The venture capital contract and the Institutional Theory in a Spanish setting

Purpose: This paper examines the principles of the Institutional Theory in order to increase the understanding of the contractual covenants that Spanish venture capital firms use in their relationship with the portfolio companies. Design/methodology/approach: The study is based on the data obtained by means of a postal survey addressed to the 70 Spanish venture capital firms registered in the ASCRI (Asociación Española de Entidades de Capital Riesgo) in June, 2002, with a response rate of 68.33%. As a theoretical framework we base on the Institutional Theory as a mechanism to understand the venture capital contractual process. Findings: The results show that a large part of the Spanish venture capital contracts are homogeneous. However, between public and private venture capital firms there is some heterogeneity not only in relation to the industry but also within the field in the design of contracts. It might be due to the coercive pressures exerted by the government on public entities. Research Limitations: Although survey data might create potential biases and possible measurement problems, we consider that our sample has large enough coverage of the venture capital industry (68.33%) that, although cautiously, valid conclusions can be drawn. Originality/value: To the best of our knowledge, this study is one of the first empirical contributions analyzing financial contracts of venture capital firms in Spain. A better understanding of covenants included in venture capital contracts can help Spanish firms to understand the particular terms and restraints of venture capitalists before providing capital. Moreover, this paper also has clear benefits for policy makers and venture capitalists.Fundación Séneca (Project 15403/PHCS/10), and by Ministerio de Ciencia e Innovación (Project ECO2011-29080

Contractual Relations between European VC–Funds and Investors: The Impact of Reputation and Bargaining Power on Contractual Design

The paper explores factors that influence the design of financing contracts between venture capital investors and European venture capital funds. 122 Private Placement Memoranda and 46 Partnership Agreements are investigated in respect to the use of covenant restrictions and compensation schemes. The analysis focuses on the impact of two key factors: the reputation of VC-funds and changes in the overall demand for venture capital services. We find that established funds are more severely restricted by contractual covenants. This contradicts the conventional wisdom which assumes that established market participants care more about their reputation, have less incentive to behave opportunistically and therefore need less covenant restrictions. We also find that managers of established funds are more often obliged to invest own capital alongside with investors money. We interpret this as evidence that established funds have actually less reason to care about their reputation as compared to young funds. One reason for this surprising result could be that managers of established VC funds are older and closer to retirement and therefore put less weight on the effects of their actions on future business opportunities. We also explore the effects of venture capital supply on contract design. Gompers and Lerner (1996) show that VC-funds in the US are able to reduce the number of restrictive covenants in years with high supply of venture capital and interpret this as a result of increased bargaining power by VC-funds. We do not find similar evidence for Europe. Instead, we find that VC-funds receive less base compensation and higher performance related compensation in years with strong capital inflows into the VC industry. This may be interpreted as a signal of overconfidence: Strong investor demand seems to coincide with overoptimistic expectations by fund managers which make them willing to accept higher powered incentive schemes.Venture Capital, Contracting, Limited Partnership, Funds, Principal Agent, Compensation, Covenants, Reputation, Bargaining Power

Contractual relations between European VC-funds and investors: the impact of reputation and bargaining power on contractual design

The paper explores factors that influence the design of financing contracts between venture capital investors and European venture capital funds. 122 Private Placement Memoranda and 46 Partnership Agreements are investigated in respect to the use of covenant restrictions and compensation schemes. The analysis focuses on the impact of two key factors: the reputation of VC-funds and changes in the overall demand for venture capital services. We find that established funds are more severely restricted by contractual covenants. This contradicts the conventional wisdom which assumes that established market participants care more about their reputation, have less incentive to behave opportunistically and therefore need less covenant restrictions. We also find that managers of established funds are more often obliged to invest own capital alongside with investors money. We interpret this as evidence that established funds have actually less reason to care about their reputation as compared to young funds. One reason for this surprising result could be that managers of established VC funds are older and closer to retirement and therefore put less weight on the effects of their actions on future business opportunities. We also explore the effects of venture capital supply on contract design. Gompers and Lerner (1996) show that VC-funds in the US are able to reduce the number of restrictive covenants in years with high supply of venture capital and interpret this as a result of increased bargaining power by VC-funds. We do not find similar evidence for Europe. Instead, we find that VC-funds receive less base compensation and higher performance related compensation in years with strong capital inflows into the VC industry. This may be interpreted as a signal of overconfidence: Strong investor demand seems to coincide with overoptimistic expectations by fund managers which make them willing to accept higher powered incentive schemes

Mitigation of Moral Hazard and Adverse Selection in Venture Capital Financing: The Influence of the Country’s Institutional Setting

A venture capitalist (VC) needs to trade off benefits and costs when attempting to mitigate agency problems in their investor-investee relationship. We argue that signals of ventures complement the VC’s capacity to screen and conduct a due diligence during the pre-investment phase, but its attractiveness may diminish in institutional settings supporting greater transparency. Similarly, whereas a VC may opt for contractual covenants to curb potential opportunism by ventures in the post-investment phase, this may only be effective in settings supportive of shareholder rights enforcement. Using an international sample of VC contracts, our study finds broad support for these conjectures. It delineates theoretical and practical implications for how investors can best deploy their capital in different institutional settings whilst nurturing their relationships with entrepreneurs

Understanding the Economic Value of Legal Covenants in Investment Contracts: A Real-Options Approach to Venture Equity Contracts

Valuing early-stage high-technology growth-oriented companies is a challenge to current valuation methodologies. This inability to come up with robust point estimates of value should not and does not lead to a breakdown of market liquidity: instead, efforts are redirected towards the design of investment contracts which materially skew the distribution of payoffs in favor of the venture investors. In effect, limitations in valuation abilities are addressed by designing the investment contracts as baskets of real options instead of linear payoff functions. This paper investigates four common features (covenants) of venture capital investment contracts from a real option perspective, using both analytical solutions and numerical analyis to draw inferences for a better understanding of contract features. The impact of the concept for pricing issues, valuation negotiation and for contract design are considered. It is shown, for example, how "contingent pre-contracting" for follow-up rounds is theoretically a better proposition than the simple "rights of first refusal" commonly found in many contracts. We also provide for results (such as timing of investments, lengths of rounds, choices of liquidation levels, conversion levels) that take into account full interaction of the different features considered. We document some complex facts, such as the concavity of the VC contract value depending on the amount invested at the different stages, the actual share impact of the most common anti-dilution feature, some endogenous motivation for early VC exits from otherwise performing companies and stress overall the importance of a full analysis for efficient contract negotiations and understanding.

THREE ESSAYS IN EMPIRICAL CORPORATE FINANCE

In Chapter 1, I study the effect of limited attention on resource allocation by venture capitalists. Using engagement in the IPO process as a measure of distraction, I document that investments made by distracted venture capitalists into new portfolio companies tend to underperform in terms of their future financial success. Such companies are 7% less likely to go public or become acquired, and also exhibit lower exit multiples. The adverse effect of the attention constraints is present only in the vicinity of the distracting IPO and manifests itself both for individual partners and venture capital funds. Overall, the evidence indicates that the scarcity of attention hypothesis holds in the context of deal sourcing and screening in venture capital, highlighting the presence of skill in the company selection process. In Chapter 2, I document that the private information disclosure shapes the choice of limited partners by venture capital firms. Following the court rulings in 2002-2003, public pensions and public university endowments disclose historical fund-level performance information. The response of venture capital firms to the disclosure was heterogeneous. Top-tier firms that tend to have oversubscribed funds exclude public institutions from their new funds compared to less successful and younger firms. Subsequently, domestic nonpublic institutional investors and foreign limited partners experience an increase in their capital commitments to top-tier venture capital firms. I find no evidence suggesting that the changes are driven by the unwillingness to disclose poor post-dotcom bubble returns. The reversal of the trend highlights the uncertainty over the scope of regulation as the primary reason behind the capital reallocations. In Chapter 3, together with Christoph Herpfer and Roberto Steri we investigate the link between competition in credit markets and an important non-price term in lending, financial covenants. Using an exhaustive dataset covering the U.S. market for leveraged loans, we exploit a regulatory action as a plausibly exogenous reduction in the ability of regulated banks to offer loan contracts with lax covenant protection. As regulated banks demand relatively more covenants, borrowers switch to unregulated lenders, or shadow banks. As a consequence, the market share of regulated banks declined by roughly $30bn, to the advantage of the shadow banking system. This shift is not driven by a general drop in loan supply or change in other lending terms by regulated banks. Our results suggest the necessity to internalize the effects of non-price competition between the regulated and the non-regulated sectors in regulatory decision making

Non-Compete Covenants: Incentives to Innovate or Impediments to Growth

We find that the enforcement of non-compete clauses significantly impedes entrepreneurship and employment growth. Based on a panel of metropolitan areas in the United States from 1993 to 2002, our results indicate that, relative to states that enforce non-compete covenants, an increase in the local supply of venture capital in states that restrict the scope of these agreements has significantly stronger positive effects on (i) the number of patents, (ii) the number of firm starts, and (iii) employment. We address potential endogeneity issues in the supply of venture capital by using endowment returns as an instrumental variable. Our results point to a strong interaction between financial intermediation and the legal regime in promoting entrepreneurship and economic growth.

Engineering a venture capital market: lessons from the American experience

The venture capital market and firms whose creation and early stages were financed by venture capital are among the crown jewels of the American economy. Beyond representing an important engine of macroeconomic growth and job creation, these firms have been a major force in commercializing cutting edge science, whether through their impact on existing industries as with the radical changes in pharmaceuticals catalyzed by venture-backed firms commercialization of biotechnology, or by the their role in developing entirely new industries as with the emergence of the internet and world wide web. The venture capital market thus provides a unique link between finance and innovation, providing start-up and early stage firms - organizational forms particularly well suited to innovation - with capital market access that is tailored to the special task of financing these high risk, high return activities

Venture Capital on the Downside: Preferred Stock and Corporate Control

This Article takes the occasion of the simultaneous collapse of the high technology stock market and the failure of the dot-coin startups, along with the subsequent retrenchment of the venture capital business, to examine the law and economics of downside arrangements in venture capital contracts. The subject matter implicates core concerns of legal and economic theory of the firm. Debates about the separation of ownership and control, relational investing, takeover policy, the law and economics of debt capitalization, and bankruptcy reform, all grapple with the downside problem of controlling and terminating unsuccessful managers for the benefit of outside debt and equity investors (and the related upside problem of incentivizing effective but fallible managers). The factors motivating these debates also bear on venture capital contracting. But venture capital presents a special puzzle for solution. Convertible preferred stock is the dominant financial contract in the venture capital market, at least in the United States. This contrasts with other contexts in corporate finance, where preferred stock is thought to be a financing vehicle long in decline. The only mature firms that finance with preferred, which once was ubiquitous in American capital structures, tend to be firms in regulated industries having little choice in the matter. Tax rules favoring debt finance provide the primary explanation for preferred\u27s decline. But many corporate law observers would suggest dysfunctional downside contracting as a concomitant cause. Simply, preferred performs badly on the downside, where senior security contracts supposedly are at their most effective. Preferred stockholders routinely have been victimized in distress situations by opportunistic issuers who strip them of their contract rights, transferring value to the junior equity holders who control the firm\u27s management. The cumulation of bad experiences adds impetus to a wider trend in favor of debt as the mode of senior participation

The economics of the private equity market

The private equity market is an important source of funds for start-ups, private middle-market companies, firms in financial distress, and public firms seeking buyout financing. Over the past fifteen years, it has been the fastest growing corporate finance market, far surpassing the public equity and public and private bond markets. In this article, Stephen Prowse examines the economic foundations of the private equity market and describes its institutional structure. He also explores reasons for the market's explosive growth and highlights the main characteristics of that growth, including data on returns to private equity investors. He describes the important investors, intermediaries, and issuers in the market and their interactions with each other. In particular, he investigates how the major intermediary in the market--the limited partnership--addresses the severe information problems associated with investing in small private firms.Capital market ; Financial markets ; Venture capital