Avoiding Capability Traps Through Contingent Contracts: The Role of Cash and Knowhow in Startups

The impact of an investor’s cash and knowhow on an entrepreneur’s performance has been debated. Investors may argue that their knowhow can substitute for cash, whereas entrepreneurs view knowhow to be a complement for cash, asking for more knowhow when they seek more cash. We model the impact of cash and knowhow in two-stage contingent contracts, subject to the entrepreneur meeting performance goals at the end of the first stage. Analytical findings are tested using angel investment data. Results reveal a nuanced relationship between cash and knowhow. Increasing the level of knowhow provision in the first stage of the contract makes the investor’s offer more attractive to the entrepreneur. However, contracts for such knowhow can create a capability trap, such that insufficient knowhow transfer results in failure to secure second stage financing. Analyzing contract parameters illustrates a tradeoff between the capability trap risk and the amount of second stage investment.