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

Abstract

This is the accepted version of the paper.This version of the publication may differ from the final published version. Abstract. This paper develops a theory of the joint allocation of control and cash-flow rights in venture capital (VC) deals. When the need for VC advice and support calls for a high-powered outside claim, the entrepreneur should optimally retain control in order to avoid undue interference. Hence, I predict that more high-powered claims should be associated with fewer control rights. This challenges the idea that control should always be attached to equity-like claims, and is in line with contractual terms used in venture capital, in corporate venturing and in partnerships between biotech start-ups and large corporations. The paper also rationalizes evidence that venture capital contracts include contingencies triggering both a reduction in VC control and the automatic conversion of VC's preferred stock into common. Permanent repository link

Venture Capitalists, Monitoring and Advising

“…One issue that has received relatively less attention in the theoretical literature is the joint allocation of control rights and cashflow rights. Some important exceptions include Cestone (2000) and Hellmann (2000). Cestone focuses on the potential trade-off between the need to encourage entrepreneurial initiative in the early stages of a venture and the need to elicit the venture capitalist's support (help and advice) in later stages.…”

“…strategic advice, customer introductions) but do not monitor (intervene). This case has been studied, in different settings, in a number of contributions, including Bottazzi et al (2005), Casamatta (2003), Cestone (2000), Hellmann (1998), , Lerner and Schoar (2005), Suarez (2000, 2004), and Schmidt (2003). The main novelty here is is the analysis of how the possibility of collusion shapes optimal financial contracts between entrepreneurs and financiers/advisers.…”

Why do entrepreneurs refuse venture capital?

“…Differently from Hellmann (1998), Cestone (2013) suggests that, when the VC investor needs high-powered outside claims, the entrepreneur should have more control rights to avoid excessive interference of the VC investor, and thus to have high incentives to provide effort. This leads to the fact that high-powered outside claims must be associated to lower control rights for the VC investor.…”

“…3 Second, appropriability hazards toward the entrepreneurial venture's technology and the related fear of expropriation might induce entrepreneurs with the most promising novel technologies to self-select out of the VC market (Ueda, 2004), and look elsewhere for other sources of external financing. Finally, while some VCs -e.g., bank-affiliated and government-managed VCs (Andrieu, 2013;Cumming et al, 2017;Grilli andMurtinu, 2014, 2015) -take a 'hands-off' approach to venture oversight (Bottazzi et al, 2008), others are very active in monitoring entrepreneurs' behavior, and many entrepreneurs see this managerial activism as an excessive intrusion in their firm's management (Cestone, 2013;Hellmann, 1998;Sapienza, 1992). The relatively higher presence of hands-off VCs in continental Europe (and in Italy) may lead to a lower likelihood of refusing VC offers; this tendency may be even reinforced by the implicit 'one-shot' nature of the decision at stake in thin VC markets, as the Italian one (see footnote 1).…”

“…Therefore, the first contribution of this study is to understand which venture-level characteristics influence the likelihood that entrepreneurs refuse VC. This is extremely important because VC, in addition to advantages -such as financial resources, advice, and access to other investors, suppliers and clients -, may lead to disadvantages such as window-dressing effects (Cornelli and Yosha, 2003) or agency costs with the entrepreneurs, that is, conflicts about corporate strategy (Hellmann and Puri, 2000), appropriability hazards (Ueda, 2004), and excessive intrusion in a firm's management (Cestone, 2013;Hellmann, 1998;Sapienza, 1992).…”