What VC contracts tell us about the expected performance of a start-up

by Filippo Ippolito

It is well known that venture capitalists do not use simple equity or debt to finance start-ups. They typically employ complex securities that contain a state-contingent allocation of cash-flow and voting rights.

Why do they do so? And what can we learn from these contracts in terms of perceived risk and expected returns on investments?

Common securities used by VCs

When VCs finance a start-up they typically write a complex contract with the entrepreneur. In most cases the contract discusses in great detail the allocation of cash-flow, board, voting, liquidation, and redemption rights, as well as the terms for automatic conversion, anti-dilution protection, vesting, non-compete clauses and staging (see Kaplan and Stromberg (2002)).

Let’s examine each of these terms in turn:

Cash flow rights: The evidence from the U.S. shows that VCs typically control 50% of cash flow rights, the founders 30%, and others the remaining 20%. State-contingencies change these allocations. With maximum vesting, founders and employees get an extra 8% of cash flows. VCs will have maximum ownership if managers do not meet any of the performance or time vesting milestones. 

Board and voting rights: These two types of rights are highly correlated, and both are typically state contingent. VCs have board majority in 25% of cases, and this turns into 35% of cases if performance turns for the worse. These numbers translate into a voting majority for VCs in 52% of cases in the base scenario, that grows to 69% if performance is poor. In fact, it is often common to allow for a switch in control depending on performance.

Liquidation rights: Almost always, VCs enjoy liquidation rights that are at least as large as their original cumulative investment. A common way to make liquidation rights strong is to make preferred dividends cumulative, in the sense that unpaid dividends contribute to the liquidation claim.

Redemption rights: VCs are granted “put options” that allow them to redeem their investments. Redemption rights provide support to liquidation rights, and guarantee that VCs can walk out of the firm in case performance is disappointing.

Automatic conversion: This clause is almost always present and it mainly relates to the conversion of the VCs claim into common equity in case of IPO.

Anti-dilution protection: This clause protects VCs from possible dilution in later financing rounds. With “full ratchet” the VC receives a claim to enough additional shares in the new financing round to guarantee the same (lower) price as new investors.

Vesting and non-compete clauses: By delaying the claim of the entrepreneur on the firm’s equity, stopping him/her from working for other firms in the sector, these clauses help prevent the entrepreneur from leaving the firm.

Stage financing: On average, an entrepreneurial firm receives 3.6 rounds of VC financing, with an inter-round duration of 20 months. (Tian (2011))

Convertible preferred stock is the most commonly used security by VCs, being present in an estimated 80% of cases. Its features are that it pays preferred dividends, it gets priority in case of liquidation, and it can be converted into common stock. In many cases, convertible preferred stock is participating. This means that the VC also has the right to participate in the distribution of earnings in addition to the preferred dividend (double-dipping).

Why do we observe these contracts?

The contractual clauses listed above illustrate how complex VC contracts can be. The question is why do VCs bother including so many technical terms in their agreement with the entrepreneur? Why not simply use standard equity and debt financing? The answer lies in the extraordinary uncertainty that VCs face when financing a start-up. 

More specifically, VCs face a number of agency problems. Broadly speaking, these problems relate to the fact that VCs cannot fully observe neither the ability nor the effort of the entrepreneur. Consequently, VCs use contracts as a way to screen entrepreneurs, and to provide the right incentives for managers to maximise the value of the start-up.

We typically refer to four types of problems:

1.   Adverse selection: The entrepreneur may know about his/her ability to run the project, and about the profitability-risk profile of the project more than the VC. The VC wants to screen away low-profitability high-risk projects

2.    Entrepreneur’s moral hazard: The VC is concerned that the entrepreneur may not work to the maximum to create value. The entrepreneur may have other projects running in parallel, or may simply be unwilling to pull all the available resources to maximise returns, particularly if his/her equity stake in the project is not large.

3.   Disagreements down the line: Developing a start-up requires tons of decisions. The VC and the entrepreneur may disagree on what is best for the firm. The VC tends to have a focus solely on creating value and doing it relatively fast. The entrepreneur often sees the project in terms of a life objective.

4.    Hold-up by the entrepreneur: The entrepreneur can “hold-up” the VC by threatening to leave the venture when the entrepreneur’s human capital is particularly valuable to the company.

VCs contracts are especially designed to deal with these types of problems. Let’s see how.

Adverse selection: The objective of the VC is to avoid wasting money on low quality projects/entrepreneurs. This is typically achieved by delaying the compensation of the manager (vesting), and via stage financing. The latter helps VCs minimise their exposure to the firm, and walk away with minimum losses. Additionally, VCs will want redemption rights and high priority in case of liquidation. These two debt-like features of the contract ensure the VC can walk away from the firm at a minimum loss, if the project turns out to be a lemon.

Entrepreneur’s moral hazard: The main issue here is that the initial capital provided by the entrepreneur is likely to be very small as compared to the amount financed by the VC. This means that with a standard equity contract, the entrepreneur would end up owning a very small percentage of the firm. This may affect his/her incentive to maximise firm value. It then becomes paramount to make the cash-flows, voting and board rights dependent on performance. In this way the entrepreneur is fully motivated to maximise firm value because his/her stake in the firm will increase if the firm performs well. Stage financing and low liquidation rights for the entrepreneur help reinforce this mechanism.

Disagreement down the line: This point is a little bit more contentious. The VC wants to ensure that his/her return on investment are maximised. How to achieve this objective is often a matter of opinions. Broadly speaking, this can be achieved by making board and voting rights state-contingent. The entrepreneur gets more voting power if he/she is performing well.

Entrepreneur’s hold-up: The main issue is here to stop the entrepreneur from leaving the firm. This can be achieved by including non-compete clauses, by delaying the vesting of shares, and through lock-ups in case of an IPO.

You can see now that simply equity or debt are not well-suited for addressing all these concerns. Complex contracts with lots of nuances and state-contingent clauses are the necessary answer.

What do these contracts tell us about expected and realised returns of investments?

Let’s come to the question that I consider most interesting. What can we infer about the risk-return profile of an investment by looking at the contractual terms that VC investors are using? This question is relevant for any sub-sequent investor in the firm. I suggest that investors in later rounds and IPO investors should carefully examine the contractual terms employed by VCs, because these terms can be very informative about the perception of risk and the expectation of returns that previous VCs have for the project.

What I am proposing here is an exercise in reverse engineering: I look at the clauses that VCs have included in previous financing rounds, and I infer what their expectations must be in terms of performance and risk. Clearly, these clauses are telling us much about expectations ex-ante (as in before the VC stepped in) as about expectations ex-post (as in after the VC has stepped in and improved firm performance, also thanks to the inclusion of the contractual clauses mentioned above).

Let’s examine the terms of the contract one by one (see Tian (2011), Caselli, Garcia-Appendini and Ippolito (2013) and Kaplan and Stromberg (2004)):

(BAD NEWS) Financing rounds: The evidence shows that firms that receive more financing rounds are less likely to end up in an IPO (versus an acquisition), and are expected to have lower ROA, ROE and sales. Within-round and across-round staging using explicit milestones is higher when perceived risk is high.

(MOSTLY GOOD NEWS) Covenants: The inclusion of permitted transfers, redemption rights, the right of first refusal, and an exit ratchet clause are associated with better performance (IRR, change in sales, change in ROA, change in ROE, probability of IPO). In general, more covenants in the VC contract are associated with better performance. However, redemption rights and full-ratchet anti-dilution protection are associated with higher perceived risk.

(BAD NEWS) Performance benchmarks: The use of performance benchmarks (equity stake), board contingencies and time vesting tend to be more common in high risk firms. 

Conclusions

The evidence shows that VCs do not employ standard debt and equity securities to finance start-ups, but more complex state-contingent hybrid securities. The state-contingent nature of the securities determines cash-flow, voting, board, conversion, anti-dilution and liquidation rights.

The complexity and flexibility of VC contracts is a response to the potentially conflictual relations that can evolve between VCs and entrepreneurs as a result of the so-called agency conflicts. The choice of clauses in a VC contract reveals the perceived risks that VCs want to keep under control.

With a little bit of reverse engineering, we can figure out what VCs in previous rounds thought of the risks and opportunities offered by the firm.

Essential Bibliography

1.   Bengtsson, O. and Sensoy, B.A., 2011. Investor abilities and financial contracting: Evidence from venture capital. Journal of Financial Intermediation, 20(4), pp.477-502.

2.   Caselli, S., Garcia-Appendini, E. and Ippolito, F., 2013. Contracts and returns in private equity investments. Journal of Financial Intermediation, 22(2), pp.201-217.

3.   Cumming, D., 2008. Contracts and exits in venture capital finance. The Review of Financial Studies, 21(5), pp.1947-1982.

4.   Kaplan, S.N. and Str?mberg, P., 2003. Financial contracting theory meets the real world: An empirical analysis of venture capital contracts. The review of economic studies, 70(2), pp.281-315.

5.   Kaplan, S.N. and Str?mberg, P.E., 2004. Characteristics, contracts, and actions: Evidence from venture capitalist analyses. The Journal of Finance, 59(5), pp.2177-2210.

6.   Tian, X., 2011. The causes and consequences of venture capital stage financing. Journal of Financial Economics, 101(1), pp.132-159.

About me

Filippo Ippolito is Associate Professor of Finance at Universitat Pompeu Fabra in Barcelona, and a research affiliate at the Centre for Economic Policy Research (CEPR), London. He is the Director of the Master in Finance at the Barcelona Graduate School of Economics. Filippo holds a PhD in Finance from Said Business School, Oxford, and an MPhil from the University of Oxford. He has work experience in the financial and consulting sectors. His research focuses on corporate policies in the presence of frictions, and the implications for equity returns. Filippo has published in the Journal of Finance, Journal of Financial Economics, Journal of Financial Intermediation, Journal of Monetary Economics, Journal of Money, Credit and Banking, and Journal of Corporate Finance.