We consider the provision of venture capital in a dynamic model with multiple research stages, where time and investment needed to meet each benchmark are unknown. The allocation of funds is subject moral hazard. The optimal contract provides for incentive payments linked to attaining the next benchmark, which must be increasing in the funding horizon of each stage. Benchmarking reduces agency costs, directly by shortening the agent’s guaranteed funding horizon, and indirectly via an implicit incentive eﬀect of information rents in future ﬁnancing rounds. The ex ante need to provide incentives and the venture capitalist’s desire to cut information rents ex post create a hold-up conflict, which can be overcome by providing all funds in every stage in a single up-front payment. Empirical patterns of the evolution of ﬁnancing rounds and research intensity over the lifetime of a project are explained as optimal choices: the optimal capital allocated and the funding horizon are increasing from one stage to the next. This emphasizes the notion that early stages are the riskiest in an innovative venture.
Bergemann, Dirk and Hege, Ulrich, "The Value of Benchmarking" (2002). Cowles Foundation Discussion Papers. 1643.