Facts about contracts capital structure, and goverance
Amornsiripanitch, N., Gompers, P.A. and Xuan, Y. (2019) ‘More than Money: Venture Capitalists on Boards’, The Journal of Law, Economics, and Organization, 35(3), pp. 513–543.
We explore patterns of board structure and function in the venture capital industry, identifying factors that influence whether venture capitalists receive a board seat and whether they take action to help portfolio companies in which they invest. In a comprehensive sample of US-based and non-US-based companies, we find that a venture capital firm’s prior relationship with the founder, lead investor status, track record, network size, and geographical proximity to the portfolio company are positively correlated with its likelihood of taking a board seat in an investment round. When venture capital investors serve on the board, portfolio companies tend to recruit managers and board members from these investors’ network and are more likely to exit via relationship-based acquisitions. These patterns are particularly strong for successful and well-connected venture capitalists on the board.
Ewens, Michael, Alexander Gorbenko, and Arthur Korteweg. “Venture capital contracts.” Journal of Financial Economics 143.1 (2022): 131-158.
We estimate the impact of venture capital (VC) contract terms on startup outcomes and the split of value between the entrepreneur and investor, accounting for endogenous selection via a novel dynamic search-and-matching model. The estimation uses a new, large data set of first financing rounds of startup companies. Consistent with efficient contracting theories, there is an optimal equity split between agents, which maximizes the probability of success. However, venture capitalists (VCs) use their bargaining power to receive more investor-friendly terms compared to the contract that maximizes startup values. Better VCs still benefit the startup and the entrepreneur due to their positive value creation. Counterfactuals show that reducing search frictions shifts the bargaining power to VCs and benefits them at the expense of entrepreneurs. The results show that the selection of agents into deals is a first-order factor to take into account in studies of contracting.
Kaplan, S.N. and Strömberg, P. (2003) ‘Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts’, The Review of Economic Studies, 70(2), pp. 281–315.
We compare the characteristics of real-world financial contracts to their counterparts in financial contracting theory. We do so by studying the actual contracts between venture capitalists (VCs) and entrepreneurs. The distinguishing characteristic of VC financings is that they allow VCs to separately allocate cash flow rights, board rights, voting rights, liquidation rights, and other control rights. We describe and measure these rights. We then interpret our results in relation to existing financial contracting theories. We also describe the interrelation and the evolution across financing rounds of the different rights.We compare the characteristics of real-world financial contracts to their counterparts in financial contracting theory. We do so by studying the actual contracts between venture capitalists (VCs) and entrepreneurs. The distinguishing characteristic of VC financings is that they allow VCs to separately allocate cash flow rights, board rights, voting rights, liquidation rights, and other control rights. We describe and measure these rights. We then interpret our results in relation to existing financial contracting theories. We also describe the interrelation and the evolution across financing rounds of the different rights.
Kaplan, S.N. and Strömberg, P. (2004) ‘Characteristics, Contracts, and Actions: Evidence from Venture Capitalist Analyses’, The Journal of Finance, 59(5), pp. 2177–2210.
We study the investment analyses of 67 portfolio investments by 11 venture capital (VC) firms. VCs describe the strengths and risks of the investments as well as expected post-investment actions. We classify the risks into three categories and relate them to the allocation of cash flow rights, contingencies, control rights, and liquidation rights between VCs and entrepreneurs. The risk results suggest that agency and hold-up problems are important to contract design and monitoring, but that risk sharing is not. Greater VC control is associated with increased management intervention, while greater VC equity incentives are associated with increased value-added support.
Robb, A.M. and Robinson, D.T. (2014) ‘The Capital Structure Decisions of New Firms’, The Review of Financial Studies, 27(1), pp. 153–179.
We study capital structure choices that entrepreneurs make in their firms’ initial year of operation, using restricted-access data from the Kauffman Firm Survey. Firms in our data rely heavily on external debt sources, such as bank financing, and less extensively on friends-and-family-based funding sources. Many startups receive debt financed through the personal balance sheets of the entrepreneur, effectively resulting in the entrepreneur holding levered equity claims in their startups. This fact is robust to numerous controls, including credit quality. The reliance on external debt underscores the importance of credit markets for the success of nascent business activity.
Contract theory (for startups)
Admati, Anat R., and Paul Pfleiderer. “Robust financial contracting and the role of venture capitalists.” The Journal of Finance 49.2 (1994): 371-402.
We derive a role for inside investors, such as venture capitalists, in resolving various agency problems that arise in a multistage financial contracting problem. Absent an inside investor, the choice of securities is unlikely to reveal all private information, and overinvestment may occur. An inside investor, however, always makes optimal investment decisions if and only if he holds a fixed-fraction contract, where he always receives a fixed fraction of the project’s payoff and finances that same fraction of future investments. This contract also eliminates any incentives of the venture capitalist to misprice securities issued in later financing rounds.
Aghion, P. and Tirole, J. (1994) ‘The Management of Innovation’, The Quarterly Journal of Economics, 109(4), pp. 1185–1209.
The paper analyzes the organization of the R&D activity in an incomplete contract framework. It provides theoretical foundations: (a) to understand how the allocation of property rights on innovations may affect both the frequency and the magnitude of these innovations; (b) to rationalize commonly observed features in research employment contracts, such as shop rights, trailer clauses, and the “hired for” doctrine; (c) to discuss the robustness of the so-called Schumpeterian hypotheses to endogenizing the organization of R&D; and (d) to provide a rationale for cofinancing arrangements in research activities.
Cornelli, F. and Yosha, O. (2003) ‘Stage Financing and the Role of Convertible Securities’, The Review of Economic Studies, 70(1), pp. 1–32.
Venture capital financing is characterized by extensive use of convertible securities and stage financing. In a model where a venture capitalist provides staged financing for a project, we illustrate an advantage of convertible debt (or warrants) over a mixture of debt and equity. Essentially, when the venture capitalist retains the option to abandon the project, the entrepreneur has an incentive to engage in window dressing and bias positively the short-term performance of the project, reducing the probability that it will be liquidated. An appropriately designed convertible security prevents such behaviour because window dressing also increases the probability that the venture capitalist will exercise the conversion option becoming the owner of a substantial fraction of the project’s equity.
Gompers, P.A. (1995) ‘Optimal Investment, Monitoring, and the Staging of Venture Capital’, The Journal of Finance, 50(5), pp. 1461–1489.
This paper examines the structure of staged venture capital investments when agency and monitoring costs exist. Expected agency costs increase as assets become less tangible, growth options increase, and asset specificity rises. Data from a random sample of 794 venture capital-backed firms support the predictions. Venture capitalists concentrate investments in early stage and high technology companies where informational asymmetries are highest. Decreases in industry ratios of tangible assets to total assets, higher market-to-book ratios, and greater R&D intensities lead to more frequent monitoring. Venture capitalists periodically gather information and maintain the option to discontinue funding projects with little probability of going public.
Hellmann, T. (1998) ‘The Allocation of Control Rights in Venture Capital Contracts’, The RAND Journal of Economics, 29(1), pp. 57–76.
Venture capitalists often hold extensive control rights over entrepreneurial companies, including the right to fire entrepreneurs. This article examines why, and under what circumstances, entrepreneurs would voluntarily relinquish control. Control rights protect the venture capitalists from hold-up by the entrepreneurs. This provides the correct incentives for the venture capitalists to search for a superior management team. Wealth-constrained entrepreneurs may give up control even if the change in management imposes a greater loss of private benefit to them than a monetary gain to the company. The model also explains why entrepreneurs accept vesting of their stock and low severance.
Neher, D.V. (1999) ‘Staged Financing: An Agency Perspective’, The Review of Economic Studies, 66(2), pp. 255–274.
This paper investigates the structure of outside investment in a profitable entrepreneurial venture. Though efficient, financing the venture up front may be infeasible because the entrepreneur cannot commit to not renegotiate down the outside investor’s claim once she’s sunk her investment. Staging the investment over time helps to mitigate this commitment problem. The early rounds of investment create collateral that support the later rounds. We characterize the optimal staged investment path and show how it is affected by various features of the venture. The predictions of the model are consistent with observations on staged financing in venture capital.