Venture capitalists as economic principals.

• Author: Kaplan, Steven N.
• Position: Research Summaries

There is a large academic literature on the principal-agent problem in financial contracting. (1) This literature focuses on the conflicts of interest between an agent--an entrepreneur with a venture that needs financing--and a principal--an investor with the funds to finance the venture. According to these theories, there are a number of ways that the investor/principal can mitigate these conflicts. First, the investor can collect information before deciding whether to invest, in order to screen out ex ante unprofitable projects and bad entrepreneurs. Second, investors can structure financial contracts--that is, the allocation of cash flow, control and liquidation rights--between themselves and entrepreneurs to provide incentives for the entrepreneurs to behave appropriately. And third, the investors can engage both in collecting information and in monitoring it once the project is under way.

Despite the large volume of theory, the empirical work in comparing the contracts and actions of real world principals to their counterparts in financial contracting theory has lagged behind. In this paper, we describe recent empirical work and its relation to theory for one prominent class of such principals--venture capitalists (VCs). In our view, VCs are real world entities that closely approximate the investors of theory. VCs invest in entrepreneurs who need financing to fund a promising project or company. VCs have strong incentives to maximize value, but at the same time receive few or no private benefits of control. Although they are intermediaries, VCs typically receive at least 20 percent of the profits on their portfolios.

In this article, we describe recent empirical work--both ours and others'--on the three things that VCs do: contracting, screening, and monitoring. Unlike previous empirical work that has relied largely on surveys, our work (and much of the work we describe) relies on detailed information collected from actual VC financings.

Contracting

In a forthcoming article (2), we compare the characteristics of real world financial contracts to their counter parts in financial contracting theory. We do so by conducting a detailed study of 213 actual contracts between VCs and entrepreneurs. We find first that VC financings allow VCs to separately allocate cash flow rights, voting rights, board rights, liquidation rights, and other control rights. The separation of these rights is apparent, for example, in that VCs control roughly half of the cash flow rights on average, but have a majority of board seats in only 25 percent of the investments.

Second, while convertible securities are used most frequently, VCs also implement the same set of rights using combinations of multiple classes of common stock and straight preferred stock. We also point out that VCs use a variant of convertible preferred called "participating preferred" in roughly 40 percent of the financings. Participating preferred, under most circumstances, behaves like a position of straight preferred stock and common stock rather than like a position of convertible preferred.

Third, cash flow rights, voting rights, control rights, and future financings are frequently contingent on observable measures of financial and non-financial performance. These state contingencies are more common in the early stages of the VC-entrepreneur relationships (first VC rounds) and in earlier stage investments.

Fourth, voting rights, board rights, and liquidation rights...