Compensation of venture capitalists with two principals

Venture capitalists enjoy incentive-laden compensation schemes where they are paid a fixed amount (management fees) plus a share of profit (success fees). This scheme is of course intended to provide venture capitalists with strong incentives under the heavy information asymmetry (Sahlman, 1982, J. Financial Economics) In this paper, we consider how to design a proper compensation scheme for a venture capitalist with two principals. More concretely, not only our venture capitalist is compensated from a limited partnership fund (via the abovementioned scheme) but also receives salary and bonus from shareholders of VC firm. This complicates the incentive structure and especially puts outside investors (limited partners) at risk. Our model in fact reflects reality of venture capital market in Korea, and also may be applicable generally when a venture capitalist is himself an active investor or an employee of a VC firm (e.g. corporate VC). In a related work, we have already found some limited empirical evidence that Korean venture capitalists behave differently according to the source of money (i.e. whether shareholders' or limited partners'). (Kim et al, 2003, Korea J. of Finance) This paper will consider how LP fund compensation schemes should be designed in order to prevent moral hazard in such a situation.