How Do Legal Differences and Experience Affect Financial Contracts?
Research by Steven N. Kaplan and Per Strömberg
Financial contracts play an important role in structuring
incentives between entrepreneurs and investors, thus making
it possible for new ventures to obtain financing. Effective
financial contracts have been developed over several business
cycles in the United States. Do U.S.-style contracts also
work in other countries?
In earlier studies, University of Chicago Graduate School
of Business professors Steven N. Kaplan and Per Strömberg
have shown that venture capital (VC) contracts in the United
States successfully address the risks and monitoring needs
of venture capitalists. These contracts carefully allocate
cash flow rights, liquidation rights, and control rights between
the entrepreneur and the venture capitalist. The terms of
these contracts usually depend on company performance.
Almost all VC contracts in the United States use convertible
preferred stock, which usually includes control rights and
liquidation rights that protect the venture capitalist. Pure
common stock has no such protection. With convertible preferred
stock, the VCs get more equity if the company performs well,
and get control of the company if performance targets are
not met.
Though venture capital investments are much less prevalent
outside of the United States, there was a surge of VC activity
abroad during the Internet boom.
In a recent study, "How Do Legal Differences and Learning
Affect Financial Contracts?," Kaplan and Strömberg,
along with Frederic Martel of the University of Lausanne IMD
and UBS Global Asset Management, compare venture capital contracts
in 23 countries to contracts in the United States. The authors
analyze how the contracts allocate cash flow, and board, liquidation,
and other control rights.
The ability of a venture capitalist to design financial contracts
may be affected by a country's institutional environment,
including: the nature of corporate and contract law, the quality
of legal enforcement, accounting systems, tax regulations,
and financial markets.
Different styles of contracts may be optimal in different
countries. However, the authors find that differences in legal
rules, tax rules, accounting rules, and market institutions
do not explain the variations in contracts among the sample
countries.
Venture capital investing outside the United States is more
recent, and must be adapted to different legal rules. Learning
about optimal contracts takes time.
Is it the case that unsuccessful VCs simply have not learned
how to design the best contracts?
Convertible preferred stock is not as widely used in VC contracts
outside the United States. For the purpose of the study, the
use of convertible preferred stock is indicative of using
U.S.-style contracts, since this stock is used in virtually
all U.S. financings.
The authors find that past experience outweighs the institutional
variables in determining the differences between contracts.
More experienced and sophisticated venture capitalists are
able to implement U.S.-style contracts regardless of legal
regime.
"Our results suggest that U.S.-style contracts are economically
efficient not only in the United States, but in all developed
countries," says Kaplan.
The Variations
For the 23 countries represented in the study, Kaplan, Strömberg,
and Martel compared 145 investments in 107 companies by 70
lead VCs. Their data came from VCs who invest abroad. Additional
data was provided by an institutional investor who invests
in VC partnerships abroad. All VC partnerships in the study
are for-profit, non-governmental entities.
For each company and for each financing round, the VCs provided
the authors with term sheets, stock and security purchase
agreements, the company's business plan, and the VC's internal
analysis of the investment.
The companies studied are concentrated in Western Europe.
All but eight of the investment rounds were completed after
1997. The majority of the companies
(58 percent) are software and Internet firms. Roughly two-thirds
of the investments were for young companies. The average VC
invested between $6 million and $7 million in a given venture.
The results show much more variation in the types of securities
used outside the United States than within the United States.
While more than 95 percent of U.S. financings use some type
of convertible preferred stock, fewer than 54 percent of the
non-U.S. financings use convertible preferred stock. As a
result, VC contracts outside the United States have weaker
liquidation and exit rights. Ordinary common stock is found
more often outside the United States and is used in almost
28 percent of the financings, versus less than 1 percent in
the United States.
Venture capital investments in other countries are also less
likely to use contingencies, such as funding milestones, vesting
provisions, and anti-dilution rights. These contingencies
all increase the sensitivity of the founder's cash flow rights
to the new firm's performance. Overall, VC contracts outside
the United States have weaker investor rights of all types
than those in the United States.
In addition to the characteristics of the contracts, the
authors considered how contracts vary with the legal origin
of the country in which the portfolio company is located.
Certain provisions typical of U.S.-style contracts may be
infeasible or costly to enforce in other countries. The study
covers five different legal regimes: common law, civil law,
German law, Scandinavian law, and communist.
The authors find that contracts in common law countries,
such as the United Kingdom, are more likely to resemble U.S.-style
contracts, while contracts elsewhere are more likely to differ.
Common law countries tend to have more market-based financial
systems with more equity markets.
Overall, legal, tax, and institutional differences do not
provide an adequate explanation for the relationship between
contract characteristics and legal origin.
Measuring Sophistication
How much does VC experience affect the type of financial
contracts they use?
Using legal variables and measures of VC "sophistication,"
the authors compared the importance of legal regime to learning
and experience.
These "sophistication" measures included:
Size: Smaller VCs, with no more than $200 million
under management, versus larger VCs.
Age: Younger VCs with four or less years of experience,
versus older VCs.
Experience with the United States: 37 financings were
led by VCs based in the United States, 87 financings were
led by VCs who had previously invested in the United States,
and 37 financings were led by VCs with no U.S. experience.
The authors find VCs are more likely to use U.S.-style contracts
when the VC is larger, older, and has previous experience
working with U.S. investors.
These measures turn out to be strong predictors for whether
the VC uses a U.S-style contract, with convertible preferred
stock, liquidation rights, stronger exit provisions, and other
rights.
The results suggest that VC sophistication variables are
more important in determining how VCs structure contracts
than legal and institutional variables.
To explore the relationship between VC sophistication and
post-investment success, the authors studied the survival
of the 70 VCs represented as lead investors in the sample.
As of August 2003, 59 of the 70 funds are still active, while
11 have failed or been acquired. The authors then separated
the VC funds depending on the securities they used when acting
as lead investors. Of the 37 funds that used convertible preferred
stock (and U.S.-style contracts) exclusively, all have survived
the tech bust. On the other hand, 10 of the 29 funds that
exclusively used common stock (and non-U.S.-style contracts)
have failed.
Survival and failure results do not prove a simple cause
and effect scenario, but it is clear that the more successful
VCs use convertible or participating preferred (another type
of convertible preferred) rather than common stock. VCs who
use U.S.-style contracts are significantly less likely to
fail.
While some VCs are able to get around institutional constraints
to implement U.S.-style contracts, it is not as simple as
exporting U.S.-style contracts abroad. Even in cases where
VCs would like to implement U.S.-style contracts, it may cost
the VCs to do so. There are "fixed costs of learning,"
for example, the potentially sizeable legal fees associated
with having contracts rewritten to these specifications.
"Our results imply that if you have a different legal
system, you aren't stuck," says Strömberg. "While
it may be difficult to write around laws in other countries,
it is still possible to replicate U.S.-style mechanisms in
your financial contracts if you are clever and find the right
lawyer."
Besides rewriting contracts to include U.S.-style provisions,
21 percent of the companies in the sample reincorporate in
another country with a less restrictive institutional environment.
"Inexperienced and unsophisticated venture capitalists
may not have understood why convertible preferred stock was
necessary, and chose common stock instead," says Kaplan.
"In the end, those VCs had very little protection, and
some ended up going out of business when the technology market
crashed."
Since contracts are important for VC success, the authors
expect that over time, the more sophisticated and successful
VCs will implement more effective contracts. Furthermore,
the evolution to more effective contracts is likely to accelerate
in periods of high volatility, such as the bursting of the
tech bubble.
Convergence
As financial markets become more global, the authors expect
a greater convergence toward U.S.-style contracts.
"If I were advising a country about how to set up its
legal and financial structure, I would make it easier for
VCs to write U.S.-style contracts," says Kaplan.
Strömberg notes that for policymakers in other countries,
it is important to allow investing by U.S. venture capitalists,
because their systems can learn a great deal from U.S. VCs.
The authors find that though many foreign VCs have gone stale,
these VCs have learned from the experience, and are taking
heed to structure their future contracts with more U.S.-style
provisions, including convertible preferred stock.
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.
