Understanding the Economic Value of Legal Covenants in Investment Contracts : A Real-Options Approach to Venture Equity Contracts

Valuing early-stage high-technology growth-oriented companies is a challenge to current valuation methodologies. Efforts are redirected towards the design of investment contracts which materially skew the distribution of payoffs in favor of the venture investors. In effect, limitations in valuation abilities are addressed by designing the investment contracts as baskets of real options instead of linear payoff functions. This paper investigates four common features (covenants) of venture cap-ital investment contracts. The impact of the concept for pricing issues, valuation negotiation and for contract design are considered. It is shown for example how "contingent pre-contracting" for follow-up rounds is theoretically a better proposi-tion than the simple "rights of first refusal" commonly found in many contracts. We also provide for results (such as timing of investments, length of rounds, choices of liquidation levels, conversion levels) that take into account full interaction of the diferent features considered. We document some complex facts, such as the con-cavity of the VC contract value depending on the amount invested at the diferent stages, the actual share impact of the most common antidilution feature, some en-dogenous motivation for early VC exits from otherwise performing companies, and stress overall the importance of a full analysis for efficient contract negociation and understanding.