What is the role of legal systems in financial intermediation? Theory and evidence

We develop a theory’ and empirical test of how the legal system affects the relationship between venture capitalists and entrepreneurs. The theory uses a double moral hazard framework to show how optimal contracts and investor actions depend on the quality of the legal system. The empirical evidence...

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Bibliographic Details
Published in:Journal of financial intermediation 2009-10, Vol.18 (4), p.559-598
Main Authors: Bottazzi, Laura, Da Rin, Marco, Hellmann, Thomas
Format: Article
Language:English
Subjects:
Behavior
Contract law
Contracts
Entrepreneurs
Europe
Financial intermediaries
Investment decision
Legal protection
Legal systems
Moral hazard
Studies
Venture capital
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Summary:We develop a theory’ and empirical test of how the legal system affects the relationship between venture capitalists and entrepreneurs. The theory uses a double moral hazard framework to show how optimal contracts and investor actions depend on the quality of the legal system. The empirical evidence is based on a sample of European venture capital deals. The main results are that with better legal protection, investors give more non-contractible support and demand more downside protection. These predictions are supported by the empirical analysis. Using a new empirical approach of comparing two sets of fixed-effect regressions, we also find that the investor’s legal system is more important than that of the company in determining investor behavior.
ISSN:1042-9573
1096-0473
DOI:10.1016/j.jfi.2008.04.003