VC-Contracting.ppt

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 rightsFraction 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.


Table 2 Cash flow rightsFraction 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.


Table 3: Voting rightsPercentage of votes that investors and management

have to effect corporate decisions.

Panel AVCs 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 roundsVCs 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.


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.


Table 6: ContingenciesExtent 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.




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.




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.




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.


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.


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).


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.


VC

Founder

Other

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

Founder

Other


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.


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 modelPrincipal (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 TheoriesPrincipal-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.


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).


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.


VC

Founder

Other

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

Founder

Other

O. Bengtsson and B. A. Sensoy, O. Bengtsson and B. A. Sensoy, “Investor Abilities and Financial Contracting: Evidence from Venture Capital,” ”

November 2009November 2009

2004 - 20072004 - 2007

646 VCs646 VCs1,266 startup companies 1,266 startup companies over 1,534 investment over 1,534 investment

roundsrounds



Downside protectionDownside protection: Extent to which the VC : Extent to which the VC receives a greater fraction of company cash flows receives a greater fraction of company cash flows if company performance is poor.if company performance is poor.

• Liquidation preference.Liquidation preference.• Anti-dilution rights.Anti-dilution rights.• Cumulative dividends.Cumulative dividends.• Redemption rights.Redemption rights.• Participation rights.Participation rights.• Pay-to-play provision.Pay-to-play provision.



More experienced VCs require less downside protectionMore experienced VCs require less downside protection::

More experienced VCs better than less experienced VCs:More experienced VCs better than less experienced VCs:– Survivorship bias (poorly performing VCs find it hard to raise follow-on Survivorship bias (poorly performing VCs find it hard to raise follow-on

funds).funds).

– Learning-by-doing nature of VC investing.Learning-by-doing nature of VC investing.

Consistent with above: Consistent with above: Baker and Gompers (2003), Kaplan and Baker and Gompers (2003), Kaplan and

Stromberg (2003) and Wongsunmai (2008): Stromberg (2003) and Wongsunmai (2008): More experienced VCs more More experienced VCs more likely to sit on board of directors – increases their ability to control likely to sit on board of directors – increases their ability to control agency problems, and credibly threatening to replace the agency problems, and credibly threatening to replace the entrepreneur.entrepreneur.

Sorensen (2007): Companies backed by more experienced VCs more Sorensen (2007): Companies backed by more experienced VCs more likely to go public.likely to go public.

Chemmanur, Krishnan, Nandy (2008): Companies backed by more Chemmanur, Krishnan, Nandy (2008): Companies backed by more experienced VCs grow faster, spend less.experienced VCs grow faster, spend less.



More experienced VCs require less downside protectionMore experienced VCs require less downside protection::

More experienced VCs better than less experienced VCs:More experienced VCs better than less experienced VCs:– Survivorship bias (poorly performing VCs find it hard to raise follow-on Survivorship bias (poorly performing VCs find it hard to raise follow-on

funds).funds).

– Learning-by-doing nature of VC investing.Learning-by-doing nature of VC investing.

Refusal of an experienced VC to participate in a follow-up investment Refusal of an experienced VC to participate in a follow-up investment more costly to the company than refusal of an inexperienced VC: more costly to the company than refusal of an inexperienced VC:

– Loss of value-added services.Loss of value-added services.

– Negative signal to other potential VCs.Negative signal to other potential VCs.

VC-Contracting.ppt

Economy & Finance

venture capital contracts

contingencies panel

subsequent vc rounds

shares contingent

financing rounds

panel bprerevenue rounds

panel d

panel c