Effective Venture Capital Contracts Come in Many Forms
Research by Steven N. Kaplan and Per Strömberg
How much can venture capitalists protect themselves against
losses if an investment goes bad? How much control should
entrepreneurs be prepared to give up? What happens to both
parties when a new venture succeeds? To successfully tackle
the good, bad, and in-between stages of new ventures, writing
the appropriate financial contract is key.
From 1996 to 1999, venture capitalists (VCs) became well-known
players beyond the business community, as more and more people
learned who exactly gave the dot-coms their start-up money.
VCs and entrepreneurs unite based on a promising idea and
a solid business plan. If VCs decide to invest, they will
give the entrepreneur a term sheet listing conditions for
investment. This begins a set of negotiations to hammer out
a contract, a process that can take anywhere from a few days
to a year.
A wide array of economic theories on venture capital has
been developed in recent years, with the majority taking conflicting
positions about which aspects of financial contracts are most
important and what types of contracts are possible. In "Financial
Contracting Theory Meets the Real World: An Empirical Analysis
of Venture Capital Contracts," two University of Chicago
Graduate School of Business professors, Steven N. Kaplan and
Per Strömberg, take a comprehensive approach to studying
venture capital contracts, rather than relying upon market
folklore and anecdotal evidence as some have done in the past.
Using a broad sample of venture capital contracts, they find
that real-world contracts are far more complex than existing
theories predicted, with a surprising degree of variation
from one contract to the next.
Kaplan and Strömberg find that venture capital financings
allow VCs to separately allocate cash flow rights, board rights,
voting rights, liquidation rights, and other control rights,
often contingent on measures of performance. In general, board
rights, voting rights, and liquidation rights are allocated
so that the VCs obtain full control if the company performs
poorly. As company performance improves, the entrepreneur
obtains more control rights. If the company performs very
well, the VCs give up most of their control and liquidation
rights and retain only their cash flow rights.
"Entrepreneurs have to understand that while many contracts
look very harsh, and it may seem like the VCs have too much
control, that's really not the case," says Kaplan. "If
you don't write the contracts a certain way, the VCs won't
give you any money, and some entrepreneurs have trouble understanding
For new entrepreneurs, it is important to grasp the finer
points of venture capital contracts, and in particular the
rights of VCs. As the authors have found in follow-up conversations
with the VCs in the study, even seasoned VCs can benefit from
knowing how other VCs are structuring their contracts. By
bringing attention to the intricacies of venture capital contracts,
the study opens the door to more informed negotiations and
better decision making.
"Underlying all the negotiations is the desire for everyone
to get the required rate of return for the money they are
putting in," says Strömberg. "You also need
to align incentives to make sure everyone is working toward
the same goals, and to allocate control so that things can
be changed if goals are not met."
Kaplan and Strömberg based their study on a sample of
213 investments in 119 companies by 14 venture capital firms.
Each firm provided the contractual agreements governing each
financing round in which the firm participated. When available,
the venture capital firm also provided the company's business
plan, internal evaluations of the investment, and information
on subsequent performance.
"These contracts are tailored to different situations,
and there are a lot of levers that VCs can pull," says
One of the first decisions in contract negotiations is the
type of security issued to the VCs. Separate securities are
used for VCs and entrepreneurs in order to give VCs different
rights. Rights regarding board control and liquidation, for
example, are tied to the VC's stock. Kaplan and Strömberg
find that convertible preferred stock is the most commonly
used security, used in 204 of the 213 financing rounds in
the study. The "convertible preferred" aspect of
the stock allows the VC to convert the stock into a common
stock if the company does well, and to use the stock like
a bond if the company does poorly. Even in cases when common
stock is used, VCs get a different class of common stock with
different rights from those of the founders.
Similarly, contracts allow for different cash flow rights
for venture capitalists and founders. "Cash flow rights
determine how the pie will be split between VCs and entrepreneurs
once the company goes public," says Strömberg, "and
the split is often contingent on performance measures."
In the sample contracts, the VC controls approximately 50
percent of the cash flow rights on average, founders control
30 percent, and others control 20 percent, indicating that
founders give up a large fraction of ownership.
Liquidation cash flow rights and redemption rights work together
to protect the VC's investment if the company is sold or performs
poorly. In nearly all cases, VCs have claims in liquidation
that are senior to the common stock claims of founders. In
98 percent of the cases, VC claims are at least as large as
"Liquidation rights are not going to be very important
if the company fails, because there will be nothing left to
liquidate," says Strömberg. "These rights become
important when the company is simply performing OK, but not
great. Putting liquidation and redemption rights together
means that if nothing has happened in five years' time, for
example, the VC has the right to demand repayment. It's a
way to get money out of ventures that are only performing
Board and voting rights allow VCs to have input in decisions
about top management, corporate strategies, and any other
action not already specified in the original contract. In
18 percent of the cases, provisions are made so that the VC
will get full control of the board if the company performs
poorly. In first venture capital rounds, 41 percent of the
cases allow VCs to have voting majority.
Building Incentives for Entrepreneurs
Kaplan and Strömberg find that venture capital financings
include a number of additional terms and conditions beyond
the basic rights. For example, venture capital financings
often include automatic conversion provisions in which the
security held by the VC automatically converts into common
stock under certain conditions. These conditions require that
certain financial targets be met, and almost exclusively depend
on an initial public offering that exceeds a designated common
stock price. If the company goes public for a high value,
the VCs only keep their cash flow rights, ceding the majority
of control to the entrepreneurs. At some point after VCs give
up control, they sell their stock and move on to new investments.
An automatic conversion provision is present in 95 percent
of the financing rounds. Financings that included this provision
also required that the stock price of the initial public offering
be on average three times greater than the stock price of
the financing round. The VCs are therefore not willing to
give up control unless they triple their money.
Many contracts also utilize vesting and noncompete clauses
to make it costly for the entrepreneur to leave the firm.
Tying the entrepreneur to the firm is particularly important
in cases where most of the value of the venture lies in the
entrepreneur's unique skills. Vesting clauses also give the
VCs a way to remove a badly performing CEO without having
to keep him or her as a potentially obstructing minority investor
down the road.
The vesting provision requires that the entrepreneur's shares
vest over time, and thus if the entrepreneur leaves before
the end of the vesting period, they will lose all of their
stock. This provision is used in approximately 41 percent
of financing rounds. The VCs also can require the entrepreneurs
to sign a noncompete contract that prohibits him or her from
working for another firm in the same industry for some period
of time after leaving. Noncompete clauses are used in approximately
70 percent of the financings.
Of the many possible contingencies attached to different
rights, 73 percent of the financings include at least one
contingency. In almost 15 percent of the financings, the VCs
provide only a portion of the total funding commitment at
the signing of the financing. Additional funding is contingent
on subsequent performance and actions. Along with financial
performance, VCs also may consider such indicators as product
performance or FDA or patent approvals. Kaplan and Strömberg's
findings contradict earlier theories, which argued that such
performance-based contingencies cannot be written into contracts
because they cannot be measured. VCs can and do write contracts
with a variety of contingencies, indicating managerial actions
that the VC is trying to induce or avoid.
Public Policy Angle
This study is the first in a series of papers by Kaplan and
Strömberg on the venture capital investment process.
A second paper examines the screening of investments, looking
at how VCs monitor and support their investments after the
contracts are written. A third paper compares U.S. venture
capital contracts to those outside the United States.
In regards to these studies of financial contracts, Kaplan
notes, "There's a potential public policy angle to them.
The contracts in the United States appear to be particularly
sensible or efficient. If other countries would like to increase
VC investment, they might want to alter their laws to facilitate
the ability to write such contracts."
Steven N. Kaplan is Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago Graduate School of Business. Per Strömberg is associate professor of finance at the University of Chicago Graduate School of Business.