venture capital contracting in indiaventure capital industry in india is well established, active...

Venture Capital Contracting in India

A thesis submitted to the Bucerius/WHU Master of Law and Business Program in partial fulfillment of the requirements for the award of the Master of Law and Business (“MLB”) Degree

Pranay Chandran

July 16, 2010

12603 words (excluding footnotes)

Supervisor 1: Prof. G. Marcus Cole

Supervisor 2: Mr. Manoj Menon

Table of Contents

1 Introduction ..................................................................................................................................... 1

2 Development of Venture Capital in India ....................................................................................... 4

2.1 Development of the Indian Venture Capital Industry ..................................................................... 4

2.1.1 Pre-liberalization ..................................................................................................................... 4

2.1.2 Post-liberalization ................................................................................................................... 6

3 Understanding Venture Capital ..................................................................................................... 10

3.1 What is Venture Capital? .............................................................................................................. 10

3.2 The Venture Capital Process ........................................................................................................ 11

3.3 Why is Venture Capital relevant? ................................................................................................. 14

3.4 The engineering problem .............................................................................................................. 15

4 Rationale of Venture Capital Contracting ..................................................................................... 17

4.1 The Risk in “Risk Capital” ........................................................................................................... 17

4.2 Obligations of the Venture Capitalist ........................................................................................... 18

4.3 Designing a Contract .................................................................................................................... 18

4.4 Control Mechanisms ..................................................................................................................... 19

4.5 Staged Financing .......................................................................................................................... 19

4.6 Syndication .................................................................................................................................... 20

4.7 Use of Convertible Securities ........................................................................................................ 20

4.8 Other forms of Control .................................................................................................................. 22

4.8.1 Board representation and management ................................................................................. 22

4.8.2 Covenants .............................................................................................................................. 23

4.8.3 Compensation ....................................................................................................................... 24

4.8.4 Contingencies ........................................................................................................................ 25

5 The Venture Capital Investor and Portfolio Company Contract ................................................... 26

5.1 Ownership and Voting Rights ....................................................................................................... 26

5.2 Staging .......................................................................................................................................... 27

5.3 Securities ....................................................................................................................................... 27

5.4 Liquidation Rights ......................................................................................................................... 28

5.5 Conversion Rights ......................................................................................................................... 28

5.6 Anti-Dilution Protection ............................................................................................................... 28

5.7 Redemption, puts, buy-backs and calls ......................................................................................... 29

5.8 Board structure ............................................................................................................................. 29

5.9 Pre-emptive rights and Transfer related rights ............................................................................ 30

5.10 Affirmative voting rights ............................................................................................................... 30

5.11 Option carve-out & Employment contracts .................................................................................. 30

5.12 Information rights ......................................................................................................................... 31

6 Discussion and Analysis of Empirical Study ................................................................................ 32

7 Conclusion .................................................................................................................................... 36

8 Bibliography ................................................................................................................................. 37

9 Annexure: Brief Summary of Empirical Study ................................................................................ i

1

1 Introduction

Venture capital fulfils a void in financial markets as an intermediary providing capital to

relatively small and young companies which may have difficulties raising finances from

other, more conventional channels. These companies operate in fast changing markets hence

they are faced with high levels of uncertainty leading to high degrees of information

asymmetry for an investor. However these companies bear the potential of high rewards.

While these firms are still privately held, venture capitalists finance them by acquiring stakes

through equity or equity linked securities, despite the high risk components. In its evolution

over time the venture capital industry has developed a wide range of mechanisms designed to

overcome the variety of problems emerging in the venture capital process.1

India today is vibrant and fast growing market for private equity in general and venture

capital in particular. The number of deals and their aggregate value has been steadily

increasing post-liberlaization at a phenomenal rate. As a result of the global financial

meltdown the deal value of the private equity and venture capital industry had experienced a

considerable dip of 62% in 2009. However India was one country that emerged relatively

unscathed by the crisis, and by the first quarter of 2010 the GDP growth rate has returned to

pre-crisis levels of 8% which by most conservative market estimates is expected to grow over

the next few years. Market sources estimate that there are approximately 375 private equity

firms currently operating in India and at least another 50 have raised or are in the process of

raising funds and are planning to start their operations in the near future. The aggregate

amount of funds raised by the private equity firms for investment in India is estimated to be

approximately US$50 billion. Thus the prospects of the private equity and venture capital

industry continue to be robust.

In 2001 Dossani and Kenney2 examined early efforts to create a venture capital industry in

India. In the context of cross-national transference of institutions the authors tried to

determine whether the US style venture capital industry could be successfully transferred to

the Indian context and if so, how: by modifying the environment, by hybridizing the

institution itself, or by a combination of these two factors. Due to the fact that at the time of

writing the paper, the Indian venture capital industry was still in its nascent stages, the

conclusion of this study was necessarily deferred. The authors themselves write:

“For India, we have argued that the environment itself has had to be and needs to continue

being changed..... Interestingly, in India we believe that venture capital as an institution may

actually need to be changed less than in the case of Taiwan, however this conclusion is not

yet entirely verified.”

Nearly ten years on, this paper seeks to pick up at the point left off. There have since been

considerable developments in the global venture capital market, and also in India. By just

looking at the volume of deals and funds being invested one is of the impression that the

venture capital industry in India is well established, active and relatively healthy.

1 Paul Gompers & Josh Lerner, “The Venture Capital Revolution”, Journal of Economic Perspectives, Vol. 15, No.

2 (Spring, 2001), 145-168, at p. 145 2 Rafiq Dossani and Martin Kenney, “Creating an Environment for Venture Capital in India”, World

Development, Vol.30 (2), at p. 249

2

This paper primarily seeks to find out whether the institution of venture capital – the complex

contracting structure developed to tackle extreme uncertainty, asymmetric information and

agency costs in a system based on private ordering- has been transferred “as is” or in a hybrid

form. This is sought to be achieved through an empirical examination of a sample set of

actual contracts between the venture capital investor and the entrepreneur in light of what we

already know the existing literature on such contracts in US venture capital investments.

For this purpose we first show that the very institution of venture capital can be

fundamentally understood as being the contracting structure between the limited partners, the

venture capitalist and the portfolio company. This contracting structure is constituted of two

main contracts, the partnership agreement, which governs the relationship between the

limited partner and venture capitalist and the stock purchase agreement, which governs the

relations between the company and the venture capitalist. These two contracts are mutually

related that successful transference of one of these contracts could imply a successful

transference of the entire contracting structure. This paper focuses on the contracts between

the venture capitalist and the company.

The first section contextualizes the discussion with a look at the development of the venture

capital industry in India. In this part we re-visit the historical development of the venture

capital industry in India. It continues to give an overview of the current situation in India. We

also take a brief overview of the regulations specifically governing venture capital in India

today through an examination of the relevant laws and statutes.

The following section seeks to provide an understanding of venture capital. It provides an

overview of the entire venture capital process starting from raising of the fund to the

investment and monitoring of the investment and the exit from the company. It also seeks to

single out the contracting structure as the core of the institution of venture capital, thus

validating the focus on the venture capital financing contract as the basis of determining the

success of the transference of the institution of venture capital.

In the next section we examine the venture capital financing contract in further detail by

looking at the rationale and tools used in venture capital financing agreements. This is

undertaken through a review of existing literature.

The following section we provide the findings of our empirical study. For the purpose of

enabling a comparison we also provide the findings of numerous studies conducted on the US

Venture capital market in order to determine what constitute the standard contracting terms.

Our findings are presented light of this. This is intended to show how similar or different the

actual contracting models are in the two industries.

This is followed by a detailed discussion and analysis of our findings. The last section

encapsulates a brief conclusion.

The scope of this paper is limited to an examination of the contract between the venture

capitalist and the company in the Indian context with the aim of determining if it is a direct

transference of the institution of venture capital. A discussion of the Indian environment, and

framework is undertaken only for the purpose of contextualizing the discussions. Further

3

other aspects of the venture capital process is not discussed in detail, they have been

discussed with a view of providing an understanding of the topic in general.

The discussion in this paper is based on a descriptive and analytical review of existing

literature. Further a large part of the paper is based on an empirical study of Indian venture

capital financing contracts. The sample set consists of hand collected set of 30 executed stock

purchase agreements and term sheets used for venture capital financings in India. The data set

was collected for practitioners operating in the field. Due to the confidential nature of these

documents, some of the details in some of the agreements were removed, and thus did not a

permit a complete examination of all the samples in the data set. However as the main aim is

to determine the contractual terms used in the agreements, the sample set was sufficient.

4

2 Development of Venture Capital in India

In this section we look at the development of the venture capital industry in India and a brief

overview of the regulations governing venture capital funds in order to contextualize the

discussion in this paper.

2.1 Development of the Indian Venture Capital Industry

In order to understand the development of the venture capital market in India, one must see it

in the context of the development of the overall economic policy and the Indian government’s

interest in encouraging economic growth.

India's first Prime Minister, Jawaharlal Nehru, inspired by the ideologies of Fabian socialism

and the exploitative experience of colonialism, spear-headed the government of newly

independent India towards the path of democratic socialism for its economy. The economic

policy was characterized by central planning, protectionism, public ownership, extensive

regulation, and a great deal of bureaucratic red tape. Noble as their intentions were, this

"license raj"3 resulted in pervasive corruption and massive inefficiency and further strangled

the private sector and led to an overall slow rate of economic growth4.

The 1980s saw a growing consensus on the failure of the effectiveness of the socialist

economic policies and a need for liberalization. Ironically, it was the government of Rajiv

Gandhi, the grandson of Nehru who came into power in 1984, that initiated the move towards

a more market driven economy. The policy reforms in the mid- and late-1980s, although ad

hoc and implemented quietly5, it laid the foundation of the more extensive reforms in July

1991 and beyond. Minor as they may seem in retrospect, were the beginning of the

acceleration of growth. The policy measures included import liberalization, incentives for

exports, corrections of the real exchange rate and freeing up of several sectors from

investment licensing, all contributed to productive efficiency and allowed faster industrial

growth. It must also be mentioned that both external and internal borrowing allowed high

levels of public expenditures and growth through demand. However, these very factors led to

the June 1991 macroeconomic crisis that brought the economy to a standstill.6

As a result, India stagnated until bold neoliberal economic reforms in 1991, triggered the

current wave of rapid economic growth.

2.1.1 Pre-liberalization

As noted before, the period prior to the 80’s were still early days for Venture Capital

globally. Further considering India from 1950 to 1980 was a fairly classic case of a statist,

3 The term was coined by Indian statesman Chakravarthi Rajagopalachari, who firmly opposed it for its

potential for political corruption and economic stagnation 4 The average Annual Real GDP Growth of India between 1950-1980 was 3.7%

5 In view of the continuing dominance of leftist ideology in India, pre-1991 reforms were introduced quietly

and without fanfare, hence the term often used to describe them is “reforms by stealth” 6 Arvind Panagariya, “India in the 1980s and 1990s: A Triumph of Reforms”, IMF Working Paper, WP/04/43,

March 2004

5

import-substitution model of development, with a socialist flourish7having a centrally

controlled industrial license regime, it would not be hard to imagine that there was not much

room for an organised venture capital industry to develop. Entrepreneurs mainly had to

depend on private placements, public offerings and lending by the financial institutions and

the need for risk capital was, to minimal extents, fulfilled by Individual investors and

development financial institutions8.The need for venture capital was identified by policy

makers in 1973 with regards to funding new entrepreneurs and technology. This interestingly

coincides with the beginning of the shift in ideology of India’s political economy around

1980 from the statist and nationalist model of development of the Nehru era in the direction

of a more state and business alliance led model for economic growth9.

A more serious consideration of venture capital was juxtaposed to an active interest on the

part of the World Bank in encouraging economic liberalization in India10. In 1988 the Indian

government announced its first guidelines regarding venture capital operations.

Some of the beneficial features included relatively low capital gains tax rate for venture

capital funds, permission to exit investments at a premium. The restrictions imposed by the

guidelines were far more. The promoters had to be banks, large financial institutions, or

private investors (but only upto 20%). It stipulated the maximum amounts that could be

invested; the kind of companies investment could be made in and who the profile of the

founders. It imposed bureaucratic constraints such as a list of approved investment areas,

vetting of the portfolio firm’s application by government-sponsored development banks; and

approval of the Controller of Capital Issues of the Ministry of Finance of the line of business

in which a venture capital firm wished to invest.11

The World Bank’s involvement also included providing a loan of $45 million to the Indian

Government, which was to be passed on to four public sector financial institutions to enable

them to set up venture capital operations under the 1988 guidelines.

The 1988 guidelines essentially only enabled state-controlled financial institutions and banks

to establish venture capital subsidiaries. There was minimal interest from the private sector in

establishing a venture capital firm. The performance of these early venture capital operations

were modest at best. The problems were numerous. The restrictive nature of the regulations

of the time did not give the opportunity to maximise gains. One example was the

implementation of novel instruments like the “conditional loan” by some venture capital

institutions, but these did not provide capital gains. The institutions were also mandated to

operate only in a limited number of sectors or within specific states. This led some of these

institutions to see themselves as organizations funding technology and hence they did not

focus on the best business opportunities. In addition to this, much of the management of these

7 Atul Kohli, “Politics of Economic Growth in India, 1980-2005 Part I: The 1980s”; Economic and Political

Weekly April 1, 2006, at p.1253 8 Chandreshekhar committee report

9 Atul Kohli, “Politics of Economic Growth in India, 1980-2005 Part I: The 1980s”; Economic and Political

Weekly April 1, 2006, at p.1255 10

Chandrashekhar Committe Report, 2000 11

For details see Rafiq Dossani & Martin Kenney, “Creating an Environment for Venture Capital in India”,

World Development, Vol.30, No.2, pp. 227-253, 2002, at p.

6

institutions were inexperienced in this unique and new form of finance. They tended to focus

on identifying good projects to invest in and financing them, there was little or no input

forthcoming on the subsequent management of the firm, setting strategy or recruitment.12

However, despite these shortcomings the most important outcome of these early efforts was

that it helped to lay the foundation for the formalization of the venture capital industry in

India. There was a realisation that there was potential for a venture capital market in India

and there were indeed viable investment opportunities in India. In addition it helped to train

the first cadre of venture capitalists in India who were instrumental in the further

enhancement of the industry in the future.13

2.1.2 Post-liberalization

Policymakers have steadily opened up the economy to foreign investment, which is key to the

growth of the venture capital market as a majority of the capital is provided by foreign

investors. India’s progressive foreign trade policy has been implemented through a

combination of fiscal reform, liberalization of trade and investment policies and rational

exchange controls. This combined with strong fundamentals comprising a favorable

demographic profile, human capital, trade openness, increasing urbanization and rising

consumer spending has made India one of the fastest growing markets in the world.

The formalisation of the Indian venture capital community began in 1993 with the formation

of the Indian Venture Capital Association ("IVCA") headquartered in Bangalore. In 1996, the

Securities and Exchange Board of India ("SEBI") introduced the SEBI (Venture Capital

Funds) Regulations, 1996 (“VCF Regulations”), for regulating and promoting the activities of

domestic venture capital funds. The move liberated the industry from a number of

bureaucratic hassles and paved the path for the entry of a number of foreign funds into India.

In 2000 the SEBI announced the SEBI (Foreign Venture Capital Investor) Regulations, 2000

(“FVCI Regulations”) enabling foreign venture capital and private equity investors to register

with it and avail of certain benefits provided there under. The relevant regulators include the

Foreign Investment Promotion Board, the Reserve Bank of India (‘RBI’) and the SEBI.

The legal regime available for formation and functioning of a domestic VCFs is overlapping

and sometimes unclear. The laws applicable to a domestic VCF are the Securities Contract

Regulations Act, 1956 and the Companies Act, 1956. The Indian regulatory system through

the Reserve Bank of India and the Securities and Exchange Board of India regulates and

oversees financial intermediaries. RBI is governed and regulated by the Reserve Bank of

India Act, 1934 and SEBI by the SEBI Act. Any financial institution in India is governed

and regulated by the RBI Act and the rules and regulations made thereunder. However, a

financial institution may also be regulated by SEBI Act and hence by SEBI. IT Act provides

the taxation framework for taxation of VCFs.

SEBI Act does not differentiate between a private equity fund and a venture capital fund. It

refers to venture capital fund without defining it. Section 12(1B) of the SEBI Act

12

Id 13

Id

7

provides that, no person shall sponsor or carry on any venture capital fund, unless he obtains

a certificate of registration with SEBI in accordance with the VCF Regulations.

In terms of the VCF Regulations, any company, trust or body corporate proposing to establish

a VCF is required to register with SEBI. The term VCF is defined in the VCF Regulations:

• as a trust or a company including body corporate registered in accordance with the

VCF Regulations; and

• has a dedicated pool of capital, which is raised and is to be invested in the manner

specified in the VCF Regulations.

SEBI registered VCFs can invest in domestic companies whose shares are not listed on a

recognized stock exchange in India and which is engaged in the business of providing

services, production, manufacture of article or things but does not include the following

businesses:

• Non-banking financial services excluding those non-banking financial

companies which are registered with Reserve Bank of India and have been

categorized as equipment leasing or Hire Purchase Companies;

• Gold financing excluding those companies which are engaged in gold

financing for jewellery;

• Activities not permitted under industrial policy of Government of India.

All investments of SEBI registered VCFs are subject to certain conditions , such as:

• It has to disclose the investment strategy;

• It cannot invest more than 25% of its corpus in one SEBI VCU;

• It has to invest at least 66.67% of the investible funds in unlisted equity

shares or equity linked instruments of SEBI VCU;

• Not more 33.33% of the investible funds may be invested by way of:

• -subscription to initial offer of a SEBI VCU shares of which are proposed

to be listed,

• -debt or debt instruments of a SEBI VCU in which the VCF has already

made equity investment,

• -preferential allotment of equity shares of a listed company subject to 1

year lock in,

• -equity or equity linked instruments of a financially weak company or a

sick industrial company whose shares are listed,

• -investment in special purpose vehicles for making investments in

accordance with VCF Regulations.

An FVCI (or Foreign Venture Capital Investor) is an investor incorporated or established

outside India which proposes to make investments either in domestic Venture Capital Funds

(‘VCFs’) or Venture Capital Undertakings (‘VCUs’) in India and which is registered under

the FVCI Regulations. Although foreign investors can invest in India directly under the

Foreign Direct Investment Scheme (the ‘FDI Scheme’), the SEBI grants certain benefits to

8

those investors who register themselves under the FVCI Regulations. While considering an

FVCI application, the SEBI reviews the applicant’s track record, professional competence,

financial soundness, whether the applicant is regulated by an appropriate foreign regulatory

authority or is an income tax payer, amongst other factors. The SEBI then forwards its

approval to the RBI, which then grants its approval.

Although, certain restrictions are placed on the manner in which an FVCI may use its funds,

it has the option of using all of its funds to invest in a domestic VCF, which can in turn invest

up to two-thirds of its funds in unlisted companies. While the FDI Scheme does not apply to

FVCIs, an investment by an FVCI in a listed company or in a special purpose vehicle (an

‘SPV’) that does not fall under the definition of a VCU or a VCF would qualify as an

investment under the FDI Scheme, which would be subject to the sectoral caps and other

limitations, unless special permission is obtained.

Indian VCFs are entitled to tax benefits under Section 10(23FB) of the Income Tax Act, 1961

(‘Tax Act’). Any income earned by an SEBI registered VCF, established either in the form of

a trust or a company set up to raise funds for investment in a VCU is exempt from tax.

Although an FVCI is to some degree tax exempt, there remains considerable ambiguity in the

tax regime having the potential of subjecting foreign investors to capital gains tax rate as high

as 40%. For this reason most foreign investments are structured as special purpose vehicles in

Mauritius. The chief reason is that India and Mauritius are signatories to a double-taxation

avoidance agreement. Under certain conditions, the agreement exempts a Mauritius resident

from being subject to capital gains tax in India on the sale of shares. Also, since the local

taxes in Mauritius are nominal and there are provisions for deemed foreign tax credit,

Mauritius is a common route for investments into India.

The regulatory framework has been sufficient to spur considerable venture capital activity in

the country which has shown steady growth. In 2002 India attracted private equity investment

of USD 980.18 million and fourth after in the Asia Pacific region only after South Korea,

Japan and Australia14. 2005 witnessed over 68 investments in India with a total funding of

US$ 1.8 billion. India received over US$16 billion in Private Equity (PE) funding during

2007, ranking it among the top seven countries in the world and the highest in the Asia

Pacific region15. Total number of Venture Capital investments announced in the first quarter

of 2010, despite the repercussions of the global financial crisis stands at 17 with an

announced value of US$117 million as against 23 deals at an announced value of $88 million

in the first quarter of 2009 and 37 deals amounting to $180 million in the first quarter of

200816.

This although the Indian Venture Capital industry may be relatively small compared to other

developed countries it is impressive compared to other developing economies. Due to the

future growth prospects of the economy, the venture capital industry is also set to grow

further. The Indian venture capital industry can to a large extent be considered to be well

established and vibrant in its growth prospects.

14

VCCEdge, “Annual Deal Roundup” December, 2002 15

VCCEdge, “Annual Deal Roundup” December, 2008 16

VCCEdge, “Quarterly Deal Update” April 2010

10

3 Understanding Venture Capital

In order to determine if an institution has been transferred we need to first understand what

that institution is. The term “venture capital” is colloquially used to encompass a broad genre

of financing of equity based financing. Thus it is important to understand at the very outset

what we are referring to in this paper. Venture capital is undoubtedly an American financial

innovation. The industry traces its origins back to 1946 in the USA to the establishment of

American Research and Development, the first true venture capital firm.17 Since then venture

capital as the institution we know today has emerged over a period of time through an

organic, trial and error learning process within the US venture capital market.18 The industry

has since developed and spread around the globe adapting to different environments, thus

varying the understanding of venture capital. However much of the fundamental literature

and theory on venture capital financing was developed based on the study of the US venture

capital market and still remains relevant today. This paper is thus based on the premise that

the US venture capital industry is the reference point for our understanding of the institution

of venture capital. In this section we seek to highlight what this understanding is and why the

venture capital contracts form the core of the very institution. This provides the basis for

arguing later on that transference of the contracting model amounts to the transference of the

institution itself.

3.1 What is Venture Capital?

Venture capital can be defined generally as independently managed, dedicated pools of

capital that focus on equity or equity-linked investments in privately held, high-growth

companies.19 Venture capital investment is one form of investing under the broad umbrella of

private equity investments. Private equity generally refers to investments institutions or

individuals in either listed public companies or private unlisted companies. As opposed to

mere retail investors, private equity investors are actively involved in the subsequent

management of the companies they invest in. Private equity principally includes venture

capital, leveraged buy outs and management buy outs.

Venture capital investing is further divided on the basis of which stage of development the

investee company is in. Thus there are either seed, start-up or expansion investments. Seed

and start-up stage investments are often clubbed together and termed generally as early stage

investments20.

17

ARD was a publically traded closed-end fund that made high risk investments in emerging companies

involved in developing technology for World War II; see Paul Gompers & Josh Lerner, “The Venture Capital

Revolution”, The Journal of Economic Perspectives, Vol.15, No.2 (Spring, 2001), 145-168, p.146 18

Gilson, Ronald J., “Engineering a Venture Capital Market: Lessons from the American Experience”, Stanford

Law Review, Vol. 55, April 2003 19

Paul Gompers & Josh Lerner, “The Venture Capital Revolution”, Journal of Economic Perspectives, Vol. 15,

No. 2 (Spring, 2001), 145-168, at pp. 155 20

Leslie Jeng & Philippe Wells, “The Determinants of Venture Capital Funding: Evidence Across Countries”,

May 1998, at p.4

11

Seed investment refers to a, typically, small amount of capital provided to an entrepreneur to

determine whether an idea, be it technology or a new marketing approach, deserves

commercialization and further investment. This stage does not involve production for sale21.

Startup investment is targeted at companies that are less than one year old and the funds are

typically used for product development, prototype testing, and test marketing. It involves

examining the market-penetration potential, assembling a management team, and refining the

business plan22.

Once the prototypes exhibit minimal further technical risk and the market studies are

heartening enough to provide comfort in setting up a manufacturing process and shipping in

commercial quantities it is strictly referred to as First Stage, but comes within the general

rubric of early stage. Early-stage companies are typically cash burning and unlikely to be

profitable23.

After completing the early stage the company has already been active and has some amount

of feedback from the market. It is thus in a better position to determine the speed and limits

of the product penetrating the market. It also may be expecting or experiencing rapid

expansion which requires more working capital than can be generated from internal cash

flow. Thus further capital may be used for further expansion of manufacturing facilities,

expanded marketing, or product enhancements. This is termed as expansion stage

investments.24

Venture capital financing generally refers to the investing in such early or expansion stage

companies where the need for cash is high, the chances of success are uncertain and hence

risky, but at the same time in the eventuality of such success the rewards are extremely

beneficial.

3.2 The Venture Capital Process

The Venture Capital process is best understood, and also termed, as the venture cycle25 which

first starts with the venture capitalist raising the venture fund; followed by the venture

capitalists investing these funds in the portfolio firms while monitoring and adding value to

them; the next stage in the cycle is when the venture capitalist successfully exits from the

company and returns capital to its investors; the cycle completes itself when the venture

capitalist raises a new fund.

The venture capital limited partnerships has emerged as the main vehicle used in the

institutional venture capital industry.26 Not only does this form offer certain legal and tax

21

William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial

Economics 27 (1990), pp. 473-521, at p. 479 22

id 23

id 24


Economics 27 (1990), pp. 473-521, at p. 479 25

Paul Gompers & Josh Lerner, “The Venture Capital Cycle”, MIT Press, Cambridge, (2000) 26

These include incorporated venture-capital companies, publicly traded closed-end funds, venture-capital

subsidiaries of industrial and financial corporations, and independent small-business investment companies,

12

benefits27, but it creates conditions which govern the relationship between the investor and

venture capitalist and corresponding incentives which are fundamental to the functioning of

the venture capital process28. Most of the top venture capital firms are organized as general

partnerships. These firms form a distinct limited partnership fund, typically with a target

amount of capital to be raised and a dedicated investment target sector. The venture capitalist

would also act as the general partner. Although some venture funds are created by public

offerings of the partnership interests, most venture funds are organized by private negotiation

between the venture capitalist and certain institutional investors. The limited partners make

capital commitments, which the general partner then draws on over time as the fund becomes

fully invested.29 These funds usually invest in projects over the first three to five years of

existence which is generally limited and designed to be 7-10 years. As general partner, the

VC firm makes and monitors the venture capital fund’s investments.30 For its services, the

general partner generally receives a percentage claim on the realized return (commonly 20

percent) as well as an annual management fee of 2.5 percent (typically) of the fund’s total

committed capital31.

This is not the same in all parts of the world. In the UK firms are also generally organised as

limited partnerships. However in countries like France and Germany the involvement of

banks is far more prominent. Further in Europe there is a prevalence of captive funds i.e.

where more than 80% of the financing is derived from one source, usually operating as

subsidiaries of banks. Further, while the sources of funds in the US are usually dominated by

pension funds, in countries like Germany funds are mainly sourced by banks.32

As investors commit large amounts of money for long-terms for illiquid, non-transparent

investments over which they exercise no direct control there is vast scope for agency

problems. Venture capitalists have incentives to deviate from behaviour that is in the interest

of the investor33. Monitoring is exercised through the partnership agreement of the fund itself

by the means of numerous covenants.34 Further, structural aspects like the limited term of the

see, William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial

Economics 27 (1990), pp. 473-521, at p. 487 27

Ibid at p.489 28


No. 2 (Spring, 2001), 145-168, at pp. 153-154; The contractual and organizational techniques within this

business form are best suited to respond to the problems of financial contracting in the face of extreme forms

of uncertainty, information asymmetry and agency costs. See Gilson, Ronald J., “Engineering a Venture Capital

Market: Lessons from the American Experience”, Stanford Law Review, Vol. 55, April 2003 29

William L. Megginson, Towards a Global Model of Venture Capital?, December 31, 2001 30


Law Review, Vol. 55, April 2003, at p. 6 31

The compensation system plays a critical role in aligning the interests of the venture capitalists and the

limited partners. see William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”,

Journal of Financial Economics 27 (1990), pp. 473-521, at pp. 491, 494 32


May 1998 33

Including setting up new funds to finance the most promising companies and making side deals with the

best portfolio companies, William L. Megginson, Towards a Global Model of Venture Capital?, December 31,

2001 34

e.g.; by specifying the time general partner devotes to managing the fund, ability of general partners to co-

invest in portfolio companies, restrict follow-on funds from investing in securities held by a previous funds,

13

fund which necessitates distributions, combined with informal aspects such as reputational

considerations, help control these agency conflicts35.

Once a fund is raised, the venture capitalists must review and identify investment

opportunities, structure and execute deals with entrepreneurs, monitor investments, and try to

obtain a return on their capital36. Young firms, particularly in high-technology industries, are

fraught with uncertainties and informational asymmetries from the perspective of an investor.

Such firms typically operate in new markets where information to the potential investor is

minimal; have no established track record to assess performance; lack tangible assets; and

much of their value lie in their potential for future growth.37 Such firms require an “active

investor”38 who have a large financial interest in their investments, and can still provide an

impartial view of the management of these firms. By alleviating these information gaps and

agency costs, venture capitalists enable such firms to receive finance which they would not

be able to obtain from conventional sources39. Venture capital has developed different tools

and control arrangements, some unique to this industry, which help them minimize these

issues. This includes extensive scrutiny and due diligences of the firm prior to providing any

capital and subsequently monitoring the firm through staged financing40, syndication of the

investments with other venture capital firms, board representation and control of

management, compensation arrangements creating appropriate incentives such as equity

based compensation schemes, use of convertible securities41, and numerous other restrictive

covenants in the contractual arrangement42.

prevent the raising of a new fund until some part of the existing fund has been invested. see William A.

Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial Economics 27

(1990), pp. 473-521, at p. 492; It should be noted that restrictive covenants are usually costly to negotiate and

hence are only used in very serious cases, see Paul Gompers & Josh Lerner, “The Use of Covenants: An

Empirical Analysis of Venture Partnership Agreements”, Journal of Financial Economics 39 (1996), pp. 463-498,

at p. 35

The fixed term assures that general partner’s performance is readily observable and measurable by the

market in terms of how the general partner’s investment decisions favoured increased risk over expected

return. A general partner’s track record is essential in persuading investments in successor funds. Thus

opportunistic behaviour by the general partner with respect to investment decisions or operating decisions

will be punished through the reputation market when it seeks to raise the successor funds. See Gilson, Ronald

J., “Engineering a Venture Capital Market: Lessons from the American Experience”, Stanford Law Review, Vol.

55, April 2003, at p. 31 36


Economics 27 (1990), pp. 473-521, at pp. 503 37

Id 38

id 39

Conventional debt based modes of financing are usually not suited for start-ups. They seldom have tangible

assets to serve as collateral on loans. Further it may be inappropriate from a cash management perspective as

such debt may result in tying down the cash flows of the company. Further investment in equity of such type

of companies also may prove too costly considering essential characteristics such as cost due to adverse

selection and moral hazard, administration costs, information gathering and search efforts. See Leslie Jeng &

Philippe Wells, “The Determinants of Venture Capital Funding: Evidence Across Countries”, May 1998 40

See Paul Gompers, “Optimal Investment, Monitoring, and the Staging of Venture Capital”, Vol.50, No.5 (Dec.

1995), 1461-1489 41

Klaus Schmidt, “Convertible Securities and Venture Capital Finance”, The Journal of Finance, Vol. LVII, No.3,

June 2003, pp.1139-1165 42


No. 2 (Spring, 2001), 145-168, at pp. 155

14

The final stage, before the cycle is restarted, requires the venture capitalist to manage an exit

from these investments. Typically, the investor would seek to take the most successful firms

public, as this has the potential for the maximum returns. Other exit options include strategic

sales, or for less successful firms keeping them operational or liquidation. Contractual

arrangements have been developed which provides various flexible options of exit to the

venture capitalist43.

This paper focuses on the investment and monitoring stage of the cycle.

3.3 Why is Venture Capital relevant?

Numerous studies have shown that VC investing has positive economic impacts. In the 90s, a

part of the strong competitiveness and protracted growth of the US economy could be

attributed to the rapid pace of innovation induced by entrepreneurial firms44. Little doubt

today exists that a strong venture capital industry has been fundamental to America’s

leadership in the commercialization of technological innovation. Hellmann and Puri45 show

how firms pursuing an “innovator strategy” are much more likely to obtain VC funding and

that they are, pursuant to such funding, able to bring products to market significantly faster

than other companies. In another study it has further been suggested that venture funding has

a strong positive impact on innovation, to the extent that a dollar of venture capital is three to

four times more potent at stimulating patenting then conventional corporate research and

development.46

Venture capital not only helps in spurring job creation in an economy47, but it has also been

observed that this job creation is at a much faster rate than Fortune 500 companies.48 In 1998

the European Commission’s Communication “Risk Capital: A Key to Job Creation in the

European Union” states as its main message that ‘developing risk capital in the European

Union, leading towards the development of pan-European risk capital markets is essential for

major job creation in the EU’49

. Similar views have been echoed by numerous studies, and

this is one major reason policy makers the world over champion the cause of creating a

venture capital market.

As indicated, entrepreneurial growth companies have great difficulty obtaining external

financing due to various factors such as risky growth options and pervasive informational

asymmetry. Literature on entrepreneurship suggests that liquidity constraints are binding and

43

Paul Gompers & Josh Lerner, “The Venture Capital Cycle”, MIT Press, Cambridge, (2000) p.6 44

Laura Bottazzi & Marco Da Rin, “Venture Capital in Europe and the Financing of Innovative Companies”,

Economic Policy, v.34, 229-69, April 2002 45

Hellmann, Thomas and Manju Puri, “The Interaction Between Product Market and Financing Strategy: The

Role of Venture Capital,” Review of Financial Studies 13 (Winter 2000), pp. 959-984. 46

Samuel Kortum & Josh Lerner, “Assessing the Contribution of Venture Capital to Innovation”, The Rand

Journal of Economics, Vol. 31, No. 4. (Winter, 2000), pp. 674-692, at p.675 47

An NVCA study found that on average every $36,000 in VC investment creates one new job. See William L.

Megginson, Towards a Global Model of Venture Capital?, December 31, 2001 48


May 1998 49

Laura Bottazzi & Marco Da Rin, “Venture Capital in Europe and the Financing of Innovative Companies”,

Economic Policy, v.34, 229-69, April 2002

15

critical to entrepreneurs50, and thus may restrict growth in entrepreneurial activity. By

financing such companies venture capitalists fill a gap in the financial intermediation market,

which in itself adds value to an economy as these companies go on to generate sales, exports,

research spending, jobs and other factors which contribute to macro-economic growth. By

performing their role as active investors VCs create further value as they bring much more

than money to their portfolio companies, thus facilitating their development and growth.

3.4 The engineering problem

Since the mid-1980s there has been much interest in the transference of institution of venture

capital to other countries. Important proponents of this transfer were the International Finance

Corporation and various bilateral and multilateral development organizations including the

Asian Development Bank, the West German Deutsche Entwicklungs Gesellschaft (DEG),

and the British Commonwealth Fund among others (Kenney, n.d.) with mixed results. By the

90s the importance of venture capital, due to the reasons mentioned above, was

acknowledged and thus the idea received endorsement from institutions such as OECD and

World Bank. This was mainly attributable to the success of the US venture capital industry

and the visible spike in entrepreneurial high-technology firms. Thus policy makers have since

tried to encourage both developed and developing countries to try and create an indigenous

venture capital industry and consider strategies for encouraging the availability of venture

capital.

However, the venture capital industry as the institution we know today has emerged over a

period of time through a learning process, its development has been organic and to a large

extent idiosyncratic.51 The elements of this process of accretion includes a wide range of

mostly random factors such as the prohibition of non-compete covenants in the California

Civil Code; the creation of Stanford Industrial Park; and the clarification of the “prudent man

rule” in relation to the Employment Retirement Income Security Act52. Thus the development

of the U.S Venture capital industry has been without government design and extremely path

dependent which is not duplicable elsewhere.

So while the development path cannot be replicated in other countries the outcome of this

path can. However, other countries would necessarily require their governments to provide

the impetus and direction for the development of a venture capital industry. Thus we have

seen a proliferation of government programs and policies designed to form or nurture a

venture capital market, mostly with luke-warm results, early manifestations in Europe

included Germany in the 1970’s with the Deutsche Wagnisfinanzierungsgesellschaft.53

50


May 1998 51


Law Review, Vol. 55, April 2003 52


No. 2 (Spring, 2001), 145-168, at p. 148 53

For details please refer to Gilson, Ronald J., “Engineering a Venture Capital Market: Lessons from the

American Experience”, Stanford Law Review, Vol. 55, April 2003; and Leslie Jeng & Philippe Wells, “The

Determinants of Venture Capital Funding: Evidence Across Countries”, May 1998

16

Thus for any policy maker it is essential to determine what exactly is to be facilitated. Gilson

identified that the essence of the U.S. venture capital market is private the contracting

structure that has been developed to manage the extreme uncertainty, information asymmetry,

and agency costs that characterise start-up financing. Early stage financing has been made

feasible by the venture capital industry in the US as the contracting model manages these

barriers.

This contracting structure confronts a “simultaneity problem”, i.e. requiring the simultaneous

availability of three central inputs: capital, specialized financial intermediaries, and

entrepreneurs. In order to engineer a viable venture capital industry, it is upto the government

to confront this simultaneity problem. This could be achieved by providing seed capital and

helping to create the necessary financial intermediaries that together will encourage the

supply of entrepreneurs, while at the same time maintaining the pattern of intense incentives

coupled with intense monitoring that characterizes the contracting structure. The government

should not deal with the simultaneity problem by both providing capital and itself act as the

financial intermediary as the government cannot respond to the trio of contracting problems

inherent in early stage, high technology financing. A specialized financial intermediary is

necessary for which the government is not a substitute.54

Thus the core of the institution of venture capital is the complicated contracting structure

comprising of two fundamental contracts: that between the limited partners and the venture

capitalist; and that between venture capitalist and its portfolio company. It is also pointed out

how these contracts are “braided”, whereby they are intertwined so as one reflects the other.

Gilsen argues that inorder to engineer a venture capital market one has to facilitate the

complex contracting structure which can be executed only by a financial intermediary. This

could be extended to imply that if this contracting structure is transferred it would amount to

transference of the institution itself. Further, due to the fact that these two fundamental

contracts are so closely linked, a successful transference of one would imply is or could be

also transferred.

54


Law Review, Vol. 55, April 2003

17

4 Rationale of Venture Capital Contracting

Venture capital investment agreements are legal contracts that essentially allocate risk, return,

and ownership rights between the entrepreneur and the investing venture capital fund. This

distribution of rights depends on a number of factors including the capability of the

entrepreneur; the attractiveness of the portfolio company or the business plan; the stage of the

company’s development; negotiation skills of the parties55; and also the overall state of the

venture capital market56.

4.1 The Risk in “Risk Capital”

All kinds of financial contracts must deal with three fundamental problems, uncertainty,

information asymmetry and agency costs stemming from opportunism. Venture capital

contracting, due to its very nature, faces these problems in a magnified form.

Due to the fact that the company is generally in its early stage of development there is large

uncertainty as to the future performance. Uncertainty surrounds the quality of the

management, which is hard to evaluate upfront, as the success of the company may be

heavily dependent on them. There is also an element of scientific uncertainty with regards to

the technology or innovative aspects of the company57.

The venture capitalist and the entrepreneur are also likely to be placed at different levels of

information. The companies tend to operate in relatively new markets where information is

not readily available. The entrepreneurs may be aware of certain detrimental market

conditions but are incentivised to keep the project going as they receive personal benefits.58

The fate of the companies may be dependent on technologies of which the entrepreneur is in

a far more knowledgeable position than the investor.59 Further much of the company’s value

lies in its future potential, and little on present tangible factors.60 This presents a great level of

informational asymmetry to the detriment of the investor.

Agency costs also may arise from the fact that the entrepreneur may be incentivised to

engage in wasteful expenditure as he may benefit disproportionately since he does not bear

the cost of committing capital.61 He may invest in strategies which may have high personal

55

William L. Megginson, Towards a Global Model of Venture Capital?, December 31, 2001 56 Gompers, Paul and Josh Lerner, “Money Chasing Deals? The Impact of Fund Inflows on Private Equity

Valuations,” Journal of Financial Economics 55 (February 2000), pp. 281-325. 57


Law Review, Vol. 55, April 2003, at p.13 58


No. 2 (Spring, 2001), 145-168, at p. 155 59

Paul A. Gompers, Ownership and Control in Entrepreneurial Firms: An Examination of Convertible Securities

in Venture Capital Investments 3 (1998), at p.13, (unpublished manuscript, on file with the Harvard Law School

Library) http://www.people.hbs.edu/pgompers/Convert.PDF visited on June 10, 2010 60

Trester, Jeffrey J.: “Venture Capital Contracting Under Asymmetric Information.” Wharton School Working

Paper, Journal of Banking & Finance Volume 22, Issues 6-8, August 1998, Pages 675-699 61


No. 2 (Spring, 2001), 145-168, at p. 154

18

returns but low pay-offs to the investors. Further they may have the incentive to pursue high

risk strategies as they may benefit from success, but suffer little or no loss due to failures.62

4.2 Obligations of the Venture Capitalist

It must be kept in mind that the venture capitalist is also subject to strict obligations to their

limited partners under the terms of the partnership agreement of the fund, which itself is

designed to control similar problems of agency and informational asymmetry.63 The venture

capitalist must create value on its investment as a large part of their income is based on the

profits of the funds. The limited term of the fund and requirements of distribution of returns

make it necessary for the VC to be able to achieve liquidity on their investments within a

specified time-frame, to be able to pay out to their limited partners. Failure to provide timely

returns to their limited partners lead to serious contractual consequences under the

partnership agreement.64 Further the ability to harvest investments reflects the performance of

the venture capitalists and has reputational implications on their ability to raise additional

capital for a new fund, thus affecting their very business.65

Thus one of the main aims of the venture capitalist when investing, is to eventually convert

their illiquid holdings, the investment in the start-up (having no viable market at the time),

into cash or other liquid form and, hopefully, with a sizable return66. For this reason it is

widely recognized that a venture capitalists decision to invest in an entrepreneurial firm is

based on exit potential.67 Although they are not short-term investors, venture capitalists are

not in the business of making long-term or strategic investments, and require liquidity within

term of their funds.

4.3 Designing a Contract

Thus the challenge of venture capital contracting is managing the inherent problems in light

of the eventual goal. Financial contracting theory identifies two kinds of rights in such

contracts, cash flow and control rights.68 The venture capital financing contracts are designed

in such a manner so as to enable the venture capitalists to separately allocate cash flow

rights69 and various control rights. The allocation is made in such a manner that if the

62

Paul Gompers, “Optimal Investment, Monitoring, and the Staging of Venture Capital”, Journal of Finance,

Vol. 50, No. 5 (Dec., 1995), 1461-1489, at p. 1465 63

Paul Gompers & Josh Lerner, The Venture Capital Cycle, (2000) MIT Press, Cambridge, see pp.29-42 64


Economics 27 (1990), pp. 473-521, at pp. 489-493 65


Law Review, Vol. 55, April 2003, at p.10 66

Many venture capitalists demand a compound annual return of 50 percent or more on early-stage

investments, but are satisfied with half that on later-stage deals, William L. Megginson, Towards a Global

Model of Venture Capital?, December 31, 2001 67

Douglas J. Cumming, “Contracts and Exits in Venture Capital Finance”, LEFIC Working Paper 2002-14,

October 2002 68

id 69

Means the fraction of a portfolio company’s equity value that different investors and management have a

19

company does badly, the venture capitalists obtain full control, but as performance improves,

the entrepreneur obtains more control rights. If the company is a success, the venture

capitalists only retain their cash flow rights, but relinquish most of their control rights.70

These cash flow incentives and control rights are used in a complementary manner to obtain

optimum results.71 Thus venture capitalists have developed various tools to help optimise

their financing arrangements. The following sections will discuss some of the main and most

common components of venture capital contract design.

4.4 Control Mechanisms

Venture capitalists have developed a structure for their investments which enables them to

keep control of the firm. There are three control mechanisms72 which are common to nearly

all venture capital financing arrangements:

4.5 Staged Financing

Staging the infusion of capital is considered the most important mechanism for controlling

the firm.73 Venture capitalists seldom invest the total required amount at once. They tend to

invest at distinct stages of development of the company and only enough to fund the

company until its next development stage.74 Further they demand a very high required return

on the initial investment “tranche”. On achieving the required targets, the funding for the

next stage is provided at more attractive terms as the risk has been reduced.75 Staged

financing enables the venture capitalists to preserve the right to deny or delay additional

funding when they obtain negative information about the potential of future returns. This has

a signalling effect to other capital suppliers that the company in question is an investment

risk.76 Thus while minimizing risk for the venture capitalist; it transfers much of the financial

risk onto the entrepreneur. It thus keeps the entrepreneur on a “tight leash” and reduces the

claim to. see Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An

Empirical Analysis of Venture Capital Contracts,” Working Paper 7660, National Bureau Of Economic Research

(April 2000); http://www.nber.org/papers/w7660, at p. 14;

Venture capitalists’ cash flow rights are different from those of other participants in the startups they typically

receive convertible preferred stock with preferences that are triggered in a liquidity event. See Power and

Payouts in the Sale of Startups, Brian Broughman and Jesse Fried, U.C. Berkeley, Last Revised: June, 2006 70

Ronald J. Gilson & Bernard Black, “Does Venture Capital Require an Active Stock Market?” (May 1999) as

published in Journal of Applied Corporate Finance, pp. 36-48, Winter 1999. Available at:

http://papers.ssrn.com/paper.taf?abstract_id=219174 Last visited on June 10,2010 at p. 15 71

Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical

Analysis of Venture Capital Contracts,” Working Paper 7660, National Bureau Of Economic Research (April

2000); http://www.nber.org/papers/w7660, at p. 6; 72


Vol. 50, No. 5 (Dec., 1995), 1461-1489, at p. 1461 73







Law Review, Vol. 55, April 2003, at p.17

20

possibility of losses due to bad decisions77. Staged financing incentivizes the entrepreneur to

create value thus aligning their interests with the investors. It also encourages managers to

conserve capital through sanctions of its misuse78.

4.6 Syndication

Syndication essentially refers to the practice by which one venture capital firm brings in

another to co-invest in a particular deal. This enables a venture capital firm to spread its

corpus of funds across more portfolio companies facilitating diversification from firm

specific risk. Syndication also provides the benefit of a “second opinion” which reduces the

possibility of a bad deal to be funded.79 Studies have shown that syndication tends to take

place amongst firms of similar standing and experience indicating that it is not undertaken

purely for funds but also the opinion of another firm with similar abilities and resources.80

4.7 Use of Convertible Securities

The ubiquity81 of the use of convertible preferred stock in the U.S. Venture capital industry is

a distinct and well established feature. Various studies82 have shown that this security is

almost the exclusive means of financing portfolio companies. Further a number of reasons

have been identified for the predominance of this form of security.

The formal attributes of convertible preferred stock is one reason. It provides preferences

over common stock in the payment of dividends, a priority in liquidation, while at the same

time enabling them to exercise rights different from common stockholders83. It thus makes

the venture capitalists claim senior to that of the entrepreneur or other existing owners, and

allocates stronger control rights, providing some degree of protection for the investor. It also

preserves the borrowing capacity of the company, as preferred is still a junior claim to debt84.

The liquidation preferences are of particular importance. In the event of a liquidation event,

which apart from dissolution usually includes a sale of the company, venture capitalists are

entitled to be paid the full amount of liquidation preferences, before common shareholders

receive anything. The liquidation preference acts as a repayment of principal on a loan, and

77


Vol. 50, No. 5 (Dec., 1995), 1461-1489, at p. 1462 78




No. 2 (Spring, 2001), 145-168, at pp. 156 80

Josh Lerner, “The Syndication of Venture Capital Investments”, Financial Management, 23, pp.16-27 81

Ronald J. Gilson & David M. Schizer, “Understanding Venture Capital Structure: A Tax Explanation for

Convertible Preferred Stock“, 116 Harv. L. Rev. 874 (January, 2003), at p. 878 82

See Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical


2000); http://www.nber.org/papers/w7660. 83



William L. Megginson, Towards a Global Model of Venture Capital?, December 31, 2001

21

thus is usually equal to the amount invested85, but could be a multiple thereof.86 However, the

validity of this line of reasoning has been questioned as start-ups are rarely in a position to

pay any dividends to their investors especially in the early stages.87 Liquidation preferences

may also be insignificant, in the event of winding-up, as portfolio companies are typically

human capital-intensive activities with few hard assets. Thus, upon liquidation the investor

cannot expect much of a payment from the assets, if any, that remain after creditors stake

their claim.88

The conversion right allows the venture capital investor to share in any upside resulting from

managerial risk-taking thus curbing a manager's incentive to increase risk by “cutting

corners”.89 The holder has the option of converting the preferred stock into common at a

specified ratio. If all classes of preferred stock are converted into common, the liquidation

preferences are eliminated and the cash flow rights become identical to the common

shareholders. The venture capitalist will convert into common stock only if the company is

sold for a sufficiently high price. Further the agreement will often require the VCs to convert

to common if the firm undergoes a qualified IPO.90

Convertible preferred stock also facilitates the separation of control and cash flow rights. This

enables venture capitalists to monitor the firm without compromising management incentives

by reducing managers' share of profits.91 If the venture capitalists invested in common stock

he would only be able to exercise effective voting control if a majority was purchased.92 The

result would place far more of the firm’s business risk on the venture group than on the

entrepreneur as a minority shareholder.

85



2000); http://www.nber.org/papers/w7660 at p.18 86

a “1x” preference or “2x” preference, see Power and Payouts in the Sale of Startups, Brian Broughman and

Jesse Fried, U.C. Berkeley, Last Revised: June, 2006 87

To be meaningful, the dividend preference must be cumulative, so that preferred dividends will accrue even

if not currently paid and combined with a requirement for the company to pay accumulated preferred

dividends before common stockholders receive any liquidity on their investment. see Ronald J. Gilson & David

M. Schizer, “Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock“, 116

Harv. L. Rev. 874 (January, 2003), at p. 880 88

A merger or sale also typically counts as a liquidation that triggers the liquidation preference where the

venture capitalists have a prior claim on acquisition proceeds and the preference is significant here. An

extension of this is the "participating" preferred securities, a type of convertible preferred stock that enables

venture investors to share in the proceeds of "liquidation" along with the common shareholders if the

proceeds exceed the amount of the preference. see Ronald J. Gilson & David M. Schizer, “Understanding

Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock“, 116 Harv. L. Rev. 874 (January,

2003), at p. 881 89

Paul A. Gompers, “Ownership and Control in Entrepreneurial Firms: An Examination of Convertible Securities

in Venture Capital Investments” 3 (1998) (unpublished manuscript, on file with the Harvard Law School Library)

http://www.people.hbs.edu/pgompers/Convert.PDF visited on June 10, 2010 90

Power and Payouts in the Sale of Startups, Brian Broughman and Jesse Fried, U.C. Berkeley, Last Revised:

June, 2006, at p.4 91



William L. Megginson, Towards a Global Model of Venture Capital?, December 31, 2001

22

Convertible preferred has certain signalling effects. Due to the liquidation preference element

in the security, in the event that the total value of the company is low the investor will receive

a large portion leaving little to other owners. It thus shifts the cost of poor performance on the

management. This enables the venture capitalists to make evaluations as it signals the

entrepreneur’s confidence of the prospects.93

Thus the preferred stock reduces the information asymmetry problem as the entrepreneur

credibly signals that the company is worth more than the liquidation preferences. It also

provides managers with desirable incentive effects by providing a payout only if the company

does very well.94

Another important determinant of the use of convertible security is tax considerations. By

issuing preferred stock to the investors, two classes of securities is created one having

superior rights as compared to the other. This seniority right of the preferred lowers the

economic value of the common enabling the management to buy or retain the common stock

at low prices without incurring taxable income. If the investor has the same security and

rights as the common stockholder then these managers would liable to a tax on income on the

difference between the (usually low) price they paid and the (relatively high) price paid by

the venture capitalists.95 Thus, by allotting a superior stock to venture capitalists it validates

its higher price, and companies lower the tax burden on management's incentive

compensation.96

4.8 Other forms of Control

Other than the tools mentioned above, venture capitalists obtain substantial control rights

against the founder and other shareholders through contractual provisions, board seats, and

shareholder voting rights.97

4.8.1 Board representation and management

Venture capitalists typically sit on the boards of their portfolio companies, often acquiring a

majority of the seats. Board control gives them the ability to initiate fundamental transactions

such as mergers, IPOs, and liquidations.98 It further gives them the power to replace the

93




June, 2006, at p. 5 95






June, 2006, at p.4 98


June, 2006, at p.6

23

management or the entrepreneur with professionals if they are of the opinion that

performance is poor.99

This also enables them to manage and oversee the daily operations of the business. As it is

not possible to anticipate every conflict or event that may arise in the contract, the venture

capitalist chooses to play a role in ‘nursing’ the company rather than just financing them.

Venture capitalists may also add value by providing various services such as forming

strategy, providing technical and commercial advice and attracting key personnel.100 The

mere presence of venture capital in a company brings instant credibility to the firm and

provides easier access to capital and contacts for other resources.101 Further the venture

capitalist also performs a “certification” function when the company goes public, lowering its

costs and maximizing its net proceeds.102 Through their active involvement the venture

capitalist seeks to increase the likelihood of success and improve return on investment.

4.8.2 Covenants

Venture capital investment contracts make extensive use of positive and negative covenants

which are often characterized by their degree of sophistication.103 These contractual clauses

mandate the portfolio firm to do or abstain from doing certain things. The use of covenants is

related to the costs of potential conflicts and agency costs. Thus the riskier a project, like

early stage technology dependant ones, the amount and degree of restrictiveness of the

covenants increase.104

Chief amongst these are those related to liquidation as the venture capitalists are mainly

concerned about converting their holdings into cash. The venture capitalist must rely on a

sale or dissolution of the company to trigger their payouts. Thus the investor’s ability to

liquidate assets if the firm defaults, is the main way to ensure repayment, but there is a

possibility that the management may disagree on the timing or the method.105 Control rights

help the investor obtain a liquidity event within the investment time frame dictated by their

fund obligations, despite the objection of other shareholders who may rather see status quo

being maintained as it would be to their benefit.106 Thus the agreement has a number of

99


No. 2 (Spring, 2001), 145-168, at p. 156 100

Thomas Hellmann, “The Allocation of Control Rights in Venture Capital Contracts”, The RAND Journal of

Economics, Vol.29, No.1 (Spring, 1998), 57-76, at p.57 101



William L. Megginson & Kathleen A. Weiss, “Venture Capitalist Certification in Initial Public Offerings”, The

Journal of Finance, Vol. 46, No.3, (July 1991), 879-903, at p.879 103


Paul A. Gompers, “Ownership and Control in Entrepreneurial Firms: An Examination of Convertible

Securities in Venture Capital Investments” 3 (1998) (unpublished manuscript, on file with the Harvard Law

School Library) http://www.people.hbs.edu/pgompers/Convert.PDF visited on June 10, 2010, at p. 5 105




June, 2006, at p.6

24

features that control the process by which the liquidation can be achieved, the primary one

being the use of convertible preferred securities, as discussed above.

Demand, participation in transfers, and redemption rights preserve exit opportunities and

avenues to attain liquidity for venture capital investors. Demand registration rights enable

them to force the firm to initiate procedures for a public offering.107 Further, through

participation rights, venture capitalists ensure that exit avenues through transfer of shares are

always open to them, even if such sales are arranged by other stakeholders.

The venture capitalists often have the right to force redemption of their stock or the right to

put the stock to the company inorder to achieve liquidity. These give the investor the right to

demand that the firm redeems their claim, usually at liquidation value, after a certain time

period merely by putting their securities back to the company. This strengthens their ability to

attain liquidity as it does not require them to wait for arduous winding-up procedures to

receive their claim.108 This right may be exercised if there is no other exit alternative

available, such as sale or IPO, but the company is still financially viable and able to pay.

The financing contracts also typically contain protective provisions which provide the

venture capitalists with specific veto rights or affirmative voting rights. These provisions

require that for certain transactions or actions by the company or its managers would require

the specific approval of the venture capitalist. These are actions which would affect the

investment or any interests of the investor, such as the sale of the company’s key assets.109

4.8.3 Compensation

Compensation schemes are designed that align the interest of entrepreneurs with that of the

investor. Entrepreneurs are typically offered smaller cash salaries, which is offset by stock

ownership in the venture. The common stock or stock options do not pay off unless the value

of the company is built leading to an opportunity to convert illiquid holdings to cash.110

Usually sanctions are also incorporated. If the employee is terminated, perhaps for poor

performance, all unvested shares or options are returned to the company and, usually, the

company retains the right to repurchase shares from the employee at predetermined prices.

The sanctions help to mitigate the entrepreneur’s incentive to increase risk.111

107




2000); http://www.nber.org/papers/w7660. at p.14 109


June, 2006, at p.6; also see Annexure Table 2, for typical liquidation events in Indian VC financing contracts 110


Law Review, Vol. 55, April 2003 at p.22 111


Economics 27 (1990), pp. 473-521, at pp. 508

25

4.8.4 Contingencies

Further it has been noted that investors often design contracts such that, cash flow rights,

voting rights, control rights, and future financings are contingent on observable measures of

financial and non-financial performance in the future. These contingencies are related to the

performance measure that is most important to the investors and the company.112

112



2000); http://www.nber.org/papers/w7660. at pp.6-7

26

5 The Venture Capital Investor and Portfolio Company Contract

In this section we examine the fundamental document governing the relationship between the

venture capitalist and the company, the stock-purchase agreement.113 It has been observed

that the contracts between the venture capitalists and companies, in the US Venture capital

industry, are similar in many ways. Numerous studies have described these regularities that

have been observed in almost all real funding agreements. Sahlman (1990) and Kaplan &

Strömberg (2000) conducted perhaps the most extensive of these studies. In the paragraphs to

follow we will outline these “standard” clauses as established in Sahlman, Kaplan &

Strömberg and other studies on venture capital investment contracts in the US.

Further, we present the findings of our sample-set of Indian venture capital financing

agreements in light of these standard practices of US venture capital contracting so as to

make apparent the similarities or differences. This is done with the aim of determining

whether the basic contracting model between venture capitalists and their portfolio company

in India is a direct transference of the US venture capital model, or if there are significant

variations to say it is hybridized or completely different. Discussions and analysis is reserved

for later on in this section.

5.1 Ownership and Voting Rights

Studies show that although substantial equity ownership on the part of the entrepreneurs is

desirable, a large part of the ownership is provided to the venture capital investor. Further

venture capitalists almost always have a voting majority, particularly in early stage financing.

It has also been noted that voting control switches between parties depending on various pre-

determined contingencies.114

The Indian VCs tend to take a large stake in the company while leaving a majority to the

entrepreneur. The average VC stake in the sample is around 32.32%, with a majority of them

being in the mid to high 30% range. Only 2 agreements in the sample provided a majority to

the VC.

All financings provide that the venture capitalist exercises his votes on a fully converted basis

thus the votes exercised are in proportion to their stakes in the company. Thus we did not

note any tendency for the VCs to have a voting majority in the companies. However it was

noted that the stakes of the VCs in early stage companies was substantially higher than the

stakes taken in late stage financings.

A majority of the financings in the sample provided for an increase in the stake and voting

control of the VC in the event that certain milestones or performance targets were not

achieved.

113

Different terms are used for the same document such as “Share Purchase and Investor Rights Agreement”,

“Share Subscription and Shareholders Agreement” etc., here we use the term “stock purchase agreement” to

refer to the legal contract between the investor and the company to purchase shares and govern the

relationship between the parties. 114



2000); http://www.nber.org/papers/w7660. at p.15

27

5.2 Staging

The investments, under US contracts, are typically staged, i.e., they invest more than once

during the life of a company. The investment amounts are expected to be adequate to take the

company to the next stage of development, when more capital will be required for further

development115. Further the investment amount often increases with each round.116

In the sample, about 67% of the investments were staged. The agreements typically set the

parameters of the development to be achieved by the company upon which further financing

would be provided. A number of financings which were not staged were noted to be of

smaller investment amounts. However the financings which were staged, it was noted that the

second tranche funding amounts were typically of the same or smaller investment amounts,

and primarily on similar terms. The time period between each funding stage was usually one

year or less.

5.3 Securities

As discussed in the previous section convertible preferred stock is by far the most common

form of security used.117 A number of financings also provide for cumulative preferred

dividend rights.118 A variant of convertible preferred called participating preferred is also

seen to be prevalent.119

In the Indian financing arrangements 25 out of 30 contracts in the sample used some form of

convertible preferred shares. Except only seven, all the 25 provided the investor with, a

mostly nominal amount, of equity shares also. Out of the remaining three contracts used

convertible debentures as the security, the rest using common equity shares.

A majority of the convertible preferred securities provide for pro rata participation in the

remainder after liquidation, and also provided the investor the rights to cumulative dividends.

Further, 16 of them were compulsorily convertible after a specified time period.

115




Vol. 50, No. 5 (Dec., 1995), 1461-1489, at p. 1485 117






Id.

28

5.4 Liquidation Rights

Upon liquidation the venture capitalist’s claim is almost always senior to the common stock

claims of the founders and other shareholders. Further the claims of the investor are typically

at least as large as the original investments.120

In the sample all but one contract provides the investor with a preferential claim in

liquidation to the common shareholders. The amount of the claim in all these financing

arrangements was at least equal to the investment amount. A majority of these liquidation

claims were for more than the investment amount, adjusted upward by means of a required

return multiple or on the basis of accumulated dividends. It is further noted that definitions

for a liquidation event typically include, change in control, a merger or reorganization in

addition to winding up.

5.5 Conversion Rights

In the US, venture capital contracts typically provide for automatic conversion of securities.

The contract explicitly provides the events that trigger conversion. Initial public offerings,

meeting specified qualifications, almost always trigger a conversion121. Automatic conversion

is also provided for upon reaching other milestones. These include income, sales or other

targets which tend to measure the performance and success of the company. It also sets the

conversion price, usually to the purchase price of the convertible security so as to ensure a

one for one conversion.122

A large majority of the Indian financing contracts provide for automatic conversion. As most

of the instruments are compulsorily convertible they prescribe a term after which it has to be

converted. The triggering event for most of these financings providing automatic conversion

is an IPO, a small number also includes a strategic sale or some specific milestone. The

conversion price is almost always adjustable, to the benefit of the investor, by computing the

conversion ratio based on various factors including achieving revenue projections, post-

money valuations, or to maintain a pre-determined stake.

5.6 Anti-Dilution Protection

In the US, contracts typically include anti-dilution protections to the venture capitalist against

future financing rounds at lower valuations than the current round, it also ensures that the

120




As no investment bank would be willing to underwrite an equity offering if venture investors maintained a

higher priority claim. See Ronald J. Gilson & Bernard Black, “Does Venture Capital Require an Active Stock

Market?” (May 1999) as published in Journal of Applied Corporate Finance, pp. 36-48, Winter 1999. Available

at: http://papers.ssrn.com/paper.taf?abstract_id=219174 Last visited on June 10,2010 at p. 15 122



School Library) http://www.people.hbs.edu/pgompers/Convert.PDF visited on June 10, 2010, at p. 9

29

entrepreneur does not try to take undue advantage by performing stock splits or issuing

special dividends.123

All but 4 contracts in our sample provided for some mechanism of anti-dilution protection. A

majority of these were on a “Full-Ratchet” basis. The second most popular form was the

“Broad Based Weighted Average” basis. Many of these also provided for adjustment for

bonus issues, stock splits, dividends, etc.

5.7 Redemption, puts, buy-backs and calls

VC Agreements in the US typically give the venture capitalists the right to put the security to

the company for redemption in order to strengthen their liquidation rights. Under these

provisions after a certain period of time the investor has the right to require the firm to

redeem its claim, typically at liquidation value.124 Sometimes, the company retains the right

to call the security from the venture capitalists on certain conditions for a predetermined

price125.

In the Indian contracts, 83.3% provided the investor the right to demand the company to buy-

back their securities. While most of these provided that redemption could be exercised after a

certain period of time, some contracts provided redemption/buy back as a remedy for breach.

Most contracts provided that the redemption price would be the same as the liquidation

preference amount, however some, especially where redemption was a cure for breach,

provided for a repayment of a larger amount. Only two of the contracts gave the company the

option of calling the security.

5.8 Board structure

Most VC agreements provide for venture capitalist representation on the company’s board.

They are less likely to have board control than they are to have voting control. Board control

tends to increase with subsequent funding rounds.126 Often, the agreement calls for other

mutually acceptable people to be elected to the board.127

In our sample, only three financings did not provide the investor with board representation.

Among the others only one agreement provided the investor with a majority of seats on the

123



School Library) http://www.people.hbs.edu/pgompers/Convert.PDF visited on June 10, 2010, at p. 9 124








2000); http://www.nber.org/papers/w7660. at pp.16,17. 127


Economics 27 (1990), pp. 473-521, at pp. 506

30

board. Two provided for exactly 50% of the board seats. Typically the number of board seats

is reflective of their stake in the company.

5.9 Pre-emptive rights and Transfer related rights

Generally the venture capitalists retain rights to sell shares after conversion at the same time

and on the same terms as the entrepreneurs or other main shareholders. They are also entitled

to participate in new financings by buying the newly issued shares in proportion to their

holdings on a converted basis prior to the new issuance128.

Apart from 3 instances all the contracts in our sample provide the investor with pre-emptive

rights. Almost all the agreements provide the investor with a tag-along right whereby the

Investor has the option to sell or transfer its shares with the selling shareholder to a third

party on the same terms and conditions. About 75% were also provided with a Right of First

Refusal requiring the other shareholders offer any shares to the investor before trying to sell

them. A large number also gives the investor a Drag-along right whereby they can require the

other shareholders to sell shares along with the investor if he so requires in order to facilitate

an exit through a third party sale.

5.10 Affirmative voting rights

The financing contracts typically contain protective provisions which provide the venture

capitalists with specific veto rights or affirmative voting rights.129

Almost all contracts in the sample provide the investor with an affirmative voting right on

numerous issues affecting them. The most common manner of incorporating this provision is

by requiring the presence and vote of the investor or his representative inorder to put forth

and pass any resolution or take any action on a matter affecting the investor. All agreements

providing for such a right also list out specifically the issues which would require such an

affirmative vote, both at a board and shareholder level.

5.11 Option carve-out & Employment contracts

US contracts commonly fix the number of shares outstanding and the size of the pool of

shares that would be granted to employees and provide for making amendments. Further most

agreements require key employees to execute employment contracts and abide by non-

compete provisions.130

A large number of contracts in the sample (particularly companies in information technology

related business) provided for a carve-out of the option pool. Other than specific provisions in

this regard, the carve-out was often accounted for in arriving at the relavant capital structure,

128

Id 129


June, 2006, at p.6; also see Annexure Table 2, for typical liquidation events in Indian VC financing contracts 130

Id

31

and other calculations related to the shares of the company. The agreements also typically

provide that any option scheme would be made only with the approval of the investor.

Further a majority of agreements provided that the promoter and the key management team

would execute employment agreement as approved by the investor. The clauses also provide

the key terms of these employment agreements which include non-compete clauses,

minimum term, assignment of intellectual property, etc. Further many of the agreements

themselves included non-compete provisions.

5.12 Information rights

Most agreements require regular transmission of information, including financial statements

and budgets, and permit the venture capitalists to inspect the company’s financial accounts at

will.131

In the Indian contracts all but three provided the investor with detailed information rights

namely to do with accounts and financial statements of the company. Further investors

typically have a say in the appointment of the auditors of the company, often requiring them

to appoint auditors known to the VC.

131

Id

32

6 Discussion and Analysis of Empirical Study

The Indian VC financings in the sample are similar in many ways to their US counterparts.

There are some differences and variations, but what is apparent is that the Indian VC

contracts predominantly use the same tools and contracting mechanisms to contend with the

problems inherent in venture financing.

By taking up a large stake, well short of the majority, we see that Indian VCs approach is

consistent with the existing theories on the use of cash flow rights to incentivise the

entrepreneur inorder to alleviate agency costs132. One point of difference from the US

contracting is that Indian VCs seldom have a majority of the voting power, even in early

stage companies. This is primarily due to the provisions of the Indian Companies Act

whereby a shareholder’s voting right can only be in proportion to his share of the paid-up

equity capital of the company.133 Further the conditions pursuant to which a company can

issue equity shares with differential voting rights are unlikely to be fulfilled by start-ups.134

However, a large stake combined with the other contractual clauses is sufficient for the VC to

exercise considerable control.

The use of staging in Indian VC contracts is consistent with existing theories based on US

practices.135 The companies, being mostly early stage, received relatively small investment

amounts for a short duration thus facilitating monitoring by the VC. Although it must be

noted that the terms of investment were not made more attractive upon achieving the required

targets136, but this could be attributed to the fact that, due to the short time period, they

remained within the broad early stage which remains risky for an investor.

The overwhelming use of convertible securities is testament to the adoption of US tools.

Particularly in relation to the use of cumulative participating preferred shares, which is a

unique innovation of the US VC industry. This essentially provides that the preferred

dividends will accrue even if not currently paid, and enables the investors, upon liquidation,

to first receive their principal preference amount137, and thereafter participate in the

remaining proceeds along with the common shareholders on a pro rata basis. This helps

strengthen a liquidation preference.138

The use of a nominal amount of equity shares in combination with the preferred is mainly to

enable investor to be represented at meetings of all classes, as a preference holder can vote

132

William A. Sahlman, “The Structure and Governance of Venture Capital Organizations”, Journal of Financial

Economics, 27 (1990). 133

Section 87(1)(b); This also explains why Indian VCs retain the right to vote on an “as if converted” basis 134

One such condition is distributable profits for last 3 years; see The Companies (Issue of Share Capital with

Differential Voting Rights) Rules, 2001 135

Paul Gompers & Josh Lerner, “The Venture Capital Cycle”, MIT Press, Cambridge, (2000) 136

See supra n.87 p.506 137

Usually equal to the amount invested or a multiple thereof. 138

Supra n.68 at pp.883-884

33

only on resolutions which directly affect their rights139. However, it must be noted that

venture financing in the US sometimes use securities in combination with convertible

preferred stock.140

The predominance of a preferential claim in liquidation is a corollary of the choice of

security, however the particularly onerous computations of the liquidation preference

amounts are of particular note. By often seeking “2x” or 30% IRR multiple, the Indian VCs

exhibit their high expectations and strong bargaining power, alternatively perhaps pointing to

the lack of sophistication of the entrepreneurs.

This trend is also apparent in the buy-back/redemption rights141 in the sample. Most of them

are in the form of a “Put Option” of the investor, giving them the benefit of a guaranteed exit,

if all else fails. However it is noted that many of them are for at least, if not higher than, the

liquidation amount. Only a negligible number of contracts gave the entrepreneur the right to

“Call” the securities. Pointing again to the stronger position of the VC in many of these

arrangements.

A similar trend is noted in the use of the full ratchet as the main tool of anti-dilution

protection. It is the most onerous of all options as it reduces the price of the protected issue to

that of the new “down” round diluting the entrepreneur’s stake. In a weighted average ratchet,

and its variations142, the adjustment of the conversion price is based on the number of shares

issued and the conversion price of the new issue, muting the effect of dilution on the

entrepreneur. 143 Still another example is the use of the drag along right in various

agreements, which, although used, is not considered a regular clause in the studies on US VC

contracts as compared to pre-emptive, tag or ROFR rights.

Automatic conversion provides that the security held by the venture capitalists automatically

convert into common equity under certain conditions. This conversion to common equity

represents a call option on control for the entrepreneur as it eliminates the restrictive

covenants and control rights of the VC.144 Thus it would be beneficial for an entrepreneur to

have various triggers for this conversion. However we see that most financings only provide

139

See Sections 87(2) & 106 Indian Companies Act 140




There exists some ambiguity on issuing Redeemable preference shares to foreign investors preventing exit

through redemption, as they may be classified as debt under foreign exchange regulations, see Press Note

dated 30 April 2007 in supersession of the earlier Press Note dated 31 July 1997;and, RBI Circular, dated June8

2007, A.P. (DIR Series) Circular No.73

A buyback of shares is subject to numerous restrictions including that it may only use certain types of it funds

to effect the buy back, and may buy back only 25% of its securities in any financial year; see Section 77A, read

with Private Limited Company and Unlisted Public Limited Company (Buy-back of Securities) Rules, 1999 142

“Broad-based weighted average ratchet” or “narrow based weighted average ratchet” 143




See Ronald J. Gilson & Bernard Black, “Does Venture Capital Require an Active Stock Market?” (May 1999)

as published in Journal of Applied Corporate Finance, pp. 36-48, Winter 1999. Available at:

http://papers.ssrn.com/paper.taf?abstract_id=219174 Last visited on June 10,2010 at p. 15

34

IPO as a conversion trigger, reducing the entrepreneur’s options to regain control. Although

many of the agreements provide for compulsory conversion after a fixed term, due to

requirements of foreign exchange regulations145, this does not represent a valid option to the

entrepreneur as the terms are extremely long.

The conversion ratios in the Indian VC contracts were often adjustable based on performance

and how they match the projections in the business plan. This is also a well established

method of dealing with agency issues:

“...projections are critical to valuing the company and pricing the venture capital fund’s

investment. This reduces information asymmetry by its impact on the credibility of the

projections contained in the entrepreneur’s business plan. Yet, the entrepreneur

obviously has better information concerning the accuracy of the business plan’s

projections ....... the entrepreneur has an obvious incentive to overstate the project's

prospects. By accepting a contractual structure that imposes significant penalties if the

entrepreneur fails to meets specified milestones based on the business plan’s projections

..... the entrepreneur makes those projections credible.”146

Similarly various rights and benefits are made contingent on performance by the company, in

accordance with studies on the US VC industry where it has been found that state

contingencies are common in early stage financings.147

The Indian VCs ensure that they have a representation on the board but do not require a

majority as they have the protection of extensive affirmative voting rights. This is

strengthened by provisions related to quorum whereby inorder to constitute the quorum for

all meetings the presence of the investor’s nominee is required.

It is noted, in stark contrast to the use of other tools, that the VC investments in the sample

were rarely syndicated. This perhaps can be explained by the fact that the deal sizes are

relatively small compared to the average US VC investment. However, this line of reasoning

would question the “second opinion” explanation148 provided for syndicated deals, making

financial considerations chief in the minds of VCs when syndicating their investments.

It must be clarified that all the contracts in the sample also contained numerous other clauses,

including detailed provisions regarding exit and their procedures. However these are not

presented as it would be beyond the scope of this paper.

In summation it is firstly noted that the typical Indian VC contract provide for terms which

may seem to place onerous burdens on the entrepreneur and being weighted heavily in favour

of the investor. However, as it has been emphasised throughout, due to the very nature of

venture capital financing the contract must deal with extreme forms of uncertainty,

informational asymmetry and agency costs. These problems may be further magnified in the

145

see Press Note dated 30 April 2007 in supersession of the earlier Press Note dated 31 July 1997;and, RBI

Circular, dated June8 2007, A.P. (DIR Series) Circular No.73 146

Gilsen engineering at p.18 147


Analysis of Venture Capital Contracts”, National Bureau of Economic Research, Working Paper 7660 (April

2000). Available at: http://www.nber.org/papers/w7660, visited on June 10, 2010 at p. 6 148

Paul Gompers & Josh Lerner, “The Venture Capital Cycle”, MIT Press, Cambridge, (2000)at p. 186

35

context of an emerging economy like India where markets and industries are still developing.

Also aspects like the regulatory environment and corporate governance standards being

relatively lower than more mature economies. Further cultural aspects like a tendency

towards closely held, family controlled companies may also contribute to some extent. Thus

the venture capital contract in India uses the strongest available tools to deal with these issues

of uncertainty and agency.

Of greater interest is the observation that the tools and mechanisms used in Indian venture

capital contracting to combat these issues in this different environment are those that have

developed in the US over a period of time through an organic learning process. Although

certain variations exist, the contracting model of Indian venture capital financing cannot be

said to be hybridized. Due to the fundamental similarities in the contracting models it could

be considered as more of a direct transference.

36

7 Conclusion

The core of the institution of venture capital is the complicated contracting structure

comprising of two fundamental contracts: that between the limited partners and the venture

capitalist; and that between venture capitalist and its portfolio company. Thus if this

contracting structure is transferred it would amount to transference of the institution itself.

Further, due to the fact that these two fundamental contracts are inter linked, a successful

transference of one would imply the other is or could be also transferred.

Venture capital investment agreements are legal contracts that essentially allocate risk, return,

and ownership rights between the entrepreneur and the investing venture capital fund.

Venture capital contracting, due to its very nature, faces the problems of uncertainty,

information asymmetry and agency costs in a magnified form. The venture capitalist is also

subject to strict obligations to their limited partners under the terms of the partnership

agreement of the fund, which itself is designed to control similar problems of agency and

informational asymmetry. Thus the challenge of venture capital contracting is managing the

inherent problems in light of the eventual goal. Thus venture capitalists have developed

various tools to help optimise their financing arrangements. The following sections will

discuss some of the main and most common components of venture capital contract design.

Through our examination of contracts we noted that typical Indian VC contract provide for

terms which may seem to place onerous burdens on the entrepreneur and being weighted

heavily in favour of the investor. However, as it has been emphasised throughout, due to the

very nature of venture capital financing the contract must deal with extreme forms of

uncertainty, informational asymmetry and agency costs. These problems may be further

magnified in the context of an emerging economy like India where markets and industries are

still developing. Also aspects like the regulatory environment and corporate governance

standards being relatively lower than more mature economies. Further cultural aspects like a

tendency towards closely held, family controlled companies may also contribute to some

extent. Thus the venture capital contract in India uses the strongest available tools to deal

with these issues of uncertainty and agency.

Of greater interest is the observation that the tools and mechanisms used in Indian venture

capital contracting to combat these issues in this different environment are those that have

developed in the US over a period of time through an organic learning process. Although

certain variations exist, the contracting model of Indian venture capital financing cannot be

said to be hybridized. Due to the fundamental similarities in the contracting models it could

be considered as more of a direct transference.

Thus from the perspective of the venture capital financing contract itself we conclude that the

institution of venture capital has been directly transferred with little modification. However,

further research is required regarding the contracting governing the relationship between the

venture capitalist and the limited partner in order to truly determine if it is a complete

transference of the institution of venture capital.

37

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American Experience”, Stanford Law Review, Vol. 55 (April 2003). 6. Jeffrey J. Trester, “Venture Capital Contracting Under Asymmetric Information.”

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Finance, Vol. LVII, No.3 (June 2003). 9. Laura Bottazzi and Marco Da Rin, “Venture Capital in Europe and the Financing of

Innovative Companies”, Economic Policy, Vol.34 (April 2002). 10. Leslie Jeng and Philippe Wells, “The Determinants of Venture Capital Funding:

Evidence Across Countries”, May 1998 11. Paul Gompers and Josh Lerner, “The Use of Covenants: An Empirical Analysis of

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Economic Perspectives, Vol. 15, No. 2 (Spring 2001). 13. Paul Gompers, “Optimal Investment, Monitoring, and the Staging of Venture

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of Convertible Securities in Venture Capital Investments 3 (1998), at p.13, (unpublished manuscript, on file with the Harvard Law School Library) http://www.people.hbs.edu/pgompers/Convert.PDF visited on June 10, 2010

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• VCCEdge, “Annual Deal Roundup” December 2002.



• VCCEdge, “Quarterly Deal Update” April 2010

• Chandreshekhar Committee Report, 2000

i

9 Annexure: Brief Summary of Empirical Study

Table 1

Control Mechanisms

Contract

No.

Stake/

Voting

Right

Staging Syndication Securities

1. 40.6% Yes 2 tranches of equal sums

No Tranche I – equity Tranche II – convertible preferred

2. 30% Yes Cash flow linked

No Compulsorily Convertible Cumulative Preference Shares

3. NA Yes No Fully Convertible Cumulative Preference Shares

4. 38.6% Yes No -Equity -Redeemable Optionally Convertible Cumulative Preference Shares

5. NA No No -Equity -Redeemable Optionally Convertible Cumulative Preference Shares

6. 42.75% Yes Upon achieving milestones

No Equity

7. 10.08% No No -Compulsory Convertible Preference Shares -Equity

8. NA Yes Upon achieving milestones

No -Tranche I- Optionally convertible debentures Tranche II- Optionally -Convertible Redeemable Preference Shares

9. NA Yes Upon achieving milestones

No Equity

10. 38.8% Yes Upon achieving milestones

No Compulsorily Convertible Preferred Stock

11. 51.5% Yes No Convertible preferred

12. 39.02%

Yes No Optionally Convertible Debentures

13. 15.2% No No -Equity -Non Cumulative

ii

Contract

No.

Stake/

Voting

Right


Compulsorily Convertible Preference Shares

14. 7.5% No No Compulsorily Convertible Preference Shares

15. 21.14% Yes Cash flow linked

Yes -Equity Shares -Compulsorily Convertible Cumulative Participating Preference Shares

16. 49% Yes No Preferred Stock and Equity Stock


No Optionally Convertible Debentures

18. 14.3% Yes Yes - Equity -Compulsorily And Fully Convertible Preference

19. 37.40% No Cash flow linked

No -Equity -Compulsorily Convertible Cumulative Participatory Preference Shares

20. NA No Yes Redeemable Optionally Convertible Cumulative Participating Preference Shares

21. 21.07% & 4.05%

Yes Upon achieving milestones

Yes - Equity -Compulsorily Convertible Participating Preference Shares

22. 32.44% & 19.64

Yes Yes -Equity - Compulsorily Convertible Debentures


Yes - Equity -Compulsorily Convertible Cumulative Participating Preference Shares - Optionally Convertible Cumulative Participating Preference Shares

24. 33% Yes Cash flow linked

No - Equity -Compulsorily Convertible Cumulative Participating Preference Shares

25. 51% Yes Upon achieving milestones

No -Equity - Optionally Converted Preference Shares

26. 40% Yes Cash flow No - Equity

iii

Contract

No.

Stake/

Voting

Right


linked -Compulsorily Convertible Cumulative Participating Preference Shares

27. NA No No Equity & Preferred Shares

28. NA No Yes Equity & Preferred Shares

29. 16.22% No Yes Equity & Compulsorily Convertible Preference Shares

30. NA No No Equity & Compulsorily Convertible Preference Shares

iv

Table 2

Contract Terms I: Liquidation Rights

Contrac

t No.

Liquidatio

n

Preference

to

Common

Minimum

liquidation

amount

Redemption or Puts Liquidatio

n Events*

1. Yes With participation

1x Yes In events of breach of agreement

Standard

2. Yes 1x Promoter’s Call Option

Standard


1x No Standard


1x+ 30% IRR

Yes -Optional redemption within prescribed time -Put option in events of breach of agreement - both with premium of 30% IRR

Standard


1x + 25% compounded annual return

Yes -Optional redemption within prescribed time (+25% CAR) -Put option in events of breach of

Standard

v

Contrac

t No.

Liquidatio

n

Preference

to

Common

Minimum

liquidation

amount


n Events*

agreement (+30% CAR)


2x No General right to demand liquidity

Standard


1x +accumulated dividends

Yes Standard

8. Yes 1x No Standard

9. No No No No

10. Yes 1x Yes At FMV or 1x + 10% pa

Standard


1x Yes Standard

12. Yes As debenture holder

2x Yes General right to demand liquidity

Standard

13. Yes Statutory preferred rights

No No Standard


1x + accumulated dividends

Yes Standard


1x + 25% IRR

Yes Upon liquidation or breach of terms also at 1x + 25% IRR

Standard

16. Yes 1x +25% annualized return

Yes Standard

17. Yes As debenture holder

1x plus accumulated interest

Yes General right to demand liquidity

Standard

18. Yes With 1x + Yes On breach Standard

vi

Contrac

t No.

Liquidatio

n

Preference

to

Common

Minimum

liquidation

amount


n Events*

participation

accumulated dividends

at FMV or 1.1x


1x Yes On breach Standard


1x + 27% IRR

Yes At 1x + 27% IRR Also provides a call after 2 years

Standard


1x + 14% p.a.

Yes Standard

22. Yes 2x Yes Standard


1x + accumulated dividends

Yes At 1x + 14% annualized returns

Standard


1x + accumulated dividends+ 18% annualized returns

Yes Standard



Yes Standard



Yes Standard

27. Yes 1x Yes Standard

28. Yes 1x + 25% IRR

Yes Standard


1x +adjustment

Yes Standard

30. Yes With 2.5x Yes Standard

vii

Contrac

t No.

Liquidatio

n

Preference

to

Common

Minimum

liquidation

amount


n Events*

participation

+adjustment


1x Yes 1x + 30%p.a.

Standard

*Standard Liquidation Events:

(i) A compromise or arrangement with the creditors/debtors of the Company

or failure to pay debts, under which the Company may be wound up as per

law;

(ii) Appointment of a provisional or official liquidator by an appropriate court

under any applicable Law;

(iii) Commencement of any voluntary liquidation, dissolution or winding up;

(iv) A merger, acquisition, Change in Control, consolidation, or other

transaction or series of transactions in which the Company’s shareholders

prior to such transaction or transactions will not retain a majority of the

voting power of the surviving entity;

(v) A sale, lease, license or other Transfer of all or more than 50% (fifty per

cent) of the Company’s Assets;

viii

Table 3

Contract Terms II: Conversion Rights

Contract

No.

Automatic

Conversion

Triggers for

Conversion

Conversion

ratio

Anti dilution protection

1. No Optional after 1 year

Adjustable according to revenue targets

Full ratchet

2. Yes IPO, Strategic Sale

Adjustable Broad Based Weighted Average Anti-Dilution Protection

3. No Optional upon Notice by investor within 5 years

Adjustable according to revenue targets

No Only ROFR

4. Yes Only for IPO; Optional after 1 year

Adjustable according to Post money valuation formula

Full ratchet Adjustment for stock splits, etc.

5. No Optional Adjustable according to achieving revenue projections

Full ratchet

6. Nil (equity) Nil Nil Full ratchet

7. Yes 20 years Adjustable according to achieving revenue projections

Full ratchet

8. No Optional Based on predetermined stake of investor

No

9. No Nil Nil Nil

10. Yes IPO and fixed term

Adjustable based on projections in pre money valuation formula

Broad Based Weighted Average Anti-Dilution Protection

Adjustment for stock splits, etc.

11. NA NA NA NA

12. No Optional after specified date

Adjustable based on revenue targets

Full ratchet Adjustment for stock splits, etc.

13. Yes Milestone One for one Narrow Based

ix

Contract

No.

Automatic

Conversion

Triggers for

Conversion

Conversion

ratio


and fixed term

Weighted Average Anti-Dilution Protection

14. Yes IPO or 19 years from closing

Based on post money valuation

full ratchet basis Adjustment for stock splits, etc.


At pre-determine price, subject to adjustment, but within pre-determined stake

Full Ratchet Basis

Adjustment for stock splits, etc.

16. Yes IPO NA Adjustment to reflect specified return/valutaion

Adjustment for bonus, stock splits, etc.

17. No Nil At pre-determined price

Nil

18. Yes IPO or 20 years

1:1 Broad Based Weighted Average Anti-Dilution



Adjustable according to Post money valuation formula

Full Ratchet Basis


20. Yes IPO, Milestones, or 20 years

Variations in resultant shareholding based on performance

Yes (not specified)

21. Yes Upon “qualified” financing and IPO and fixed term

Adjustable based on projections in pre money valuation formula

Full Ratchet Basis


22. Yes IPO Adjustable as per revenue target

Full Ratchet Basis

23. Yes IPO, 10 years At pre-determined price

Broad Based Weighted Average Anti-Dilution


x

Contract

No.

Automatic

Conversion

Triggers for

Conversion

Conversion

ratio





25. Yes IPO At pre-determined price

Full Ratchet Basis





27. Yes IPO Based on milestones

Full Ratchet Basis


28. Yes 3 years Based on Post Money Equity Valuation

Full-Ratchet Basis



Adjusted to arrive at pre-determined stake

Full Ratchet Anti-Dilution Protection


Adjusted on Post Money Valuation

Full Ratchet Anti-Dilution Protection

Standard Conversion Triggers:

i. IPO

ii. Sale, disposal, transfer or other exit in part or full, by a majority of the investors

iii. liquidation events

iv. Exercise any go-along along rights

v. Any buyback

xi

Table 4

Contract Terms III: Other Controls and Transfer Restrictions

Contract

No.

Affirmative

Voting

Rights

Board

representation

Transfer

Related**

Pre-

emptive

rights***

1. Yes Yes 1 of 4 seats

Drag, Tag, ROFO, ROFR

Yes


Drag, Tag, ROFO, ROFR

Yes


ROFO Yes


Tag, Drag, Promoter ROFR

Yes


Drag, Tag, ROFO

No


ROFR, Tag, Drag

Yes


ROFR, Tag, Drag

Yes

8. No No No No Second round debenture funding


ROFR, Tag Yes

10. Yes 4 of 7 seats

ROFR, Tag, Drag

Yes

11. Yes Yes 1of 4 seats

ROFR, Tag, Drag

Yes


ROFR, Tag, Drag

Yes


ROFR, Tag Yes


ROFR, Tag, ROFO Promoter ROFO

Yes


ROFR, Tag, Drag

Yes

16. No No No No

17. Yes Yes 2 of 5 ROFR, Tag, Yes

xii

Contract

No.

Affirmative

Voting

Rights

Board

representation

Transfer

Related**

Pre-

emptive

rights***

seats


ROFR, Tag, Drag

Yes


ROFR, Tag, Yes

20. No No No No Debentures Round 2


ROFR, Tag, Drag

Yes


ROFO, Tag, Drag

Yes


ROFR, Tag, Yes


ROFR, Tag, Yes


ROFR, Tag, Yes


ROFR, Tag, Drag

Yes


ROFR, Tag, Drag

Yes


ROFR, Tag, Drag

Yes


ROFR, Tag, Drag

Yes


ROFR, Tag, Drag

Yes

* Standard Consent/Affirmative Voting Requirement:

As long as the Investor holds shares, then the Company cannot approve or take any of the

following actions without having first received the written consent of the Investor/ favourable

vote of the Investor at a Board/ Shareholders meeting:

i. Business and Assets

ii. Capital Structure

iii. Additional Debt, Creation of Liens

iv. New Business Initiative

v. Dividend

vi. Auditors

vii. Intellectual property rights

viii. Annual business plan

ix. Bylaws and articles of incorporation

x. Dissolution

xiii

xi. Delegation or Change Of Board

** ROFR: Right of First Refusal - The Promoter cannot sell or transfer any shares to a

third party without first offering them to the Investor on the same terms. The Investor has the

right, but not the obligation, to purchase them.

ROFO: Right Of First Offer - A Shareholder may not sell or transfer any of Shares to a third

party without first offering them to the other Shareholders on the same terms. The other

Shareholder has the right, but not the obligation, to purchase them.

Tag: Tag-along Right - The Investor has the option to sell or transfer its Shares with the

selling shareholder to the third party on the same terms and conditions.

Drag: Drag Along Right- The Investor has the right to require the entrepreneur or other

shareholders to sell such number of shares held by them along with the entire Investor Shares

being sold to a third party buyer as maybe required, inorder to facilitate the sale of Investors

stake, at the same price and on the same terms and conditions applicable to the Investor.

*** Pre-emptive Right: The Investor has a pre-emptive right of subscription in the event

that the Company proposes to undertake any future equity financing, whether by making a

preferential allotment and/or fresh issue of Shares or convertible instruments to third parties.

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