The Effect of Capital Market Characteristics on the Value of Start-Up Firms

TLDR: In this article, the authors show that the success probability, financial contract, pre-money valuation, and value created in a start-up firm depend strongly on the characteristics of the capital market in which the startup raises finance, such as the level of capital supply and degree of capital market competition.

Abstract: We show that the success probability, financial contract, pre-money valuation, and value created in a start-up firm depend strongly on the characteristics of the capital market in which the start-up raises finance, such as the level of capital supply and degree of capital market competition, entry costs, and capital market transparency. We characterize the levels of capital supply and capital market competition for which the created surplus falls short of the second-best benchmark, implying that public policy measures affecting the supply of venture capital (e.g., changes in the capital gains tax) can increase welfare. We also investigate the effect of capital supply on the incentives of venture capitalists to screen projects. We show that screening is more intense if the level of capital supply is low, and less intense if it is high. The model is consistent with available empirical evidence and provides many new, testable implications.

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Journal of Financial Economics
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