Venture Capital meets Contract Theory - Risky Claims or Formal Control

This paper develops a fi nancial contracting model to investigate the allocation of control and cash flow rights attained through contractual covenants in Venture Capital deals.

This paper demonstrates that an innovative startup selling a venture capital investor a high-powered financial claim to spur costly support should limit the VC's control rights in the venture. This is because high-powered claims associated with control rights encourage excessive VC interference. Cestone discusses three main predictions that can be drawn from this theory and how they relate to existing empirical evidence.

The results of the research challenge the textbook assumption that riskier claims, such as common equity, should always be associated with more control rights. Our model predicts that when both entrepreneurial initiative and VC support are central to a company's success, very risky claims should be granted fewer control rights. More control rights however can be attached to relatively safe claims such as preferred equity.

Recent empirical evidence seems to corroborate this claim. The paper's prediction that riskier claims should have less control attached rests on the importance of both EN initiative and VC advice in innovative ventures. While entrepreneurial initiative is central in traditional corporate finance settings, the valuable support and advising services delivered by venture capitalists are not generally provided by other large shareholders. This explains why the hybrid financial claims (i.e., common stock with limited control attached) devised in venture capital contracts are not commonly observed in other corporate financial arrangements.

A second observation of this paper is that the combination of high-powered claims and weak control rights should be more common among investors who face a high opportunity cost in supporting the success of a portfolio company (i.e., VCs for which c is large). A widespread perception in the business community is that corporate venture funds are more prone to this than independent venture capitalists. Indeed, rather than supporting the portfolio company, corporate VCs may "cannibalize" its idea and let the information shared at various stages of the venture be exploited by the parent house. This explains why entrepreneurs often express concerns about confidentiality when dealing with corporate VCs. In line with Cestone's theory, many corporate venturing programs have adopted a "hands-off approach" to protect entrepreneurs.

Of course, some corporate VCs may resort to other commitment devices to reduce the potential conflict with portfolio companies, which would reduce the need to limit their control rights. A theory put forward here suggests that these corporate VCs may be able to attach more control rights to their equity. Case studies exist which support this theory.

VCs usually lose their superior control rights when their preferred stock is converted into common stock. In a significant number of cases, such conversion occurs automatically once the performance milestone is attained, and thus it is not just an option offered to the venture capitalist. Cestone's theory offers a framework to explain why the venture capitalist should lose control exactly at the time when the preferred stock can (or must) be converted into common stock. Within this framework, the need for automatic conversion clauses can also be rationalised, to the extent that the shift to entrepreneurial control can make the VC wary of converting her preferred equity into common in spite of a good interim performance signal accruing. In this respect, this model also adds to the few financial contracting theories that offer an explanation for the use of automatic conversion clauses.

This research paper has been conditionally accepted for publication in the Review of Finance. The complete draft version is available for download below.


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