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Parameterizing Opportunity Set Risk and Search Costs within Venture Capital Markets

I develop a theoretical model that parameterizes differences in opportunity set risk within venture capital markets as functions of differences in the opportunity benefit of deal screening, and cross-sectional differences in distributions of project risk. Using the resulting rational expectations framework, the theoretical model shows clusters of venture capital activity can be induced by non-monotonic relations between search costs for low risk projects and the opportunity benefit of deal screening. Independent of other factors, such as ability or preferences, the theoretical model endogenously generates markets characterized by single or multiple representative agents, market structures which do not encourage competition that is a function of fund sizes, incentive compatibility rationales for differences in the pay-performance sensitivities of VCs' compensation contracts, and competitive pricing equilibriums that differ in degree of market efficiency. Independent of data on market volumes, model parameters successfully rank venture capital markets in the states of California, Massachusetts, and New York as three of the most efficient markets within the United States.