Innovation, Spillovers and Venture Capital Contracts

Innovative start-ups and venture capitalists are highly clustered: Silicon Valley is probably the best-known example. Clusters differ in the contracts they use, and in how they perform. I explore the link between spillovers, contractual design and performance. I find that more "incomplete" contracts, with fewer contingencies linking entrepreneurs’ rewards to performance benchmarks, become optimal when positive spillovers are large. The contracts enable the innovative entrepreneur and his investor to extract some of the surplus they generate through positive spillovers for new entrants. This provides a new rationale for contractual incompleteness, and may help to explain observed contractual practice in Silicon Valley.