The Sophisticated Venture Capitalist

Financial contracts play an important role in structuring incentives between entrepreneurs and investors, thus making it possible for new ventures to obtain financing. Effective financial contracts have been developed over several business cycles in the United States. Do U.S.-style contracts also work in other countries?

In earlier studies, University of Chicago Graduate School of Business professors Steven N. Kaplan and Per Strömberg have shown that venture capital (VC) contracts in the United States successfully address the risks and monitoring needs of venture capitalists. These contracts carefully allocate cash flow rights, liquidation rights, and control rights between the entrepreneur and the venture capitalist. The terms of these contracts usually depend on company performance.

Almost all VC contracts in the United States use convertible preferred stock, which usually includes control rights and liquidation rights that protect the venture capitalist. Pure common stock has no such protection. With convertible preferred stock, the VCs get more equity if the company performs well, and get control of the company if performance targets are not met.

Though venture capital investments are much less prevalent outside of the United States, there was a surge of VC activity abroad during the Internet boom.

In a recent study, "How Do Legal Differences and Learning Affect Financial Contracts?," Kaplan and Strömberg, along with Frederic Martel of the University of Lausanne IMD and UBS Global Asset Management, compare venture capital contracts in 23 countries to contracts in the United States. The authors analyze how the contracts allocate cash flow, and board, liquidation, and other control rights.

The ability of a venture capitalist to design financial contracts may be affected by a country's institutional environment, including: the nature of corporate and contract law, the quality of legal enforcement, accounting systems, tax regulations, and financial markets.

Different styles of contracts may be optimal in different countries. However, the authors find that differences in legal rules, tax rules, accounting rules, and market institutions do not explain the variations in contracts among the sample countries.

Venture capital investing outside the United States is more recent, and must be adapted to different legal rules. Learning about optimal contracts takes time.

Is it the case that unsuccessful VCs simply have not learned how to design the best contracts?

Convertible preferred stock is not as widely used in VC contracts outside the United States. For the purpose of the study, the use of convertible preferred stock is indicative of using U.S.-style contracts, since this stock is used in virtually all U.S. financings.

The authors find that past experience outweighs the institutional variables in determining the differences between contracts. More experienced and sophisticated venture capitalists are able to implement U.S.-style contracts regardless of legal regime.

"Our results suggest that U.S.-style contracts are economically efficient not only in the United States, but in all developed countries," says Kaplan.

The Variations

For the 23 countries represented in the study, Kaplan, Strömberg, and Martel compared 145 investments in 107 companies by 70 lead VCs. Their data came from VCs who invest abroad. Additional data was provided by an institutional investor who invests in VC partnerships abroad. All VC partnerships in the study are for-profit, non-governmental entities.

For each company and for each financing round, the VCs provided the authors with term sheets, stock and security purchase agreements, the company's business plan, and the VC's internal analysis of the investment.

The companies studied are concentrated in Western Europe. All but eight of the investment rounds were completed after 1997. The majority of the companies (58 percent) are software and Internet firms. Roughly two-thirds of the investments were for young companies. The average VC invested between $6 million and $7 million in a given venture.

The results show much more variation in the types of securities used outside the United States than within the United States. While more than 95 percent of U.S. financings use some type of convertible preferred stock, fewer than 54 percent of the non-U.S. financings use convertible preferred stock. As a result, VC contracts outside the United States have weaker liquidation and exit rights. Ordinary common stock is found more often outside the United States and is used in almost 28 percent of the financings, versus less than 1 percent in the United States.

Venture capital investments in other countries are also less likely to use contingencies, such as funding milestones, vesting provisions, and anti-dilution rights. These contingencies all increase the sensitivity of the founder's cash flow rights to the new firm's performance. Overall, VC contracts outside the United States have weaker investor rights of all types than those in the United States.

In addition to the characteristics of the contracts, the authors considered how contracts vary with the legal origin of the country in which the portfolio company is located. Certain provisions typical of U.S.-style contracts may be infeasible or costly to enforce in other countries. The study covers five different legal regimes: common law, civil law, German law, Scandinavian law, and communist.

The authors find that contracts in common law countries, such as the United Kingdom, are more likely to resemble U.S.-style contracts, while contracts elsewhere are more likely to differ. Common law countries tend to have more market-based financial systems with more equity markets.

Overall, legal, tax, and institutional differences do not provide an adequate explanation for the relationship between contract characteristics and legal origin.

Measuring Sophistication

How much does VC experience affect the type of financial contracts they use? Using legal variables and measures of VC "sophistication," the authors compared the importance of legal regime to learning and experience.

These "sophistication" measures included:

Size: Smaller VCs, with no more than $200 million under management, versus larger VCs.

Age: Younger VCs with four or less years of experience, versus older VCs.

Experience with the United States: 37 financings were led by VCs based in the United States, 87 financings were led by VCs who had previously invested in the United States, and 37 financings were led by VCs with no U.S. experience.

The authors find VCs are more likely to use U.S.-style contracts when the VC is larger, older, and has previous experience working with U.S. investors.

These measures turn out to be strong predictors for whether the VC uses a U.S-style contract, with convertible preferred stock, liquidation rights, stronger exit provisions, and other rights.

The results suggest that VC sophistication variables are more important in determining how VCs structure contracts than legal and institutional variables.

To explore the relationship between VC sophistication and post-investment success, the authors studied the survival of the 70 VCs represented as lead investors in the sample.

As of August 2003, 59 of the 70 funds are still active, while 11 have failed or been acquired. The authors then separated the VC funds depending on the securities they used when acting as lead investors. Of the 37 funds that used convertible preferred stock (and U.S.-style contracts) exclusively, all have survived the tech bust. On the other hand, 10 of the 29 funds that exclusively used common stock (and non-U.S.-style contracts) have failed.

Survival and failure results do not prove a simple cause and effect scenario, but it is clear that the more successful VCs use convertible or participating preferred (another type of convertible preferred) rather than common stock. VCs who use U.S.-style contracts are significantly less likely to fail.

While some VCs are able to get around institutional constraints to implement U.S.-style contracts, it is not as simple as exporting U.S.-style contracts abroad. Even in cases where VCs would like to implement U.S.-style contracts, it may cost the VCs to do so. There are "fixed costs of learning," for example, the potentially sizeable legal fees associated with having contracts rewritten to these specifications.

"Our results imply that if you have a different legal system, you aren't stuck," says Strömberg. "While it may be difficult to write around laws in other countries, it is still possible to replicate U.S.-style mechanisms in your financial contracts if you are clever and find the right lawyer."

Besides rewriting contracts to include U.S.-style provisions, 21 percent of the companies in the sample reincorporate in another country with a less restrictive institutional environment.

"Inexperienced and unsophisticated venture capitalists may not have understood why convertible preferred stock was necessary, and chose common stock instead," says Kaplan. "In the end, those VCs had very little protection, and some ended up going out of business when the technology market crashed."

Since contracts are important for VC success, the authors expect that over time, the more sophisticated and successful VCs will implement more effective contracts. Furthermore, the evolution to more effective contracts is likely to accelerate in periods of high volatility, such as the bursting of the tech bubble.

Convergence

As financial markets become more global, the authors expect a greater convergence toward U.S.-style contracts.

"If I were advising a country about how to set up its legal and financial structure, I would make it easier for VCs to write U.S.-style contracts," says Kaplan.

Strömberg notes that for policymakers in other countries, it is important to allow investing by U.S. venture capitalists, because their systems can learn a great deal from U.S. VCs.

The authors find that though many foreign VCs have gone stale, these VCs have learned from the experience, and are taking heed to structure their future contracts with more U.S.-style provisions, including convertible preferred stock.