Corporate Venture Capital Contracts Journal of Alternative Investments, 2006
This draft: July 18, 2006
Douglas Cumming Associate Professor and Ontario Research Chair York University - Schulich School of Business 4700 Keele Street Toronto, Ontario M3J 1P3 Canada Web: http://www.schulich.yorku.ca/ http://Douglas.Cumming.com Email:
[email protected]
Abstract
This paper introduces a dataset of securities used by US and Canadian venture capitalists (VCs) in seed, early and expansion stage Canadian entrepreneurial firms spanning the period 1991-2004. The data indicate Canadian limited partnership VCs are more likely to use common equity and convertible securities than Canadian corporate VCs, while Canadian corporate VCs are more likely to use non-convertible debt than Canadian limited partnership VCs. Similar patterns in security design are observed in the data in this paper for cross-border US limited partnership and corporate VC investments in Canadian entrepreneurial firms. Related evidence also indicates very similar contracting practices for European corporate VC investments. The securities used offer one explanation as to why corporate VC performance is typically less successful than limited partnership VC performance. The data also challenge the conventional wisdom that VCs always use convertible preferred equity.
2 Introduction
Financial contracts between entrepreneurs and venture capitalists (VCs) have been characterized as one of the most important and distinguishing features of VC investment (Megginson, 2004; Gilson and Schizer, 2003; Sahlman, 1990). Financial contracts are vitally important to the VC investment process because contracts minimize information asymmetries and agency problems and appropriately provide incentives for both the entrepreneur and value-added VC investor(s) to add value to the enterprise. Financial contracts also facilitate the exit of VC investments in entrepreneurial firms. Given the high risk and uncertainty facing VC investments, financial contracts have emerged as highly sophisticated instruments that are a vital part of the VC cycle.
Corporate VCs are widely regarded as having performance results that are inferior to limited partnership VCs (Gompers, 2002; Gompers and Lerner, 1999). Three explanations for this inferior performance include (1) the comparatively autonomous structure of limited partnership VCs relative to corporate VCs, (2) the greater pay-for-performance sensitivity among limited partnership VCs relative to corporate VCs, and (3) the strategic rationales associated with corporate investing versus the purely financial incentives of limited partnership VCs. Limited partnerships are autonomous 10-13 year investment vehicles whereby the institutional investor limited partners cannot interfere with the day-to-day operations of the general partner VC. Limited partnership VC managers, who are also the general partner, typically receive 20% of the profits of the fund. Limited partnership VCs also have purely financial incentives to invest. Corporate VCs, by contrast, typically invest strategically in companies that meet with their corporate objectives, have less attractive financial compensation for successful performance by the managers, who are usually employees of the corporate VC, and do not enjoy the autonomy in decision making for the best long term financial interests of the VC fund.
This paper explores a new fourth explanation for the inferior performance of corporate VCs relative to limited partnership VCs: financial contracts. If financial contracts do in fact influence investment performance through the appropriate allocation of cash flow and control rights, and if limited partnership VCs write contracts that are superior to corporate VC contracts, then we may infer that corporate VC performance will be inferior to limited partnership VC performance.
3 To explore the conjecture that corporate VC underperformance is at least in part attributable to financial contracting practices of corporate VCs, this paper introduces a rich dataset of US and Canadian limited partnership and corporate VC investments that span the period 1991-2004. The data focus on security choice in the dataset, and discuss companion research that considers other aspects of security choice. The data comprise details on securities used in both US and Canadian limited partnership and corporate VC investments. The investee firms are all resident in Canada in the dataset in this paper. I do not examine investees resident in the US. Prior research has shown that VC investments in US-based entrepreneurial firms almost invariably use convertible preferred equity (estimates range from 70-95%), and there is a tax bias in favor of the use of convertible preferred equity for US-based entrepreneurial firms that receive VC finance (Gilson and Schizer, 2003; this tax bias is explained below). As explained in this paper, in all countries around the world other than the US where VC contracting data has been collected (including Canada, Europe, Australasia and developing countries), VCs use a variety of securities depending on characteristics of the nature of the transaction. Hence, it is instructive to examine a dataset in which the investees are not resident in the US. The comparison of US and Canadian VC investors provides additional insight about contract structures for limited partnership versus corporate VCs.
In brief, the data indicate Canadian limited partnership VCs are more likely to use common equity and convertible securities than Canadian corporate VCs, while Canadian corporate VCs are more likely to use non-convertible preferred equity and non-convertible debt than Canadian limited partnership VCs. Very similar patterns in security design are observed for cross-border US limited partnership and corporate VC investments in Canadian entrepreneurial firms.
The difference in the pattern of security design as between corporate and limited
partnership VCs is thus consistent with the inferior performance of corporate VCs relative to limited partnership VCs (and consistent with related theoretical work; see, e.g., Chemla and De Bettignies, 2006). The data in this paper also suggest a variety of avenues for future research.
This paper is organized as follows.
I first review the literature on VC financial
contracting. Thereafter, I introduce data on US and Canadian corporate and limited partnership VCs.
The link between financial contracts and investment performance is then discussed.
Section 2 reviews the institutional structure of limited partnership and corporate VCs. The last section considers further research and offers concluding remarks.
4 Financial Contracting in Venture Capital
VC financial contracts allocate cash flow and control rights among the investor(s) and the entrepreneurial firm’s managers and employees (Sahlman, 1990; Gompers, 1998; Bascha and Walz, 2001; Kaplan and Stromberg, 2003). Cash flow rights refer to who gets paid what fraction of the profits of the venture and at what time. Cash flow rights may be contingent in that the division of profits depends on states of nature (bull versus bear economic conditions) and actions taken by different parties (both the entrepreneurs and the investors) that affect the value of the venture. Examples of contingencies upon which cash flow rights are allocated include, but are not limited to, measures of financial performance (e.g., meeting sales or profit figures), measures of non-financial performance (e.g., obtaining a patent or FDA approval), issuance of equity (e.g., failure to achieve an IPO in five years provides VC with right to redeem preferred shares at a certain value), and taking certain actions (e.g., founding entrepreneur must stay with firm for a certain number of years, or a key employee is hired).
Control rights refer to the allocation of rights to make decisions in respect to the venture. Control rights may be active decision rights or passive veto rights, and allocated in a contingent manner as with cash flow rights. Examples of active control flow rights include, but are not limited to, the right to replace CEO, automatic conversion from preferred equity to common equity at exit, drag-along rights, right for first refusal at sale, co-sale agreements, anti-dilution protection, protection rights against new issues, redemption rights, information rights, IPO demand registration rights, and piggyback registration rights. Different types of veto rights include rights to prevent asset sales, asset purchases, changes in control, issuance of equity, and various other decisions.
Security design involves the allocation of both control and cash flow rights (Hart, 2001). Common equity holders are residual claimants whose payoff increases in proportion to the value of the firm. Equity holders also have voting rights to chose the board of directors, which in turn has the right to make specific decisions. Debt holders, by contrast, are fixed claimants whose payoff does not depend on the value of the firm so long as the firm is able to repay the principal and interest payments on the debt. If the firm is unable to repay its debt, then debt holders can force the firm into bankruptcy and acquire the rights normally held by equity holders in regards to decision rights. Debt contracts can be written with convertibility clauses that enable the debt
5 holder to convert the debt contract into common equity at prespecified (that is, specified at the time of initial contract) rates and terms of conversion.
Preferred equity holders are also fixed claimants in that the value of preferred equity depends on the present discounted value of preferred dividends associated with preferred equity. Preferred equity does not by itself provide voting rights, and a firm is not obligated to pay preferred equity dividends in the same way as the obligations associated with interest payments on debt. A firm that does not pay its prespecified preferred equity dividends on a timely basis cannot be forced into bankruptcy, unlike interest payments on debt. Preferred equity holders have priority over common equity holders in bankruptcy, but preferred equity holders rank behind debt holders in bankruptcy. Preferred equity contracts can have convertibility options which enable the contract to be converted into common equity at prespecified rates and terms of conversion.
Generally speaking, prior work has established that debt is suited towards high cash flow businesses that can meet the ongoing interest payment obligations on debt, while equity is suited towards high growth businesses (Barclay and Holderness, 1999). In the context of VC contracts, seminal papers examined the US market which indicated that US VCs finance their entrepreneurial investee firms with convertible preferred equity. This work also made clear the fact that VC contracts separate cash flow and control rights to appropriately allocate incentives that best maximize the expected value of the venture. Based on the observation that convertible preferred equity is most often used in the US, a number of theories have emerged to explain why convertible preferred equity is the apparent ‘optimal’ form of VC finance. Some of the reasons for the optimality of convertible preferred shares in VC finance are as follows. Convertible preferred equity provides the VC with a stronger claim on the liquidation value of the company in the event of bankruptcy, thereby shifting the risk from the VC(s) to the entrepreneur. Relative to straight common equity, convertible preferred equity reduces the entrepreneur's dilution of ownership. Convertible preferred shares also enable a greater amount of funds to be raised relative to straight debt as the VC has some equity participation. In the context of staged financing, convertible preferred equity mitigates window dressing problems and ensures that most positive expected NPV projects continue to receive financing. Convertible preferred shares also facilitate the conversion of illiquid holdings into cash, and mitigate problems associated with selling the firm, particularly when the incentive effects of trilateral bargaining are considered.
6 Why Might Corporate VC Contracts Differ from Limited Partnership VC Contracts?
Corporate VCs are distinct from limited partnership VCs in at least three main respects, which could in turn impact the nature of the contracts written between corporate VCs and their investee firms (Gompers, 2002; Dushnitsky and Lenox, 2006; Maula and Murray, 2001). First, limited partnerships are autonomous investment vehicles whereby the institutional investor limited partners cannot interfere with the day-to-day operations of the general partner VC, who are also the fund managers. Limited partnerships and similar forms of organization involve an assignment of rights and responsibilities in the form of a very long term contract over a period of 10-13 years. The purpose of this contract is to mitigate the potential for agency problems associated with the fund managers’ investing institutional investor capital in private entrepreneurial firms. The massive potential for agency problems in the reinvestment of capital, and the very long term nature of the limited partnership contract, make extremely important the assignment of rights and obligations in the contract in the form of restrictive covenants. Corporate VCs, by contrast, are much more unstable organizations whereby the existence of the corporate VC entity within the firm depends on the willingness of head office to which the corporate VC belongs. Hence, even apparently successful corporate VCs, such as that within Xerox, often are abandoned earlier than that which would otherwise be optimal (Gompers and Lerner, 1999). The lack of autonomy and shorter VC fund duration may inhibit the ability of corporate VC managers to learn by doing. For example, Kaplan, Martel and Stromberg (2006) show that limited partnership VCs in Sweden used to use mixes of straight debt and common equity in the 1990s, but have since switched to convertible preferred equity (although see also below for the evolution of VC contracts over time from Canadian and US VCs).
Second, corporate VCs do not enjoy the same incentive compensation arrangements as those offered to limited partnership VCs. Limited partnership VC managers typically receive 12% fixed fees based on the size of the fund and 20% of the profits of the fund, which can result in enormous salaries if the fund successfully exits investments in IPOs or acquisitions. Corporate VCs, by contrast, typically do not enjoy such performance fees in order to maintain a level fee structure across different units of the overall corporate enterprise. Successful corporate VC managers are often recruited to work at the higher paying limited partnership organizations. This could further limit the role of experience in writing optimal contracts among corporate VCs. Corporate VC managers may also be more focused on downside protection as opposed to upside
7 potential in writing contracts with entrepreneurs if corporate VC managers’ compensation packages give rise to incentives to minimize risk as opposed to maximizing returns.
Third, corporate VCs invest in a more narrow range of companies that have technological promise in the industry in which the parent company operates. To this end, a corporate VC’s choice set is more limited, their investments less diversified, and their strategic investing incentives apart from purely financial incentives. If so, corporate VCs might use stronger control rights (such as drag along and redemption rights) that enable the corporate VC to force an acquisition exit when entrepreneurs might otherwise prefer to exit by an initial public offering.
Below, we introduce a dataset that compares some of the contractual terms used by corporate VCs and limited partnership VCs, as well as the evolution of contractual forms over time. But first, we consider the preliminary issue as to whether convertible preferred equity is really the most efficient security choice for all venture capital transactions.
Is Convertible Preferred Equity Optimal in Venture Capital Finance?
The issue of whether or not convertible preferred equity is in fact the optimal form of VC finance has come into question by virtue of non-US evidence of VC contracts, alongside institutional work on tax biases in favour of convertible preferred equity in the US. Evidence from Canada (Cumming, 2005a,b), Europe (Bascha and Walz, 2001b; Cumming, 2002; Schwienbacher, 2003; Hege et al., 2003), Taiwan (Songtao, 2001) and developing countries (Lerner and Schoar, 2005) clearly shows VCs use a variety of forms of finance and convertible preferred equity is not the most frequently used security by VCs in any country in the world (that is, where data have been collected) other than the US.
There are five possible explanations for the more heterogeneous use of different securities among non-US VC contracts. First, non-US countries may have a greater presence of government investors that skew the incentives of private investors to use the most efficient security. For instance, in Canada, government sponsored VC funds comprise approximately 50% of the market as at 2005, and as government funds compete for deals with private funds they may also compete on the basis of the type of security offered to the potential investee firm (Cumming and MacIntosh, 2006). The trouble with this explanation, however, is that countries with a less significant extent of government VC funds are just as likely to use securities that resemble that
8 which is observed among VC deals in Canada, and not the US. For example, in the Netherlands common equity was used twice as often as convertible securities in 1995-2002, and the Netherlands VC market has less than 10% government VC investments (Armour and Cumming, 2006). More generally, as indicated above, all non-US countries from which VC contract data are available use a variety of forms of finance, unlike US VCs.
Second, VCs in non-US countries may not be as sophisticated or experienced as VCs in the US, and thereby may not know the best way to write contracts. There is evidence from some countries such as Sweden that VCs are more likely to write contracts that resemble the US when they have had US experience, and that those VCs which use US-style contracts are more likely to survive and more likely to adopt US-style contracts over time (Kaplan, Martel and Stromberg, 2006). That evidence, however, is not universally supported by evidence from other European countries (Cumming, 2002; Bascha and Walz, 2001b) and from Canada (Cumming, 2005a,b).
Third, different securities could be functionally equivalent (Merton, 1995), such as common equity and warrants, straight debt and straight preferred equity, and all other securities that resemble convertible preferred equity (with both downside protection and upside potential). If so, we would expect similar securities to be used with roughly the same intensity for different financing contexts; however, empirical evidence clearly shows otherwise and therefore there is little empirical support for the functional equivalence hypothesis (Cumming, 2005a,b).
Fourth, legal structures may be different in different countries (such as securities regulation and taxation), which could influence the extent to which VCs use different securities. Lerner and Schoar (2005), for example, find evidence that law quality in regards to securities regulation and rule of law gives rise to security choices that substitute for the lack of law quality among developing countries. The focus on securities regulation and general rule of law quality, however, is incomplete because VCs in countries with similar securities regulatory structures and rule of law quality, such as Canada and the US, use vastly different securities (as discussed further below). A much more compelling explanation is provided by Gilson and Schizer (2003). In their influential paper, Gilson and Schizer show US tax law biases VC’s and entrepreneur’s incentives to use convertible preferred shares. This tax bias has been shown to be absent in Canada (Sandler, 2001). Gilson and Schizer explain this tax advantage as follows (see also Fried and Ganor, 2006):
9 “[Venture capital] [p]ortfolio companies [in the US] issue convertible preferred stock to achieve more favorable tax treatment for the entrepreneur and other portfolio company employees. The goal is to shield incentive compensation from current tax at ordinary income rates, so managers can enjoy tax deferral (until incentive compensation is sold, or longer) and a preferential tax rate... [by assigning an artificially low value to the entrepreneurs’ common equity claim at the time of investment] … our analysis suggests the difficulty of financial modeling for activities in which low-visibility, “practice”-level patterns are of first-order significance. Unless informed by institutional knowledge deep enough to reveal such patterns, models will miss a significant factor that is influencing behavior.” [Gilson and Schizer, 2003, pp. 876-878]. Unfortunately, most academic VC contracting studies do not acknowledge the possibility of a tax bias in favor of convertible preferred securities for VCs and entrepreneurs in the US.
A fifth explanation that could explain the use of a variety of securities other than convertible preferred equity in non-US VC transactions is that different types of entrepreneurs are in fact different in ways that give rise to different sets of agency problems. Because investments in different entrepreneurial firms are staged with different frequency based on expected agency problems, syndicated with different frequency depending on expected agency problems, and monitored with different intensity via seats on boards of directors depending on expected agency problems (Gompers and Lerner, 1999), it would be rather surprising to expect the same security choice for all entrepreneurial firms regardless of expected agency problems. The VC finance literature is in fact a complete outlier in the broader scope of literature on capital structure generally. Since the seminal work of Jensen and Meckling (1976), all work on capital structure (outside the realm of the narrowly focused VC finance literature) is consistent with the view that capital structure choices adjust to changes in expected agency problems. It is surprising that the application of this idea to the context of VC finance is as novel as it appears next to all prior work on topic, particularly in view of the fact that agency problems are both very heterogeneous and very pronounced in VC finance.
In sum, prior evidence indicates that convertible preferred equity is the most frequently selected security for US VCs investing in US entrepreneurial firms. International evidence from all countries around the world in which VC data have been collected, by contrast, indicates a variety of forms of finance are used by VCs and convertible preferred equity is not the most frequently selected security. The use of a variety of securities does not depend on the definition
10 of VC by stage of entrepreneurial firm development, etc. However, there is scant evidence on corporate VC contracts in prior academic research. The next section below offers some new data that shed light on corporate VC contracts in an international setting with US VCs.
US and Canadian Corporate and Limited Partnership VC Investments in Canadian Entrepreneurial Firms The data introduced in this section comprise 4820 investments in Canadian seed, early and expansion stage entrepreneurial firms from 1991-2004 (Data Source: Macdonald and Associates, Limited, Toronto).
The VC investors specifically include Canadian limited
partnership VCs for 2815 investments, Canadian corporate VCs for 1245 investments, US limited partnership VCs for 342 investments, and US corporate VCs for 418 VC investments. The US investments are cross-border VC investments in Canadian entrepreneurial firms.
The data are summarized in Table 1 and Figures 1 – 2. Table 1 and Figures 1 – 2 clearly indicate that convertible preferred equity is not the most frequently selected security. Table 1 indicates that common equity is the most frequently selected security (aside from the other/unknown category) for Canadian and US limited partnership and corporate VCs financing Canadian entrepreneurial firms, and a variety of other securities are used. This evidence is highly consistent with other evidence on VC contracts from Europe, Taiwan and developing countries, as discussed above.
[Insert Table1 and Figures 1 – 2 About Here]
It is very striking to note that while US VCs finance US entrepreneurs with convertible preferred equity, US VCs finance Canadian entrepreneurial firms with a variety of forms of finance (Table 1, Figures 2a,b). Cumming (2005a,b) shows that the use of a variety of forms of finance by US VCs for Canadian entrepreneurial firms is not attributable to the definition of VC by the stage of entrepreneurial firm development, type of industry, staging, etc. Likewise, US VCs use a variety of forms of finance and the same pattern of securities as reported in Table 1 and Figures 2a,b for investments that are not syndicated with Canadian VCs.
The data in Table 1 and Figures 1-2 indicate Canadian limited partnership VCs are more likely to use common equity and convertible securities than Canadian corporate VCs, while Canadian corporate VCs are more likely to use non-convertible debt than Canadian limited
11 partnership VCs. Similar patterns in security design are observed for cross-border US limited partnership and corporate VC investments in Canadian entrepreneurial firms.
Figures 1a,b and 2a,b provide time series changes in the pattern of security design for the 1991-2004 period. Prior work explores these patterns over time and finds econometric evidence that security selection depends on the following four main factors (Cumming, 2005a,b). First, the characteristics of the transacting parties (both the entrepreneur and the VC) affect security design. Earlier stage high-tech companies are less likely to use securities that mandate periodic payments back to the investor prior to exit. This is intuitive, as debt-like securities are inappropriate for firms with foreseeable negative cash flows in the initial stages of development. Seed stage firms are more likely to be financed with either common equity or straight preferred equity, and less likely to be financed with straight debt, convertible debt, or mixes of debt and common equity. Life-science and other types of high-tech firms are more likely to be financed with convertible preferred equity. Corporate VCs are less likely to use securities with upside potential, consistent with the evidence from corporate funds presented in Table 1 and Figures 1 – 2. Second, market conditions affect contracts. Common equity securities without downside protection are less likely to be used after the crash of the bubble, consistent with Figures 1 and 2. Third, capital gains taxation affects contracts (and in a way consistent with the work of Gilson and Schizer, cited above). Fourth, there is some evidence of learning in that time trends point to changes in the intensity of different contracts over time, but this trend is not towards the use of convertible preferred equity (at least as at 2004).
The evidence in Table 1 indicates both US and Canadian corporate VCs are more likely to employ securities without ownership interest (that is, straight debt and/or straight preferred shares). The one exception to this statement is that Table 1 indicates US limited partnership VCs are more likely to use straight preferred equity than US corporate VCs for financing Canadian entrepreneurial firms. The most plausible explanation is that these investee firms are in different industries and financed at different points in time, consistent with prior work discussed immediately above. On a broad level, therefore, we may generally infer that corporate VCs on average select investments with less upside potential, which in turn limits returns.
As mentioned above, it is important to note that Canada’s VC market has a significant presence of government VC funds (Cumming and MacIntosh, cited above). One may therefore worry that the securities used are at least in part attributable to the unique structure of the
12 Canadian market. This concern, however, is mitigated by the fact that all markets around the world where VC contract data have been collected comprise securities which closely resemble the Canadian market (including Europe, Asia-Pacific and developing countries). The outlier country in regards to VC security design is the US, as it is the only country in the world whereby the market has converged on one security: convertible preferred equity.
European Corporate VC Investments
Prior evidence on corporate VC contracts in Europe is limited. Schwienbacher (2003), Bascha and Walz (2001b) and Kaplan, Martel and Stromberg (2006) have data from limited partnership VCs in Europe, but do not have data on corporate VCs. Cumming (2002) has data on 78 captive (corporate) and 145 non-captive VC-backed firms from continental Europe. Cumming finds that 46% [44%] of captive [non-captive] investments are made with common equity securities, 35% [31%] of captive [non-captive] investments are made with convertible securities, 10% [25%] of captive [non-captive] investments are made with mixes of debt, preferred and common equity securities, and 9% [0%] of captive [non-captive] investments are made with nonconvertible preferred equity and debt securities. In regards to veto rights over asset purchases, asset sales, changes in control and issuances of equity, captive VCs on average have one more veto right than non-captive VCs. However, only 29% of captive VC investments allocate the right to replace the founding entrepreneur as CEO to the VC, while 46% of non-captive VC investments allocate the right to replace the founding entrepreneur as CEO to the VC.
In brief, European corporate VCs are more likely to use non-convertible preferred and debt securities than non-corporate VCs. European corporate VCs are also more likely to have passive veto rights. European non-corporate VCs, by contrast, are more likely to have active rights such as the right to replace the founding entrepreneur as the CEO. The European corporate VC data are therefore consistent, and a broad level of generality, with the Canadian and US corporate VC data introduced above.
VC Contracts, Exits and Returns Performance
Above, I considered evidence indicating corporate VC contracts are systematically different from limited partnership VC contracts. Contracts may affect performance in one of three primary ways: (1) contracts specify the division of cash flows which directly ties to investor
13 profits, (2) contracts directly influence the actions taken by the investor(s) and the entrepreneur and thereby influence the success of the venture, and (3) contracts facilitate the exit process, which in turn relates to profits. These issues are reviewed in this section.
Prior US and international evidence is highly consistent with the view that VC contracts directly influence the actions taken by VC investors. Kaplan and Stromberg (2003) argue VCs are more likely to replace managers when then have stronger contractual control rights. Cumming and Johan (2005) have somewhat different but consistent data that measures the hours per week that VCs spend with the investee firms. VCs with stronger cash flow and control rights spend significantly more time with their investee companies. Similarly, countries with superior legal structures are more likely to have fewer conflicts between VCs and the investee firms due to the certainty provided by the legal system.
Theoretical research is consistent with the view that contract structures are interrelated with exit outcomes (Aghion and Bolton, 1992; Berglof, 1994; Bascha and Walz, 2001a; Hellmann, 2006). The allocation of control rights is a vital part of VC contracts as it influences the exit outcome that may result. There are five main types of VC exit: initial public offerings (IPOs), acquisitions (in which the VC and entrepreneur both exit) to a 3rd party company, secondary sales (in which the VC exits but the entrepreneur does not), buybacks (in which the entrepreneur repurchases the VC’s shares) and liquidations (write-offs). The exit outcomes for more successful entrepreneurial firms are IPOs and acquisitions.
In the VC context, contracts can influence the choice between an IPO and an acquisition. The interesting issue is that the VC invariably wants the exit that gives rise to the highest financial gain, while the entrepreneur may want to go public for non-pecuniary reasons even when the financial gain from an acquisition is superior. Empirical evidence from European VC contracts is highly consistent with the view that acquisition exits are more likely to result when VCs have stronger control rights, while IPOs are more likely when VCs have weaker control rights (Cumming, 2002, cited above). Similarly, the data in Cumming (2002) also indicate corporate VCs are more likely to use a greater number of veto rights (over asset sales, asset purchases, changes in control and issuances of equity) and more likely to use debt securities than limited partnership VCs (consistent with the Canadian and US data discussed above).
14 There is some international evidence that relates contracts to VC returns. Cumming and Walz (2004) present evidence from 3848 VC investments in 39 developed and developing countries and show that convertible preferred equity or convertible debt contracts yield higher returns. Kaplan, Martel and Stromberg (2006) provide consistent evidence on the survival of VC funds based on 145 VC investments from 23 developed countries, but do not have data on returns; rather, that paper argues that VC fund survival is more likely where VCs use convertible preferred equity. The 3848 observations in the Cumming and Walz (2004) dataset indicate convertible securities are correlated with greater returns. Note that Cumming and Walz (2004) use a functional definition of convertible securities: those that actually allow for periodic cash flows back to the VC prior to VC exit, and for the possibility of upside potential. The data are summarized in Figure 3. The average [median] return for convertible security investments (convertible preferred equity and convertible debt) is 61.89% [15.68%] (net of the MSCI index over the contemporaneous investment horizon), while the average [median] return for common equity investments is 50.11% [-24.37%]. The evidence is thus consistent with theoretical work that convertible securities are comparatively more efficient for VC investments.
[Insert Figure 3 About Here]
Overall, therefore, prior evidence is highly consistent that contracts are interconnected with returns. Corporate VCs are more likely to use contracts that do not involve upside potential, and are more likely to use veto rights than limited partnership VCs. As contracts influence the division of cash flow and control rights, influence incentives and affect the exit process, it is natural to expect contracts to be related to returns. While there is no direct evidence on point, we may expect that based on prior work and the data introduced in this paper that part of the reason that corporate VC returns lag behind those of limited partnerships is in fact related to the differences in the contracts that these different fund types employ.
Lessons for Corporations Setting Up Venture Capital Funds
Prior evidence has shown corporate VCs are much more unstable organizations whereby the existence of the corporate VC entity within the firm depends on the willingness of head office to which the corporate VC belongs. Hence, even apparently successful corporate VCs, such as that within Xerox, often are abandoned earlier than that which would otherwise be optimal (Gompers and Lerner, 1999).
Corporate VC managers do not enjoy the same incentive
15 compensation arrangements as those offered to limited partnership VCs. Limited partnership VC managers typically receive 1-2% fixed fees based on the size of the fund and 20% of the profits of the fund, which can result in enormous salaries if the fund successfully exits investments in IPOs or acquisitions. Corporate VCs, by contrast, typically do not enjoy such performance fees in order to maintain a level fee structure across different units of the overall corporate enterprise. The US and Canadian corporate VC data discussed above indicated corporate VC managers write contracts that more often focus on downside protection than upside potential, relative to limited partnership VCs.
Corporate VCs invest in a more narrow range of companies that have technological promise in the industry in which the parent company operates. To this end, a corporate VC’s choice set is more limited, their investments less diversified, and their strategic investing incentives could lead to financial contracting practices (such as veto rights, etc.) that uniquely focus on maintaining technology transfer to the corporation associated with the corporate VC.
Corporations considering setting up corporate VCs should consider providing as much autonomy as possible to their corporate VC managers, so long as the corporate VC maintains its strategic direction established at the outset of the fund.
The instability of corporate VC
organizations may inhibit the ability of corporate VC managers to learn which contracts do and do not work best for the types of companies that they finance. Further, corporate VCs that are viewed as mere employees of the larger corporation may lack the incentives to write incentive contracts and allocate control rights for the corporate VC and their investee entrepreneurs in a way that are in the best interest of the corporate investor. Corporate VC organizations should strive towards incentivising managers as much as possible to provide incentives to write the most efficient contracts to achieve the financial and strategic directions of the fund.
Concluding Remarks and Future Research
The returns to limited partnership VC investments are widely regarded as being on average greater than the returns to corporate VC investments. Prior research is consistent with the view that the returns to corporate VC investments are lower than the returns to limited partnership VC investments due to (1) the comparatively autonomous structure of limited partnership VCs relative to corporate VCs, (2) the pay structures of limited partnership VCs relative to corporate VCs, and (3) the strategic rationales associated with corporate investing. In
16 this paper I explored the possibility of a fourth factor: corporate VCs are less adept at writing efficient contracts with their investee entrepreneurs, thereby giving rise to lower returns.
In this paper, I examined the full range of literature on VC contracts from around the world. The literature showed that VCs in the US often use convertible preferred equity, while VCs in other countries sometimes use convertible preferred equity but that is not the most commonly selected form of finance; rather, common equity is the most frequently selected form of VC finance in all countries around the world outside the US. In the US, there is a tax bias in favor of the use of convertible preferred equity.
I provided new data in this paper from US and corporate and limited VC cross-border investments in Canadian entrepreneurial firms, as well as Canadian corporate and limited partnership VC investments in Canadian entrepreneurial firms. The data indicate that convertible preferred equity investments are not the most frequently selected security by US corporate or limited partnership VCs investing in Canadian entrepreneurs, and likewise not by Canadian corporate and limited partnership VCs investing domestically in Canada. A variety of forms of finance are used.
I noted, however, that US and Canadian corporate VCs have a greater
propensity to use non-convertible debt, while US and Canadian limited partnership VCs are more likely to use common equity and convertible securities.
Companion evidence presented in this paper from limited partnership VCs indicated investments with convertible securities yield higher average returns than straight common equity. I also discussed related evidence from European VC contracts that indicate corporate VC contracts involve greater control rights and less upside potential. This European evidence also indicates corporate VCs are more likely to have acquisition exits and lower returns.
At this stage, the extent to which lower corporate VC returns are attributable to their financial contracts with investees, or whether this is due to organizational structure or pay for performance sensitivities, is unknown. It is also possible, if not probable, that corporate VCs select their contracts as a result of their organizational structure and their mix of strategic and financial incentives. Future research could more directly examine the returns of corporate VCs in relation to their organizational structure in direct comparison to their financial contracts. Further research could also examine in greater detail the issue of whether contracts affect returns, or if there is a reverse causality in so far as different contracts are used for different expected returns.
17 To date, comparatively little evidence exists from US corporate VC contracts, and future research could fill this gap and examine how patterns of corporate VC contracts evolve over time. References Aghion, P., and P. Bolton, 1992. “An Incomplete Contracts Approach to Financial Contracting,” Review of Economic Studies 59, 473-494. Armour, J., and D. Cumming, 2006 “The Legislative Road to Silicon Valley” Oxford Economic Papers 58, 596-635. Barclay, M., and C. Holderness, 1999. “The Capital Structure Puzzle: Another Look at the Evidence” Journal of Applied Corporate Finance 12, 8-20. Bascha, A., and U. Walz, 2001a. “Convertible Securities and Optimal Exit Decisions in Venture Capital Finance,” Journal of Corporate Finance 7, 285-306 Bascha, A., and U. Walz, 2001b, “Financing Practices in the German Venture Capital Industry: An Empirical Assessment,” Working Paper, University of Tünbingen. Berglöf, E., 1994, “A Control Theory of Venture Capital Finance,” Journal of Law, Economics, and Organization, 10, 247-67. Chemla, G., and J.E. De Bettignies, 2006. “Corporate Venturing, Allocation of Talent, and Competition for Star Managers, UBC Working Paper. Cumming, D.J., 2002. “Contracts and Exits in Venture Capital Finance” Working Paper. Cumming, D.J., 2005a. “Capital Structure in Venture Finance,” Journal of Corporate Finance 11, 550-585. Cumming, D.J., 2005b. “Agency Costs, Institutions, Learning and Taxation in Venture Capital Contracting,” Journal of Business Venturing 20, 573-622. Cumming, D.J., and J. MacIntosh, 2006. “Crowding Out Private Equity: Canadian Evidence” Journal of Business Venturing 21, 569-609 Cumming, D.J., and S.A. Johan, 2006. “Advice and Monitoring in Venture Finance,” Financial Markets and Portfolio Management, forthcoming. Dushnitsky, G., and M. Lenox, 2006. “When Does Corporate Venture Capital Create Firm Value?” Journal of Business Venturing, forthcoming Fried, J.M., and M. Ganor, 2006. “The Vulnerability of Common Shareholders in VC-Backed Firms,” New York University Law Review, forthcoming. Gilson, R.J., and D. Schizer, 2003. “Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock,” Harvard Law Review 116, 875-916.
18 Gompers, P.A., 1998. “Ownership and Control in Entrepreneurial Firms: An Examination of Convertible Securities in Venture Capital Investments.” Working Paper, Harvard University. Gompers, P.A., 2002. “Corporations and the Financing of Innovation: The Corporate Venturing Experience,” Federal Reserve Bank of Atlanta Economic Review, 1-17 Gompers, P.A., and J. Lerner, 1999. The Venture Capital Cycle, MIT Press. Hart, O., 2001. "Financial Contracting," Journal of Economic Literature 39, 1070-1100. Hege, U., F. Palomino and A. Schwienbacher, 2003, “Determinants of Venture Capital Performance: Europe and the United States,” Working Paper. HEC School of Management. Hellmann, T., 2006. “IPOs, Acquisitions and the Use of Convertible Securities in Venture Capital” Journal of Financial Economics 81, 649-679 Jensen, M.C., and W.H. Meckling, 1976. “Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure,” Journal of Financial Economics 3, 305-360 Kaplan, S.N., and P. Strömberg, 2003.“Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts,” Review of Economic Studies 70, 281-315. Kaplan, S.N., F. Martel, and P. Strömberg, 2006. “How do Legal Differences and Experience Affect Financial Contracts?” Working Paper, University of Chicago. Lerner, J., and A. Schoar, 2005. “Does Legal Enforcement Affect Financial Transactions? The Contractual Channel in Private Equity,” Quarterly Journal of Economics 120, 223-246 Maula, M., and G. Murray, 2001, Corporate Venture Capital and Creation of US Public Companies: The Impact of Sources of Venture Capital on the Performance of Portfolio Companies, Strategy in the Entrepreneurial Millennium, John Wiley and Sons. Megginson, W.L., 2004. “Towards a Global Model of Venture Capital?” Journal of Applied Corporate Finance 16, 8-26. Merton, R.C., 1995. “A Functional Perspective of Financial Intermediation,” Financial Management 24, 23-41. Sahlman, W.A., 1990. “The Structure and Governance of Venture Capital Organizations,” Journal of Financial Economics 27, 473-524. Sandler, D., 2001. “The Tax Treatment of Employee Stock Options: Generous to a Fault,” Canadian Tax Journal 49, 259-302 Schwienbacher, A., 2003. “Venture Capital Exits in Europe and the United States,” Working Paper, University of Amsterdam. Siegel, R., E. Siegel and I.C. MacMillan, 1988. “Corporate Venture Capitalists: Autonomy, Obstacles and Performance,” Journal of Business Venturing 3, 233-247. Songtao, L., 2001. “Venture Capital Development in Taiwan,” Asia and Pacific Economics 3.
19
Table 1. Securities Used by Canadian and US VCs Financing Canadian Entrepreneurial Firms This table presents summary statistics of the number of investments (and the percentage of total investments in parentheses) used by Canadian and US limited partnership VCs and corporate VCs for investments in entrepreneurial firms resident in Canada for the period 1991-2004. The entrepreneurial firms are those that were in the seed, early or expansion stage of development at the time of first investment. Comparison of proportions tests for each of the four categories. *, **, *** Significant at the 10%, 5% and 1% levels, respectively. Number of Investments Comparison of Proportions Tests (1) Canada (2) Canada (3) US Limited (4) US Limited (1) vs (2) (1) vs (3) (1) vs (4) (2) vs (3) (2) vs (4) (3) vs (4) Corporate VCs Partnership VCs Corporate VCs Partnership VCs Common Shares 772 (27.42%) 191 (15.34%) 73 (21.35%) 76 (18.18%) 8.35*** 2.40** 4.01*** -2.64*** -1.37 1.09 Convertible Preferred Shares
274 (9.73%)
108 (8.67%)
32 (9.36%)
37 (8.85%)
1.07
0.22
0.57
-0.39
-0.11
0.24
Convertible Debt
354 (12.58%)
109 (8.76%)
44 (12.87%)
36 (8.61%)
3.53***
-0.15
2.32**
-2.28***
0.09
1.90*
Preferred Shares
251 (8.92%)
101 (8.11%)
52 (15.20%)
35 (8.37%)
0.84
-3.73***
0.37
-3.94***
-0.17
2.94***
Debt
223 (7.92%)
153 (12.29%)
22 (6.43%)
82 (19.62%)
-4.43***
0.97
-7.63***
3.06***
-3.72***
-5.26***
Warrants
7 (0.25%)
3 (0.24%)
2 (0.58%)
0 (0.00%)
0.05
-1.10
1.02
-1.00
1.00
1.57
Preferred and Common Shares Preferred and Convertible Preferred Shares Preferred Shares and Debt Preferred Shares and Convertible Debt Preferred Shares and Warrants Common and Convertible Preferred Shares Common Shares and Debt Common Shares and Convertible Debt Common Shares and Warrants Convertible Preferred Shares and Debt Convertible Preferred Shares and Convertible Debt Convertible Preferred Shares and Warrants Debt and Convertible Debt
55 (1.95%)
16 (1.29%)
8 (2.34%)
1 (19.62%)
1.50
-0.48
2.51**
-1.41
1.84*
2.66***
4 (0.14%)
2 (0.16%)
1 (0.29%)
1 (0.24%)
-0.14
-0.66
-0.47
-0.50
-0.33
0.14
2 (0.07%)
3 (0.24%)
2 (0.58%)
0 (0.00%)
-1.42
-2.52**
0.55
-1.00
1.00
1.57
2 (0.07%)
3 (0.24%)
2 (0.58%)
0 (0.00%)
-1.42
-2.52**
0.55
-1.00
1.00
1.57
13 (0.46%)
3 (0.24%)
0 (0.00%)
0 (0.00%)
1.04
1.26
1.39
0.91
1.00
N/A
12 (0.43%)
5 (0.40%)
0 (0.00%)
2 (0.48%)
0.11
1.21
-0.15
1.17
-0.21
-1.28
44 (1.56%)
35 (2.81%)
6 (1.75%)
15 (3.59%)
-2.65***
-0.27
-2.89***
1.09
-0.81
-1.53
39 (1.39%)
20 (1.61%)
1 (0.29%)
2 (0.48%)
-0.54
1.71*
1.55
1.88*
1.75*
-0.41
16 (0.57%)
3 (0.24%)
0 (0.00%)
1 (0.24%)
1.41
1.40
0.87
0.91
0.01
-0.91
0 (0.00%)
1 (0.08%)
1 (0.29%)
0 (0.00%)
-1.50
-2.87***
N/A
-0.98
0.58
1.11
1 (0.04%)
1 (0.08%)
0 (0.00%)
0 (0.00%)
-0.59
0.35
0.39
0.52
0.58
N/A
15 (0.53%)
3 (0.24%)
0 (0.00%)
0 (0.00%)
1.29
1.35
1.50
0.91
1.00
N/A
1 (0.04%)
1 (0.08%)
1 (0.29%)
0 (0.00%)
-0.59
-1.78*
0.39
-0.98
0.58
1.11
Debt and Warrants
28 (0.99%)
0 (0.00%)
1 (0.29%)
0 (0.00%)
3.53***
1.29
2.05**
-1.91*
N/A
1.11
Convertible Debt and Warrants Other Combinations of Securities or Unknown Total
8 (0.28%)
6 (0.48%)
0 (0.00%)
4 (0.96%)
-0.99
0.99
-2.11**
1.29
-1.09
-1.81*
694 (24.65%)
478 (38.39%)
94 (27.49%)
126 (20.14%)
-8.15***
-1.03
-1.94*
3.40***
3.02***
-0.56
2815
1245
342
418
20
Figure 1a. Securities used by Canadian Limited Partnership VCs for Seed, Early and Expansion Canadian Entrepreneurial Firms 160
140
Nymber of Investments
120
100
80
60
40
20
0 1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Year Preferred
Common
Convertible Preferred
Debt
Convertible Debt
Preferred and Common
Debt and Common
21
Figure 1b. Securities used by Canadian Corporate VCs for Seed, Early and Expansion Canadian Entrepreneurial Firms 70
60
Numberr of Investments
50
40
30
20
10
0 1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Year Preferred
Common
Convertible Preferred
Debt
Convertible Debt
Preferred and Common
Debt and Common
22
Figure 2a. Securities used by US Limited Partnership VCs for Seed, Early and Expansion Canadian Entrepreneurial Firms 14
12
Number of Investments
10
8
6
4
2
0 1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Year Preferred
Common
Convertible Preferred
Debt
Convertible Debt
Preferred and Common
Debt and Common
23
Figure 2b. Securities used by US Corporate VCs for Seed, Early and Expansion Canadian Entrepreneurial Firms 25
Number of Investments
20
15
10
5
0 1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Year Preferred
Common
Convertible Preferred
Debt
Convertible Debt
Preferred and Common
Debt and Common
24
Figure 3. Histogram of Returns by Type of Security from 39 Countries, 1971-2003, for Start-up, Early and Expansion Stage Venture Capital Investments
350
250
200
150
100
50
1000
950
850
800
Common Equity Convertible Securities 900
Percentage Return - MSCI Index Return over Contemporaneous Horizon
750
700
650
600
550
500
450
400
350
300
250
200
150
100
50
0
-50
0 -100
Number of Investments
300
