14 May ANALYZE THE WEALTH TRANSFER BETWEEN THE INVESTOR AND THE ENTREPRENEUR.
If an entrepreneur devotes all of her effort to a venture, it will be worth $1.25 million. If she devotes no effort to it, she can consume $1.25 million worth of other goods and activities. Suppose that as the sole owner, she prefers to devote enough effort to the venture to achieve a value of $1.0 million.
a) Now suppose that she desires to sell 40 percent of the equity to an outside investor, and that the investor purchases the equity based on its existing value of $1.0 million. However, with the entrepreneur’s reduced ownership, she would decide to devote less effort to the venture, so that its new value would be only $700,000. Analyze the wealth transfer between the investor and the entrepreneur.
b) Suppose the investor correctly anticipates that the entrepreneur will reduce effort once some of the equity is sold, and that with correct anticipation, the entrepreneur would devote enough effort to make the venture worth $800,000. How much should the investor pay? What does the entrepreneur end up with instead of the original $1.0 million of value in the venture and $250,000 of other consumption?
c) Suppose the entrepreneur is a workaholic, but that the investor does not know that she is. The investor believes she would reduce effort to the point where the venture is only worth $600,000. How might the parties use monitoring and bonding arrangements to change the deal? What can you say about how much they would be willing to spend on monitoring and bonding?
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