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1 Fairness Norms and Self-interest in VC/E Contracting: A Behavioral Game-theoretic Approach Existing VC/E Financial Contracting Models assume narrow self-interest. Double-sided Agency problems (both E and VC exert Value-adding Effort) (Casamatta JF 2003, Repullo and Suarez 2004, Fairchild JFR 2004). Procedural Justice Theory: Fairness and Trust important. No existing behavioral Game theoretic models of VC/E contracting.

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2 My Model: VC/E Financial Contracting, combining double-sided Moral Hazard (VC and E shirking incentives) and fairness norms. 2 stages: VC and E negotiate financial contract. Then both exert value-adding efforts.

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3 How to model fairness? Fairness Norms. Fair VCs and Es in society. self-interested VCs and Es in society. Matching process: one E emerges with a business plan. Approaches one VC at random for finance. Players cannot observe each other’s type.

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4 Timeline Date 0: VC makes ultimatum offer of equity stake to E; Date 1: VC and E exert value-adding effort in running the business Date 2 Success Probability => income R. Failure probability =>income zero

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5 Expected Value of Project Represents VCs relative ability (to E).

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6 Fairness Norms Fair VC makes fair (payoff equalising) equity offer Self-interested VC makes self-interested ultimatum offer E observes equity offer. Fair E compares equity offer to social norm. Self-interested E does not, then exerts effort.

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7 Expected Payoffs If VC is fair, by definition,

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8 Solve by backward induction: If VC is fair; Since for both E types. =>

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9 VC is fair; continued. Given Optimal Effort Levels: Fair VC’s equity proposal (equity norm):

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10 VC is self-interested: From Equation (1), fair E’s optimal effort;

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11 Self-interested VC’s optimal Equity proposal Substitute players’ optimal efforts into V= PR, and then into (1) and (2). Then, optimal equity proposal maximises VC’s indirect payoff =>

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12 Examples; VC has no value-adding ability (dumb money) => => r =0 => r => 1,

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13 Example 2 VC has equal ability to E; => r =0 => r => 1, We show that as r => 1

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14 Table 1.

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15 Graph

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16 Table of venture performance

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17 Graph of Venture Performance.

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18 Future Research. Dynamic Fairness Game:ex post opportunism (Utset 2002). Complementary Efforts. Trust Games. Experiments. Control Rights.

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