Ebook Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts
There is a large academic literature on the principal-agent problem in financial contracting. The papers in this literature often begin with a situation in which an investor negotiates with an entrepreneur over the financing of a project or company. Despite the large volume of theory, relatively little empirical work exists that compares the characteristics of real world financial contracts to their counterparts in financial contracting theory. In this paper, we attempt to inform theory by describing in detail the contracts between venture capitalists (VCs) and entrepreneurs. We compare the actual contracts to the assumed and predicted ones in different financial contracting theories.
In doing this, we assume that VCs are real world entities who closely approximate the investors of theory. VCs invest in entrepreneurs who need financing to fund a promising venture. VCs have strong incentives to maximize value, but, at the same time, receive few or no private benefits of control. Although they are intermediaries, VCs typically receive at least 20% of the profits on their portfolios.
We study 213 VC investments in 119 portfolio companies by 14 VC firms. Each VC firm provided the contractual agreements governing each financing round in which the firm participated. The VC firm also provided (if available) the company’s business plan, internal analyses evaluating the investment, and information on subsequent performance.
We find that VC financings allow VCs to separately allocate cash flow rights, board rights, voting rights, liquidation rights, and other control rights. These rights are often contingent on observable measures of financial and non-financial performance. In general, board rights, voting rights, and liquidation rights are allocated such that if the firm performs poorly, the VCs obtain full control. As performance improves, the entrepreneur retains / obtains more control rights. If the firm performs very well, the VCs retain their cash flow rights, but relinquish most of their control and liquidation rights.
We also report that it is common for VCs to include non-compete and vesting provisions that make it more expensive for the entrepreneur to leave the firm, thus mitigating the potential hold-up problem between the entrepreneur and the investor.
Finally, the cash flow incentives, control rights, and contingencies in these contracts are used more as complements than as substitutes. Ventures in which the VCs have voting and board majorities are also more likely to make the entrepreneur's equity claim and the release of committed funds contingent on performance milestones.
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