Ebook Venture Capital Exit Rights
The question how hold-up can be overcome is central to much of the literature on incomplete contracts. The problem permeates all types of incomplete contracts, including financial and venture capital contracts (Kaplan and Strömberg (2003)). More specifically, Chemla, Habib, and Ljungqvist (2007), extending the model of Nöldeke and Schmidt (1995), propose exit rights as a means to overcome hold-up in the relationship between the venture capitalist (VC) and the entrepreneur with respect to the VC’s exit decision. In this paper we empirically analyze why and when exit rights are being used and to which party these rights are allocated. Our results confirm the above view: exit rights are more frequently held by the VC when he is more likely to be held-up by the entrepreneur.
Given the VC’s limited investment horizon, his exit decision is of vital importance (see Sahlmann (1990) and Gompers and Lerner (2004)). The VC is, however, not the sole owner of the portfolio firm. The firm’s founders normally hold substantial equity stakes, too. This may cause problems as the VC’s and the entrepreneur’s preferences are often not aligned when it comes to the exit decision. First, the entrepreneur derives private benefits from being an owner-manager (Hellmann (1998)). This may lead him to oppose certain exit choices, such as a trade sale in which he typically experiences significant losses of control benefits. Second, both the VC’s organizational structure (Sahlmann (1990)) and the temporary nature of his competitive advantage make the VC more impatient than the entrepreneur and thus create room for hold-up by the entrepreneur. Both reasons may result in ex-post renegotiation. Ex-post renegotiation and the possible losses incurred by the VC in turn may lead to ex-ante under-investment. Therefore, it is not surprising to see that the contracts between the VC and the founders often include provisions that govern this crucial exit decision. Exit rights comprise clauses related to the two most important exit channels, initial public offerings (including demand rights and piggy back rights) and trade sales (including drag-along rights, tag-along rights, and preemption rights).
In this paper we analyze the allocation of exit rights in general but stress two of the most important clauses, drag-along rights and tag-along rights. A drag-along right gives its holder the right to force all other shareholders in the firm to sell their shares to an (outside) buyer at the same price at which the right holder sells his shares. The tag-along right allows the holder to include his shares in a sale for the same price as all other shareholders. Thus these rights possess option-type characteristics.
In order to do so, we introduce a new hand-collected sample of 464 contracts between VCs and entrepreneurs from Germany. Our sample ranges from 1990 to 2004 and is randomly drawn from a large proportion of the German VC market. Our data set not only provides us with the contracts between the VC and the entrepreneur but also allows us to observe characteristics of the firm, the VC, and the entrepreneur.
We use three different proxies for the presence of a hold-up problem: the firm’s current investment round, the presence of exit-expectations and the use of a closed-end fund by the VC. The intuition behind the round variable is simple: on average the higher the round, the closer the exit and thus the more likely the fact that the VC wants to pursue an exit that the entrepreneur uses to enter into renegotiations in the absence of exit rights. Also, the higher the round, the more of the VC’s money and expertise has been sunk in the firm. This increases the VC’s lock-in and ceteribus paribus should increase his desire to gain protection in form of exit rights. The same is true for exit-expectations: if the VC has specific exit expectations, he is more aware of a potential hold-up problem and is more eager to include such rights in the contract. Finally, if the VC has a closed-end fund, the VC’s exit problem is more pressing as opposed to an open-end fund as he has a shorter time horizon, that is he is less patient. This is both due to the limited life span of his fund and due to the fact that he may need a timely exit to prove his ability to the market.
We show that the use of these exit rights is linked to our proxy variables for the presence of a hold-up problem: higher round contracts, contracts of VCs with specific exit expectations, and contracts of VCs that are organized in the form of closed-end funds all entail more exit rights. We also observe an almost exclusive allocation of exit rights towards the VC, but not towards the entrepreneur.
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