Title: The effect of the legal system and empathy in venture capital contracting: theory and evidence

Authors: Richard Fairchild; Yiyuan Mai

Addresses: School of Management, University of Bath, Bath BA2 7AY, UK ' School of Management, Huazhong University of Science and Technology, Wuhan 430074, China

Abstract: We examine the relationship between a society's legal system, a society's culture of empathy, the strength of venture capital contracts and venture performance. We develop a double-sided moral hazard model in which an entrepreneur and a venture capitalist exert value-adding efforts in a venture. The venture capitalist can select a strong contract, containing a punishment threat for entrepreneurial poor performance, or a weak contract which contains no such threat. However, the ability to punish the entrepreneur depends on the effectiveness of the legal system. Furthermore, selection of the strong contract destroys trust and empathy between the parties, adversely affecting performance. A strong contract is optimal if the legal system is strong and empathy is low, while a weak contract is optimal if the legal system is weak and empathy is high. We discuss international policy implications, and present results from our survey of Chinese venture capitalists that supports our model.

Keywords: venture capital performance; double-sided moral hazard; legal systems; law; empathy; contract strength; venture capital contracts; entrepreneurship; value added; trust; China; punishment threat; poor performance.

DOI: 10.1504/IJBAF.2013.057361

International Journal of Behavioural Accounting and Finance, 2013 Vol.4 No.1, pp.32 - 53

Received: 08 May 2021
Accepted: 12 May 2021

Published online: 27 Oct 2013 *

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