© cumming & johan (2013)forms of vc finance security design cumming & johan (2013, chapter...

© Cumming & Johan (2013) Forms of VC Finance

Security Design

Cumming & Johan (2013, Chapter 11)

1


Forms of Finance

Review of Different Security PropertiesThe Conventional Wisdom

DataExplanations for the Data

Summary

• Debt 1st priority in bankruptcy Stipulated interest payments Non-payment of interest can force bankruptcy

• Preferred Equity 2nd priority in bankruptcy Stipulated preferred dividend payments Non-payment of dividends cannot force bankruptcy

2


Forms of Finance (Con’t)

• Common Equity Last priority in bankruptcy Dividends may or may not be forthcoming Residual claimants upside potential capital gains!

• Warrants Option to purchase common equity Like an American call option to purchase the firm (but different

because increases # securities when exercised)



Summary

3


Forms of Finance (Con’t)

• Convertible debt Debt + option to convert from debt to common equity Similar to debt + warrants

• Convertible preferred equity Preferred equity + option to convert from preferred equity to

common equity Similar to preferred equity + warrants



Summary

4

© Cumming & Johan (2013) Forms of VC Finance5

Figure 2.1. Payoff Functions

$

Value of Entrepreneurial Firm

Payoff to Common Equity

Payoff to Debt

Payoff toPreferred Equity

45o 45o 45o

Present Value of Interest + Principal on Debt

Present Value of Pre-Specified Preferred Dividends

Slope is 45o for 100% of the common shares(45o * X/100 for X% of the common shares)

5


The Conventional Wisdom

• “Convertible preferred equity is optimal” No threat of bankruptcy for entrepreneurial firm (contrast to

debt & interest payments) Priority for the VC in the event of bankruptcy Upside potential for the VC Entrepreneur would not agree unless truly committed to the

venture – mitigates adverse selection problems Provides incentives for the VC to help the firm in bad times (VC

a residual claimant in bankruptcy) Pricing of securities is robust to errors in firm valuation



Summary

6


The Conventional Wisdom (Con’t)

• “Convertible preferred equity is optimal” Mitigates ‘window-dressing’ problems in staged financing

arrangements Mitigates ‘risk-shifting’ problems Terms of the contract can be flexible Incentives for the entrepreneur (terms of conversion less

favorable for VC the more successful the firm) Incentives for the VC (ensure worth converting the securities)



Summary

7


Detailed Intuition on why Convertible Preferred Equity might be ‘Optimal’

1. Incentives for investor to add value Share in profit potential of company Downside protection for investor in case of bankruptcy

2. Incentives for entrepreneur to work hard Also share in profit potential Ownership provided to investor not as great as with common

equity Terms of conversion are graduated, such that conversion for

investor worse the better off the performance E.g., value < 10,000,000 convert 2 preferred for 1 common E.g., value > 10,000,000 convert 3 preferred for 1 common

(better for entrepreneur in this second case)



Summary

8


Empirical Evidence in U.S. Research

• Gompers (1998) Harvard University Working Paper 50 venture capital investments from limited partnership funds

in US

• Kaplan and Stromberg (2003) Review of Economic Studies 213 investments from 14 venture capital funds (limited

partnerships) in US

• No industry-wide evidence from the United States



Summary

9


Question

• Does it make sense to use the same form of finance for all different possible types of entrepreneurial firms?!



Summary

10


All of these countries show VCs using a variety of forms of finance, not just convertibles

• Canada – Cumming (2005 Journal of Corporate Finance; 2005 Journal of Business Venturing)

• Australia – Cumming et al. (2005 Journal of Banking and Finance)

• Europe – Schwienbacher (2008 Financial Markets and Portfolio Management); Cumming

(2008 Review of Financial Studies); Cumming and Johan (2008 European Economic Review), Bascha and Walz (2008 Chapter in Venture Capital in Europe); Parhangkas and Smith (2000 Working Paper)

• Taiwan – Songtao (2000 Asia & Pacific Finance)

• Developing Countries – Lerner and Schoar (2005 Quarterly Journal of Economics); Cumming Schmidt and

Walz (2013 Journal of Business Venturing)

• To the best of our knowledge, every country outside the US where data have been collected up to January 2013 shows patterns that are consistent with the Canadian data, not the US data. In no country is convertible preferred equity used most frequently except in the US!!!



Summary

11


Empirical Evidence from Canada

• 12,343 transactions!• 1991-2003• Source: Macdonald & Associates, Ltd.

• Observations from all types of venture capital funds (private independent LPs, corporate, government, LSVCC, US VCs financing Canadian entrepreneurs)

• This is by far the largest and most comprehensive data on security design in VC and PE of any country worldwide where VC or PE data have been collected



Summary

12


Canadian Venture Capital Securities, All Types of Venture Capital Funds and Entrepreneurial Firms, 1991(Q1) - 2003(Q3)

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

50.00%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Year

% o

f Tot

al

Preferred Common Convertible Preferred Debt Convertible Debt Debt and Common Preferred and Common Other

13


Canadian Venture Capital Securities, Private Independent Limited Partner Venture Capitalists and Start-up Entrepreneurial Firms Only, 1991(Q1) - 2003 (Q3)

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Year

% o

f Tot

al

Preferred Common Convertible Preferred Debt Convertible Debt Debt and Common Preferred and Common Other

14


Table 11.2. Panel A. Private Independent Limited Partnership Venture Capitalists

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14)

Average Average Average Average Year

Total # # Inv. # Inv. # Inv. # Inv. # Inv. # Inv. # Inv. Average $Can Invested $ Invested / Average Capital Number Trend

Forms of Finance Investments Start-up Expansion Buyout Turnaround High-Tech Syndication New Round # Real 1992 ('000) $ Deal Size TSX Index Gains Tax (1991=1)

Common 971 600 281 43 19 731 511 393 2.59 904.67 0.61 6573.97 0.36 7.65

Preferred 302 231 65 3 1 268 235 90 2.70 1152.68 0.40 7265.32 0.31 9.63

Convertible Preferred 373 250 109 4 9 330 286 111 2.70 1001.90 0.40 7385.29 0.32 9.51

Preferred and Warrants 12 10 2 0 0 10 10 3 2.08 2260.03 0.38 7870.14 0.28 10.67

Convertible Debt 471 254 188 13 10 365 252 174 2.67 629.28 0.59 6727.11 0.34 8.45

Straight Debt and Warrants

30 11 19 0 0 29 15 5 3.80 2206.59 0.58 7469.07 0.24 11.80

Straight Debt 303 138 106 15 15 190 126 110 2.70 746.96 0.71 6202.50 0.35 7.18

Warrants 9 6 2 0 0 9 3 5 1.78 468.66 0.81 7339.72 0.23 11.67

Common and Straight Debt

77 23 28 11 4 28 33 41 1.87 921.93 0.73 5127.49 0.37 5.61

Common and Preferred and Debt

9 1 5 0 2 2 3 3 2.89 1552.35 0.78 5081.26 0.36 5.33

Preferred and Debt 6 3 1 0 1 4 4 2 2.17 658.76 0.50 5063.33 0.32 6.50

Preferred and Common 56 35 14 7 0 40 27 19 2.64 926.03 0.64 6550.70 0.34 7.84

Common and Warrants 17 16 1 0 0 17 12 11 1.47 683.81 0.52 8712.52 0.31 10.59

Other Combinations 328 220 93 9 5 280 236 134 2.45 1113.25 0.42 7593.22 0.32 9.75

Total 2964 1798 914 105 66 2303 1753 1101 2.61 923.77 0.55 6828.96 0.34 8.42

This table continues on the following page…


Table 11.2. (Continued)Panel B. Corporate Venture Capitalists

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14)




Common 226 115 91 13 3 167 161 93 2.40 1256.67 0.48 7120.91 0.33 8.92

Preferred 118 71 36 8 3 94 98 32 2.68 1446.84 0.37 7309.08 0.28 10.25

Convertible Preferred

138 75 50 9 3 118 115 50 2.62 1302.65 0.39 7572.82 0.31 9.83

Preferred and Warrants

4 2 1 1 0 4 4 0 4.50 559.96 0.06 7852.96 0.27 11.25



0 0 0 0 0 0 0 0 0.00 0.00 0.00 0.00 0.00 0.00

Straight Debt 211 60 95 39 10 108 101 115 2.06 1301.70 0.72 7236.76 0.35 8.94

Warrants 3 2 1 0 0 1 1 0 2.67 106.61 0.60 7268.03 0.23 11.67


61 14 26 16 4 23 32 38 1.64 1341.42 0.68 6933.61 0.37 8.13


3 1 2 0 0 0 1 2 1.67 228.20 0.83 6914.13 0.32 7.67


Preferred and Common

14 3 9 2 0 8 11 5 2.43 915.05 0.47 6759.44 0.36 7.86

Common and Warrants

3 3 0 0 0 3 2 1 1.67 1116.44 0.53 7893.37 0.28 11.33

Other Combinations

238 139 87 7 1 170 176 85 2.45 976.62 0.38 7465.16 0.28 11.36

Total 1178 555 467 101 35 815 815 475 2.47 1170.56 0.49 7317.62 0.32 9.70



Table 11.2. (Continued)Panel C. Labour Sponsored Venture Capitalists

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14)




Common 825 371 298 38 98 421 363 362 2.45 1165.33 0.69 6917.75 0.35 8.60

Preferred 247 144 79 4 18 184 165 73 3.08 1482.24 0.52 7353.41 0.31 9.81


259 156 96 4 1 222 202 85 2.76 1246.19 0.43 7357.85 0.30 10.03


6 4 2 0 0 6 6 1 3.50 1757.78 0.41 7367.19 0.23 11.83



11 3 6 0 0 7 3 1 3.00 1145.58 0.79 7284.13 0.26 11.27

Straight Debt 633 230 215 27 136 286 182 192 3.27 991.56 0.74 7122.48 0.32 9.45

Warrants 11 8 1 1 1 9 2 4 2.55 747.12 0.80 7575.80 0.31 9.82


249 80 79 18 62 76 73 139 1.88 1120.90 0.83 6664.50 0.37 7.92


16 3 5 3 5 4 6 8 1.94 701.46 0.86 6626.72 0.35 8.06



87 31 32 8 14 29 35 44 2.10 703.32 0.75 6865.81 0.36 8.36

Common and Warrants

8 4 4 0 0 4 5 4 3.00 364.72 0.45 7969.09 0.28 11.88

Other Combinations

409 221 140 14 23 260 224 148 2.95 956.79 0.55 7353.49 0.32 9.88

Total 3188 1475 1112 130 393 1804 1495 1202 2.74 1080.02 0.64 7113.46 0.33 9.23



Table 11.2. (Continued)Panel D. Government Venture Capitalists

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14)




Common 578 415 136 8 16 400 309 291 2.10 677.23 0.64 6131.48 0.34 7.07

Preferred 162 111 46 3 2 153 136 44 3.06 924.05 0.36 7245.46 0.28 10.38


194 123 60 8 3 177 171 48 3.19 914.16 0.31 7317.02 0.29 10.59


9 7 0 2 0 9 8 2 3.33 1062.13 0.30 7833.90 0.26 11.33



3 1 1 1 0 2 3 1 3.33 14149.48 0.26 7268.03 0.23 11.67

Straight Debt 174 99 52 10 10 107 120 71 2.52 517.71 0.49 6538.93 0.31 9.16

Warrants 7 5 2 0 0 7 7 0 4.71 573.45 0.26 8436.37 0.29 10.71


55 26 21 2 5 30 32 27 2.20 480.87 0.58 5996.55 0.35 7.40


2 0 1 0 0 0 0 1 2.00 112.80 1.00 5330.75 0.38 5.50



24 10 10 0 3 18 12 8 2.38 530.34 0.64 5786.24 0.36 6.67

Common and Warrants

2 2 0 0 0 2 0 1 1.50 461.77 0.75 7731.72 0.23 11.00

Other Combinations

247 175 53 5 11 192 175 93 2.44 646.62 0.39 6851.07 0.29 10.05

Total 1768 1171 474 44 65 1342 1201 687 2.58 685.16 0.49 6696.29 0.31 8.88



Table 11.2. (Continued)Panel E. US Venture Capitalists (financing Canadian entrepreneurial firms)

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14)




Common 195 104 84 4 0 185 172 52 2.85 4639.64 0.30 7392.33 0.30 10.03

Preferred 116 83 32 0 1 109 107 17 2.91 4199.92 0.28 7745.56 0.28 10.68


115 60 53 1 0 107 112 14 3.73 3419.40 0.23 7550.11 0.30 10.28


1 1 0 0 0 1 1 1 1.00 193.30 0.09 7731.70 0.23 11.00



2 0 2 0 0 2 2 0 4.00 3543.81 0.28 7731.72 0.23 11.00

Straight Debt 24 7 10 5 1 15 23 11 2.67 1028.47 0.37 6885.07 0.36 8.25

Warrants 3 3 0 0 0 3 3 0 4.00 51.55 0.05 7731.72 0.23 11.00


5 3 1 1 0 3 4 3 3.40 2313.14 0.49 6683.24 0.39 7.20


1 0 1 0 0 1 1 0 2.00 17244.00 0.32 9607.70 0.37 10.00



4 0 4 0 0 3 4 3 1.25 625.14 0.24 6850.94 0.36 6.75

Common and Warrants

2 1 1 0 0 2 1 2 1.00 3340.14 0.53 7383.95 0.23 11.50

Other Combinations

246 138 105 2 0 241 227 83 2.65 5575.36 0.24 8302.35 0.30 10.79

Total 755 425 308 13 2 712 696 195 2.95 4424.82 0.27 7744.34 0.30 10.31



Table 11.2. (Continued)Panel F. Institutional Investors

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14)




Common 670 344 262 21 30 445 472 296 2.26 1696.17 0.57 7242.23 0.34 8.93

Preferred 198 108 83 3 4 163 153 56 3.01 1548.05 0.45 7541.30 0.30 10.26


215 119 79 11 4 172 199 78 2.77 1699.22 0.36 7372.62 0.32 9.68


5 5 0 0 0 5 5 1 2.40 2399.00 0.15 7592.61 0.23 11.20



1 1 0 0 0 1 1 0 2.00 56.70 0.02 7731.70 0.23 11.00

Straight Debt 504 213 262 7 10 249 215 205 2.61 868.01 0.73 7343.35 0.32 9.73

Warrants 5 3 2 0 0 5 5 0 7.60 3244.43 0.53 8482.13 0.29 10.60


125 49 63 7 5 55 63 73 1.99 1099.53 0.72 7150.85 0.35 8.71


3 1 2 0 0 2 2 1 1.67 2487.02 0.48 7901.01 0.32 10.33



40 22 15 1 2 27 30 20 1.90 1979.21 0.57 7440.54 0.36 8.65

Common and Warrants

8 8 0 0 0 8 7 5 1.50 3002.97 0.41 8817.29 0.32 10.50

Other Combinations

342 196 127 7 10 245 265 150 2.39 3089.33 0.47 7619.50 0.31 10.29

Total 2510 1234 1105 65 76 1654 1682 1016 2.58 1580.39 0.57 7382.21 0.32 9.55


Data Summary: Major Puzzles

• Mix of forms of finance observed is NOT explained by:

1. Type of VC fund2. Type of entrepreneurial firm3. Amount invested4. When invested5. United States versus Canadian VC funds for Canadian

entrepreneurial firms



Summary

21


Explanations

1. Not enough U.S. data2. U.S. venture capitalists are more sophisticated3. Restrictive covenants on venture capital funds4. Exit more difficult in Canada5. U.S. Tax Laws(!)6. Differences in types of firms financed – agency costs

differ by transaction type



Summary

22


1. Enough U.S. Data?

• Gompers (1998) 50 observations

• Kaplan and Stromberg (2003) 213 observations

• Unavailable data on security design from the population of US investments



Summary

23


2. Sophistication?

• That forms of finance other than convertible preferred equity is used is not de facto evidence of a lack of sophistication

• Some ‘sophisticated’ U.S. VCs use other forms of finance (based on casual search of U.S. VC web pages)



Summary

24


Sophistication (Continued)

• The PricewaterhouseCoopers MoneyTreeTM Survey (http://www.pwcmoneytree.com/) of U.S. venture capital financings indicates: “Debt is very often part of a venture capital deal”



Summary

25



Benchmark Capital states (see www.benchmark.com):

• “At Benchmark Capital, we're focused on one, and only one, mission: to help talented entrepreneurs build great technology companies. That's what drives us and everything we do - from how we organize our firm to our investment strategy Our investment strategy is simple: be the first venture investor in technology companies that seek to create new markets. We focus on early-stage investing and take a labor-intensive, service-oriented approach in markets where we have direct experience. These markets include application services, infrastructure services, Internet retail, Internet services - business, Internet services - consumer, mobile Internet, networking equipment, semiconductor, and software. Minimum investment: $500,000; Maximum investment: $5,000,000…

• “Raising debt funding is a recent phenomenon for venture-backed start-ups and such funding can be a valuable source of capital. To help companies evaluate debt terms, we recently conducted an informal survey of our portfolio companies that summarizes the terms and conditions being offered to venture-backed start-ups. The spreadsheet below [see www.benchmark.com] contains a summary of our findings.” [Emphasis added.]



Summary

26



St. Paul Venture Capital states (http://www.stpaulvc.com/):

• “With annual investments placing us among the top 10 venture capital firms in the United States, we have committed more than $1.5 billion to venture capital investments since our founding in 1998…

• While the dominant portion of our investing is in early-stage companies, we also invest in more established companies which are showing excellent progress and could benefit from an additional round of private financing. These are often companies with proven business models that are raising funds to finance rapid growth. Or they may be pursuing an acquisition-and-consolidation strategy in an industry burdened with inefficiencies. We also invest selectively in equity securities of middle-market management buyouts. As with our early-stage investments, we bring strategic thinking and financial engineering skills to the relationship, as well as capital. Our involvement is frequently weighted toward the front end in our later stage deals, structuring mutually beneficial multi-party financings and developing equity and debt structures to fit a company's unique circumstances.” [Emphasis added.]



Summary

27



Northwest Venture Associates states (http://nwva.com/):

• “Northwest Venture Associates ("NWVA") has $190 million under management and is the largest venture capital fund manager focused exclusively on companies headquartered in the Pacific Northwest. The funds were established to provide equity capital and financial guidance to successful, rapidly growing Northwest businesses managed by entrepreneurial, creative and ethical individuals…

• The preferred size of our investment ranges from $250,000 to $7,500,000, in the form of common or convertible preferred stock. In many cases, we can arrange the balance of your capital needs with investors whose objectives are similar to yours and to ours. We have extensive contacts with other equity funds and syndicates of high net worth individuals. In addition, we can facilitate investments from strategic partners. Our ultimate objective is to earn a rate of return commensurate with the risk we are assuming. Our time frame is roughly five years from the date of our investment in a company. The mechanism for realizing our return may include an initial public offering (IPO), sale or stock repurchase.” [Emphasis added.]



Summary

28


3. Restrictive Covenants

• Most U.S. venture capital limited partnerships face restrictive covenants on the types of forms of finance they may use

• E.g., many are restricted against using debt (e.g., from leveraging up the fund) (see Chapter 5)– The frequency of use of this restriction changes over time, etc.

• Less of an incentive to use debt when financing entrepreneurs to match the timing of cash flows into and out of a VC or PE fund when the fund itself does not use debt



Summary

29


Restrictive Covenants (continued)

• Canadian data: not just limited partnerships, but also government, hybrid, LSVCCs and corporate VC funds

• Each faces different types of constraints



Summary

30


4. Exit More Difficult in Canada?

• Securities regulation: IPOs more costly• Fewer strategic acquirers• Lots of buybacks• Possibly less of a need for equity-type securities(?)

• **Later on we relate contract choice to exit outcome (Chapters 14, 20 and 21)



Summary

31


5. TAX

• U.S. Tax Law biases the selected form of VC finance in the U.S. (Gilson and Schizer, 2003 Harvard Law Review)

• These tax biases do not exist in Canada (Sandler, Canadian Tax Journal, 2001)



Summary

32


Taxation in the US Gilson & Schizer(2003 Harvard Law Review)

• US VCs + US Entrepreneurs: tax bias• Convertible Preferred Equity lowers the value of Entrepreneur’s common

shares lowers the strike price for employee stock options.• Tax is deferred until the incentive compensation is sold• “Eat em up Preferreds” [!]

• Suggest (note 51) adverse tax consequences in Canada with preferred dividends, but VC backed entrepreneurial firms typically do not pay significant dividends ($ comes from capital gain upon exit)

• If adverse tax consequences with preferred dividends, would never expect straight (non-convertible) preferred equity in Canada



Summary

33


Taxation in CanadaSandler (2001 Can Tax Journal)

• No clear perception on how Revenue Canada (IRS equivalent) would treat US Style “Eat em up preferreds”

• BUT: No Canadian VC uses ConvPrefs more than 50% of the time (Cumming, 2005)

• Would US VCs try “Eat em up preferreds” in Canada?

• No pertinent change in tax code in years covered by the data• Significant changes in intensity of use of different forms of finance over

time• Suggestive that factors other than tax are determinative of capital

structure



Summary

34


6. Types of Transactions

• Different transactions are, yes, different

• E.g., moral hazard costs may be more problematic among different types of firms

• E.g., adverse selection problems may be different for other types of firms



Summary

35


Agency Problems

• The degree to which agency costs are pronounced (and therefore the choice of security) depends on:(i.e., NOT the same for every financing transaction!!!)

Entrepreneurial firm development stagesstart-up, expansion, buyout, turnaround

Other non-mutually exclusive entrepreneurial firm characteristicshigh-tech, # employees, etc.

Type of transactionstaging and/or syndication, capital contribution



Summary

36


Principal Agent

Venture Capitalist 1 Venture Capitalist 2

Entrepreneur



Summary

37


Objective

• Determine which form of finance may be optimal depending on:Characteristics of entrepreneurial firmCharacteristics of VC firm(s)Regulatory environment



Summary

38


1. Buyout Stage Firms

• The operating management of the entrepreneurial firm acquires a product line, a division, or a company

• Established firmsAdverse selection costs of debt are less

significant relative to earlier stage firmsSyndication unnecessary



Summary

39


Buyout (Con’t)

• Moral HazardEffort of entrepreneur is importantEffort of venture capitalist is less important

• Transparent type of transactionStaging re monitoring is unnecessary



Summary

40


Buyout (Con’t)

• What form(s) of finance would you expect?



Summary

41


2. Turnaround Stage

• The entrepreneurial firm is earning less than its cost of capital

• Established FirmBut risk of a ‘lemon’ is significant (significant

adverse selection problems)



Summary

42


Turnaround (Con’t)

• Moral HazardEffort of both VC and entrepreneur significant

• Trilateral BargainingRisk entrepreneur may give up control of the

firm (after contracting with the VC) to an outside third party to lower the firm’s cost of capital



Summary

43


Turnaround (Con’t)

• Which form(s) of finance does this suggest?



Summary

44


3. Start-up Stage

• The firm may be based on a concept without a product or any marketing, or it may have a product being developed, but not yet sold commercially

• No track recordAdverse selection problems are significant



Summary

45


4. Expansion Stage

• The entrepreneurial firm requires significant capital for plant expansion, marketing, and to initiate full commercial production and sales

• Short track recordAdverse selection significant



Summary

46


Start up and Expansion (Con’t)

• Moral hazard Effort of both entrepreneur and VC(s) significant Staging

• Need for Syndication Prevent hold-up problems and renegotiation Maximize growth options with a greater number of suppliers of

capital



Summary

47


Staged Round 1: VC1 invests in Entrepreneur

Staged Round 2: VC1 and VC2 invest in Entrepreneur

VC2 invests based on recommendation of VC1

VC1 may “trick” VC2 to invest

How to contracts to mitigate this problem?!

Consider Agency Problems Among Syndicated VCs:



Summary

48


Changing equity ownership percentagesand the value of the entrepreneurial firm

VC150%

ENT25%

VC225% VC1

50%

ENT45%

VC25%

VC1 increases price paid by VC2,Decrease ownership of VC2Increase ownership of ENTIncrease value of FirmIncrease payoff to VC1 !!!

Case 1 Case 2

Low firm value

High firm value, high ENT share

49


Agency Problems (Continued)

• Start-up and Expansion VC Contracting objectives:

1. Continue financing positive expected NPV projects after each performance review

2. Limit mispricing of securities between lead (inside) and follow-on (outside) investors

3. Limit misstatement of capital requirements



Summary

50


Agency Problems (Continued)

Competing explanations for start-up and expansion stage firms:

1. Convertible securities (almost all papers) Problem: interdependent payoffs may lead inside VC to misstate

capital requirements and misprice securities sold to outside VC

2. Fixed-fraction contracts (Admati & Pflederer, 1994 JF) Problem: not robust to moral hazard costs and/or bankruptcy states

3. Straight Preferred Equity (Cumming, 2005 JBV, 2005 JCF) “Inside VC” uses straight preferred equity to act as an unbiased

intermediary between “outside VC” and the entrepreneurial firm



Summary

51


Figure 11.A1 Payoffs to Debt, Preferred Equity and Common Equity*

* The relative magnitudes of P (prespecified preferred equity dividends) and D (interest and principal on debt) are arbitrary and may be reversed.

Payoff

Value of Entrepreneurial Firm

Common Equity

Debt

Preferred Equity

D

P

52


Table 11.A1. Syndication Example

This table presents a syndication example to highlight the non-robustness of the optimal contract derived by Admati and Pfleiderer (1994). Suppose there are two financing rounds. The first part of the Table provides the amounts invested. The second part of the Table outlines three cases (A – C). For each case, the inside VC 1 knows the salvage value of the firm if there is second-round financing. The outside VC 2 relies on the information provided by VC1. If second-round investment does not happen then the salvage value of the firm is equal to $10.

First-Round Financing Second-Round Financing Total Amount Invested

Amounts invested by the three VC1 $50 VC1 $50 VC1 $100

parties for Cases A, B and C. Entrepreneur $50 Entrepreneur $0 Entrepreneur $50

VC2 $0 VC2 $50 VC2 $50

Total $100 Total $100 Total $200

Salvage Net Payoffs Second-round financing

Case Value VC1 VC2 Entrepreneur Should happen? Will happen?

A. Fixed-fraction contract with equal

priority and no effort-related moral $140 ($30) $0+1 ($30)-1 Yes Yes

hazard costs

B. Fixed-fraction contract with equal

priority and effort-related moral hazard $120+40ß2 -$100+.5(120+40ß) -$50+(.5-ß)(120+40ß) -$50+ß(120+40ß) Yes No3

costs

C. Proposed contract with moral hazard

VC1: Straight Preferred Equity $120+40ß4 ($30) 0 ($50) Yes Yes

VC2: Convertible Debt

Entrepreneur: Common Equity

Notes:

1. The price of second-stage securities must be low enough to provide (a risk neutral) VC 2 with at least 35.7% (50/140) of the firm's equity.

2. Value of the firm itself depends on the entrepreneur's residual claim (ß), and therefore also depends the price of securities issued at the second stage.

3. VC1 overstates the value of second-stage securities to minimize moral hazard (and VC 2's share, 1-ß) and maximize the value of the firm. VC2 will not participate.

4. Moral hazard costs could be normalized to 0 without loss of generality with respect to optimal continuation in case D. The entrepreneur's equity share does not affect VC 1's payoff in non-bankruptcy states. In bankruptcy states, trilateral bargaining dissuades VC1 from seeking outside VC2 participation.


5. Other Factors

• Learning (changes over time)

• Market conditions (pre- and post-Internet bubble)

• Sophistication (differences among VCs):• Canadian VCs versus US VCs investing in

Canadian entrepreneurial firms



Summary

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6. LSVCC: Canadian Government Funds

• Registered Retirement Savings Plan eligible investments Tax incentive for using debt

• LSVCC Funds worried about the book value of their investments Debt pays interest

• Economic issues Moral hazard Adverse selection



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Conclusions / Summary

• Unlike US VCs financing US entrepreneurs, no single unique ‘optimal’ security for Canadian VCs and US VCs financing Canada entrepreneurs

• Canadian evidence is remarkably similar to the rest of world

• Possible explanations

– Tax bias in US in favor of using convertibles, unlike Canada / elsewhere

– Agency problems differ across different transactions different securities

– Market conditions

– Learning / Institutional Factors



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Conclusions / Summary

• Agency costs differ according to the characteristics of the entrepreneurial firm and the characteristics of the VC(s)

• From corporate finance we know (review Chapter 2): Optimal forms of finance depend on agency costs

• Therefore optimal forms of finance depend on the characteristics of the entrepreneurial firm and the characteristics of the VC(s)



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Note

• The form of finance is not the only way to alleviate informational asymmetries and agency problems (moral hazard and adverse selection) across different types of entrepreneurial financing transactions

• Chapter 12 looks at other contractual terms used in actual venture capital deals in Europe (not US due to tax bias), albeit not as many deals as in the Canadian financing data presented in this Chapter



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