Advice and monitoring in venture finance

Abstract

This paper provides empirical insight into the role of contracts and legal systems for managing investor–investee relationships along two dimensions: providing advice and addressing conflict. We examine a new detailed dataset from European venture capital (VC) funds. We match very specific contractual terms in VC contracts with the effort (total time spent) and advice that VCs provide to their entrepreneurial investee firms. We also analyze VC–entrepreneur conflicts. We compare the importance of contractual versus non-contractual governance mechanisms, as well as the role of legal systems in different countries for facilitating VC–entrepreneur relationships. The data indicate VC cash-flow and control rights significantly facilitating effort and advice that VCs provide to entrepreneurs. VC–entrepreneur conflicts are closely tied to the quality of laws in which the entrepreneur resides: higher quality legal systems mitigate VC–entrepreneur conflicts. The data further indicate that non-contractual governance mechanisms significantly facilitate VC advice and mitigate VC–entrepreneur conflicts. The results provide a unique unifying look into the role of actual VC contracts and legal settings versus non-contractual governance mechanisms, risk, and success potential on VC–entrepreneur relationships in an international context. Copyright Swiss Society for Financial Market Research 2007Venture capital, Monitoring, Advice, G24, G28, G31, G32,

Venture capital investment practices in Europe and the United States

“…For instance, Casamatta (2003) presents a theoretical analysis of advice provided by VCs. A further theoretical analysis of monitoring and advising is offered by Schindele (2006), for which empirical support is provided by Cumming and Johan (2007). Gygax and Griffiths (2007) extend the range of determinants by considering social and economic factors, for which they provide empirical evidence.…”

Performance differentiation: cutting losses and maximizing profits of private equity and venture capital investments

“…So far, several studies have focused on the determinants of VC and PE performance, however, without separate analyses for the antecedents of good versus bad performing investments. For example, Cumming and Walz (2004) and Cumming and Johan (2007) concentrate on the influence of market and legal factors as well as on the impact of certain characteristics of VC funds, entrepreneurial firms, and investments on the returns of unrealized, partially realized, and fully realized investments. But they do not differentiate in their analysis between the performance of winners and losers of a fund.…”

Venture Capital Meets Contract Theory: Risky Claims or Formal Control?

“…In the last decade empirical studies of venture capital finance have highlighted that in VC deals control rights are allocated independently of cash-flow rights, through separate and distinct contractual covenants (see Kaplan and Strömberg, 2003, or Cumming and Johan, 2007and 2009. This suggests that the rights held by VC investors cannot be described by the standard array of securities defined in corporate finance textbooks.…”

“…Intuitively, when the need for costly support calls for very high-powered VC incentives, the entrepreneur should retain control, thus avoiding investor interference. This implies that when VC support is particularly costly, the venture capitalist holds a class of common stock with no formal 2 Hellmann and Puri (2002), Kaplan and Strömberg (2004), and Cumming and Johan (2007) identify two different roles for venture capitalists. A supporting role, which is welcome by firm founders, whereby the VC contributes to the venture by helping hire key personnel or providing advice on R&D, strategy and product development.…”

“…17 See for instance Gorman and Sahlman (1989), Sahlman (1990), Hellmann and Puri (2002) and Cumming and Johan (2007). 18 The risk of value-destroying actions is perceived as very strong in the venture capital world (see also the discussion in Section ??).…”