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Venture Capital Meets Contract Theory: Risky Claims or Formal Control?

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Author Info
Cestone, Giacinta

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Abstract

This Paper develops a theory of the joint allocation of control and cash-flow rights in venture capital deals. I argue that when the need for investor support calls for very high-powered outside claims, entrepreneurs should optimally retain control in order to avoid undue interference. Hence, I predict that risky claims should be negatively correlated to control rights, both along the life of a start-up and across deals. This challenges the idea that control should always be attached to more equity-like claims, and is in line with contractual terms used in venture capital, in corporate venturing and in partnerships between biotech start-ups and large corporations. The Paper also rationalizes the evidence, documented in Gompers (1999) and Kaplan and Stromberg (2000), that venture capital contracts include contingencies triggering both a reduction in VC control and the conversion of VC's preferred stock into common stock.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3462.

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Date of creation: Jul 2002
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Handle: RePEc:cpr:ceprdp:3462

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Related research
Keywords: control rights; corporate governance; security design; venture capital;

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Find related papers by JEL classification:
G30 - Financial Economics - - Corporate Finance and Governance - - - General

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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. Giacinta Cestone & Lucy White, . "Anti-Competitive Financial Contracting: The Design Of Financial Claims," UFAE and IAE Working Papers 453.00, Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC). [Downloadable!]
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  2. Cornelli, Francesca & Yosha, Oved, 1997. "Stage Financing and the Role of Convertible Debt," CEPR Discussion Papers 1735, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  3. Schmidt, Klaus M., 1999. "Convertible Securities and Venture Capital Finance," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
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  4. Thomas Hellmann & Manju Puri, 2002. "Venture Capital and the Professionalization of Start-Up Firms: Empirical Evidence," Journal of Finance, American Finance Association, vol. 57(1), pages 169-197, 02. [Downloadable!] (restricted)
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  5. Aghion, Philippe & Bolton, Patrick, 1992. "An Incomplete Contracts Approach to Financial Contracting," Review of Economic Studies, Blackwell Publishing, vol. 59(3), pages 473-94, July. [Downloadable!] (restricted)
  6. Tirole, Jean, 2001. "Corporate Governance," Econometrica, Econometric Society, vol. 69(1), pages 1-35, January.
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  7. Harris, Milton & Raviv, Artur, 1991. " The Theory of Capital Structure," Journal of Finance, American Finance Association, vol. 46(1), pages 297-355, March. [Downloadable!] (restricted)
  8. Holmstrom, Bengt & Tirole, Jean, 1997. "Financial Intermediation, Loanable Funds, and the Real Sector," The Quarterly Journal of Economics, MIT Press, vol. 112(3), pages 663-91, August.
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  9. Steven N. Kaplan & Per Stromberg, 2000. "Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts," NBER Working Papers 7660, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  10. Burkart, Mike & Gromb, Denis & Panunzi, Fausto, 1997. "Large Shareholders, Monitoring, and the Value of the Firm," The Quarterly Journal of Economics, MIT Press, vol. 112(3), pages 693-728, August.
  11. Bruno Biais & Catherine Casamatta, 1999. "Optimal Leverage and Aggregate Investment," Journal of Finance, American Finance Association, vol. 54(4), pages 1291-1323, 08. [Downloadable!] (restricted)
  12. Dewatripont, Mathias & Tirole, Jean, 1994. "A Theory of Debt and Equity: Diversity of Securities and Manager-Shareholder Congruence," The Quarterly Journal of Economics, MIT Press, vol. 109(4), pages 1027-54, November. [Downloadable!] (restricted)
  13. Masako Ueda, 2000. "Bank versus Venture Capital," Economics Working Papers 522, Department of Economics and Business, Universitat Pompeu Fabra. [Downloadable!]
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  14. Cornelli, F. & Yosha, O., 1997. "Stage Financing and the Role of Convertible Debt," Papers 23-97, Tel Aviv.
  15. Gorman, Michael & Sahlman, William A., 1989. "What do venture capitalists do?," Journal of Business Venturing, Elsevier, vol. 4(4), pages 231-248, July. [Downloadable!] (restricted)
  16. Thomas Hellmann, 1998. "The Allocation of Control Rights in Venture Capital Contracts," RAND Journal of Economics, The RAND Corporation, vol. 29(1), pages 57-76, Spring. [Downloadable!] (restricted)
Full references

Cited by:
(explanations, 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. Ambec, S., 2004. "On the governance of start-ups," Working Papers 200406, Grenoble Applied Economics Laboratory (GAEL). [Downloadable!]
  2. L. Bottazzi & M. Da Rin & T. Hellmann, 2007. "Who are the active investors? Evidence from Venture Capital," Working Papers 611, Dipartimento Scienze Economiche, Universita' di Bologna. [Downloadable!]
    Other versions:
  3. Dessi, Roberta, 2004. "Start-up Finance, Monitoring and Collusion," IDEI Working Papers 264, Institut d'Économie Industrielle (IDEI), Toulouse. [Downloadable!]
  4. Ouidad Yousfi, 2009. "Leveraged Buy Out: Dynamic agency model with write-off option," EconomiX Working Papers 2009-13, University of Paris West - Nanterre la Défense, EconomiX. [Downloadable!]
  5. Bottazzi, L. & Da Rin, M. & Hellmann, T., 2008. "What is the Role of Legal Systems in Financial Intermediation? Theory and Evidence," Discussion Paper 2008-014, Tilburg University, Tilburg Law and Economic Center. [Downloadable!]
    Other versions:
  6. Casamatta, Catherine & Haritchabalet, Carole, 2007. "Competition Between Informed Venture Capitalists for the Financing of Entrepreneurs," IDEI Working Papers 444, Institut d'Économie Industrielle (IDEI), Toulouse. [Downloadable!]
  7. Kaplan, Steven N. & Strömberg, Per, 2003. "Characteristics, Contracts and Actions: Evidence from Venture Capitalist Analyses," SIFR Research Report Series 14, Institute for Financial Research. [Downloadable!]
    Other versions:
  8. Ibolya Schindele, 2002. "Support and Interference: Venture Financing with Multiple Tasks," IEHAS Discussion Papers 0215, Institute of Economics, Hungarian Academy of Sciences. [Downloadable!]
  9. Casamatta, Catherine & Haritchabalet, Carole, 2007. "Experience, Screening and Syndication in Venture Capital Investments," IDEI Working Papers 443, Institut d'Économie Industrielle (IDEI), Toulouse. [Downloadable!]
  10. Inderst, Roman & Mueller, Holger M, 2002. "Venture Capital Contracts and Market Structure," CEPR Discussion Papers 3203, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  11. Douglas Cumming & Sofia Johan, 2007. "Advice and monitoring in venture finance," Financial Markets and Portfolio Management, Springer, vol. 21(1), pages 3-43, March. [Downloadable!] (restricted)
    Other versions:
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