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


  • Cestone, Giacinta


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.

Suggested Citation

  • Cestone, Giacinta, 2002. "Venture Capital Meets Contract Theory: Risky Claims or Formal Control?," CEPR Discussion Papers 3462, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:3462

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    References listed on IDEAS

    1. Giacinta Cestone & Lucy White, 2003. "Anticompetitive Financial Contracting: The Design of Financial Claims," Journal of Finance, American Finance Association, vol. 58(5), pages 2109-2142, October.
    2. Cornelli, Francesca & Yosha, Oved, 1997. "Stage Financing and the Role of Convertible Debt," CEPR Discussion Papers 1735, C.E.P.R. Discussion Papers.
    3. Klaus M. Schmidt, 2003. "Convertible Securities and Venture Capital Finance," Journal of Finance, American Finance Association, vol. 58(3), pages 1139-1166, June.
    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, February.
    5. Catherine Casamatta, 2003. "Financing and Advising: Optimal Financial Contracts with Venture Capitalists," Journal of Finance, American Finance Association, vol. 58(5), pages 2059-2086, October.
    6. Philippe Aghion & Patrick Bolton, 1992. "An Incomplete Contracts Approach to Financial Contracting," Review of Economic Studies, Oxford University Press, vol. 59(3), pages 473-494.
    7. Tirole, Jean, 2001. "Corporate Governance," Econometrica, Econometric Society, vol. 69(1), pages 1-35, January.
    8. Harris, Milton & Raviv, Artur, 1991. " The Theory of Capital Structure," Journal of Finance, American Finance Association, vol. 46(1), pages 297-355, March.
    9. Steven N. Kaplan & Per Strömberg, 2003. "Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts," Review of Economic Studies, Oxford University Press, vol. 70(2), pages 281-315.
    10. Bruno Biais & Catherine Casamatta, 1999. "Optimal Leverage and Aggregate Investment," Journal of Finance, American Finance Association, vol. 54(4), pages 1291-1323, August.
    11. Bengt Holmstrom & Jean Tirole, 1997. "Financial Intermediation, Loanable Funds, and The Real Sector," The Quarterly Journal of Economics, Oxford University Press, vol. 112(3), pages 663-691.
    12. Masako Ueda, 2000. "Bank versus venture capital," Economics Working Papers 522, Department of Economics and Business, Universitat Pompeu Fabra.
    13. Mike Burkart & Denis Gromb & Fausto Panunzi, 1997. "Large Shareholders, Monitoring, and the Value of the Firm," The Quarterly Journal of Economics, Oxford University Press, vol. 112(3), pages 693-728.
    14. Cornelli, F. & Yosha, O., 1997. "Stage Financing and the Role of Convertible Debt," Papers 23-97, Tel Aviv.
    15. Roberta Dessí, 1999. "Financing Entrepreneurs: Optimal Contracts and the Role of Intermediaries," FMG Discussion Papers dp328, Financial Markets Group.
    16. Gorman, Michael & Sahlman, William A., 1989. "What do venture capitalists do?," Journal of Business Venturing, Elsevier, vol. 4(4), pages 231-248, July.
    17. Mathias Dewatripont & Jean Tirole, 1994. "A Theory of Debt and Equity: Diversity of Securities and Manager-Shareholder Congruence," The Quarterly Journal of Economics, Oxford University Press, vol. 109(4), pages 1027-1054.
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    Cited by:

    1. Steven N. Kaplan & Per Strömberg, 2004. "Characteristics, Contracts, and Actions: Evidence from Venture Capitalist Analyses," Journal of Finance, American Finance Association, vol. 59(5), pages 2177-2210, October.
    2. Casamatta, Catherine & Haritchabalet, Carole, 2007. "Experience, screening and syndication in venture capital investments," Journal of Financial Intermediation, Elsevier, vol. 16(3), pages 368-398, July.
    3. Bottazzi, Laura & Da Rin, Marco & Hellmann, Thomas, 2009. "What is the role of legal systems in financial intermediation? Theory and evidence," Journal of Financial Intermediation, Elsevier, vol. 18(4), pages 559-598, October.
    4. Cumming, Douglas J., 2005. "Capital structure in venture finance," Journal of Corporate Finance, Elsevier, vol. 11(3), pages 550-585, June.
    5. Ibolya Schindele, 2002. "Support and Interference: Venture Financing with Multiple Tasks," IEHAS Discussion Papers 0215, Institute of Economics, Centre for Economic and Regional Studies, Hungarian Academy of Sciences.
    6. Rin, Marco Da & Hellmann, Thomas & Puri, Manju, 2013. "A Survey of Venture Capital Research," Handbook of the Economics of Finance, Elsevier.
    7. Roberta Dessï¾’, 2005. "Start-Up Finance, Monitoring, and Collusion," RAND Journal of Economics, The RAND Corporation, vol. 36(2), pages 255-274, Summer.
    8. Cumming, Douglas & Johan, Sofia Atiqah binti, 2008. "Preplanned exit strategies in venture capital," European Economic Review, Elsevier, vol. 52(7), pages 1209-1241, October.
    9. Dessi, Roberta & Yin, Nina, 2015. "Venture Capital and Knowledge Transfer," TSE Working Papers 15-555, Toulouse School of Economics (TSE).
    10. Ouidad Yousfi, 2009. "Leveraged Buy Out: Dynamic agency model with write-off option," EconomiX Working Papers 2009-13, University of Paris Nanterre, EconomiX.
    11. Catherine Casamatta & Carole Haritchabalet, 2014. "Dealing with Venture Capitalists: Shopping Around or Exclusive Negotiation," Review of Finance, European Finance Association, vol. 18(5), pages 1743-1773.
    12. Hellmann, Thomas, 2006. "IPOs, acquisitions, and the use of convertible securities in venture capital," Journal of Financial Economics, Elsevier, vol. 81(3), pages 649-679, September.
    13. Douglas Cumming & Sofia Johan, 2007. "Advice and monitoring in venture finance," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 21(1), pages 3-43, March.
    14. Ambec, S., 2004. "On the governance of start-ups," Working Papers 200406, Grenoble Applied Economics Laboratory (GAEL).
    15. Dessi, Roberta, 2011. "Innovation, Spillovers and Venture Capital Contracts," IDEI Working Papers 684, Institut d'Économie Industrielle (IDEI), Toulouse, revised Dec 2013.
    16. Bottazzi, Laura & Da Rin, Marco & Hellmann, Thomas, 2008. "Who are the active investors?: Evidence from venture capital," Journal of Financial Economics, Elsevier, vol. 89(3), pages 488-512, September.
    17. Inderst, Roman & Mueller, Holger M, 2002. "Venture Capital Contracts and Market Structure," CEPR Discussion Papers 3203, C.E.P.R. Discussion Papers.
    18. Becsky-Nagy Patricia & Karaszi Erika, 2015. "Capital Structure And Venture Capital," Annals of Faculty of Economics, University of Oradea, Faculty of Economics, vol. 1(1), pages 783-791, July.

    More about this item


    control rights; corporate governance; security design; venture capital;

    JEL classification:

    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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