Venture Capital and Capital Allocation

Abstract

I show that venture capitalists' motivation to build reputation can have beneficial effects in the primary market, mitigating information frictions and helping firms go public. Because uninformed reputation-motivated venture capitalists 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 venture capitalists 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.