Venture Capital and Capital Allocation

Venture Capital and Capital Allocation


Article first published online: 14th February 2019 DOI: 10.1111/jofi.12756


I show that venture capitalists' motivation to build reputation can have beneficial effects in the primary market, mitigating information frictions and helping firms IPO. Because uninformed reputation‐motivated VCs want to appear informed, they are biased against backing firms—by not backing firms, they avoid taking low‐value firms to market, which would ultimately reveal their lack of information. In equilibrium, reputation‐motivated VCs back relatively few bad firms, creating a certification effect that mitigates information frictions. However, they also back relatively few good firms, and, thus, reputation motivation decreases welfare when good firms are abundant or profitable.

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