Vol. 3 No. 4 | Spring 2002


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Bargaining Power

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, 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 this."

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.

The Rights

"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 Kaplan.

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 their investment.

"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 okay, 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 marginally."

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. Also, vesting clauses 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.

Future Studies

This study is the first in a series of papers on the venture capital investment process that Kaplan and Strömberg are developing. A second paper examines the screening of investments, looking at how VCs monitor and support their investments after the contracts are written. They are currently researching venture capital outside the United States. Until recently, venture capital has been less prevalent and less successful outside the United States, and their study examines why this is the case.

In regards to this initial study on financial contracts, Kaplan notes, "There's a real public policy angle to it. If these contracts are sensible in the United States, and other countries want to know how they can get more VCs to invest, then these are the things other countries should allow their laws to do."


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.

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