Ebook The Staging Of Venture Capital Financing: Milestone Vs. Rounds
It is now difficult to envision grooming of technology-based start-up firms without venture capital backing. From an academic perspective, two features of venture capital are of particular interest compared to other forms of financing. First, venture capital investment is often called smart money, denoting the fact that it plays a dual role. In addition to providing funding, venture capitalists serve their portfolio firms by providing coaching and guidance, as well as networking for strategic alliances and for further funding. Second, unlike investments in quoted companies, there are only a few investors involved in the funding, all of whom are presumed to be sophisticated. Therefore the terms of the funding need not be simple. In fact, they tend to be quite complicated so as to best address the various aspects of each particular case. Even a casual inspection of a typical term sheet reveals a strikingly large number of features, such as convertible and preferred securities, warrants, staged investment with milestones, anti-dilution ratchets, voting arrangements, liquidation preferences, and vesting arrangements.
The current study takes a close look at one phenomenon the venture capitalist contractual commitment over time to the investment. Two types of financial arrangements are contrasted. The first is milestone financing, which includes both an immediate funding by the venture capitalist and a commitment for an additional investment later. The future funding commitment is at a predetermined price and is received by the start-up company once pre specified technological or operational milestones are met. The second arrangement is round financing, in which there is no pre-commitment to invest beyond the current funding needs. Therefore, any subsequent investment is priced based on the realization and the status of the start-up company at the time of the subsequent round. We refer to the former arrangement as milestone investment, and the latter as round investment.
The paper will characterize the situations where the use of milestones is better, vis-?-vis the circumstances where round investment is superior. In the process we explicitly account for several other key characteristics of investment in start-ups the effort level of the entrepreneur, and the degree of involvement expended by the venture capitalist. Other pervasive features that our model accommodates are differential beliefs about the likelihood success of the start-up firm (the entrepreneur is often more optimistic) and the possibility that the venture capitalist has a preference for liquid investments. As will be elaborated upon later, venture capital funds have a strong incentive to exit their investment sooner rather than later, which we phrase liquidity preference. All these considerations play a role in the relative attractiveness of milestone financing compared to round financing. For instance, whether the entrepreneurial effort becomes more or less important when technology succeeds can make apivotal difference to the optimal financial arrangement.
In a comprehensive study, Kaplan and Strömberg (2003) document the features of venture capital contracts. They analyze the terms sheets of over 200 rounds of venture backed investments and link the statistics to agency problems. They also list numerous types of observable and verifiable contingencies that are used in venture capital contracts. Sahlman (1990) and Lerner (1995) provide evidence on the dual role of venture capitalists and their involvement in monitoring and governance. Subsequently, Hellman and Puri (2000, 2002) statistically confirm that the in-kind services of venture capitalists are of economic significance, through a reduction in time to bring a product to market and by professionalizing the start-up company. Also on the empirical side, Gompers (1995) provides detailed statistics on staging of venture capital investments and explores factors that influence the amount invested in a round and the duration between rounds.
From an analytical perspective, Schmidt (2003) and Repullo and Suarez (2004) model the advisory role of the venture capitalists within a double-sided moral hazard framework which gives rise to features in convertible securities used in venture capital financing. Cornelli and Yosha (2003) show that the use of convertible securities mitigates the incentive of entrepreneurs to engage in window dressing practices. The rationale for the advisory role of venture capitalist is analyzed in Casamatta (2003). Under moral hazard, if the entrepreneurial effort is more efficient (less costly) than that of the consultant, the latter is not hired unless invested financially in the project, in the spirit of venture capital involvement. Chemmanur and Chen (2003) study an opposite paradigm whereby pure financing (angel investing) is contrasted with active involvement of venture capital investment. The desired form of financing is characterized based on factors such as scarcity of venture capital funding. Along similar lines, Leshchinskii (2002) contrasts angel investing to venture capital financing by assuming that venture capitalists also aim to benefit from the interaction among their investments.
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