general
terms, the objective function of an LSE is to maximize a linear combination of both goals;
i.e., achieving the highest expected monetary gains as the PME and maximizing
independence. Let us denote the weight put on the first objective by Thus, the LSE's
objective function is given by:
bbprofit maximizingQ 1bbindependence maximizingQ: 7
The profit-maximizing function is expected to be the same as in the previous subsection,
while the second function is specific to the LSE. For simplification, we consider the
extreme case of =0. A PME is the other extreme, since then =1. We impose this
simplification throughout the paper, since it does not fundamentally change our results (it
only makes them more extreme, so that the presentation of results becomes clearer).
An entrepreneur who wants to maximize her expected shareholding will prefer S2 over
S1 iff
14
pTq
2
VKk
V
_ _
zwTq
1
T
VK
V
_ _
8
or
pTzwTq
1
T
VK
VKk
: 9
In terms of V, we obtain:
V zKk
pT
pTwTq
1
T
_ _
: 10
13
As mentioned by Bhid (1999), it is sometimes better for entrepreneurs to commence start-ups on their own,
as outside investors can hinder entrepreneurs from following the try-it, fix-it approach required in the uncertain
environment in which start-ups flourish.
14
This means that the independence-maximizing function is: max wTq
1
T
VK
V
_
; pTq
2
VKk
V
_ _ _ _
:
This can easily be compared to the first-best case [Eq. (5)]. The threshold level of V is
clearly lower for an LSE. This is because an LSE does not incorporate costs unrelated to her
independence, such as k and c. Both are sunk costs when the E bargains with an
interested VC for her level of independence, since they were already incurred at time t =0.
Let us now derive the optimal financing strategy for a serial entrepreneur. If
pTzwT; 11
such an entrepreneur will prefer S2, and S1 otherwise.
15
Lemma 2 summarizes the comparison of the three types of entrepreneur. This shows that
the entrepreneurial type can have a substantial effect on financing choices.
Lemma 2. (Comparison of entrepreneurial types) Relative to a life-style entrepreneur, a
serial entrepreneur and a PME will more often prefer S1 over S2. The outcome for an SE
relative to a PME depends on the parameter values. For the most profitable ventures, an SE
chooses S1 more often than a PME does.
The first sentence states that the LSE is the least likely to choose S1. The second sentence
states that compared to the first-best option (PME), the SE will more often prefer S1 if
pTNwTq
1
T
VK
VKk

k c
VKk
12
or
1q
1
TwTVK1wTkNc: 13
The first term is what the VC obtains under S1 if there is a match (this is a cost for the E
due to her expected loss in bargaining power). The second term represents the reduction in
costs under S1, since k is not lost with probability (1w(T)). The right-hand side is the
additional cost under S2. It is straightforward to see that this is more likely when V is large
[primarily because personal costs, k+c, become less important; see Eq. (12)]. The results of
Lemma 2 are well depicted in Figs. 1 and 2. Fig. 1 shows the ratio p/was a function of the firm
value (V). Note that this ratio gives the ratio of the two uncertainties the entrepreneur needs to
solve. Fig. 2 shows each probability on a separate axis, while keeping V constant. For each
type of entrepreneur, S2 is chosen when above the respective line. This shows that S2 is most
likely for the LSE. The intuition is that an LSE cares about her own independence, as well as
profits. Such an entrepreneurial type may more often prefer to go ahead if the option
minimizes dilution of her own stake. She will then open the company to outside investors as
late as possible, which requires working with her own resources until they are exhausted.
5.3. Creation and exit of entrepreneurial firms
Our analysis has implications for the creation and death of entrepreneurial firms. Note
that here this is endogenously derived, as it is the result of financing choices. Moreover, the
15
As for the LSE, a more complete setting for the SE is as Eq. (7). Here again, we impose the simplifying
assumption that =0.
model has predictive power to explain why some firms are started quickly (by choosing S2)
while others are delayed (S1). Under S1, firm creation is delayed and only happens with
probability w(T). Under S2, the creation of the firm is certain and is carried out right at the
beginning. This of course contrasts with the probability of creating a successful venture,
which equals w(T) under S1, and p(T) under S2. Obviously, both financing strategies also
differ with respect to the exit of entrepreneurial firms.
Overall, the more conservative wait-and-see strategy is associated with less
entrepreneurial activity, as it generates a lower level of firm creation, but also fewer
Fig. 1. Venture profits and choice of financing strategy. The graph plots Von the x-axis and the ratio p(T )/w(T ) on
the y-axis. The straight thin line is for an LSE, the bold line for a PME, and the dotted line for an SE. In each case,
S2 is preferred to S1 for all parameter values above the given line. The following numerical values are used: k=0.1,
K=0.5, T=1, =0.5, =0.5, c=0.25.
Fig. 2. Financing probability, technological risk, and choice of financing strategy. The graph plots w(T ) on the
x-axis and p(T ) on the y-axis. The straight thin line is for an LSE, the bold line for a PME, and the dotted
line for an SE. In each case, S2 is preferred to S1 for all parameter values above the given line. The same
parameter values as in Fig. 1 are used.
deaths.
16
On the other hand, the just-do-it strategy generates a greater turnover of firms,
since these are created up-front knowing that there is a chance of early exit for many of
them. In times of highly profitable investment opportunities (e.g., in times of important
technological breakthroughs, such as for many IT technologies in the late 1990s), we expect
an increase in entrepreneurial firm creations and exits.
Given that different entrepreneurial types have different propensities for choosing one or
other financing strategy, the likelihood of firm creation and exit will also differ as a function
of this parameter. On average, SEs are most likely to create successful ventures, as they
choose the financing strategy that most likely leads to success (regardless of value
considerations). Given that LSEs more often favor S2, they are more likely to generate a
high turnover of entrepreneurial firms in the economy.
6. Initial angel finance
In this section, we examine what happens when the entrepreneur has no savings and thus
needs to raise outside finance even for the amount k in order to follow the just-do-it
strategy. If she does not raise this money, she is forced to choose S1. We address in this
section the possibility that the entrepreneur can raise the initial amount k from business
angels, as described in Section 4.2.
The analysis provided in this section allows the following research questions to be
answered: when an entrepreneur is completely wealthless, does this deter her from choosing
the more adventurous S2 strategy? Which entrepreneurs will first go to a BA before
approaching VCs, and which ones bypass BAs to go directly to VCs? What is the optimal
contract that still leads to the first-best choice of strategy? If the first-best outcome cannot
be achieved, are entrepreneurs more likely to choose S1 or S2? Compared to a PME, how
does this additional financing constraint affect the choice of strategy by LSEs and SEs?
The first-best benchmark remains the pure-profit maximizing entrepreneur, with the
strategy choice given by Lemma 1. The reason why this is still the first-best option is that
the entrepreneur is not forced to raise angel finance under S1, so that her outside option
remains the same. In fact, her outside option is to choose S1 without raising the smaller
amount k; this gives her an expected value of w(T)
1
(T)[VK], which we denote by
e
.
This is identical to the right-hand side of the first-best condition stated in Lemma 1 and
leads to joint profit maximization.
Given this outside option, two conditions need to be satisfied in order to achieve the
first-best option as stated in Lemma 1 (which states that S2 is optimal):
P
e
2
z

P
e
14
and
P
e
2
zP
e
1
; 15
in addition to the entrepreneur's and business angel's participation constraints. Obviously,
under angel finance
1
e
and
2
e
may differ from Eqs. (1) and (2). The first condition implies
16
Here, we use the term entrepreneurial activity to refer to the turnover of entrepreneurial firms in the
economy.
that the E is better off accepting angel finance, while the second condition guarantees that in
any case she will indeed choose S2 under angel finance.
Lemma 3. (Agency problem) When the entrepreneur requires angel finance under the just-
do-it strategy at t =0, an agency problem arises if Condition (14) is satisfied, but not
Condition (15). In this case, the entrepreneur would like to raise angel capital, but will
inefficiently choose the alternative wait-and-see strategy.
Proof. See the Appendix. We show that when Lemma 1 holds, the joint profits of the
entrepreneur and business angel are maximized when the former raises angel finance and
opts for S2. This also implies that if Lemma 1 does not hold, it is never optimal to raise
angel finance.
When angel finance is not needed (as in Section 5), both conditions collapse into one, as
given in Lemma 1. In this section, this adverse behavior is called the postponement effect,
since the entrepreneur will inefficiently prefer to postpone the investment by choosing S1.
In practice, intense monitoring may guarantee that the entrepreneur will not inefficiently
postpone investment of k. Alternatively, the business angel can use financial contracting to
induce her to behave with due diligence. In the remainder of this section, we discuss which
contracting forms mitigate this agency problem. We examine this in the case of a profit-
maximizing entrepreneur. In the last subsection, we also discuss the impact of
entrepreneurial types on the distortion.
We examine different contracting forms typically considered: common equity,
liquidation preference, and seniority rights [such as (convertible) preferred equity or
common debt] for investors.
17
More specifically, we first start with common equity
contracts, and show that this may lead to a distortion; the entrepreneur is tempted to choose
the wait-and-see strategy when obtaining funds k from a BA, although the alternative
strategy would be better from the joint-profit maximization perspective. This prevents
business angels from injecting funds into the venture in the first place. Some ventures will
then not be able to raise angel finance. We then show that investors need other claims than
common equity to achieve the first-best outcome.
Let us first introduce additional notations and the extended timeline of the game. We
denote by the fraction of common equity retained by the entrepreneur (the business angel
gets the rest), so that 01. The variable D denotes the amount of preferred equity (or
common debt) that the BA holds. Finally, we allow for liquidation preference given to the
business angel as a fraction of liquidation value, which we denote by . The greater , the
greater is the BA's level of liquidation rights. The sequence of the contracting stage is as
follows. First, the BA offers a contract to the entrepreneur. The E then decides whether to
accept the offer. Finally, the E sets her continuation strategy (either S1 or S2). We again
solve this through backward induction.
17
Wong (2002) provides empirical evidence that many of these securities and contractual arrangements are often
used by business angels. He studies investment rounds carried out by business angels and shows that 38% of the
rounds in his sample involve the issuance of convertible securities (either convertible notes or convertible-
preferred equity). Common equity is used in 40% of the rounds; the remainder is preferred equity. Convertibles
and preferred shares are therefore not uncommon for angel finance.
This more general form of contracting allows the entrepreneur's profit levels to be
rewritten as:
P
e
2
ad pTVKkDc 16
and
P
e
1
ad wTq
1
TVKkD 1k1wTd maxkD; 0 f g: 17
Let us now consider the different forms of security design separately. Instead of
discussing optimal contracts for any possible parameter values, we limit the exposure to
determining how different security types mitigate the agency problem. Given the relatively
simple framework used here, the analysis of liquidation rights and convertibles is identical.
The same is true for preferred equity and other forms of seniority rights such as debt.
Therefore, in the analysis that follows, we discuss them together.
6.1. Common equity finance
Common equity finance implies =0 and D=0 in Eqs. (16) and (17). Rewriting
Conditions (14) and (15) yields:
ad pTVKkcz
P
e
18
and
ad pTVKkczad wTq
1
TVKk 1wTk: 19
As mentioned earlier, Condition (18) states under which condition the E takes angel
finance. Condition (19) states that given , the entrepreneur only chooses S2 if her
difference in monetary gain compensates her for personal effort costs. The first term on the
right-hand side (i.e., when S1 is adopted) differs here from our basic setting without angel
finance, since now the VC and the E bargain for the amount (V(Kk)), regardless of the
financing strategy chosen. The second term is what we call the postponement effect. By
raising k through equity but not investing it immediately, the E increases her reservation
value by the amount (1w(T))k. This amount corresponds to the fraction of expected
liquidation value the E gets under S1. If she had not raised this money, she would be left
with a reservation value of 0 under S1.
We examine conditions under which the first-best outcome is achieved, i.e., under the
assumption that Lemma 1 holds. Thus, the E will open the firm to the BA iff the equity
stake is at least equal to
a
1
k
pTVKk
: 20
For this level of equity, the right-hand side of Condition (18) yields p(T)(V(Kk)) kc.
Analysis of the first-best outcome then reduces to examining the condition
2
e
1
e
, subject to
. This is because under Lemma 1,
is the optimal sharing rule if the entrepreneur indeed

chooses S2. Using Eq. (20), we can derive the threshold value of w for which the first-best
outcome is always achieved:
w V pTVKkkc=a
qVKkk:
21
This clearly differs from Eq. (6).
Proposition 1. If the business angel obtains common equity when financing a project, the
entrepreneur chooses the wait-and-see strategy more often than in the first-best case.
Proof. See the Appendix. We need to show that Eq. (21) implies lower parameter values
than Eq. (6).
Compared to an entrepreneur who has the initial amount k available from her own savings
(cf. Section 5), Proposition 1 states that a completely wealthless entrepreneur is less likely to
rely on S1 under equity finance owing to the postponement effect. Technically speaking, given
that we also have two conditions to satisfy, we need a more flexible instrument than common
equity to cope with the agency problem. In the next two subsections, we showthat the BAmay
require other claims than the entrepreneur in order to induce the first-best strategy. This will
reduce the entrepreneur's gains in the case of postponement of the investment.
6.2. Initial finance with liquidation preference
Consider now a contract in which the BA obtains not only a fraction of shares (1), but
also liquidation preference up to a pre-specified fraction of the amount k (face value of his
investment).
18
Such liquidation provisions are usually included in the share purchase
agreement of convertible-preferred equity (hereafter simply called convertibles).
19
In this
case, the E will not obtain the expected amount of (1w(T))k if she decides to choose S1
under angel financing [cf. right-hand side of Eq. (19)], but only a fraction (1) of it. Thus,
we now have D=0 only in Eqs. (16) and (17).
The condition for achieving the first-best outcome is now:
ad pTVKkczad fwTq
1
TVKk 1k1wTkg 22
still subject to =1k/ [ p(V(Kk))]. This condition replaces Eq. (19). The minimum
(and optimal) level of liquidation preference is:
k
1pwq
1
VKkc=a
1wk:
23
This represents the threshold level of liquidation rights needed to ensure the first-best
outcome. As long as
1 holds, the first-best outcome can be achieved. In the Proof of

18
Here, the liquidation value is equal to the face value of the investment because we supposed that no money
was required under S1. If a fraction were needed, we would have a liquidation value of (1)k.
19
In fact, convertible-preferred equity typically implies a value of 1. In our case, we consider the more
general case of interpreting as a liquidation preference, and only mention convertibles as an example how to
implement this. Furthermore, our analysis will yield minimum values of , so that our results also hold for any
values of greater than those derived. At the same time, is still bounded above by 1 owing to the limited
liability of the entrepreneur.
Proposition 2 (see below), we show that
N1 never occurs. This means that the agency

problem can always be solved. The intuition is simple. Since the entrepreneur's incentive to
postpone is driven by the fact that she would obtain something under S1 in the case of failure,
the obvious solution to this agency problem is to ensure that nothing goes to the E in such an
event. When =1, this is precisely the case. This is summarized in the next proposition.
Proposition 2. We denote
as presented in Eq. (23) and
=1k/ [p(V(Kk))].
When the business angel is given a fraction of shares (1
) and liquidation preference
, the first-best financing strategy can always be adopted.

Proof. See the Appendix. We need to show that
2
e
1
e
under
and
, which is shown
to always be the case.
Proposition 2 stems from the fact that the postponement effect can be mitigated with
liquidation preference, while common equity finance implies =0. Thus, the provision of
liquidation preference makes angel finance worthwhile more often, as it gives an additional
degree of freedom in the contracting space. The use of liquidation preference (or
convertibles) creates a commitment for the E to choose S2 in events for which under
common equity she would choose S1. Under this commitment, the BA is ready to invest.
20
More generally, it may be argued that at times when follow-up fund-raising becomes
uncertain (e.g., if there is an equity gap, such as the investment size between angel finance
and venture capital finance), security design issues matter, and optimal contracting may
lead to more efficient outcomes.
Note that the allocation of shares
is set independently of
, since
needs to satisfy
Condition (22).
is only necessary to guarantee that in equilibrium the entrepreneur

chooses S2. Thus, a liquidation preference clause does not affect the entrepreneur's or the
business angel's gains, since S1 is not chosen in equilibrium.
Corollary 1. (Comparative statics) The use of liquidation provisions is less likely for high
venture profits (V), high probability (p(T)), low total investment (K) and low bargaining
power (
1
).
Proof. Partial derivatives of Eq. (23) are used.
For low values of V, S1 is optimal in any case (see Lemma 1). As V increases, S2 is the
better strategy. However, the business angel will require a liquidation preference for
intermediate levels of V. This reduces the gains of the entrepreneur for waiting. Only for a
higher level of Vare liquidation provisions redundant. The same holds for the probability p
(T), as it affects profits in a similar way as V. On the other hand, it is exactly the opposite for
investment K, since this reduces profits. As for bargaining power vis-a-vis venture
capitalists (
1
(T)), the lower the bargaining power, the smaller is the entrepreneur's fraction
of shares under S1 and thus the lower are the incentives for her to wait-and-see. With
respect to the duration T, it again depends on the specific hazard-functions assumed. Other
variables have an ambiguous effect.
20
This leads to a similar situation as in Bergemann and Hege (1998), as it also requires a different treatment of
success and liquidation events.
6.3. Initial finance with preferred equity (or seniority rights)
While it is apparent that some seniority claims need to be given to the BA, in this
subsection we show that introducing preferred equity or common debt (next to common
equity) may also solve the problem at hand. The difference is that preferred equity affects
the payoff of both strategies. While it indeed gives seniority claims to the business angel in
the case of liquidation, it also affects seniority in the event of success, and this for both
strategies. In contrast, liquidation provisions only affect the payoffs in the case of an
unsuccessful wait-and-see strategy.
In this case, the conditions for achieving the first-best outcome are:
apTVKkDc z

P
e
24
and
apTVKkDcza
wTq
1
TVKkD
1wTd maxkD; 0
_ _
25
Lemma 1 requires that and D are such that
a
pVKkk
pVKkpD
:
Then, Condition (24) becomes identical to the condition stated in Lemma 1. As for
Condition (25), two separate cases need to be examined: Dk and Dbk. In the first case,
the last term in Condition (25) cancels out, while in the second case it equals kDN0. Both
are presented and discussed in the Appendix (see the Proof of the next proposition). The
results are summarized in Proposition 3.
Proposition 3. Preferred equity (or any other form of seniority rights for investors)
enables the first-best outcome to be achieved.
Proof. See the Appendix.
Note, however, that such a solution to this agency problem may require a significant
leverage ratio for the entrepreneurial firm. If high leverage generates other conflicts or
inefficiencies within the firm [not modeled here, but as evidenced in the large literature on
corporate finance, such as risk-shifting (Jensen and Meckling, 1976) and debt overhang
problems (Myers, 1974)], the use of liquidation provisions may be more appropriate. The
latter has the advantage that seniority rights are lost upon conversion or that liquidation
preference is only effective for downside risk.
6.4. Business angels (early investors) and entrepreneurial types
Here we examine how BAs affect the strategy choice of the different entrepreneurial
types considered, and which type is more likely to seek angel capital to finance the just-do-
it strategy. In other words, we address the question of which type of entrepreneur is more
likely to seek a VC directly as opposed to first taking angel finance. The results are
summarized in the next proposition.
Proposition 4. Compared to the situation in which the entrepreneur can self-finance the
initial amount (Lemma 2), an LSE who needs external funds for k is less likely to choose the
just-do-it strategy. An SE remains unaffected.
These results are easy to obtain. The new trade-off for the LSE is:
pTa
VKk
V
_ _
zwTq
1
T
VK
V
_ _
; 26
where * is as in Eq. (20).
21
This yields the following condition:
pTzwT
q
1
TVK
VKk

k
VKk
:
The additional term (see the right-hand side) stems from the fact that the LSE now needs to
issue equity to the business angel under S2. This increases her threshold for this strategy.
The trade-off for an SE is still
pTzwT; 27
so that she is as likely to adopt a wait-and-see strategy as before. This is because her trade-
off is unaffected by the allocation of cash flow rights (under the assumptions made earlier).
Fig. 3 shows graphically the outcome of the three different entrepreneurial types. For the
PME, we consider outcomes under optimal contracting.
7. Professionalization of the VC market
In this section we examine the impact of the degree of professionalization of the VC
market on the choice of financing strategy for different entrepreneurial types. In the spirit of
Hsu (2004), a more professional VC market is characterized by more reputable and capable
venture capitalists in the economy.
We model this by assuming that a more professional VC market has a greater ratio of
good over bad VCs. Suppose that the fraction of the VCs are good, and the remainder
are bad. A good VC achieves V for sure upon financing, while a bad VC only achieves V
with probability (1), where 01.
22
It measures the quality difference between good
and bad (or experienced and inexperienced) venture capitalists.
This means that under S2, the E can choose her VCso that she will always be able to attract
a good VC. Under S1, the expected payoff is now: V+(1)(1)V=(1(1))V. Let us
also denote : =1(1). This clearly affects the strategy choice of all types of
entrepreneurs.
23
21
Here, it is enough to consider common equity only. This is because the condition above replaces the incentive
compatibility constraint analyzed in previous parts of this section, while the level of simply comes from the
participation constraint (which can easily be met with common equity, since it only requires one parameter).
22
This heterogeneity in investor qualities may also affect the value V. While we abstract from this here,
assuming that a bad VC reduces the probability of success and at the same time the final value of the venture,
would not affect our results.
23
In addition, it can also affect the degree of competition, measured by (see Inderst and Mller, 2004, for a
related discussion).
Proposition 5. A more professional VC market makes the wait-and-see strategy more
likely. The greater the quality difference between venture capitalists, the more likely is the
just-do-it strategy.
Proof. See the Appendix. Note that the analysis remains similar to that in Section 5, except
that the profit level is now Vinstead of V. Thus, any increase in (decrease in ) enhances
(reduces) the returns of the venture upon success.
Entrepreneurs are more likely to directly approach venture capitalists rather than starting
the early steps on their own if the market is highly professionalized, but less likely when the
variance in quality is large. The intuition is that a more professional market for venture
capital (measured here by the fraction of good VCs) improves the expected returns of the
venture when having an experienced VC on board, which makes it less worthwhile starting
a company without one. If the availability of professional VCs is large, it is more likely that
the E is able to attract one even without having achieved any intermediate milestone. On the
other hand, a greater variance in quality makes S2 more worthwhile, since being successful
in first achieving the intermediate milestone enables the E to ultimately secure the
participation of capable VCs in the future.
8. Empirical implications
The theoretical analysis allows us to derive a number of newempirical predictions regarding
security design, the interplay between angel and venture capital finance, the level of entre-
preneurial activity in the economy, and the professionalization of the venture capital market.
More broadly speaking, note that the possible distortion shown in Section 6.1 (the
postponement effect) is much more general than for entrepreneurial start-ups. This actually
Fig. 3. Financing probabilities, choice of financing strategy, and entrepreneurial types. The graph plots w(T) on the
x-axis and p(T ) on the y-axis. The straight thin line is for an LSE, the bold line for a PME, and the dotted line for an
SE. In each case, S2 is preferred to S1 for all parameter values above the given line. Compared to Fig. 2
(benchmark situation), only the LSE outcome has changed, since the corresponding threshold level is shifted
upwards, closer to the PME line. The same parameter values as in Fig. 1 are used.
applies to any situation whereby a manager holds some equity stake in the firm and raises
money for an investment that can be delayed. We can therefore make a direct link to the real
option literature, given that this represents an option to wait (or option to postpone).
24
From the perspective of start-up finance, the analysis indicates that entrepreneurs with
the most profitable projects are more likely to choose the just-do-it strategy, and thus first
work towards achieving an intermediate milestone before contacting venture capitalists.
This gives them the highest chances of finding interested venture capitalists while
minimizing dilution. This is increased when the entrepreneur's monetary contribution is
small. These results also hold for the choice between approaching business angels or
venture capitalists first, since the former implies the just-do-it strategy and the latter the
wait-and-see strategy. In other words, here the most promising ventures first seek angel
capital.
Given that providers of seed capital (such as business angels) potentially face an agency
problem when the entrepreneur has the option to postpone critical investments, the use of
contractual arrangements such as (convertible) preferred equity and liquidation preference
is more likely for less profitable ventures and for which total investments are large. It is also
more likely if the chances of finding a venture capitalist are low.
With respect to the degree of competition in the venture capital market (proxied by the
variable ), increased competition makes the wait-and-see strategy more likely, since it
increases the likelihood of finding an interested venture capitalist and at the same time
affects the bargaining power of the entrepreneur vis-a-vis the venture capitalist. Both effects
clearly favor the entrepreneur. It is not worth spending time trying to achieve a milestone
with limited resources. This is because it reduces the expected time required to start the
venture. This is even more the case when venture capitalists become more professional.
The theoretical framework presented here also generates predictions with respect to
different entrepreneurial types. For instance, ceteris paribus, a life-style entrepreneur is
more likely to opt for the just-do-it strategy, as it minimizes her dilution of control. She will
exploit her own resources as much as she can (see Bhid, 1999 for a detailed discussion on
bootstrap finance). Moreover, while a life-style entrepreneur is more likely to start a new
venture (compared to the two other types), at the same time she is less likely to successfully
build a viable firm. In contrast, serial entrepreneurs are most likely to build up successful
firms.
9. Concluding remarks
This paper recognizes the existence of different entrepreneurial types and indicates that
they may choose different financing strategies to achieve similar goals. Most of the existing
24
Suppose, for instance, that the NPVis pVk if the investment is made today (k represents the investment outlay
required, V the value of the investment in the case of success, and p the probability of success), and w(Vk) if it is
delayed (here, w stands for the probability of success if delayed). Thus, the manager will postpone whenever Vk
(1w) / ( pw). Depending on the compensation scheme received, the manager may or may not make efficient
investment decisions. Linking financial options to real options is not new. Recent studies include Mayers (1998) in
connection with the overinvestment problem, Myers (2000) for an analysis of agency costs under equity finance
when investment is not verifiable, and Cosh et al. (2005) for an empirical analysis of the pecking order theory and the
link between finance and investment decisions.
theoretical studies have focused solely on the pure profit-maximizing entrepreneur.
However, entrepreneurial traits are much richer. The only variation studied is with respect
to entrepreneurs enjoying personal benefits of control. Future research on entrepreneurship
theory should aim to take a similar approach. To conclude, let us highlight here some open
research questions that relate to the link between financing strategy and entrepreneurial
types.
There is empirical evidence that different entrepreneurial types ultimately also pursue
different types of projects, as well as financing strategies. For instance, does the choice of
financing strategy affect the choice of projects an entrepreneur may pursue (e.g., high
growth may be associated with just-do-it strategy)? While this goes beyond the scope of this
study, future research in this direction is warranted. In particular, it may incorporate other
entrepreneurial types that differ in parameters not examined here (i.e., others not related to
the financial perspective). Another interesting question for future research is the effect of
weak intellectual property rights on the choice of financing strategy adopted by different
entrepreneurial types. Patenting often creates a race for milestones. A trade-off similar to
ours may then arise if intellectual property rights are weak. In this case, the wait-and-see
strategy may be seen as a way to avoid expropriation of milestones achieved, as investors
need to pre-commit early.
Another important issue is the impact of failure on follow-up opportunities. Landier
(2002) provides evidence of a stigma of failure in Europe that makes it particularly
difficult for entrepreneurs who failed to get a second chance. How does this stigma of
failure affect the trade-off considered? Which type of entrepreneur is most affected by the
stigma? Recent studies on cross-country comparisons highlight further interesting issues to
Table 1
Definition of variables
Variable Definition
k Amount of capital required to start the just-do-it strategy
K Total amount of capital required to finalize the project
V Value of the venture if successfully completed
T Time until the option to invest in the given project loses its value
Instantaneous probability under S1 of finding a venture capitalist
Instantaneous probability under S2 of achieving the intermediate milestone
w(T,) Probability of finding a venture capitalist under S1
p(T,) Probability of achieving the intermediate milestone under S2
c Additional effort cost under S2
1
e
,
2
e
Expected profits of the entrepreneur under S1 or S2
e
Outside option of the entrepreneur under angel finance; i.e., not taking angel finance and adopting S1
1
,
2
Bargaining power of the entrepreneur vis-a-vis the interested venture capitalist under S1 or S2
Liquidation preference of the business angel as a fraction of the liquidation value of the venture
Fraction of shares held by the entrepreneur under angel finance, while the BA gets the fraction (1)
D Present value of debt-type claims (preferred shares) given to the business angel
Fraction of good venture capitalists in the whole population of venture capitalists in the economy; the
rest are bad venture capitalists
Probability that a bad venture capitalist does not achieve venture value V
:=1(1)
be investigated when examining various forms of entrepreneurs around the world.
Moreover, the role of governments in fostering entrepreneurship and providing seed capital
could be researched in the setting developed in this article (Keuschnigg and Nielsen, 2003;
Leleux and Surlemont, 2003; Armour and Cumming, 2006; Cumming and MacIntosh,
2006).
Moreover, the amount to be invested was considered exogenous and identical under both
strategies. How would the trade-off be affected if the burn rate were endogenous? Setting a
higher burn rate may accelerate achievement of the milestone required, but at the expense of
reducing the time until the capital resources are exhausted. When would entrepreneurs
prefer higher burn rates? And which type is most likely to undertake the project at higher
rates?
A further simplification in this paper is that entrepreneurs could not change their strategy
once they opted for one. When would they want to optimally decide to switch from one
strategy to the other over time? In which direction would the switch of strategy go? All of
these questions, and many more, are worth being investigated in the future (Table 1).
Appendix A
Proof of Lemma 3. We show that when Condition (3) holds, joint profit maximization is
achieved when the E raises angel finance and chooses S2. This proof is very similar to why
the entrepreneur does not want to inject her own savings under S1; see Footnote 11.
Suppose Condition (3) holds. Then, joint profits under S2 are: p(V(Kk)) kc.
Since
e
=w[VK], Condition (14) is satisfied, as it is the same as Condition (3). To ensure
that it is best to choose S2 when angel finance is raised [cf. Condition (15)], we need to
compare joint profits under S2 and S1 under angel finance. These are equal to p(V(Kk))
kc and w[
1
(V(Kk)) k], respectively. It is easy to see that this condition is satisfied
whenever Lemma 1 holds, since w[
1
(V(Kk)) k] bw[VK]. Once simplified, this
inequality reduces to the simple condition
1
b1. In other words, from the perspective of
joint profit maximization, it is never optimal to raise angel finance but choose S1 if Lemma
1 holds.
Proof of Proposition 1. Under
=1k/ [p(V(Kk))], Eq. (19) implies that

pVKkkcza
d wq
1
VKk 1wk:
A conflict arises when the right-hand side is strictly greater than w
1
[VK], since then
the entrepreneur will not always choose S2 after having obtained angel finance at
.
25
This condition should be less restrictive than Condition (15). After simple rewriting, this
yields the following condition:
a
d wq
1
VK 11q
1
wkNwq
1
VK;
where 0b(1(1
1
)w) b1. We need to show that this condition includes feasible
parameter values. For instance, this is the case for k=1, V=50, K=3, c=2.4, T=1, =0.6,
25
If this does not hold, Eq. (18) is not satisfied (and thus Lemma 1), since w
1
[VK] is also
e
.
and =0.25. For these parameter values, the entrepreneur has incentive to raise angel
finance but choose S1.
After some algebraic manipulations:
1
q
1
p 1
k
VK
_ _
1
VK
_ _
1
w
1q
1
_ _
N1:
Comparative static results are easily derived from this expression.
Proof of Proposition 2. Setting =1 and
=1k/ (p(V(Kk))), we need to show that

the first-best strategy (Lemma 1) is obtained. This requires that
2
e
1
e
for all feasible
parameter values. This is the case here, as
1
e
is then always smaller than
e
=w[VK]
[Condition (14)]:
wq
1
VKza
wq
1
VKk:
After some simple algebra, this condition reduces to the following: p1. This is the case
by definition.
Proof of Proposition 3. The first condition under preferred equity finance requires
a
pVKkk
pVKkD
;
so that Lemma 1 holds. We now examine two separate cases: Dk (Case 1) and Dbk
(Case 2). In both cases, we focus on the condition
2
e
1
e
, which ensures that the
entrepreneur will choose S2 when seeking angel finance.
For Dk, the condition is
pVKkkcza
wq
1
VKkD:
It is straightforward to check that the left-hand side is lowest when D is as large as
possible, since its first-order derivative is strictly negative:
A
pVKkk
pVKkD
wq
1
VKkD
_ _
AD
wp
1q
1
VKk
q
1
VKkD
2
_ _
b0:
Thus, the first-best outcome is more likely achieved when D=k/ p (sole debt finance).
We still need to show that under this outcome, the first-best option is achieved for all
relevant parameter values. It is enough to show that
1
e
when D=k/ p:
wq
1
VKz
pVKkk
pVKkk=p
wq
1
VKkk=p;
i.e., whenever p
1
1, which always holds. Therefore, the first-best outcome is always
achieved in Case 1.
For Dbk, the condition is:
pVKkkczawq
1
VKkD 1wkD:
The level of D that minimizes the agency problem is such that the right-hand side is
lowest. Its first-order condition is
A
pVKkkwq
1
VKkD1wkD
pVKkD
_ _
AD
p
w1q
1
k1wq
1
VK
pVKkD
2
_ _
b0:
Thus, D=k is optimal. Since at this value, we have shown in the previous case that
increasing D further improves the condition, only Case 1 is relevant (where the first-best
outcome can always be achieved).
Proof of Proposition 5. The entrepreneur's expected profits are now:
P
e
1
wTq
1
T/VK
P
e
2
pTVKkkc:
Thus, the condition for S2 to be optimal [which replaces Eq. (3)] becomes:
pTVKkkczwTq
1
T/VK:
Since 1, it is straightforward to see that S1 is less likely when is large and/or
small.
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A theoretical analysis of optimal

financing strategies for different types

Tel.: +32 10 478440.

. This is because under Lemma 1,

is the optimal sharing rule if the entrepreneur indeed

1 holds, the first-best outcome can be achieved. In the Proof of

N1 never occurs. This means that the agency

as presented in Eq. (23) and

) and liquidation preference

, the first-best financing strategy can always be adopted.

is only necessary to guarantee that in equilibrium the entrepreneur

=1k/ [p(V(Kk))], Eq. (19) implies that

=1k/ (p(V(Kk))), we need to show that

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