Valuation adjustment mechanisms in venture capital and entrepreneurial firms' performance

The study examines the impact of a widely adopted contractual mechanism between entrepreneurs and venture capitalists (VCs)—the valuation adjustment mechanism (VAM)—on firm performance. We find that VAM agreements lead to a significant decline in firms' profitability. This effect is concentrated in firms that are imposed by accounting targets, especially annual performance targets in VAMs. The adverse impact of VAMs diminishes when firms are backed by more experienced VCs or when VCs hold a larger equity stake. In addition, we also document that the detrimental effect of VAMs is attributable to firms without any independent director. Our finding reveals that the decline in profitability is driven by aggressive expansion strategies, which increase both revenue and cost of goods sold, while diminishing gross profit margins. Moreover, firms with VAMs also cut R&D expenditures and are more likely to delist from the NTB in the long-run. Overall, our results suggest that VAMs exert significant short-term pressure on entrepreneurs and they have to use short-term-oriented expansion strategies that harm profitability and long-term sales growth. Our findings hold up to a battery of endogeneity tests and robustness checks, including the use of parallel trend assumption test, instrumental variables, propensity score matching, stacked DiD, and different sample periods.