The cash provisions to the start-up companies are such that the next performance milestones are attainable. Hence, by staging capital provisions venture capitalists are able to check whether the expected net capital return of investing in the next project stage is still positive. Previous investment costs are sunk.
The economic rationale to this behavior is that ceteris paribus (c.p.) the ex ante overall firm value, is higher compared to a situation where the founder gets the whole planned investment sum upfront.
This is because the founder usually invests none or little of his own capital but participates proportionally in the total project returns. Hence, there is the possibility that he does not have the right incentives to abandon timely projects with an overall negative capital return.
Theoretical analyses have shown that the efficient decision about project continuation should be transferred to an informed investor, that is, a venture capitalist, whereby the detailed specii cation of the financing contract depends on further circumstances.
For example, there could be informational asymmetries between the project founder and the venture capitalist caused by "window dressing", that is, the manipulation of signals about project quality by the project founder. In such cases the combination of capital staging and convertible securities could provide an efficient solution.