This file is part of IDEAS, which uses RePEc data


[ Papers | Articles | Software | Books | Chapters | Authors | Institutions | JEL Classification | NEP reports | Search | New papers by email | Author registration | Rankings | Volunteers | FAQ | Blog | Help! ]

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

Author info | Abstract | Publisher info | Download info | Related research | Statistics
Author Info
Didier Cossin (HEC-University of Lausanne, FAME and IMD)
Benoît Leleux (IMD)
Entela Saliasi (HEC-University of Lausanne and FAME)
Abstract

Valuing early-stage high-technology growth-oriented companies is a challenge to current valuation methodologies. This inability to come up with robust point estimates of value should not and does not lead to a breakdown of market liquidity: instead, 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 capital investment contracts from a real option perspective, using both analytical solutions and numerical analyis to draw inferences for a better understanding of contract features. 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 proposition than the simple "rights of first refusal" commonly found in many contracts. We also provide for results (such as timing of investments, lengths of rounds, choices of liquidation levels, conversion levels) that take into account full interaction of the different features considered. We document some complex facts, such as the concavity of the VC contract value depending on the amount invested at the different stages, the actual share impact of the most common anti-dilution feature, some endogenous motivation for early VC exits from otherwise performing companies and stress overall the importance of a full analysis for efficient contract negotiations and understanding.

Download Info
To download:

If you experience problems downloading a file, check if you have the proper application to view it first. Information about this may be contained in the File-Format links below. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://www.swissfinanceinstitute.ch/rp63.pdf
File Format: application/pdf
File Function:
Download Restriction: no

Publisher Info
Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp63.

Download reference. The following formats are available: HTML (with abstract), plain text (with abstract), BibTeX, RIS (EndNote, RefMan, ProCite), ReDIF
Length:
Date of creation: Oct 2002
Date of revision:
Handle: RePEc:chf:rpseri:rp63

Contact details of provider:
Postal: 40 bd. du Pont d'Arve, Case postale 3, CH - 1211 Geneva 4
Phone: 41 22 / 312 09 61
Fax: 41 22 / 312 10 26
Web page: http://www.swissfinanceinstitute.ch
More information through EDIRC

For technical questions regarding this item, or to correct its listing, contact: (Marilyn Barja).

Related research
Keywords:

Other versions of this item:

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Jonathan B. Berk & Richard C. Green & Vasant Naik, 1998. "Valuation and Return Dynamics of New Ventures," NBER Working Papers 6745, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  2. Bascha, Andreas & Walz, Uwe, 2001. "Convertible securities and optimal exit decisions in venture capital finance," Journal of Corporate Finance, Elsevier, vol. 7(3), pages 285-306, September. [Downloadable!] (restricted)
  3. Black, Bernard S. & Gilson, Ronald J., 1998. "Venture capital and the structure of capital markets: banks versus stock markets," Journal of Financial Economics, Elsevier, vol. 47(3), pages 243-277, March. [Downloadable!] (restricted)
  4. Laura Casares Field, 2001. "The Expiration of IPO Share Lockups," Journal of Finance, American Finance Association, vol. 56(2), pages 471-500, 04. [Downloadable!] (restricted)
  5. Georg Noeldeke & Klaus Schmidt, 1998. "Sequential Investments and Options to Own," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
    Other versions:
  6. Kaplan, Steven & Strömberg, Per Johan, 2002. "Characteristics, Contracts and Actions: Evidence from Venture Capitalist Analyses," CEPR Discussion Papers 3243, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  7. Anderson, Ronald W & Sundaresan, Suresh, 1996. "Design and Valuation of Debt Contracts," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 9(1), pages 37-68. [Downloadable!] (restricted)
  8. Kaplan, Steven & Strömberg, Per Johan, 2000. "Financial Contracting Theory Meets The Real World: An Empirical Analysis Of Venture Capital Contracts," CEPR Discussion Papers 2421, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  9. Kumar, Ram L., 1999. "Understanding DSS value: an options perspective," Omega, Elsevier, vol. 27(3), pages 295-304, June. [Downloadable!] (restricted)
  10. Bergemann, Dirk & Hege, Ulrich, 1998. "Venture capital financing, moral hazard, and learning," Journal of Banking & Finance, Elsevier, vol. 22(6-8), pages 703-735, August. [Downloadable!] (restricted)
    Other versions:
  11. Joshua Lerner, 1994. "The Syndication of Venture Capital Investments," Financial Management, Financial Management Association, vol. 23(3), Fall.
  12. Allen, Franklin & Faulhaber, Gerald R., 1989. "Signalling by underpricing in the IPO market," Journal of Financial Economics, Elsevier, vol. 23(2), pages 303-323, August. [Downloadable!] (restricted)
  13. Geske, Robert & Johnson, Herb E, 1984. " The American Put Option Valued Analytically," Journal of Finance, American Finance Association, vol. 39(5), pages 1511-24, December. [Downloadable!] (restricted)
  14. Barraquand, J?r?me & Martineau, Didier, 1995. "Numerical Valuation of High Dimensional Multivariate American Securities," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 30(03), pages 383-405, September. [Downloadable!]
  15. Gompers, Paul A, 1995. " Optimal Investment, Monitoring, and the Staging of Venture Capital," Journal of Finance, American Finance Association, vol. 50(5), pages 1461-89, December. [Downloadable!] (restricted)
  16. Gompers, Paul & Lerner, Josh, 1996. "The Use of Covenants: An Empirical Analysis of Venture Partnership Agreements," Journal of Law & Economics, University of Chicago Press, vol. 39(2), pages 463-98, October.
  17. Grenadier, Steven R. & Weiss, Allen M., 1997. "Investment in technological innovations: An option pricing approach," Journal of Financial Economics, Elsevier, vol. 44(3), pages 397-416, June. [Downloadable!] (restricted)
  18. John H. Cochrane, 2001. "The Risk and Return of Venture Capital," NBER Working Papers 8066, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  19. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May. [Downloadable!] (restricted)
  20. Eduardo Schwartz & Carlos Zozaya-Gorostiza, 2000. "Valuation of Information Technology Investments as Real Options," University of California at Los Angeles, Anderson Graduate School of Management 1030, Anderson Graduate School of Management, UCLA. [Downloadable!]
  21. Bernardo, Antonio E. & Chowdhry, Bhagwan, 2002. "Resources, real options, and corporate strategy," Journal of Financial Economics, Elsevier, vol. 63(2), pages 211-234, February. [Downloadable!] (restricted)
  22. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-86, March. [Downloadable!] (restricted)
  23. Admati, Anat R & Pfleiderer, Paul, 1994. " Robust Financial Contracting and the Role of Venture Capitalists," Journal of Finance, American Finance Association, vol. 49(2), pages 371-402, June. [Downloadable!] (restricted)
  24. Barone-Adesi, Giovanni & Whaley, Robert E, 1987. " Efficient Analytic Approximation of American Option Values," Journal of Finance, American Finance Association, vol. 42(2), pages 301-20, June. [Downloadable!] (restricted)
  25. Sahlman, William A., 1990. "The structure and governance of venture-capital organizations," Journal of Financial Economics, Elsevier, vol. 27(2), pages 473-521, October. [Downloadable!] (restricted)
  26. Gompers, Paul A., 1996. "Grandstanding in the venture capital industry," Journal of Financial Economics, Elsevier, vol. 42(1), pages 133-156, September. [Downloadable!] (restricted)
  27. Ingersoll, Jonathan Jr., 1977. "A contingent-claims valuation of convertible securities," Journal of Financial Economics, Elsevier, vol. 4(3), pages 289-321, May. [Downloadable!] (restricted)
  28. Jonathan B. Berk Richard C. Green and Vasant Naik., 1998. "Valuation and Return Dynamics of New Ventures," Research Program in Finance Working Papers RPF-284, University of California at Berkeley. [Downloadable!]
Full references

Statistics
Access and download statistics

Did you know? RePEc also has a blog.

This page was last updated on 2009-11-19.

This information is provided to you by IDEAS at the Department of Economics, College of Liberal Arts and Sciences, University of Connecticut using RePEc data on a server sponsored by the Society for Economic Dynamics.