If an entrepreneur devotes all of her effort to a venture, it will be worth $1.2

Question

If an entrepreneur devotes all of her effort to a venture, it will be worth $1.25 million. If she devotes no effort to it, she can consume $1.25 million worth of other goods and activities. Suppose that as the sole owner, she prefers to devote enough effort to the venture to achieve a value of $1.0 million.

a) Now suppose that she desires to sell 40 percent of the equity to an outside investor, and that the investor purchases the equity based on its existing value of $1.0 million. However, with the entrepreneur’s reduced ownership, she would decide to devote less effort to the venture, so that its new value would be only $700,000. Analyze the wealth transfer between the investor and the entrepreneur.

b) Suppose the investor correctly anticipates that the entrepreneur will reduce effort once some of the equity is sold, and that with correct anticipation, the entrepreneur would devote enough effort to make the venture worth $800,000. How much should the investor pay? What does the entrepreneur end up with instead of the original $1.0 million of value in the venture and $250,000 of other consumption?

c) Suppose the entrepreneur is a workaholic, but that the investor does not know that she is. The investor believes she would reduce effort to the point where the venture is only worth $600,000. How might the parties use monitoring and bonding arrangements to change the deal? What can you say about how much they would be willing to spend on monitoring and bonding?

Explanation / Answer

a)Purchase value of equity to investor=40 percent of  $1.0 million=$400000 is wealth transfer between the investor and the entrepreneur.

b) investor should pay 40 percent of  $800,000 = 320000

the entrepreneur end up with = 60 percent of $800,000=480000 value in venture and 320,000- $250,000=$170,000 in cash.

c) investor should pay 40 percent of  $600000= 240000. The investor might scrutinize and observe the behavior of the entrepreneur that she acts in his best interests.And penalize the entrepreneur for acting in ways that is deterimental to his interests.He might be williing to spend at most 320000-240000=$80000 anywhere between 0 and 80000 .

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