Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts

In this paper, we compare the characteristics of real world financial contracts to their counterparts in financial contracting theory. We do so by conducting a detailed study of actual contracts between venture capitalists (VCs) and entrepreneurs. VCs are the real world entities who arguably most closely approximate the investors of theory. (1) The distinguishing characteristic of VC financings is that they allow VCs to separately allocate cash flow rights, voting rights, board rights, liquidation rights, and other control rights. We explicitly measure and report the allocation of these rights. (2) While convertible securities are used most frequently, VCs also implement a similar allocation of rights using combinations of multiple classes of common stock and straight preferred stock. (3) Cash flow rights, voting rights, control rights, and future financings are frequently contingent on observable measures of financial and non-financial performance. These state contingencies are more common in early stage financings. (4) If the company performs poorly, the VCs obtain full control. As company performance improves, the entrepreneur retains / obtains more control rights. If the company performs very well, the VCs retain their cash flow rights, but relinquish most of their control and liquidation rights. The entrepreneur’s cash flow rights also increase with firm performance. (5) It is common for VCs to include non-compete and vesting provisions aimed at mitigating the potential hold-up problem between the entrepreneur and the investor. We interpret our results as most consistent with the theoretical work of Aghion and Bolton (1992) and Dewatripont and Tirole (1994). No theory, however, appears to explain the multi-dimensional nature of the allocation of control rights in these financings. * Graduate School of Business, University of Chicago. This research has been supported by the Kauffman Foundation, by the Lynde and Harry Bradley Foundation and the Olin Foundation through grants to the Center for the Study of the Economy and the State, and by the Center For Research in Security Prices. Peter Lang and Konstantin Semyonov provided excellent research assistance. Amar Bhide, Mathias Dewatripont, Ron Gilson, Rick Green, Jeremy Stein, Luigi Zingales and seminar participants at Maryland, NYU, and the Stockholm School of Economics provided helpful comments. We are grateful to the venture capital partnerships for providing data. Ted Meyer was particularly helpful. Address correspondence to Per Stromberg, Graduate School of Business, The University of Chicago, 1101 East 58th Street, Chicago, IL 60637 or e-mail at [email protected].