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Abstract
We develop a theory and empirical test of how the legal system affects the relationship between venture capitalists and entrepreneurs. The theory uses a double moral hazard framework to show how optimal contracts and investor actions depend on the quality of the legal system. The empirical evidence is based on a sample of European venture capital deals. The main results are that with better legal protection, investors give more non-contractible support and demand more downside protection. These predictions are supported by the empirical analysis. Using a new empirical approach of comparing two sets of fixed-effect regressions, we also find that the investor’s legal system is more important than that of the company in determining investor behavior.

Keywords: Financial Intermediation, Law and Finance, Corporate Governance, Venture Capital

1 Introduction
The work of La Porte et al. (1997, 1998, and 2000) demonstrates the importance of the legal system for economic activity. Their work and a large ensuing literature show that countries with different legal origins also systematically differ in terms of their financial systems. In this paper we ask how financial intermediation is affected by the nature of the legal system, focusing specifically on venture capital. We look at how the entire relationship–contractual and non-contractual– between an investor and an entrepreneur depends on the legal system.

Since it is not immediately obvious how the legal system should affect this relationship, we let our analysis be guided by theory. We examine how optimal contracts, and the resulting investor behavior, depend on the legal system. We propose a simple theory that makes three predictions. First, the better the legal system the more investors provide value-adding support. The underlying intuition is that investing in support activities is only worthwhile if the legal system provides investors with sufficient guarantees that these efforts will not be wasted. Second, the better the legal system the more they demand contractual downside protection, using securities such as debt, convertible debt, or preferred equity. The main intuition is that in a better legal system it is optimal to give the entrepreneur stronger upside incentives. In order to satisfy their participation constraint, investors thus require additional cash flow rights on the downside. Third, we consider the influence of the legal system on intermediaries’ incentives to develop the competencies necessary to provide value added services, predicting that intermediaries from countries with a better legal system will provide more value added services, even when investing abroad.
To test the predictions of the theory, we use a hand-collected dataset on European venture capital investments for the period 1998-2001. We focus on venture capital as specialized form of financial intermediation because prior research has already established the richness of relationships between venture capital firms and their companies.1 Venture capital investors can play a value-adding role in the companies they finance, both through contracting and by providing largely non-contractible inputs such as advice and support. Europe is an excellent testing ground for our purposes, since it consists of a set of comparable countries with reasonably mature venture capital markets, yet it feature本论文由英语论文网提供整理，提供论文代写，英语论文代写，代写论文，代写英语论文，代写留学生论文，代写英文论文，留学生论文代写相关核心关键词搜索。