Venture Capital Contracting in Theory and Practice
This paper provides a comprehensive theoretical and empirical literature review of venture capital contracts, highlighting discrepancies between theory and practice.
Venture Capital (VC) firms supply financing to emerging firms that they view as having the potential for high growth, often taking a stake in the company in exchange for their financial investment. The drawing up of contract between investor and investee is a complex task, and conflict can arise around areas such as uncertainty over how the two parties will interact in the course of their relationship.
A large body of literature that addresses how contract design can cope with potential friction between VCs and their portfolio companies does exist. However, due to the relative opaqueness of the VC industry, research has focused on self-reported surveys, which come with their own bias. Empirical research is relatively sparse, but what there is highlights several discrepancies between theoretical contract design principles and actual contracting choices observed in practice.
The purpose of this paper therefore is to review the theoretical literature alongside the practical use of different contract design features by VCs with the aim of answering the following questions:
(1) How does the choice of securities (i.e. - common equity, preferred equity, debt, convertible debt, and mixes of these) give rise to different adverse selection problems in terms of attracting different types of entrepreneurial companies?
{2) How does the choice of securities in conjunction with cash flow and control rights provisions affect the effort levels of entrepreneur and investor, and
(3) How does this ultimately shape entrepreneurial outcomes?
This research draws on the findings of seminal theoretical and empirical contributions on venture capital contracting practices to arrive at a number of conclusions relevant for the shaping of future research.
A working paper version of the research is available to download at the link below. The final version of the paper is published at Entrepreneurship: Theory and Practice.
