Table Of ContentVenture Capital and Private Equity Contracting
Venture Capital and Private
Equity Contracting
An International Perspective
Second Edition
Douglas J. Cumming
Professor and Ontario Research Chair, York University,
Schulich School of Business Toronto, ON, Canada
Sofia A. Johan
Adjunct Professor, York University, Schulich School of Business
Toronto, ON, Canada
and
Extramural Research Fellow, Tilburg Law and Economic Centre (TILEC)
The Netherlands
AMSTERDAM(cid:129)BOSTON(cid:129)HEIDELBERG(cid:129)LONDON(cid:129)NEWYORK(cid:129)OXFORD
PARIS(cid:129)SANDIEGO(cid:129)SANFRANCISCO(cid:129)SINGAPORE(cid:129)SYDNEY(cid:129)TOKYO
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Preface
Thisbookisintendedforadvancedundergraduateandgraduatestudentsinbusiness,
economics, law, and management. This book is also directed at practitioners with
aninterestinthe venture capital andprivateequityindustry.We consideranumber
of different countries in this book. The terms venture capital and private equity
maydifferindifferentcountries,thereforeinthisbookwegenerallyrefertoventure
capital as risk capital for small private entrepreneurial firms and private equity as
encompassing a broader array of investors, entrepreneurial firms and transactions,
includinglaterstageinvestments,turnaroundinvestments,andbuyouttransactions.
Financial contracting is the common theme that links the topics covered in this
book. This book explains the ways in which these contracts differ across different
types of venture capital and private equity funds, different types of institutional
investors, different entrepreneurial firms, and differ across countries and over time.
Thisbookwillshowwhenandhowfinancialcontractsarematerialtotheallocation
of risks, incentives, and rewards for investors and investees alike. This book will
further show when and how financial contracts have a significant relationship with
actualinvestmentoutcomesandsuccess.
Whyshouldwecareaboutfinancialcontracting?Venturecapitalandprivateequity
funds are financial intermediaries between sources of capital and entrepreneurial
firms. Sources of capital typically include large institutional investors including
pensionfunds,banks,insurancecompanies,andendowments.Theseandothersources
ofcapitaldonothavethetimeorexpertisetoinvestdirectlyinentrepreneurialfirms,
particularly high-growth firms in high-tech industries. As such, specialized venture
capitalandprivateequityfundsfacilitatetheinvestmentprocess,atapriceofcourse.
Thesefundsareforallintentsandpurposesorganizationsthatareestablished,capital-
ized, and operated under specific contractual terms and obligations agreed between
the investors and the venture capital and private equity funds. Another different type
of financial contract governs the relationship between venture capital and private
equity funds and their investee entrepreneurial firms, how such firms are capitalized
and how they are in turn operated. It is obvious therefore that financial contracting
isnotsomethingthatventurecapitalandprivateequityfundsdo,itisalsoinessence
whattheyare.
Broadly framed questions addressed in this book include, but are not limited to,
thefollowing:
(cid:1) Whatcovenantsandcompensationtermsareusedinlimitedpartnershipcontracts?
(cid:1) Inwhatwaysarelimitedpartnershipcontractsrelatedtomarketconditionsandfundmanager
characteristics,andhowdothesecontractsdifferacrosscountries?
xx Preface
(cid:1) What are the cash flow and control rights that are typically assigned in venture capital
and private equity contracts with investee firms, and when do fund managers demand
morecontractualrights?
(cid:1) Do different contractual rights assigned to different parties influence the effort provided
bytheinvestor(s)?
(cid:1) Inwhatwaysaredifferentfinancialcontractsrelatedtothesuccessofventurecapitaland
privateequityinvestments?
By considering venture capital and private equity contracting in an international
setting, this book offers an understanding of why venture capital and private equity
marketsdifferwithrespectto
(cid:1) Fundgovernance
(cid:1) Investeefirmgovernance
(cid:1) Investeefirmperformance
In this book, we provide examples of actual contracts that have been used in
practice, including a limited partnership agreement, a term sheet, a shareholder
agreement,and a subscriptionagreement.In addition,we provide datasets ofventure
capital and private equity that include details on a large number of actual contracts.
It is important and relevant to review data to show real investment contracts from
actual transactions, and explain how financial contracts are central to actual invest-
ment decisions and investment outcomes. Without analyzing data, we would at best
belimitedtoourbestguesses,whichisnottheintentionhere.Thedataconsideredin
this bookare international inscope,witha focus onCanada, Europe,and the United
States. It is important to consider data from a multitude of countries to understand
how and why venture capital and private equity markets differ around the world. As
well,idiosyncraticfeaturesofcertaincountriesmaydistortourunderstandingofhow
venturecapitalandprivateequitycontractsworkinpractice.
In short, by considering international datasets, and not data from just one country
such as the United States, we are able to gain a significant amount of insight into
how venture capital and private equity funds operate in relation to their legal and
institutional environment. Each chapter inthis book, where possible and appropriate,
will refer to and analyze data. Note however that venture capital and private equity
funds are not compelled to publicly report data, nor are they willing to do so. As
such, thereisalwaysmore data that can becollected. Itisthe authors’hopethat this
book will not only provide an understanding of how venture capital and private
equity funds operate through financial contracts, but also that it will inspire further
empiricalworkinthefieldsothatwemaybetterunderstandthenatureandevolution
ofventurecapitalandprivateequitymarketsinyearstocome.
A Brief Note on Organization and Data
Part I of this book comprises three chapters. Chapter 1 briefly refers to aggregate
industrystatisticsonventurecapitalandprivateequity markets aroundtheworld to
Preface xxi
compare the size of the markets in different countries. Chapter 2 describes agency
problems in venture capital and private equity investment. Chapter 2 is the only
chapter that does not consider data. The intention in Chapter 2 is to provide a
framework for understanding agency problems. Chapter 3 provides an overview of
the empirical methods considered in this book. The description of the statistical
and econometric techniques used is intended to be user friendly so that all readers
can follow along each of the chapters regardless of background. As well, Chapter3
provides an overview of the institutional and legal settings in the countries consid-
ered in the different chapters. A central theme in this book is that differences in
venture capital and private equity markets, including but not limited to contracting
practices, are attributable to international differences in legal and institutional
settings.
PartIIofthisbook(Chapters4(cid:1)9)considersventurecapitalandprivateequity
fundraising and the structure of limited partnerships (Chapters 4(cid:1)7), as well as
listed private equity (Chapter 8), and public policy toward fundraising and fund
structure (Chapter 9). In order to understand the contractual structure of limited
partnerships, we do not exclusively focus on contracts themselves, but rather
provide a context in which to understand the contracts by providing evidence on
motivations underlying institutional investment in venture capital and private
equity. We provide some country-specific data (Chapters 4 and 7) from the
United States and The Netherlands, as well as data from a multitude of countries
(Chapters 4(cid:1)6, 8, and 9). We start with the perspective of institutional investors
in Chapter 4 to understand the motivations underlying the source of capital—
institutional investors. Outside the United States, institutional investors have
comparatively less experience with venture capital and private equity investment.
Chapter 4 examines recent data from institutional investors from The Netherlands
to study a market somewhat less developed than that in the United States, but
nevertheless with significant commitments to venture capital and private equity
funds, commitments to funds both domestic and international, as well as commit-
ments in niche areas such asthe sociallyresponsible investmentclass. Also, regu-
latory changes to make The Netherlands particularly interesting to study from the
perspective of institutional investors. In the United States, many institutional
investors have longstanding relationships with venture capital and private equity
fund managers that span multiple decades. In Chapter 7, we examine data from
the United States pertinent to the issue of “style drift,” which refers to situations
in which fund managers deviate from stated objectives in limited partnership
contracts. Chapters 5 and 6 provide a broader perspective with data from venture
capital and private equity funds from a multitude of countries (Belgium, Brazil,
Canada, Cayman Islands, Finland, Germany, Italy, Luxembourg, Malaysia,
Netherland Antilles, The Netherlands, New Zealand, Philippines, South Africa,
Switzerland, the United Kingdom, and the United States). This international com-
parative evidence highlights the role of legal and institutional differences around
the world and the impact on fund governance. Likewise, the data introduced in
Chapter 8 on listed private equity and Chapter 9 on the role of government and
public policy are fromavariety ofcountries.
xxii Preface
While Part II focuses on fund structure and governance, the subsequent sections
of this book highlight a role of financial contracts with entrepreneurs (Part III),
governanceprovidedtoinvestees(PartIV),andthedivestmentprocess(PartV).
Part III (Chapters 10(cid:1)13) covers material pertaining to financial contracting
with entrepreneurs. Chapter 10 first summarizes evidence on investment activities
in a number of studies from the United States. Chapter 11 considers evidence from
financialcontractingfromUnitedStatesandCanadianventurecapitalists,withafocus
on security design. Chapter 12 considers evidence on financial contracting from
Europe, and Chapter 13 provides evidence from an even broader set of countries
around the world. It is worthwhile to compare evidence on financial contracts from
the United States, Canada, and Europe to understand how laws and regulations,
among other things, influence the design of financial contracts and venture capital
governancemoregenerally.
Part IV (Chapters 14(cid:1)18) relates financial contracts and other investment
mechanismstothegovernanceprovidedtotheinvestee firm.Chapter14provides a
survey of all of the factors that might influence investee governance. Chapter 15
considers the relation between contracts and actual investor effort in terms of
advice and monitoring, as well as disagreement between investors and investees.
Chapters 16(cid:1)18 consider noncontractual factors that influence investor effort, par-
ticularly the role of geographic proximity (Chapter 16), portfolio size (Chapter 17),
andfundsize(Chapter18).
Part V (Chapters 19(cid:1)22) studies the exit outcomes of venture capital and private
equity-backed companies. Because investees typically do not have cash flows to pay
interest on debt or dividends on equity, venture capital and private equity investors
invest with a view toward capital gain in an exit event. Chapter 19 provides an
overview of the exit decision and summarizes evidence on exits from Australasia,
Canada, Europe, and the United States. Chapters 20 and 21 show exits are signifi-
cantly related to the governance of the fund (as considered in Chapters 4(cid:1)9) and
contractsbetweeninvestorsand investees(asconsideredinChapters10(cid:1)14)and the
effort provided (Chapters 15(cid:1)18). Exit outcomes are considered with reference to
extensive data from Canada (Chapter 20) and Europe (Chapter 21). Thereafter,
Chapter 22 provides evidence on the financial returns to venture capital investment
from 39 countries around the world from North and South America, Europe,
Africa, and Australasia. The data indicate financial structures and governance are
significantly relatedtoreturns.Aswell,Chapter22discussesevidenceonreporting
biases of the performance of unexited institutional investors for companies that
havenotyethadanexitevent.
Selected chapters in this book are based on previously published material, as
summarizedbelow:
Chapter4:
Cumming, D., and S.A. Johan, 2007. “Regulatory Harmonization and the Development
ofPrivateEquityMarkets”JournalofBankingandFinance,31,3218(cid:1)3250.
Cumming, D., and S.A. Johan, 2007. “Socially Responsible Institutional Investment in
PrivateEquity”JournalofBusinessEthics75,395(cid:1)416.
Preface xxiii
Chapter5:
Cumming, D., and S.A. Johan, 2006. “Is it the Law or the Lawyers? Investment
CovenantsaroundtheWorld”EuropeanFinancialManagement12,553(cid:1)574.
Chapter6:
Cumming, D., and S.A. Johan, 2009. “Legality and Venture Capital Fund Manager
Compensation” Venture Capital: An International Journal of Entrepreneurial Finance
11,23(cid:1)54.
Chapter7:
Cumming,D.J.,G.FlemingandA.Schwienbacher,2009.“StyleDriftinPrivateEquity”
JournalofBusinessFinanceandAccounting36(5(cid:1)6),645(cid:1)678.
Chapter8:
Cumming, D.J., G. Fleming and S.A. Johan, 2011. “Institutional Investment in Listed
PrivateEquity”EuropeanFinancialManagement17(3),594(cid:1)618.
Chapter9:
Cumming, D., 2007. “Government Policy Towards Entrepreneurial Finance in Canada:
Proposals to Move from Labour Sponsored Venture Capital Corporations to More
EffectivePublicPolicy”CDHoweInstituteCommentaryNo247.
Chapter11:
Cumming, D., 2005. “Agency Costs, Institutions, Learning and Taxation in Venture
CapitalContracting”JournalofBusinessVenturing20,573(cid:1)622.
Chapter12:
Cumming, D., and S.A. Johan, 2008. “Preplanned Exit Strategies in Venture Capital”
EuropeanEconomicReview52,1209(cid:1)1241.
Chapter13:
Cumming, D.J., D. Schmidt and U. Walz, 2010. “Legality and Venture Capital
GovernanceAroundtheWorld”JournalofBusinessVenturing25,54(cid:1)72.
Chapter15:
Cumming, D., and S.A. Johan, 2007. “Advice and Monitoring in Venture Capital
Finance”FinancialMarketsandPortfolioManagement21,3(cid:1)43.
Chapter16:
Cumming,D.J.,andN.Dai,2010.“LocalBiasinVentureCapital” JournalofEmpirical
Finance17,362(cid:1)380.
Chapter17:
Cumming, D., 2006. “The Determinants of Venture Capital Portfolio Size: Empirical
Evidence”JournalofBusiness79,1083(cid:1)1126.
Chapter18:
Cumming, D.J., and N. Dai, 2011. “Limited Attention, Fund Size and the Valuation of
VentureCapitalBackedCompanies”JournalofEmpiricalFinance18(1),2(cid:1)15.
Chapter20:
Cumming,D.J.,andS.A.Johan,2010.“VentureCapitalInvestmentDuration”Journalof
SmallBusinessManagement48,228(cid:1)257.
xxiv Preface
Chapter21:
Cumming, D., 2008. “Contracts and Exits in Venture Capital Finance” Review of
FinancialStudies21,1947(cid:1)1982.
Chapter22:
Cumming, D.J., and U. Walz, 2010. “Private Equity Returns and Disclosure Around the
World”JournalofInternationalBusinessStudies41(4),727(cid:1)754.
We are indebted to Na Dai, Grant Fleming, Armin Schwienbacher, Daniel
Schmidt,andUweWalzforthegenerosityinallowingustousesomeofthematerial
upon which Chapters 7, 8, 13, 16, 18, and 22 are based, asthat work was developed
jointlywiththeseexcellentcoauthors.
Each chapter of the book has been adapted in a way that begins with a list of
learningobjectives.Aswell,eachchapterendswithalistofkeytermsandanumberof
discussionquestions.PowerPointlectureslidesforeachchapterandonlineAppendices
1(cid:1)4 are available online at http://www.venturecapitalprivateequitycontracting.com/
andhttp://booksite.elsevier.com/9780124095373/.
