Start-ups, venture capitalists, and the capital gains tax

A model of start-up finance with double moral hazard is proposed. Entrepreneurs have ideas and technical competence, but lack own resources as well as commercial experience. Venture capitalists (VCs) provide start-up finance and managerial support. Both types of agents thus jointly contribute to the firm's success, but neither type's effort is verifiable. We find that the market equilibrium is biased towards inefficiently low entrepreneurial effort and venture capital support. In this situation, the capital gains tax is particularly harmful. The introduction of a small tax impairs effort and advice and leads to a first-order welfare loss. Several other policies towards venture capital and start-up entrepreneurship are also investigated.