Engineering a Venture Capital Market: Lessons from the American Experience  by Ronald J. Gilson

Because the VC industry presents high risks, it is necessary to have a framework of both explicit and implicit agreements. Both must exist at the same time. Explicit agreements rely on a country’s legal system, while implicit agreements rely on reputational markets. The interaction of the two systems creates a mechanism of checks and balances between the parties, which addresses issues regarding incentives, monitoring, information asymmetry, and agency costs.

  • How helpful? Scale of 1 to 5

5.

  • Topic Tags

Information asymmetry, agency costs, VC incentives, founders incentives, compensation structures, VC control

  • Relevant questions addressed

How do explicit agreements protect investors and founders?

How do implicit agreements protect investors and founders?

How are they enforced?

  • Summary bullet points
  • Investment in high tech startups is highly risky because of
    • Great uncertainty around the future of the company, both on the managerial and operational side and on the technological side
    • Information asymmetry: founders know the technology, investors only know of visible actions
    • Agency costs and divergence of founders and investors’ interests.
  • The U.S. legal system is well equipped to address these risks, avoiding market collapse
  • The U.S. market structure
    • couples high incentives for all parties with high degrees of monitoring
    • Utilizes both “implicit and explicit contracts”
  • 5 pillars of this market structure are identified
    • Staged financing reduces agency costs allowing investors to stop funding the startup. Stages are determined through achievement of set milestones that reduce uncertainty.
      • It creates alignment of founders and investors’ goals, establishes accountability and creates strong incentives, especially around next round financing
      • It addresses information asymmetry.
        • Better startups will be more willing to accept intense monitoring and incentives.
        • Lends credibility to the founders’ projections about the business
      • For these techniques to be efficient, misuse must be constrained
    • Control is often held disproportionately with respect to equity by investors
      • In the form of staged financing, it is powerful, periodic control which incentivizes monitoring of alignments
      • Control of the BoD allows for control between stages. This control can be more or less strong. It incentivizes the investors to monitor performance and alignment, and the founders to perform.
      • Information asymmetry is addressed by the balancing act of the continual learning on the founders’ part and ongoing monitoring on the investors’ part.
    • Compensation is structured as to incentivize founders and the company’s performance
      • Low wage and potential for increases in stock valuation for founders
      • Stock option to management
      • Vesting schedules on options and stock, with vesting provisions to incentivize the team to remain at the company
      • Creates potential downsides for the VC who is incentivized to monitor performance
      • Again, better companies will be more willing to accept more demanding incentives
    • The exit is structured as a “call option on control” for the founders. The agreements usually provide that if the company goes through an adequate IPO, control mechanisms by the investors like preferred stock and board control will end
      • In this case, the market monitors and incentivizes investors to accept adequate IPOs and revert control back when the right occasion opens up
    • These mechanisms are possible thanks to explicit agreements and to the reliability of implicit agreements and the role of reputation in the industry
      • These mechanisms build a system of reciprocal checks and balances
      • The VC is usually the more powerful party in the relationship. Reputation is especially important to them as
        • They expect “repeated future transactions”
        • The market shares ideas around what constitutes appropriate behavior
        • There is evidence of whether past behavior meets expectations
        • The market is highly concentrated, competitive, and localized and information travels quickly.
  • Follow-up links