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Contractual relations between European VC-funds and investors: The impact of reputation and bargaining power on contractual design

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  • Schmidt, Daniel
  • Wahrenburg, Mark
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    Abstract

    The paper explores factors that influence the design of financing contracts between venture capital investors and European venture capital funds. 122 Private Placement Memoranda and 46 Partnership Agreements are investigated in respect to the use of covenant restrictions and compensation schemes. The analysis focuses on the impact of two key factors: the reputation of VC-funds and changes in the overall demand for venture capital services. We find that established funds are more severely restricted by contractual covenants. This contradicts the conventional wisdom which assumes that established market participants care more about their reputation, have less incentive to behave opportunistically and therefore need less covenant restrictions. We also find that managers of established funds are more often obliged to invest own capital alongside with investors money. We interpret this as evidence that established funds have actually less reason to care about their reputation as compared to young funds. One reason for this surprising result could be that managers of established VC funds are older and closer to retirement and therefore put less weight on the effects of their actions on future business opportunities. We also explore the effects of venture capital supply on contract design. Gompers and Lerner (1996) show that VC-funds in the US are able to reduce the number of restrictive covenants in years with high supply of venture capital and interpret this as a result of increased bargaining power by VC-funds. We do not find similar evidence for Europe. Instead, we find that VCfunds receive less base compensation and higher performance related compensation in years with strong capital inflows into the VC industry. This may be interpreted as a signal of overconfidence: Strong investor demand seems to coincide with overoptimistic expectations by fund managers which make them willing to accept higher powered incentive schemes. --

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    Bibliographic Info

    Paper provided by Center for Financial Studies (CFS) in its series CFS Working Paper Series with number 2003/15.

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    Date of creation: 2003
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    Handle: RePEc:zbw:cfswop:200315

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    Related research

    Keywords: Venture Capital; Contracting; Limited Partnership; Funds; Principal Agent; Compensation; Covenants; Reputation; Bargaining Power;

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    References

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    1. Kyle, Albert S & Wang, F Albert, 1997. " Speculation Duopoly with Agreement to Disagree: Can Overconfidence Survive the Market Test?," Journal of Finance, American Finance Association, American Finance Association, vol. 52(5), pages 2073-90, December.
    2. Ross, Stephen A, 1973. "The Economic Theory of Agency: The Principal's Problem," American Economic Review, American Economic Association, American Economic Association, vol. 63(2), pages 134-39, May.
    3. Stiglitz, Joseph E, 1974. "Incentives and Risk Sharing in Sharecropping," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 41(2), pages 219-55, April.
    4. Aghion, Philippe & Bolton, Patrick, 1992. "An Incomplete Contracts Approach to Financial Contracting," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 59(3), pages 473-94, July.
    5. Sanford J Grossman & Oliver D Hart, 2001. "An Analysis of the Principal-Agent Problem," Levine's Working Paper Archive 391749000000000339, David K. Levine.
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    7. Gompers, Paul & Lerner, Josh, 1996. "The Use of Covenants: An Empirical Analysis of Venture Partnership Agreements," Journal of Law and Economics, University of Chicago Press, University of Chicago Press, vol. 39(2), pages 463-98, October.
    8. Ruhnka, John C. & Young, John E., 1991. "Some hypotheses about risk in venture capital investing," Journal of Business Venturing, Elsevier, vol. 6(2), pages 115-133, March.
    9. Rees, Ray, 1985. "The Theory of Principal and Agent: Part 1," Bulletin of Economic Research, Wiley Blackwell, Wiley Blackwell, vol. 37(1), pages 3-26, January.
    10. Gompers, Paul & Lerner, Josh, 1999. "An analysis of compensation in the U.S. venture capital partnership," Journal of Financial Economics, Elsevier, Elsevier, vol. 51(1), pages 3-44, January.
    11. Steven N. Kaplan & Per Stromberg, 2001. "Venture Capitalists As Principals: Contracting, Screening, and Monitoring," NBER Working Papers 8202, National Bureau of Economic Research, Inc.
    12. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 51(3), pages 393-414, July.
    13. Rees, Ray, 1985. "The Theory of Principal and Agent: Part 2," Bulletin of Economic Research, Wiley Blackwell, Wiley Blackwell, vol. 37(2), pages 75-95, May.
    14. Christopher B. Barry, 1994. "New Directions in Research on Venture Capital Finance," Financial Management, Financial Management Association, Financial Management Association, vol. 23(3), Fall.
    15. Armen A. Alchian & Harold Demsetz, 1971. "Production, Information Costs and Economic Organizations," UCLA Economics Working Papers, UCLA Department of Economics 10A, UCLA Department of Economics.
    16. Hvide, Hans K., 2002. "Pragmatic beliefs and overconfidence," Journal of Economic Behavior & Organization, Elsevier, Elsevier, vol. 48(1), pages 15-28, May.
    17. Ruhnka, John C. & Young, John E., 1987. "A venture capital model of the development process for new ventures," Journal of Business Venturing, Elsevier, vol. 2(2), pages 167-184.
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    Cited by:
    1. Balboa, Marina & Marti, Jose, 2007. "Factors that determine the reputation of private equity managers in developing markets," Journal of Business Venturing, Elsevier, vol. 22(4), pages 453-480, July.

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