Financial Contracting Theory Meets The Real World: An Empirical Analysis Of Venture Capital Contracts

We compare the characteristics of real world financial contracts to their counterparts in financial contracting theory, by studying actual contracts between venture capitalists (VCs) and entrepreneurs. (1) The distinguishing characteristic of VC financing is that they allow VCs to separately allocate cash flow rights, voting rights, board rights, liquidation rights, and other control rights. We explicitly measure and report the allocation of these rights. (2) While convertible securities are used most frequently, VCs also implement a similar allocation of rights using combinations of multiple classes of common stock and straight preferred stock. (3) Cash flow rights, voting rights, control rights, and future financing are frequently contingent on observable measures of financial and non-financial performance. (4) If the company performs poorly, the VCs obtain full control. As performance improves, the entrepreneur retains more control rights. If the company performs very well, the VCs retain their cash flow rights, but relinquish most of their control and liquidation rights.(5) It is common for VCs to include non-compete and vesting provisions, mitigating the potential hold-up problem between the entrepreneur and the investor. The contracts seem most consistent with the theoretical work of Aghion and Bolton (1992) and Dewatripont and Tirole (1994).