This article provides a comprehensive theoretical and empirical literature review of venture capital contracts. This outlines the differences between theoretical and practical uses of contract designs; that is, (1) how does the choice of securities give rise to different adverse selection problems in terms of attracting different types of entrepreneurial companies; how does the choice of securities in conjunction with cash flow and control rights provisions affect (2) the effort levels by the entrepreneur and the investor; and (3) ultimately affect entrepreneurial outcomes. This article highlights the major discrepancies between theory and practice and points out potential avenues for further research.
Get full access to this article
View all access options for this article.
References
1.
AdmatiA.R. & PfleidererP. (1994). Robust financial contracting and the role of venture capitalists. Journal of Finance, 49(2), 371–402.
2.
AghionP. & BoltonP. (1992). An incomplete contracts approach to financial contracting. The Review of Economic Studies, 59(3), 473–494.
3.
AmitR., BranderJ., & ZottC. (1998). Why do venture capital firms exist? Theory and Canadian evidence. Journal of Business Venturing, 13, 441–466.
BakerM. & GompersP.A. (1999). Executive ownership and control in newly public firms: The role of venture capitalists. SSRN Working Paper Series, No. 165173.
6.
BarneyJ.B., BusenitzL.W., FietJ.O., & MoeselD.D. (1994). The relationship between venture capitalists and managers in new firms: Determinants of contractual covenants. Managerial Finance, 20, 19–30.
7.
BaschaA. & WalzU. (2001). Convertible securities and optimal exit decisions in venture capital finance. Journal of Corporate Finance, 7, 285–306.
8.
BaschaA. & WalzU. (2002). Financing practices in the German venture capital industry. An empirical assessment. CFS Working Paper No. 2002/08. Frankfurt: Center for Financial Studies.
9.
BengtssonO. (2011). Covenants in venture capital contracts. Management Science, 57(11), 1926–1943.
10.
BengtssonO. & BernhardtD. (2011). Different problem, same solution: Contract specialization in venture capital. Working Paper, Lund University.
11.
BengtssonO. & SensoyB.A. (2011). Investor abilities and financial contracting: Evidence from venture capital. Journal of Financial Intermediation, 20, 477–502.
12.
BergemannD. & HegeU. (1998). Venture capital financing, moral hazard, and learning. Journal of Banking and Finance, 22(6–8), 703–735.
13.
BergerA.N. & UdellG.F. (1998). The economics of small business finance: The roles of private equity and debt markets in the financial growth cycles. Journal of Banking and Finance, 22, 613–673.
14.
BerglöfE. (1994). A control theory of venture capital finance. Journal of Law, Economics & Organization, 10(2), 247–267.
15.
BienzC. & HirschJ. (2006). The dynamics of venture capital contracts. CFS Working Paper No. 2006/11. Frankfurt: Center for Financial Studies.
16.
BienzC. & WalzU. (2010). Venture capital exit rights. Journal of Economics and Management Strategy, 19(4), 1071–1116.
17.
BigusJ. (2006). Staging of venture financing, investor opportunism and patent law. Journal of Business Finance & Accounting, 33(7–8), 939–960.
18.
BlackB.S. & GilsonR.J. (1998). Venture capital and the structure of capital markets: Bank vs. stock markets. Journal of Financial Economics, 47, 243–277.
19.
BoltonP. & Faure–GrimaudA. (2010). Satisficing contracts. The Review of Economic Studies, 77, 937–971.
20.
BottazziL., Da RinM., & HellmannT. (2004). The changing face of the European venture capital industry: Facts and analysis. Journal of Private Equity, 7(2), 226–253.
21.
BottazziL., Da RinM., & HellmannT. (2009). What is role of legal systems in financial intermediation? Theory and evidence. Journal of Financial Intermediation, 18(3), 559–598.
22.
BrennanM.J. & KrausA. (1987). Efficient financing under asymmetric information. Journal of Finance, 42, 1225–1243.
23.
BroughmanB. & FriedJ. (2010). Renegotiation of cash flow rights in the sale of VC–backed firms. Journal of Financial Economics, 95(3), 384–399.
24.
CasamattaC. (2003). Financing and advising: Optimal financial contracts with venture capitalists. Journal of Finance, 58(5), 2059–2085.
25.
CasamattaC. & HaritchabaletC. (2007). Experience, screening and syndication in venture capital investments. Journal of Financial Intermediation, 16(3), 368–398.
26.
ChanY.S. (1983). On the positive role of financial intermediation in allocation of venture capital in a market with imperfect information. Journal of Finance, 38(5), 1543–1568.
27.
ChanY.S., SiegelD., & ThakorA.V. (1990). Learning, corporate control and performance requirements in venture capital contracts. International Economic Review, 31(2), 365–381.
28.
CornelliF. & YoshaO. (2002). Stage financing and the role of convertible securities. The Review of Economic Studies, 70, 1–32.
29.
CummingD.J. (2001). The convertible preferred equity puzzle in Canadian venture capital finance. Working Paper, University of Alberta School of Business.
30.
CummingD.J. (2005a). Agency costs, institutions, learning and taxation in venture capital contracting. Journal of Business Venturing, 20, 573–622.
31.
CummingD.J. (2005b). Capital structure in venture finance. Journal of Corporate Finance, 11, 550–585.
32.
CummingD.J. (2006). Adverse selection and capital structure: Evidence from venture capital. Entrepreneurship Theory and Practice, 30, 155–184.
33.
CummingD.J. (2008). Contracts and exits in venture capital finance. Review of Financial Studies, 21, 1947–1982.
34.
CummingD.J. & JohanS.A. (2007). Advice and monitoring in venture capital finance. Financial Markets and Portfolio Management, 21, 3–43.
35.
CummingD.J. & JohanS.A. (2008). Preplanned exit strategies in venture capital. European Economic Review, 52, 1209–1241.
36.
CummingD.J. & JohanS.A. (2009). Venture capital and private equity contracting: An international perspective. Amsterdam: Elsevier Science Academic Press.
37.
CummingD. & WalzU. (2010). Private equity returns and disclosure around the world. Journal of International Business Studies,41(4), 727–754.
38.
CunyC.J. & TalmorE. (2005). The staging of venture capital financing: Milestone vs. rounds. Working Paper, Texas A&M University and London Business School.
39.
Da RinM., HellmannT.F., & PuriM. (2013). A survey of venture capital research. In ConstantinidesG., HarrisM., & StulzR. (Eds.), Handbook of the economics of finance (Vol. 2, pp. 573–648). Amsterdam: North Holland.
40.
De ClercqD. & SapienzaH.J. (2001). The creation of relational rents in venture capitalist–entrepreneur dyads. Venture Capital, 3(2), 107–127.
41.
DeMezaD. & WebbD.C. (1987). Too much investment: A problem of asymmetric information. The Quarterly Journal of Economics, 102, 281–292.
DesseinW. (2002). Authority and communication in organizations. Review of Economic Studies,69, 811–838.
44.
DesseinW. (2005). Information and control in ventures and alliances. Journal of Finance, 60(5), 2513–2549.
45.
DewatripontM. & TiroleJ. (1994). A theory of debt and equity: Diversity of securities and manager–shareholder congruence. The Quarterly Journal of Economics, 109(5), 1027–1054.
46.
DiamondD.W. (1991). Monitoring and reputation: The choice between loans and directly placed debt. The Journal of Political Economy, 99(4), 689–721.
47.
FriedJ.M. & BroughmanB.J. (2007). Deviations from contractual priority in the sale of VC–backed firms. American Law & Economics Association Papers, 40, 1–61.
48.
FriedJ.M. & GanorM. (2006). Agency costs of venture capitalist control in startups. New York University Law Review, 81, 967–1025.
49.
FriedV.H. & HisrichR.D. (1988). Venture capital research: Past, present and future. Entrepreneurship Theory and Practice, 13(1), 15–28.
50.
GilsonR.J. & SchizerD.M. (2003). Understanding venture capital structure: A tax explanation for convertible preferred stock. Harvard Law Review, 116, 874–916.
51.
GompersP.A. (1995). Optimal investment, monitoring, and the staging of venture capital. Journal of Finance, 50(5), 1461–1489.
52.
GompersP.A. (1997). Ownership and control in entrepreneurial firms: An examination of convertible securities in venture capital investments. Working Paper, Harvard Business School.
53.
GompersP.A. & LernerJ. (1996). The use of covenants: An empirical analysis of venture partnership agreements. Journal of Law and Economics, 39, 463–498.
54.
GompersP.A. & LernerJ. (1998). Venture capital distributions: Short–run and long–run reactions. Journal of Finance, 53(6), 2161–2183.
55.
GompersP.A. & LernerJ. (2001). The venture capital revolution. The Journal of Economic Perspectives, 15(2), 145–168.
56.
GormanM. & SahlmanW. (1989). What do venture capitalists do?Journal of Business Venturing, 4, 231–248.
57.
GreenR.C. (1983). Investment incentives, debt, and warrants. Journal of Financial Economics, 13, 115–136.
58.
HartO. & MooreJ. (1994). A theory of debt based on the alienability of human capital. The Quarterly Journal of Economics, 109, 841–879.
59.
HegeU., PalominoF., & SchwienbacherA. (2009). Venture capital performance: The disparity between Europe and the United States. Finance, 30(1), 7–50.
60.
HellmannT. (1998). The allocation of control rights in venture capital contracts. RAND Journal of Economics, 29(1), 57–76.
61.
HellmannT. (2006). IPOs, acquisitions and the use of convertible securities in venture capital. Journal of Financial Economics, 81(3), 649–679.
62.
HellmannT. & PuriM. (2002). Venture capital and the professionalization of startup firms: Empirical evidence. Journal of Finance, 57(1), 169–197.
63.
HolstromB. (1979). Moral hazard and observability. The Bell Journal of Economics, 10(1), 74–91.
64.
HommelU., RitterM., & WrightM. (2003). Verhalten der Beteiligungsfinanzierer nach dem “Downturn”—Ergebnisse einer empirischen Studie. Finanz Betrieb, 5, 323–333.
65.
HoubenE. (2002). Venture capital, double–sided adverse selection, and double–sided moral hazard. SSRN Working Paper Series, No. 365841.
66.
HsuD. (2004). What do entrepreneurs pay for venture capital affiliation?Journal of Finance, 59, 1805–1844.
67.
InderstR. & MüllerH.M. (2004). The effect of capital market characteristics on the value of startup firms. Journal of Financial Economics, 72, 319–356.
68.
JensenM.C. & MecklingW.H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3, 305–360.
69.
KanniainenV. & KeuschniggC. (2003). The optimal portfolio of start–up firms in venture capital finance. Journal of Corporate Finance, 9(5), 521–534.
70.
KanniainenV. & KeuschniggC. (2004). Start–up investment with scarce venture capital support. Journal of Banking and Finance, 28(8), 1935–1959.
71.
KaplanS.N., MartelF., & StrömbergP. (2007). How do legal differences and experience affect financial contracts?Journal of Financial Intermediation, 16, 273–311.
72.
KaplanS.N. & StrömbergP. (2003). Financial contracting theory meets the real world: An empirical analysis of venture capital contracts. The Review of Economic Studies, 70, 281–315.
73.
KaplanS.N. & StrömbergP. (2004). Characteristics, contracts and actions: Evidence from venture capital analyses. Journal of Finance, 59(5), 2177–2210.
74.
KirilenkoA.A. (2001). Valuation and control in venture finance. Journal of Finance, 56(2), 565–587.
75.
LandstromH., ManigartS., MasonC., & SapienzaH. (1998). Contracts between entrepreneurs and investors: Terms and negotiation process. In ReynoldsP.D., BygraveW.D., CarterN.M., ManigartS., MasonC.M., MeyerG.D., et al. (Eds.), Frontiers of entrepreneurship research (pp. 571–585). Wellesley, MA: Babson College.
76.
LazearE. (1986). Incentive contracts. NBER Working Papers 1917. Cambridge, MA: National Bureau of Economic Research.
77.
LernerJ. (1994). The syndication of venture capital investments. Financial Management, 23(3), 16–27.
78.
LernerJ. (1995). Venture capitalists and the oversight of private firms. Journal of Finance, 50(1), 301–318.
79.
LockettA. & WrightM. (2001). The syndication of venture capital investments. The International Journal of Management Science, Omega, 29, 375–390.
ManigartS., BaeyensK., & Van HyfteW. (2002). The survival of venture capital backed companies. Venture Capital, 4(2), 103–124.
82.
ManigartS., De WaeleK., WrightM., & RobbieK. (2002). Determinants of required returns in venture capital investments: A five–country study. Journal of Business Venturing, 17(4), 291–312.
83.
ManigartS., De WaeleK., WrightM., RobbieK., DesbrièresP., SapienzaH.J., et al. (2000). Venture capitalists, investment appraisal and accounting information: A comparative study of the US, UK, France, Belgium and Holland. European Financial Management, 6(3), 389–403.
84.
MarxL.M. (1998). Efficient venture capital financing combining debt and equity. Review of Economic Design, 3(4), 371–387.
85.
MayerC., SchoorsK., & YafehY. (2005). Sources of funds and investment activities of venture capital funds: Evidence from Germany, Israel, Japan and the United Kingdom. Journal of Corporate Finance, 11(3), 586–608.
86.
MetricA. & YasudaA. (2010). Venture capital and the finance of innovation (2nd ed.). New York: John Wiley & Sons.
87.
NeherD.V. (1999). Staged financing: An agency perspective. The Review of Economic Studies, 66, 255–274.
88.
NeusW. & WalzU. (2005). Exit timing of venture capitalists in the course of an initial public offering. Journal of Financial Intermediation, 14(2), 253–277.
89.
NoeT.H. & RebelloM.J. (1996). Asymmetric information, managerial opportunism, financing, and payout policies. Journal of Finance, 51(2), 637–660.
90.
RavidS.A. & BengtssonO. (2011). Geography and style in private equity contracting: Evidence from the U.S. venture capital market. SSRN 1782382 Working Paper.
91.
RepulloR. & SuarezJ. (2004). Venture capital finance: A security design approach. Review of Finance, 8, 75–108.
92.
RossS.A. (1977). The determination of financial structure: The incentive–signalling approach. The Bell Journal of Economics, 8(1), 23–40.
93.
SahlmanW. (1990). The structure and governance of venture capital organizations. Journal of Financial Economics, 27, 473–521.
94.
SapienzaH.J. (1992). When do venture capitalists add value?Journal of Business Venturing,7, 9–27.
95.
SapienzaH.J., ManigartS., & VermeirW. (1996). Venture capitalist governance and value added in four countries. Journal of Business Venturing, 11, 439–469.
96.
SchmidtK.M. (2003). Convertible securities and venture capital finance. Journal of Finance, 58(3), 1139–1166.
97.
SchwienbacherA. (2008). Venture capital investment practices in Europe and the United States. Financial Markets and Portfolio Management, 22, 195–217.
98.
StiglitzJ. & WeissA. (1981). Credit rationing in markets with imperfect information. American Economic Review, 73, 393–409.
99.
TianX. (2011). The causes and consequences of venture capital stage financing. Journal of Financial Economics, 101, 132–159.
100.
TresterJ.J. (1998). Venture capital contracting under asymmetric information. Journal of Banking and Finance, 22(6–8), 675–699.
101.
TykvovaT. (2007). What do economists tell us about venture capital contracts?Journal of Economic Surveys, 21(1), 65–89.
102.
WangS. & ZhouH. (2004). Staged financing in venture capital: Moral hazard and risks. Journal of Corporate Finance, 10(1), 131–155.
103.
WassermanN. (2006). Stewards, agents, and the founder discount: Executive compensation in new ventures. Academy of Management Journal, 49(5), 960–976.
104.
WrightM. & LockettA. (2003). The structure and management of alliances: Syndication in the venture capital industry. Journal of Management Studies,40, 2073–2102.
105.
WrightM., PruthiS., & LockettA. (2005). International venture capital research: From cross–country comparisons to crossing countries. International Journal of Management Reviews, 7(3), 135–165.
106.
WrightM. & RobbieK. (1998). Venture capital and private equity: A review and synthesis. Journal of Business Finance & Accounting, 25(5–6), 521–570.
