A Globalizing Industry
Handbooks in Venture Capital series
Edited by Hans Landström and Colin Mason
Chapter 4: Venture capital financial contracting: an overview of the international evidence
Venture capital (VC) funds are basically pools of capital established to make early to late stage investments in private equity. They are typically organized as limited partnerships with a lifetime of 10–13 years. VC funds invest in small private entrepreneurial companies with the expectation of capital gains after an exit outcome such as an IPO or acquisition, often carried out within three to five years after initial investment. To allocate the cash flow and control rights between a VC and entrepreneur, the parties will execute detailed contracts which will in effect regulate their relationship over the life of the investment. In practice, VC contracts are very heterogeneous in respect of the allocation of both cash flow and control rights. Venture capitalists (VCs) in different countries around the world finance companies using a variety of different securities, including common equity, preferred equity, convertible preferred equity, debt, convertible debt, warrants, as well as a mix of various forms of debt, preferred and common equity and warrants. Likewise, VCs incorporate various veto and control rights into their contracts. Control rights are utilized to establish operational oversight over the company and veto rights are used to passively influence decisions made by the company. The purpose of this chapter is to review theory and evidence from different parts of the world about the different components of VC contracts, and economic and institutional factors that drive different contractual choices. Further, I offer suggestions for future research.