Cannibalization & Incentives in Venture Financing

This paper considers the effects of strategic substitutabilities on performance and incentives in venture capital financing. The analysis points to a subtle link between two pivotal roles of venture capitalists: (i) monitoring ventures and setting performance incentives, and (ii) coordinating and shaping the product market strategies of ventures operating in similar product spaces. When strategic substitutabilities are strong, the VC's role is to soften potentially too aggressive product market strategies. In contrast, small strategic substitutabilities can lead to more aggressive performance incentives. This is because they enhance the VC's commitment to weed out losers, which strengthens entrepreneurial incentives and results in overall efficiency gains. We discuss our findings in light of case study evidence from the venture capital industry.