Venture Capital Contracts

A large body of academic work examines the problem of financial contracting, and frequently uses the context of an entrepreneur negotiating a financing deal with an investor. Entrepreneurial firms are key drivers of innovation and employment growth, and the efficient allocation of capital to early stage firms is crucial to their success (Solow, 1957). Financial contracting plays an important role at this stage, as information asymmetries and agency problems are severe (Hall and Lerner, 2010), and the observed contracts between entrepreneurs and venture capitalists (VCs) are quite complex. The predominant explanation in the theoretical literature is that the complicated contractual features, such as convertibility, improve incentives and information sharing (e.g., Cornelli and Yosha, 2003). This result is usually derived under the assumption that investors are homogeneous and competitive, and thus earn zero rents.

A contrasting view is that investors negotiate to include certain contract terms not to grow the size of the pie that is divided between the contracting parties, but to change the distribution of the pie in their favor. This is possible because VCs are not homogeneous, as evidenced by the persistence in VC returns (e.g., Kaplan and Schoar, 2005), and the positive relation between VC fees and performance (Robinson and Sensoy, 2013). Similar to models of economic superstars (Rosen, 1981), a VC of lesser quality (a shorthand for its experience, network, and other value-added activities) is usually a poor substitute for a greater quality investor. Moreover, VCs are repeat players in the market for start-up financing, with a broader view of the market and the distribution of possible outcomes, and a better understanding of the implications of complicated contract terms. As a result, they have substantial bargaining power, while lawyers and regulators do not have strong incentives to correct this imbalance. The resulting contracts are favorable to the VC, even if they reduce the start-up’s value. This comes at the expense of the entrepreneur, who experiences poor returns (e.g., Moskowitz and Vissing-Jørgensen, 2002). As of yet, there is little empirical evidence that quantifies in which direction, let alone how much, various contract terms impact outcomes and the distribution of value. This paper helps fill that gap.

A key empirical problem is that contracts are related to the underlying qualities of the entrepreneur and investor, which are unobserved. To address the resulting omitted variables problem we specify a dynamic search and matching model. In broad strokes, the model works as follows. Penniless entrepreneurs search for investors in their start-ups, and vice versa. When two potential counterparties meet, the investor offers a contract. The entrepreneur has bargaining power due to the possibility of refusing the contract and resuming the search process in the hopes of meeting a higher quality investor. The model allows for the contract to affect outcomes (the size of the pie) and the split between investor and entrepreneur (the distribution of the pie), and allows for a world with perfectly competitive investors with no bargaining power as a special case. Intuitively, the dynamic search feature of the model generates a random component to matches, which helps to identify the impact of contracts on outcomes and value splits.

The second main problem is that start-up contracts are private, and data is difficult to find. To take the model to the data, we collect a new data set that contains over 10,000 first-round VC financings between 2002 and 2015. After applying reasonable data filters, we between 1,695 and 2,581 contracts, depending on the outcome variable. This constitutes the largest set of first round contracts studied in the literature to date, and includes data on both cash flow and control rights. Nearly all contracts are some form of convertible preferred equity. We focus on the investor’s equity share upon conversion, participation rights, pay-to-play, and investor seats on the start-up’s board. Participation is a cash flow right that gives the investor a preferred equity payout with an additional common equity claim. In contrast, in a convertible preferred security without participation, the investor must ultimately choose between receiving the preferred payout or converting to common equity (e.g., Hellmann, 2006). Pay-to-play is a term that strips the investor of certain cash flow and/or voting rights if it does not participate in a subsequent round of financing. Board seats are an important control right that gives the VC direct influence over corporate decisions.

We find that contracts materially affect start-up values, with both increasing and decreasing components. Fixing the quality of investor and entrepreneur, the average start-up’s value increases with the investor’s equity share up to an ownership stake (upon conversion) of 16%. Any further increase in the VC’s share decreases firm value. An internal optimal equity share is consistent with theories of double moral hazard in which both the investor and the entrepreneur need to exert effort for the company to succeed. While 16% may appear to be a low stake in the case of common equity contracts, this corresponds to 28% of the average firm’s value, due to preferred terms such as liquidation preferences, which shift more value towards the VC. In the data, however, the average deal gives the VC an equity share of 40%, which corresponds to nearly half of the firm’s value due to preferred terms and VC board seats. Higher quality investors can bargain for higher ownership stakes, since they add more value to the firm and it is costly for the entrepreneur to search for another investor.

Other contract terms besides equity share also impact firm value and its distribution among agents. Again, fixing the agents’ qualities, participation significantly lowers the chance that the venture will succeed, while transferring a larger fraction of its value to the VC. The effects of investor board representation go in the same direction for the average start-up, but are only about a third as strong as participation, and for some deals can raise rather than lower their success probability. Pay-to-play has the opposite effect, increasing value and moving the split in favor of the entrepreneur, and is slightly weaker in magnitude than VC board seats. Although we cannot make statements about the value impact of terms that are always present (for example, liquidation preferences and anti-dilution protection exhibit virtually no variation in the data), we can estimate their joint effect on the value split. Overall, they move the split in favor of the VC and their impact on the start-up’s total value may be positive.

The equilibrium contract terms negotiated between investor and entrepreneur depend strongly on their respective qualities, and there are important interactions and trade-offs between cash flow and control rights. Entrepreneurs (VCs) match with a range of VCs (entrepreneurs) between an upper and lower threshold. While these ranges are generally increasing in the entrepreneur’s (VC’s) quality, endogenous contracting introduces exceptions to this rule, such that positively assortative matching does not necessarily hold in settings with contracts. An entrepreneur who matches with his or her lowest acceptable quality VC negotiates a contract with pay-to-play but no participation or VC board seats, and a low investor equity share. If the same entrepreneur matches with a higher quality VC, the VC’s equity share rises, up to a point where the VC has enough bargaining power to negotiate for board seats (consistent with Rosenstein, Bruno, Bygrave, and Taylor, 1993, who find that high-quality VCs are more likely to receive board seats).  Overall, we find that higher quality VCs receive both participation and board seats and the impact on firm value is nuanced.

It is important to note that the above results do not imply that a VC investment destroys value in equilibrium. An entrepreneur is still better off with a higher quality VC. For example, for an entrepreneur at the 90% (99%) quality quantile, moving from the lowest to the highest VC it can match with raises the start-up’s value by 30% (79%) and the entrepreneur’s value by 5% (32%), even though firm value is not maximized and a larger fraction of it goes to the VC due to a higher equity share, participation and board representation. Also note that even the highest quality VCs still leave almost half of firm value to the entrepreneur, despite their considerable bargaining power.   Overall, our analysis reveals that both contracts and their interaction with investor and entrepreneur quality play important roles in the financing of entrepreneurial firms by VCs.