Financial contracting theory meets the real world: an empirical analysis of Venture Capital contracts by Steven Kaplan, Per Stromberg

VC contracts closely reflect contractual theory as VCs have the power to separately allocate rights and because they have a variety of contractual tools to use in financing rounds. Staged financing, as well as performance-based incentives, non-compete agreements, and control rights are some examples

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  • Topic Tags

VC contracts, contractual structures, legal structure and incentives

  • Relevant questions addressed

How can theory explain the contractual and incentive structure of VC contracts?

  • Summary bullet points
  • VC financing approaches contractual theory because VCs can allocate different rights (voting, cash flow, board, liquidation, etc.) separately
    • Allocation of these rights
  • VCs tend to use different types of financial tools to invest
    • Convertible securities are most often used
    • VCs accomplish similar results in allocating rights using different classes of stock and other methods
  • VCs can put milestones in place to which they can tie future outcomes in terms of rights and future financing rounds
  • Control can depend on performance
    • When the company’s performance is sub-par, the VCs can obtain more control. If it then improves, the founders can regain some control.
    • Vice versa, if the company performs very well, investors lose control and liquidation rights but both investors and founders’ cash flow rights increase
  • Non-compete clauses are often included in VC contracts to avoid conflict with founders
  • Vesting provisions are also included in VC contracts to avoid conflict with founders but they are more used in early-stage financing because of the higher conflict risk
  • Different contractual strategies are often used together to achieve goals
    • Cash flow incentives
    • Control rights,
    • Contingencies
  • VCs tend to use control rights tied to key performance indicators
  • These contractual strategies are ways to discriminate good companies and founders from bad ones
  • Follow-up links

Investor abilities and financial contracting: Evidence from venture capital -

What’s a non-compete clause and how does it work? -