What Role of Legal Systems in Financial Intermediation? Theory and Evidence

How does the relationship between an investor and entrepreneur depend on the legal
system? In a double moral hazard framework, we show how optimal contracts,
corporate governance, and investor actions depend on the legal system. With better
legal protection, investors give more non-contractible support, demand more downside
protection, and exercise more governance. Investors in better legal systems develop
stronger governance and support competencies. Therefore, when investing in a different
legal systems they behave differently than local investors. We test these predictions
using a hand-collected dataset of European venture capital deals. The empirical
results confirm the predictions of the model.