Chapter 6: Venture capital

What is the motivation of Kaplan & Strömberg (2003)?

Kaplan & Strömberg study how venture capital (VC) contracts are designed in the real world. Previous theories explained how contracts should solve principal-agent problems, but there was little evidence on actual VC contracts. The paper compares real venture capital contracts with contract theory and examines how investors allocate different rights between entrepreneurs and venture capitalists. Remember: Principal-agent problem, Venture capital contracts, Allocation of control rights.

What data do Kaplan & Strömberg (2003) use?

The study analyzes 213 venture capital investments in 119 companies from 14 venture capital firms in the United States between 1986 and 1999. The authors examine financing contracts, business plans, venture capital investment memoranda, and internal performance evaluations to study actual agreements between entrepreneurs and venture capitalists.

What are the main rights allocated in venture capital contracts?

Venture capital contracts allocate several rights separately, including cash-flow rights (claims to profits), board rights (board seats and management decisions), voting rights, liquidation rights, and other control rights. Rather than giving investors only ownership, contracts divide different rights across different situations.

According to Kaplan & Strömberg (2003), what often determines board and voting rights?

The allocation of board and voting rights depends mainly on the firm's performance. Poor performance gives the venture capitalist greater control, intermediate performance results in joint control, and good performance gives the entrepreneur most control. Board and voting rights are therefore state-contingent because they depend on firm performance.

Explain cash-flow rights.

Cash-flow rights determine who receives the firm's profits. Kaplan & Strömberg find that venture capitalists usually own about 50% of the cash-flow rights, founders about 30%, and employees and others about 20%. The VC's share often decreases if firm performance improves because many contracts are state-contingent.

What are board rights?

Board rights determine who controls major company decisions, including hiring and firing managers, evaluating management, and approving corporate strategy. Venture capitalists hold a board majority in about 25% of cases, founders in about 14%, and shared control exists in most remaining cases. Board rights often change depending on firm performance.

What are voting rights?

Voting rights determine who can vote on important company decisions. Venture capitalists usually hold the voting majority, voting rights are frequently state-contingent, and venture capitalists often control more votes than their cash-flow rights alone would suggest. This helps investors protect their investment.

What are liquidation rights?

Liquidation rights determine who receives money first if the company fails. Venture capitalists almost always hold senior claims and recover their investment before common shareholders receive anything. These rights reduce investor risk.

What is anti-dilution protection?

Anti-dilution protection protects venture capitalists if later financing rounds occur at a lower company valuation. Without this protection, new shares reduce the VC's ownership percentage. Kaplan & Strömberg find anti-dilution clauses in about 95% of financing rounds.

What are vesting and non-compete clauses?

These clauses reduce the risk that founders leave the company. Founder vesting allows unvested founder shares to be repurchased cheaply if the founder leaves. Non-compete clauses prevent founders from joining competing firms for a specified period. Both clauses reduce hold-up problems and protect investors.

What are the main empirical findings of Kaplan & Strömberg (2003)?

The study finds that venture capital contracts allocate different rights separately, convertible securities are commonly used, control rights depend on firm performance, venture capitalists receive greater control when agency problems are more severe, and entrepreneurs regain control when firms perform well. Overall, venture capital contracts are highly flexible and designed to reduce conflicts between investors and entrepreneurs.

How do Kaplan & Strömberg (2003) solve the principal-agent problem?

The contracts reduce agency problems by allocating control rights according to performance, giving investors stronger control when firms perform poorly, rewarding entrepreneurs with greater control when firms perform well, and combining cash-flow, voting, board, and liquidation rights within one contract. This aligns the incentives of entrepreneurs and venture capitalists.