VC Contracting

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					Venture Capital Contracts: Kaplan-Stromberg (2001, 2003)


Table 1

•Panel D: Financing amount
      •$4.8 million committed per round
      •$3.8 million provided per round

•Panel F: Industries
      • Mostly technology based.

•Panel G: Type of security
      •Convertible preferred stock is most common.
    Venture Capital Contracts: Kaplan-Stromberg (2000)


Table 2 Cash flow rights
       Fraction of a portfolio company’s equity value that
different investors and management have claim to.

Panel A
   •VC 50%, Founders 30%
   •Substantial equity ownership on the part of
   founders/managers is desirable.
   •Founders/managers give up large fraction of ownership
   to VCs.
    Venture Capital Contracts: Kaplan-Stromberg (2000)


Table 2 Cash flow rights
       Fraction of a portfolio company’s equity value that
different investors and management have claim to.

Panel B
   •Pre-revenue round
      •VC stake is 6.1% less in good-performance state.
      •Founder stake is 3.3% more in good-performance
      state.
    Venture Capital Contracts: Kaplan-Stromberg (2000)


Table 3: Voting rights
       Percentage of votes that investors and management
have to effect corporate decisions.

Panel A
       VCs have a voting majority in 56% of financings when
performance is good.
       VCs have a voting majority in 71% of financings when
performance is bad.

Panel B Pre-revenue rounds
       VCs have a voting majority in 66% of financings when
performance is good.
       VCs have a voting majority in 87% of financings when
performance is bad.
    Venture Capital Contracts: Kaplan-Stromberg (2000)


Table 4: Board-representation

Panel A
   •6 board members
   •VC has majority of board seats in 26% of cases.
   •Founders have majority in 12% of cases.
   •Neither has majority in 62% of cases.

   •Bad performance board provisions in 15% of cases.

•Panel C
   •First VC round: VC majority in 11% of cases.
   •Subsequent VC rounds: VC majority in 38% of cases.
    Venture Capital Contracts: Kaplan-Stromberg (2000)


Table 5: Liquidation Rights

Panel A
   •Cumulative accruing dividend: 46% of cases
   •Dividend rate: 8%
   •VC liquidation rights > investment: 75% of cases


•Panel C
   •Redemption/put rights in 85% of cases.
   •Redemption maturity: 5 years.
    Venture Capital Contracts: Kaplan-Stromberg (2000)


Table 6: Contingencies
       Extent to which contracts between VCs and
entrepreneurs are written contingent on subsequent output,
performance, or actions.

Panel A: 20% of financing rounds include provisions that are
contingent on subsequent financial performance.
   •Employee shares vest if revenue goal attained.
   •VC gets voting control if realized EBIT below threshold.
   •VC preferred dividends suspended if revenue and
   operating profit goals attained.
   Venture Capital Contracts: Kaplan-Stromberg (2000)


Table 6: Contingencies
       Extent to which contracts between VCs and
entrepreneurs are written contingent on subsequent output,
performance, or actions.

Panel B: 12.5% of financing rounds include provisions that
are contingent on subsequent non-financial performance.
   •Employee shares vest when company secures threshold
   number of customers who give positive feedback.
   •Founder shares vest contingent on FDA approval of new
   drug.
   •Founder shares vest contingent on approval of patents.
   •Founder loses voting rights if terminated for cause.
    Venture Capital Contracts: Kaplan-Stromberg (2000)


Table 6: Contingencies
       Extent to which contracts between VCs and
entrepreneurs are written contingent on subsequent output,
performance, or actions.

Panel C: 14% of financing rounds include provisions that are
contingent on certain actions being taken.
   •Vesting of shares contingent on hiring new key
   executives.
   •Committed funding paid out subject to developing new
   facilities.
    Venture Capital Contracts: Kaplan-Stromberg (2000)


Table 6: Contingencies
       Extent to which contracts between VCs and
entrepreneurs are written contingent on subsequent output,
performance, or actions.

Panel D: 10% of financing rounds include provisions that are
contingent on sale of securities.
   •Founder vesting accelerates upon sale or IPO of certain
   minimum value.
   •Cumulative dividend suspended upon sale or IPO of
   certain minimum value.
    Venture Capital Contracts: Kaplan-Stromberg (2000)


Table 7: Contingencies

Panel A: 36.5% of financing rounds include provisions that
are contingent on subsequent financial or non-financial
performance, certain actions, or sale of securities.

15% of financings themselves are contingent on the
attainment of some milestone.

Non-financial performance contingencies more likely in pre-revenue
rounds.
Financial performance contingencies more likely in post-revenue rounds.
    Venture Capital Contracts: Kaplan-Stromberg (2000)


Table 8: Automatic Conversion

Convertible securities held by VC automatically converts to common
stock at the time of an IPO (of certain minimum value).

Black and Gilson (1998): If company attains a certain level
of performance, VCs are required to give up superior
control, voting, board, and liquidation rights.
       This provides entrepreneur an incentive to increase
the value of the firm over and above the monetary incentive
(provided by the entrepreneur’s equity ownership in the
company).
    Venture Capital Contracts: Kaplan-Stromberg (2000)


Table 8: Automatic Conversion

Panel A: Automatic conversion provision in 94% of financing
rounds.

IPO price 3.0X financing round stock price => VCs are not
willing to give up any control until they triple their money.

Tripling money in over 4 years => 31% return per year.
    Venture Capital Contracts: Kaplan-Stromberg (2000)


Table 8: Antidilution protection: Protects VC against future
financing round at a lower valuation than the valuation of the
current round.

Panel B: 95% of financing rounds receive antidilution
protection.



                         VC                             VC
                                                        Founder
                         Founder
                                                        Other
                         Other
    Venture Capital Contracts: Kaplan-Stromberg (2000)


Table 8: Vesting and non-compete clauses

It is not possible to write enforceable contracts that force the
entrepreneur to stay with the firm.
In real-world contracts, two methods are commonly used to
make it costly for the entrepreneur to leave the firm.
1) Entrepreneur’s shares vest over time. Longer the
entrepreneur stays with company, more shares she gets.
2) Non-compete clause: Prohibits entrepreneur from working
for another firm in the same industry for some time after she
leaves.

Founder vesting in 42% of financing rounds.
Non-compete clauses in 70% of rounds.
    Venture Capital Contracts: Kaplan-Stromberg (2000)


Table 9: Evolution of the contracts over time

Founders’ cash flow, voting, and board rights decline over
rounds while VC rights increase.

Founders relinquish voting control by second round in 88%
of times.
VCs obtain explicit voting control in over 60% of the second
VC round.
 Venture Capital Contracts: Financial-Contracting Theories

Principal-Agent model
Principal (VC) hires the agent (entrepreneur) to run the company.
VC would like the entrepreneur to work very hard.
Entrepreneur’s actions (effort) are unobservable.
However, signals (firm performance) are correlated with entrepreneur’s
actions (effort).
These signals can be contracted on.

VC will want to maximize pay-for-performance for entrepreneur => Give
the entrepreneur a substantial part of the firm’s equity.
Also, VC will want to make the entrepreneur’s compensation contingent
on as many verifiable signals correlated with entrepreneur’s effort as
possible.
  Venture Capital Contracts: Financial-Contracting Theories
Principal-Agent model

Observed contracts consistent with Principal-agent model predictions:

•Entrepreneur gets a substantial fraction of equity in the firm. (Table 2)

•Entrepreneur’s equity stake increases with firm performance. (Tables 6
and 7)

•Pay-for-performance sensitivity is greater in early stage firms where
observability problems are largest. (Table 2)

•Entrepreneur’s equity compensation conditional on multitude of signals,
financial and non-financial. (Tables 6 and 7)

Principal-agent model makes no predictions about allocation of control
rights.
 Venture Capital Contracts: Financial-Contracting Theories

Control model: Cash flow is verifiable but actions are not

Entrepreneurs derive private benefits from control:
Entrepreneur will try to avoid giving up control rights as much as
possible.

Implications:
1) As the external financing capacity of the project increases (e.g., the
later the stage, higher the verifiable monetary benefits) a movement from
more VC control to entrepreneur control.
2) If the entrepreneur has to give up control rights, he will do so first in
states where control rights are most valuable to the VC (when firm is
doing poorly).
 Venture Capital Contracts: Financial-Contracting Theories

Screening Models

Entrepreneur has better information about project’s commercial viability
than VC.

•Cash flow rights contingent on performance motivates entrepreneurs to
provide effort and
•discourages entrepreneurs with bad projects from accepting the
contract.
Venture Capital Contracts: Financial-Contracting Theories
Screening Models

Entrepreneur has better information about project’s commercial viability
than VC.

Anti-dilution provisions penalize entrepreneurs with bad projects
because the current VC investment will be repriced (at the expense of
the entrepreneur) if a future financing is completed at a lower price.




                        VC
                                                             VC
                        Founder
                                                             Founder
                        Other
                                                             Other
                         O. Bengtsson and B. A. Sensoy,
 “Investor Abilities and Financial Contracting: Evidence from Venture Capital,”
                                 November 2009



2004 - 2007
646 VCs
1,266 startup companies over 1,534 investment
rounds
                         O. Bengtsson and B. A. Sensoy,
 “Investor Abilities and Financial Contracting: Evidence from Venture Capital,”
                                 November 2009


Downside protection: Extent to which the VC
receives a greater fraction of company cash flows
if company performance is poor.
   •   Liquidation preference.
   •   Anti-dilution rights.
   •   Cumulative dividends.
   •   Redemption rights.
   •   Participation rights.
   •   Pay-to-play provision.
                          O. Bengtsson and B. A. Sensoy,
  “Investor Abilities and Financial Contracting: Evidence from Venture Capital,”
                                  November 2009


More experienced VCs require less downside protection:

More experienced VCs better than less experienced VCs:
    – Survivorship bias (poorly performing VCs find it hard to raise follow-on
      funds).
    – Learning-by-doing nature of VC investing.
Consistent with above: Baker and Gompers (2003), Kaplan and
Stromberg (2003) and Wongsunmai (2008): More experienced VCs more
likely to sit on board of directors – increases their ability to control
agency problems, and credibly threatening to replace the
entrepreneur.
Sorensen (2007): Companies backed by more experienced VCs more
likely to go public.
Chemmanur, Krishnan, Nandy (2008): Companies backed by more
experienced VCs grow faster, spend less.
                         O. Bengtsson and B. A. Sensoy,
 “Investor Abilities and Financial Contracting: Evidence from Venture Capital,”
                                 November 2009


More experienced VCs require less downside protection:

More experienced VCs better than less experienced VCs:
    – Survivorship bias (poorly performing VCs find it hard to raise follow-on
      funds).
    – Learning-by-doing nature of VC investing.


Refusal of an experienced VC to participate in a follow-up investment
more costly to the company than refusal of an inexperienced VC:
    – Loss of value-added services.
    – Negative signal to other potential VCs.

				
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