What Do Economists Tell Us about Venture Capital Contracts?

Start-ups in innovative branches require a substantial amount of capital. Their founders may not have sufficient funds to finance the implementation of the ideas alone and might therefore look for outside financing. Additionally, new firms typically do not need only capital but also managerial advice. The banking sector does generally not want to take the extreme risks connected with young innovative firms on the one hand and, on the other hand, typically does not carry out advisory functions. High costs in combination with informal opacity are the reasons why small firms usually do not engage in public equity and debt underwriting, which leaves private capital as the most appropriate possibility. A special subgroup of private capital designed for young innovative firms is venture capital. The interactions between venture capitalists and their portfolio firms are characterized by high asymmetry of information, high risk, and uncertainty. The founder usually has only limited resources and her human capital is essential for the success of the project. Normally, there is no collateral available. Different kinds of agency problems are present in venture capital markets: moral hazard, adverse selection, hold-up problems, window dressing, etc. With the provision of capital, the VC firm takes over part of the risk and of the surplus from a project. This entails an incentive problem, since the founder may exercise less effort than if she had taken the whole profit on herself. Even if the effort of the founder is very high, a failure of the project may occur due to other circumstances. In such cases, the founder typically does not want to admit the failure and stop the project - as long as the venture capitalist finances it - which may lead to a continuation of loss-making projects and wasting of scarce resources. Additionally, the danger arises that the founder could squander or misuse the money she gets from the venture capitalist. The founder might invest in strategies and projects that have high personal returns but low expected monetary payoffs to the venture capitalist. If the founder participates in the profits but does not bear a large enough part of the losses, she might take too much risk. The relationship between a venture capitalist and an entrepreneur goes beyond the standard "principal - agent" framework. Venture capitalists' effort is essential for the success of the investment because the entrepreneur usually has neither enough business experience nor the necessary networks. Using its networks, a VC firm can help the company find appropriate staff, suppliers, customers, or other partners. Furthermore, the VC firm offers experience in managerial activities so that it may collaborate on the establishing of the optimal structure of the firm and participate in organizational, financial, strategic, and other decisions. It often assists in obtaining additional financing. Entrepreneurs and venture capitalists enter into contracts that influence their behavior and mitigate the agency costs. Typically, the contracts between venture capitalists and their portfolio firms include the following elements: a staging of capital infusions, the use of special financing instruments such as convertible debt or convertible preferred stock, an active involvement of venture capitalists in their portfolio companies, distribution of certain control rights to venture capitalists, etc. Additionally, before a contract is signed, the entrepreneur and her project are very intensively screened. Often, several venture capitalists join together in order to finance a project. Several theoretical and a few empirical papers deal with the topic of how these particular features of the venture capital investment process help mitigate agency costs.

Tykvova, Tereza (2000), What Do Economists Tell Us about Venture Capital Contracts?, ZEW Discussion Paper No. 00-62, Mannheim.