Venture 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 • BOSTON • HEIDELBERG • LONDON • NEW YORK • OXFORD PARIS • SAN DIEGO • SAN FRANCISCO • SINGAPORE • SYDNEY • TOKYO Elsevier 32 Jamestown Road, London NW1 7BY 225 Wyman Street, Waltham, MA 02451, USA First Edition 2009 Second Edition 2014 Copyright © 2014, 2009 Elsevier Inc. 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Table of Contents Front-matter, Pages i,iii PDF (156 K) Copyright, Page iv PDF (172 K) Dedication, Page v PDF (12 K) Preface, Pages xix-xxiv PDF (45 K) Part One: Introduction 1 - Introduction and Overview, Pages 3-37 PDF (2398 K) 2 - Overview of Agency Theory, Empirical Methods, and Institutional Contexts, Pages 39-60 PDF (815 K) 3 - Overview of Institutional Contexts and Empirical Methods, Pages 61-76 PDF (124 K) Part Two: Fund Structure and Governance 4 - Fundraising and Regulation, Pages 79-143 PDF (1547 K) 5 - Limited Partnership Agreements, Pages 145-173 PDF (246 K) 6 - Compensation Contracts, Pages 175-205 PDF (254 K) 7 - Style Drift, Pages 207-238 PDF (220 K) 8 - Institutional Investment in Listed Private Equity, Pages 239-266 PDF (153 K) 9 - The Role of Government and Alternative Policy Options, Pages 267-302 PDF (998 K) Part Three: Financial Contracting between Funds and Entrepreneurs 10 - The Investment Process, Pages 305-317 PDF (216 K) 11 - Security Design, Pages 319-368 PDF (501 K) 12 - Preplanned Exits and Contract Design, Pages 369-403 PDF (340 K) 13 - Legal Conditions and Venture Capital Governance, Pages 405-442 PDF (227 K) Part Four: Investor Effort 14 - Investor Value Added, Pages 445-450 PDF (60 K) 15 - Contracts and Effort, Pages 451-490 PDF (241 K) 16 - Local Bias, Pages 491-521 PDF (181 K) 17 - Portfolio Size, Pages 523-562 PDF (356 K) 18 - Fund Size, Pages 563-587 PDF (159 K) Part Five: Divestment 19 - The Divestment Process, Pages 591-601 PDF (84 K) 20 - Investment Duration, Pages 603-631 PDF (738 K) 21 - Contracts and Exits, Pages 633-675 PDF (216 K) 22 - Returns, Valuation, and Disclosure, Pages 677-722 PDF (271 K) Part Six: Conclusion and Appendices 23 - Summary and Concluding Remarks, Pages 725-727 PDF (38 K) Bibliography, Pages 729-756 PDF (598 K) Preface This book is intended for advanced undergraduate and graduate students in business, economics, law, and management. This book is also directed at practitioners with an interest in the venture capital and private equity industry. We consider a number of different countries in this book. The terms venture capital and private equity may differ in different countries, therefore in this book we generally refer to venture capital as risk capital for sma ll private entrepreneurial firm s and private equity as encompassing a broader arr ay of investors, entrepreneurial firms and transactions, including later stage investments, turnaround investments, and buyout transactions. 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. This book will show when and how financial contracts are material to the allocation 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 actual investment outcomes and success. Why should we care about financial contracting? Venture capital and private equity funds are financial intermediaries between sources of capital and entrepreneurial firms. Sources of capital typically include large institutional investors including pension funds, banks, insurance companies, and endowments. These and other sources of capital do not have the time or expertise to invest directly in entrepreneurial firms, particularly high-growth firms in high-tech industries. As such, specialized venture capital and private equity funds facilitate the investment process, at a price of course. These funds are for all intents and purposes organizations that are established, 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 is not something that venture capital and private equity funds do, it is also in essence what they are. Broadly framed questions addressed in this book include, but are not limited to, the following: ● What covenants and compensation terms are used in limited partnership contracts? ● In what ways are limited partnership contracts related to market conditions and fund manager characteristics, and how do these contracts differ across countries? ● 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 more contractual rights? ● Do different contractual rights assigned to different parties influence the effort provided by the investor(s)? ● In what ways are different financial contracts related to the success of venture capital and private equity investments? By considering venture capital and private equity contracting in an international setting, this book offers an understanding of why venture capital and private equity markets differ with respect to ● Fund governance ● Investee firm governance ● Investee firm performance 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 subscription agreement. In addition, we provide datasets of venture 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 be limited to our best guesses, which is not the intention here. The data considered in this book are international in scope, with a focus on Canada, 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, idiosyncratic features of certain countries may distort our understanding of how venture capital and private equity contracts work in practice. 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 in this 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, there is always more data that can be collected. It is the authors’ hope that 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 empirical work in the field so that we may better understand the nature and evolution of venture capital and private equity markets in years to come. A Brief Note on Organization and Data Part I of this book comprises three chapters. Chapter 1 briefly refers to aggregate industry statistics on venture capital and private equity markets around the world to xx Preface compare the size of the markets in different countries. Chapter 2 describes agency problems in venture capital and private equity inve stment. 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, Chapter 3 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. Part II of this book (Chapters 4À9) considers venture capital and private equity fundraising and the structure of limited partnerships (Chapters 4À7), 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 investm ent 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 4À6, 8, and 9 ). W e start with t he perspective of institutional investors in Chapter 4 to understand the motivations underlying the source of capital— institutional investors. Outsi de the U ni ted States, institutional investors have comparatively less experience with venture c apital 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 a nd international, as w ell as commit- ments in niche areas such as the socially responsible investment class. Also, regu- latory changes to make The Netherlands particularly interesting to study from the perspective of institutional investors. In t he 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 f und managers deviate from stated objectives in limited partnership contract s. Chapte rs 5 and 6 pr ovi de a broader perspecti ve with data from venture capital and private equity funds from a multitude of countries (Belgium, Brazil, Canada,CaymanIslands,Finland,Germany, Italy, Luxembourg, Malaysia, Netherland Antill es, The Netherlands, New Zealand, Philippines, South Africa, Switzerland, the U nited K ingdom, 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 from a variety of countries. xxiPreface 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), governance provided to investees (Part IV), and the divestment process (Part V). Part III (Chapters 10À13) 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 financial contracting from United States and Canadian venture capitalists, with a focus 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 governance more generally. Part IV (Chapters 14À18) relates financial contracts and other investment mechanisms to the governance provided to the investee firm. Chapter 14 provides a survey of all of the factors that might influence inve stee 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 16À18 consider noncontractual factors that influence investor effort, par- ticularly the role of geographic proximity (Chapter 16), portfolio size (Chapter 17), and fund size (Chapter 18). Part V (Chapters 19À22) 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 4À9) and contracts between investors and investees (as considered in Chapters 10À14) and the effort provided (Chapters 15À18). 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 aroun d the world from North and South America, Europe, Africa, and Australasia. The data indicate financial structures and governance are significantly relat ed to returns. As well, Chapter 22 discusses evidence on reporting biases of the performance of unexited institutional investors for companies that have not yet had an exit event. Selected chapters in this book are based on previously published material, as summarized below: Chapter 4: Cumming, D., and S.A. Johan, 2007. “Regulatory Harmonization and the Development of Private Equity Markets” Journal of Banking and Finance, 31, 3218À3250. Cumming, D., and S.A. Johan, 2007. “Socially Responsible Institutional Investment in Private Equity” Journal of Business Ethics 75, 395À416. xxii Preface [...]... aspects of the venture capital and private equity process Further, it is important to consider international evidence to grasp the impact of laws and institutions on the respective venture capital and private equity markets The empirical methods and legal and institutional settings in this book are overviewed in Chapter 3 1.1 What is Venture Capital and Private Equity? At the outset, it is important to discuss... 100.000 14 Venture Capital and Private Equity Contracting 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 Ex Ea Iceland United States Canada The Netherlands United Kingdom Sweden Belgium Norway Finland European Union Ireland Germany France Spain Switzerland Portugal Italy Denmark Greece Austria Poland Czech Republic Hungary Slovak Republic Korea (1995–2000) Australia (1995–2000) New Zealand (1995–2000) Japan (1995–2000)... the outset, it is important to discuss what is meant by the terms venture capital and private equity Venture capital and private equity funds are financial intermediaries between sources of funds (typically institutional investors) and highgrowth and high-tech entrepreneurial firms Funds are typically established as Venture Capital and Private Equity Contracting DOI: http://dx.doi.org/10.1016/B978-0-12-409537-3.00001-3... terms and a number of discussion questions PowerPoint lecture slides for each chapter and online Appendices 1À4 are available online at http://www.venturecapitalprivateequitycontracting.com/ and http://booksite.elsevier.com/9780124095373/ 1 Introduction and Overview These days it is difficult to not have heard of the terms venture capital and private equity The venture capital and private equity. .. D., and S.A Johan, 2006 “Is it the Law or the Lawyers? Investment Covenants around the World” European Financial Management 12, 553À574 Chapter 6: Cumming, D., and S.A Johan, 2009 “Legality and Venture Capital Fund Manager Compensation” Venture Capital: An International Journal of Entrepreneurial Finance 11, 23À54 Chapter 7: Cumming, D.J., G Fleming and A Schwienbacher, 2009 “Style Drift in Private Equity ... and Armour and Cumming (2006) present evidence that public stock markets are important for venture capital markets, particularly as they offer an exit vehicle for venture capital funds to sell their investments Based on the set of countries in Table 1.3, Amour and Cumming (2006) show laws are as important and may even be more important and show that the more successful venture capital and private equity. .. Introduction and Overview 5 Wright and Lockett, 2003) Academic studies have shown us that venture capitalbacked entrepreneurial firms are on average significantly more successful than nonventure capital- backed entrepreneurial firms in terms of innovativeness (Kortum and Lerner, 2000), profitability, and share price performance upon going public (Gompers and Lerner, 1999, 2001) Venture capital and private equity. .. population and late-stage private equity investments To highlight the differences in select country rankings with these measures, in Figures 1.5 and 1.6 we present annual venture capital data from the European Venture Capital Association (EVCA) spanning the years 1989À2011 for the following western European countries: Austria, Belgium, Finland, France, Germany, Ireland, Italy, the Netherlands, Portugal,... treatment of RVPI Reporting issues in venture capital and private equity are discussed further in Chapters 4 and 22 Figures 1.9 and 1.10 show venture capital fund IRRs by different fund sizes and horizons There is a growing body of work that shows that venture capital and Table 1.4 Thomson Financials’ US Private Equity Performance Index (PEPI) Investment Horizon Performance through 09/30/2006 (expressed... commercial banks Most commercial bank loans require significant collateral and prefer to finance low-risk projects, and bank managers invest with a view solely to ensure the loan is repaid on time and with interest Riskier projects such as that considered by venture capital funds typically will not receive bank finance Some banks, however, do have a strategy of making loans to venture capital- backed