This paper develops a model of the financing of a start-up venture. The model includes three actors: an entrepreneur, a lender, and a venture capitalist. The start-up venture requires the upfront purchase of an asset. The entrepreneur’s motive in seeking external funding is a wealth constraint. Providers of external funding come in two forms: bank lending and venture capital. A lender provides funding in exchange for an interest payment and repayment of principal. If the entrepreneur defaults on the loan, the lender seizes and sells the asset to get repaid. A venture capitalist provides funding in exchange for an equity share.
The project requires an upfront investment of C to purchase the asset necessary for completing the project. With probability p, the project will generate W in revenue. Thus, the expected value of the project is E(V) = pW – C. The lender will lend L to the entrepreneur such that L < C. If the project is a success, the lender receives rL. If the project fails, the lender seizes the entrepreneur’s collateral originally valued at C. Given the lender’s objective function, lenders will offer funding, and entrepreneurs will accept funding, provided that the market rate of interest is between the minimum that lenders require and the maximum entrepreneurs would pay. From the venture capitalist objective function, it is clear that its share of the revenue should be at least proportional to its investment. The entrepreneur, assuming it has the assets to secure a loan from a lender, must decide on a funding source given its objective function. The objective of this paper is to determine the best source of funding for the entrepreneur. Since lenders do not take an equity share in the project, it is expected that the entrepreneur will seek funding from a lender before a venture capitalist. Some aspects of the model will be tested using data from the Kauffman Firm Survey.