How To Understand The Relationship Between Ownership And Control In An Entrepreneurial Firm

Transcription

1 Ownership and Control in Entrepreneurial Firms: An Examination of Convertible Securities in Venture Capital Investments Paul A. Gompers * September 1997 In this paper I analyze the allocation of ownership and control rights in entrepreneurial firms, examining the role of convertible securities in venture capital investments. Large private benefits and the importance of the firm's financing choice as an incentive contract make it optimal to separate the allocation of control rights from the allocation of cash flows. If entrepreneurial ability is private information and equity financing is utilized, adverse selection may occur with high ability entrepreneurs leaving the venture capital market. Under reasonable assumptions, convertible securities can separate out bad entrepreneurs and limit incentives to take risks. Empirical evidence from a sample of fifty venture capital contracts is consistent with the paper's predictions. The convertible stake converts to common equity when the investment has been revealed to be successful, either at the time of an initial public offering or when certain performance targets are achieved. Similarly, contracts explicitly assign important control rights to the venture investors through the use of well-specified covenants independent from the allocation of cash flows. The use of covenants increases as potential agency costs rise, i.e., in early stage firms and firms in industries characterized by high R&D expenditures and high market-to-book ratios. * Harvard University and National Bureau of Economic Research. I wish to thank Oliver Hart, Steve Kaplan, Josh Lerner, Andrew Metrick, Randall Morck, Jim Poterba, Raghu Rajan, Abraham Ravid, Richard Ruback, Bill Sahlman, Bill Schwert, Andrei Shleifer, Jeremy Stein, Luigi Zingales, and participants at the Entrepreneurship, SMEs, and the Macroeconomy conference in Jonkoping, Sweden for helpful comments and suggestions. I also wish to thank Scott Sperling and Michael Eisenson of Harvard Management Company for providing access to convertible financing documents. Any errors or omissions are my own. This research was funded by the Division of Research at the Graduate School of Business Administration, Harvard University.

2 1. Introduction Contracting between capital suppliers and entrepreneurs is fraught with many potential conflicts. Moral hazard and adverse selection result from the asymmetric information that is associated with startup companies. In addition, uncertainty makes fully state contingent contracting impossible. Observability and verifiability may both be quite limited. Venture capital firms, which specialize in financing young, high potential firms, have developed unique contractual mechanisms to finance startup companies. This paper explores the use of convertible securities in venture capital settings and seeks to explain their use in light of the complex environment associated with startup companies. My approach is similar to Smith and Warner s (1979) analysis of bond covenants. I explore the economic importance of various aspects of control rights and ownership as well as the specific conversion terms employed in a sample of fifty convertible venture financings. The results have important implications for understanding the allocation of ownership and control as well as the theory of the firm. Evidence from this sample of agreements is consistent with the view that the use of a convertible security, as opposed to straight equity or straight debt financing, serves to motivate the founder to exert the proper effort and avoid improper risk taking. A detailed analysis of the terms of the documents shows that the contracts also explicitly allocate control rights to venture investors to minimize potential losses due to agency conflicts. The use of covenants that explicitly allocate control rights to the venture capitalist increase with the potential for agency costs and conflicts of interest. This separation of ownership and control has important implications for the efficiency of entrepreneurial firms. While most theories of financial contracts derive the optimality of straight debt or equity, convertible debt and redeemable convertible preferred equity are the financial instruments that venture

3 capitalists employ most often. 1 Most existing theories of convertible securities are not appropriate for the venture capital environment and evidence on the terms of contracts employed in the industry. Recently, a number of papers have explored the use of convertible financing in venture capital transactions. Marx (1994) focuses on the venture capitalist's incentive to intervene and increase value in an entrepreneurial firm. Berglöf (1994) examines the use of convertible debt to promote efficient takeovers of entrepreneurial companies. Hellman (1994) provides an excellent principal-agent analysis of venture capital transactions, but focuses on leverage ratios rather than on the use of convertible securities. An issue that this paper seeks to answer is whether any of these theories has potential to explain the use of convertible financing. Venture capital provides a unique perspective in which to examine the nature of financial contracting and corporate control. Venture capitalists raise money from individuals and institutions to invest in early stage entrepreneurial projects. These projects are characterized by their extreme uncertainty, asymmetric information, and potentially high rewards. Venture-backed success stories include Microsoft, Cisco Systems, Genentech, and Federal Express. Venture Economics (1988), however, noted that 6.8% of venture-backed projects accounted for 50% of the return on venture investments. 34.5% of all projects experienced either a partial or total loss of invested capital. The variance in potential outcomes is quite high. The contractual relationship between venture capitalists and entrepreneurs needs to align 1 The payoff to convertible debt and redeemable convertible preferred equity are essentially equivalent and I will refer to them both as convertible venture financings. 2

4 entrepreneurs' incentives with venture capitalists' goals. The venture capital industry has developed control mechanisms to deal with incentive problems in an uncertain environment. The use of convertible financing needs to be understood in the context of the broad array of control mechanisms that are employed by venture capitalists. Sahlman (1990) gives an excellent summary of the common governance structures that typify the venture capital industry. Gompers (1995) explores the periodic reviews by venture capitalists and shows that staged capital infusion is important in minimizing agency costs. Lerner (1994) examines how syndication of investment by venture capitalists generates additional information. The ability to terminate entrepreneurs or dilute their equity holdings is also utilized by venture capitalists. While many theories of financial instruments have been developed around optimal control allocation, the use of cash flow allocation to determine control right allocation may not be optimal in a venture capital setting. Other contractual measures can address the issue of control rights. Contracts often give the venture capitalist the right to control the board of directors, approve major expenditures, and limit new security issuances. I examine these explicit control rights and explore how they alleviate various conflicts between venture capitalists and entrepreneurs. Sahlman (1990) hypothesizes that the most important role of convertible securities is to properly align the incentives of entrepreneurs and venture capitalists and to provide information about the entrepreneur. " A key feature of the contracts and operating procedures is that risk is shifted from the venture capitalists to the entrepreneur. The entrepreneur's response to these (contractual) terms enables the venture capitalist to make informed evaluations and judgments.... the convertible preferred security shifts some of the costs of poor performance to the entrepreneurial team." While Sahlman does not expand on the source of incentive problems or the mechanism by which 3

5 convertible preferred equity corrects them, this paper addresses those issues. The implication of Sahlman's statement is that the allocation of value via the stakes granted to the founders and venture capitalists acts as an incentive scheme that ensures proper actions by both the venture capitalist and the entrepreneur. The paper is organized as follows. The nature of ownership and control between entrepreneurs and venture capitalists is explored in Section 2. Section 3 discusses the major terms and conditions of convertible preferred venture investments. An analysis of the terms of a sample of fifty convertible preferred equity venture investments is analyzed is Section 4. Section 5 concludes. 2. Ownership, financial instruments, and entrepreneurial firms Grossman and Hart (1986) define ownership as the ability to exclude others from accessing an asset. Their notion of ownership is critical to understanding security design. While the Grossman and Hart definition of ownership is well understood and many models build upon its ideas to derive control theories for various securities, most papers assume that control is allocated via mechanisms like majority equity ownership. The person who owns the asset has greater than 50% of the equity in the firm. While this may be a very useful concept in certain settings, allocating ownership proportional to residual value, as is done in the case of common equity, may not always be optimal. Entrepreneurial startups are subject to tremendous agency conflicts. A firm s founder may place significant weight on increasing his private benefits at the expense of outside shareholders. The entrepreneur s human capital is also critical to the success of the firm. If the equity stake given to the entrepreneur is used as an incentive system, he will need a large fraction of the firm to induce the proper effort level. The value of the entrepreneur s input may be valuable enough such that he retains a 4

6 majority equity stake in the company. Similarly, reducing his equity stake below 50% may not be prudent if this increases the entrepreneur s desire to consume private benefits of control. The large equity ownership is necessary to align incentives when the entrepreneur s input is critical. If the entrepreneur owns greater than 50% of the equity, however, it might be impossible for investors to control other conflicts that might arise. If investors understand potential areas that could lead to future agency conflicts, they could explicitly assign control rights over those activities to themselves. This separation of equity ownership and control rights might increase efficiency and the likelihood of success. Covenants and restrictions can be understood in this framework. They assign control rights to investors over actions that are particularly damaging to them. We expect that the degree of covenant coverage should be related to potential conflicts. Smith and Warner s (1979) analysis of bond covenants discusses the explicit role that covenants play in reducing agency costs. Smith and Warner argue that writing contracts is costly. Parties negotiating certain restrictions will only include them when benefits from restricting activities outweigh costs of contracting and monitoring compliance. The greater the potential for agency conflicts, the more likely restrictions will be imposed. Similarly, Gompers and Lerner (1996) find that potential agency costs explain some of the covenant inclusion in venture capital limited partnership agreements. The greater the likelihood for conflicts between venture capitalists and their investors leads to tighter covenants in the venture capital limited partnership. In a similar manner, if the use of covenants in venture capital convertible financing agreements is related to the cost of potential conflicts, then the number of covenants should be related to proxies for agency costs. 5

7 Various proxies for agency costs can be examined. Gompers (1995) finds a group of industry accounting variables that appear to be related to agency costs in entrepreneurial firms and are related to the intensity of monitoring. These proxies may also be related to the tightness of covenant usage. First, conflicts are more likely to arise in early stage companies. The level of asymmetric information is likely to be considerably higher. Similarly, firms that have high R&D intensities are more likely to generate higher levels of asymmetric information leading to potential conflicts of interest between the entrepreneur and the venture capitalist. Finally, market-to-book ratios measure the fraction of the firm s value that is represented by the exercise of future growth opportunities. As the fraction of value that is growth options increases, so does the potential for the entrepreneur to make decisions that do not maximize shareholder value. Each of these variables should be related to the probability of covenant inclusion. Similarly, we can look at the effect of the supply of venture capital funds as a determinant of contractual restrictiveness. Gompers and Lerner (1996) find that the relative supply and demand conditions in the venture capital fundraising market affect contractual restrictiveness in the agreements between limited partners (investors) and the venture capitalist. Gompers and Lerner argue that bargaining power should be a major determinant of covenant inclusion. Similarly, Gompers and Lerner (1997a) find that the money flowing into the venture capital sector affects the price level of private equity investments. If the supply of venture capital somehow affects bargaining power of the entrepreneur versus the venture capitalist, the probability of covenant inclusion may be affected. Increases in the supply of venture capital can reduce the venture capitalist s negotiating power as competition for investment 6

8 gives entrepreneurs the ability to resist accepting financing with tight covenants. The use of convertible securities as opposed to straight equity financing can also be understood in this context. Green (1984) presents a model of convertible debt that captures the spirit of this relationship. In his model, a firm wants to issue debt to finance two investment projects, each having different levels of risk. The firm cannot guarantee ex ante allocation of funds between the two projects. As Jensen and Meckling (1976) point out, a manager whose firm has been financed by debt has an incentive to increase allocation to riskier projects. By using convertible debt, the manager limits his incentive to take risk because the warrant portion of the debt increases in value as risk increases. Green, however, never considers the use of equity financing. He conjectures that moral hazard or taxes would preclude equity, although he does not explicitly model them. Gompers (1993) builds a simple model of venture capital financing that combines both moral hazard and adverse selection. The model shows that under mild assumptions, convertible preferred equity dominates straight debt and straight equity as a financing choice for venture capitalists. The convertible preferred security can act as both an incentive compensation system for the entrepreneur (because he shares substantially in the upside of the firm but does not benefit from increasing risk) and as a screening mechanism (because the downside discipline of the preferred (debt) portion makes the deal unattractive to low quality entrepreneurs). This model is referred to as the incentive/screening model of convertible venture financing. The incentive/screening model predicts that the convertible security would not be converted to common stock until the investors receive positive information that the firm is very likely to be successful. This information might be an event like an initial public offering (IPO) or when the firm 7

9 surpasses some performance targets. At that time, the discipline of the preferred (debt) portion of the financing is relatively less important and can be eliminated. Similarly, it is likely that performance targets that impose mandatory conversion would be more likely for earlier stage and riskier companies. These are the companies that are in greater need of performance hurdles. Several recent papers examine the use of convertible securities in venture capital investments. Marx (1994) examines the incentives of a wealth constrained entrepreneur when returns to a project are uncertain but verifiable. The entrepreneur raises money from a risk averse venture capitalist. The choice of financing instrument determines the allocation of cash flows and the incentive for the venture capitalist to intervene in the company. Intervention by the venture capitalist requires incurring some fixed cost. This intervention is relatively more valuable when returns to the project are low. Debt contracts lead to too much intervention and equity contracts lead to too little. The choice of convertible preferred equity provides the proper intervention incentives and the optimal insurance for the venture capitalist. Berglöf (1994) examines how the entrepreneur and venture capitalist allocate cash flows and control rights to yield an optimal exit decision. Both the entrepreneur and the venture capitalist are assumed to want to liquidate their stake in the firm at some future date. The use of convertible debt or convertible preferred equity provides both the proper incentive to sell the firm and enables both parties to extract the maximum surplus from the buyer. Both the Berglöf and Marx papers depend upon the control aspects of the convertible preferred financing to align incentives or promote the proper decision. Because the contracts actually contain many explicit, state-contingent control rights that are allocated to investors, it is unlikely that the 8

10 primary purpose of the convertible payoff structure is to further allocate control rights. 3. Terms and conditions of convertible venture financing 3.1. Conversion characteristics In this section I discuss the major elements of the convertible preferred equity agreements between venture capitalists and entrepreneurs. This discussion is meant to provide background for the empirical tests in the next section. This discussion is meant to provide background for the empirical tests in the next section. The model term sheet in Appendix A provides insights into the structure of typical contracts. Conversion terms will be examined first, then various covenants and restrictions will be outlined. First, the contract states the conversion price, usually set to the purchase price of the convertible preferred. This ensures one for one conversion. The contracts also contain antidilution protection to ensure that the entrepreneur does not try to take advantage of them by performing stock splits or issuing special dividends. The contracts usually contain explicit formulas for calculating any adjustment to the number of commons shares into which the preferred shares convert which may be affected by selling equity below the venture capitalists purchase price. As the contract in Appendix A shows, the contracts also list explicit events which trigger automatic conversion of the preferred equity. Initial public offerings above a certain, pre-specified size almost universally trigger conversion to common. Black and Gilson (1997) argue that this conversion to common equity and the concomitant elimination of restrictive covenants represents a call option on control. They argue that this automatic conversion at IPO is an integral part of the venture capital process and one reason a robust public offering market is so important to the venture sector. In 9

11 addition, few investment banks would be willing to underwrite a common equity offering if venture investors maintained a higher priority claim than they were underwriting. In addition to automatic conversion at IPO, many contracts contain provisions for conversion upon reaching other milestones. Many of these milestones are accounting based. Income targets tend to be the most common, but sales or other targets are sometimes utilized. These targets serve as barometers of success. Upon surpassing these predetermined hurdles, the entrepreneur shows that the firm has been objectively successful Covenants and restrictions In addition to conversion provisions, the preferred equity agreements also contain numerous covenants and restrictions that serve to limit detrimental behavior by the entrepreneur. For example, the contract in Appendix A explicitly states the number of board seats that Series B investors can elect. Along with the rights in the Series A contract, the venture investors would probably control the board. This is true in many venture investments. Even if the venture investors do not own greater than fifty percent of the equity, the contracts may allocate control of the board to venture capitalists. The board control serves as an important check on management that may try to extract rents from minority shareholders. Similarly, in any future initial public offering, the outsider dominated board would lend credibility to the firm. Explicit control mechanisms give the venture investors control over specific aspects of the firm. Certain actions are expressly forbidden or require the approval of a supermajority of investors. These contractual features essentially separate out the allocation of control from the allocation of residual value. 10

12 The preferred stake of the venture capitalist always has higher priority than common stock as long as it is not converted. Many contracts give additional consideration to the preferred stock. Sometimes the contracts pay out the entire face value of the preferred claim and then lump the claim of preferred shareholders with the common. Some contracts give venture capitalists a multiple of the face value before the common shareholders (usually the firm s founders) receive anything. For the purpose of payout, sale of the firm in an acquisition is usually treated as a liquidation. This super-priority prevents the entrepreneur from making early liquidations decisions. If the venture capitalist invested in common stock that had the same priority as the entrepreneur, the founder may want to liquidate early and receive his percentage cut of the investment. For example, if venture capitalists invested two million dollars in the common stock of a startup in which the founder retained 75% of the firm, the founder could liquidate the company on day two and walk away with $1.5 million. Clearly, the greater the possibility of gaming, the greater is the need for super-priority. Many contracts also contain mandatory redemption rights. These are rights of the venture investors that allow them to put the stock back to the company. Essentially, the venture capitalists can force the firm to repay the face value of the investment at any time. This mechanism can often be used to force liquidation or merger of the firm. The mandatory redemption provisions help the venture investors determine the outcome from investment. Sale of assets is often restricted as well. Any disposal of assets above a certain dollar value or percentage of the firm s book value may be limited without the approval of venture investors. This prevents the entrepreneur from increasing the risk profile of the company. It also prevents the entrepreneur from making sweet heart deals with friends. The prohibition on asset sales prevents the 11

13 firm from changing its intended focus. The venture investors are also often concerned about changes in control. The contracts may state that the founders cannot sell any of their common stock without approval of the venture investors or offering the securities to the venture investors. Similarly, restrictions may prevent a merger or sale of the company without approval of the investors because it ultimately means a change in who controls the firm. Transfer of control restrictions are important because venture capitalists invest in people. If the management team decides to remove its human capital from the deal, venture capitalists would want to approve the terms of the transfer. Many transfers in control may hurt the position of the venture investor if they are done on terms that are unfavorable to earlier investors. The purchase of major assets above a certain size threshold may also require approval of venture investors. This restriction may be written in absolute dollar terms or may be written as a percentage of book value. The wording is usually broad enough to cover purchases of assets or merger of the firm. Restrictions on purchases may help prevent radical changes in strategy or wasteful expenditure by the entrepreneur. Many such strategy changes could have detrimental effects on the value of the venture investors stake. Finally, the contracts usually contain some provision for restricting the issuance of new securities. Almost all documents contain a provision that restricts the issuance of senior securities without the approval of previous investors. Many documents alter the restriction to include securities on the preferred equity level or any security issuance. Usually, a majority of preferred shares must vote in favor of such an issue. Restricting security issuance prevents the transfer of value from current shareholders to new security holders. 12

14 4. Empirical evidence In this section I examine evidence concerning convertible debt and convertible preferred equity in venture capital investments. The empirical tests will focus on three areas; 1) characteristics of the venture capital industry and the use of convertibles, 2) conversion features of the convertible securities, and 3) factors affecting covenants and restrictions in venture capital convertible preferred equity investments Characteristics of the venture capital industry and the use of convertibles The screening/incentive model developed in Gompers (1993) relies upon asymmetric information between the investor and the entrepreneur. The entrepreneur's ability is unknown to the venture capitalist who designs a contract to screen out potentially bad entrepreneurs and limit risk taking behavior. Venture capital-backed firms are clearly active in industries where asymmetric information is significant. Because the entrepreneur often comes to the firm with a technical background in the area of the firm's business, he is likely to be at a substantial informational advantage relative to the venture capitalist. In addition, because most entrepreneurial firms have little or no track record, these asymmetries are magnified. Unknown ability is likely to be an important concern for venture capitalists. Because the project's success is so dependent upon the entrepreneur's human capital, the venture capitalist spends significant time and resources determining the management team's ability. The single most important factor determining whether a project is funded or not is the entrepreneur's perceived ability. Lack of management skills is the reason cited most often for failure of venture capital-backed projects [Gorman and Sahlman (1989)]. In designing contracts, venture capitalists must always be wary of the desire 13

15 incompetent entrepreneurs have of seeing their projects funded. Venture capitalists need to be concerned about actions that the entrepreneur might take to increase the riskiness of a project. Although venture capitalists take an active role in advising and monitoring entrepreneurs, they are usually not involved in the day-to-day activities of the firm unless things go drastically wrong. Entrepreneurs are free to cut corners in the desire to get to market quickly, even if this substantially increases risk. Venture capitalists usually cannot observe or verify these "cut corners" or changes in strategy. One mechanism to reduce the desire to take such risks is to use convertible securities. The widespread use of convertible securities in venture financing is demonstrated by Table 1 which presents the mid-year summary from the investments of an early stage venture capital limited partnership. Of the 28 financing rounds for the five companies listed, all but five are convertible preferred equity. Common stock is purchased, but only in later rounds. This summary is consistent with the predictions of the incentive/screening model. Early financings are predicted to be convertible securities. Only after more information is available about the entrepreneur and the company would the venture capitalist choose to utilize common equity Conversion provisions The incentive/screening model emphasizes the asymmetric information about the entrepreneur's ability and the riskiness of the project. If convertible securities are used to sort out low ability entrepreneurs and reduce risk taking, then the venture capitalist would want to either delay conversion until an exit is achieved or until information arrives that signals the project is a success and the 14

16 entrepreneur has high ability. 2 If the entrepreneur could call the debt before new information about the project outcome arrives, the equilibria of the model unravel. An analysis of the common features of venture capital contracts shows that their features are consistent with the model developed in this paper. A random sample of fifty convertible preferred venture capital private placement agreements were examined from the files of the Aeneas Group. The Aeneas Group is the affiliate of Harvard Management Company that handles the University endowment's private-market investments. Their files on venture investments date back to the late 1970s. Aeneas' venture investment strategy was shaped by the philosophy of Walter Cabot, who ran Harvard Management between 1974 and While investing in risky asset classes such as venture capital and oil and gas, he emphasized the importance of conducting business with established and reputable financial intermediaries [Grassmuck (1990)]. Although the Aeneas Group has invested primarily in venture capital limited partnerships, they often look to coinvest in certain promising deals that these venture funds finance, i.e., Aeneas will make a direct investment in one of the portfolio companies identified by their venture capitalists. As such, their files include convertible preferred venture investments that represent coinvestments with many different venture capital organizations. This sample provides a more diverse group of contracts than if the investments of one venture capital firm had been examined. Summary statistics for the conversion characteristics of the fifty Aeneas contracts are presented in Table 2. The average closing date for these fifty contracts was December On average, the 2 If the project is a success, the optimal strategy is for the venture capitalist to take compensation as equity. Low ability entrepreneurs still have no incentive to accept the financing if conversion occurs only after information of success arrives. 15

17 contracts represented the purchase of 2.2 million shares at an average price of $2.83 per share. None of the issues were callable within a five year period and only 8% (4 contracts) allowed the entrepreneur to voluntarily redeem the convertible after that time. Because most firms achieve some exit within five years [Gompers (1996) shows that the median holding period is approximately three years from the first round venture investment to a firm s initial public offering], the call protection is effectively 100%. 92% of the contracts had mandatory conversion that occurs at the time of IPO. The conversion at IPO was contingent upon the price per share and the amount of money raised by the firm. The average minimum IPO price for automatic conversion was $7.25 per share and the average minimum IPO valuation was $10,463,000. In all cases, both criteria must be satisfied for automatic conversion to occur. This type of a transaction would be a strong signal that the firm has been successful. A substantial fraction (38%) were automatically converted if certain profit, sales, and/or performance milestones were attained. For those with income targets, automatic conversion to common would occur if annual income exceeded $5.7 million. Similarly, if five years elapsed from the time of financing without redemption of the convertible, some shares would automatically convert to common equity. These milestone would also be associated with successful investments. A reasonable estimate of the number of contracts that are converted is between twenty and thirty percent, the fraction of venture-backed projects that eventually go public. A small number are likely converted when a venture-financed company is acquired by an already public firm. Benton and Gunderson (1983) describe the conversion features in their legal textbook on venture capital contracts: "Venture capitalists are often reluctant to invest in a Preferred Stock that is callable.... Accordingly, most venture capitalists will opt for automatic conversion events instead 16

18 of agreeing to voluntary redemption provisions.... The venture capitalist will prefer automatic conversion provisions to voluntary redemption provisions, however, because the venture capitalist can, at the investment's outset, agree upon automatic conversion events that, if achieved, will mean that the venture capitalist's investment has been a successful one (by the venture capitalist's own standards)." 3 Clearly, venture capitalists only want conversion when they have some information about a project s outcome, consistent with the incentive/screening model presented in this paper. All contracts also contained some form of antidilution provision that adjusted the number of common shares that the preferred equity converted into if the company sold equity at a price below the implied conversion price. Table 3 examines the factors affecting various aspects of conversion in the sample of convertible contracts. The dependent variables examined are: a dummy variable that equals one if the convertible contract contains automatic conversion based on performance milestones other than an initial public offering (e.g., sales or income targets), the price of and dollar value of an IPO that induces conversion, and the value of annualized income that forces conversion for those contracts that have income triggers. The independent variables include a dummy variables to indicate whether the investment is in early stage company or not. The dummy variable equals one if the convertible preferred is either Series A or B. Early stage firms are more prone to asymmetric information and controlling the entrepreneur through tighter restrictions may be necessary. The price per share paid in the investment round and the total size of the investment are included as independent variables as well in order to control for 3 Parentheses are in original. 17

19 scale effects. I also include several accounting measures to proxy for potential agency costs. Because accounting data for private firms is unavailable, I collect annual SIC industry averages from COMPUSTAT for each firm that received venture capital financing. I match each of the fifty firms in the sample to a three digit SIC group. Variables were collected to calculate various industry measures of asset tangibility (the ratio of tangible assets to total assets), growth opportunities (market value of equity to book value), and research intensity (the ratio of R&D expenditures to sales). The data were matched by date and industry to each firm at the particular round of financing. I calculate equal weighted averages for these ratios for all firms with COMPUSTAT data in the three digit SIC industry. This matching technique was used in Gompers (1995). These industry measures were extremely useful as proxies for expected agency costs. From the previous discussion, firms that are subject to greater agency costs should have tighter covenants and restrictions and may have higher conversion hurdles. The ratio of tangible assets to total assets for the industry should be related to the liquidation value of the firm. Tangible assets lower expected agency costs because a higher fraction of the investment can be recovered if the firm does poorly. The market-to-book ratio should rise as the fraction of growth options in firm value rises. Because potential agency costs associated with investment behavior rise with growth options, the need to potentially control entrepreneurs with more restrictive contracts (e.g., more covenants and higher conversion targets) increases. I also include a measure of research and development intensity, R&D expenditure to sales. R&D intensive firms are likely 18

20 to accumulate physical and intellectual capital that is very industry- and firm-specific. As asset specificity increases, so do expected losses in liquidation and expected agency costs. Once again, the need for controlling the entrepreneur rises. In addition to measures of potential agency costs, I include a measure of the supply of venture capital funds. I utilize information from Gompers and Lerner (1997b) who analyze factors affecting the flow of capital into the venture industry. I include the amount of money committed to new venture capital limited partnerships in the prior year (in constant 1992 dollars) as a measure of the supply of venture capital. If relative supply and demand affects contractual restrictiveness, then periods of greater fundraising would lead to fewer restrictions and lower conversion hurdles. The only variable that is related to the inclusion of automatic conversion provisions is whether the company was an early stage investment. The probability of including such an automatic conversion covenant increases if the investment is early stage. This is consistent with the predictions of the incentive/screening model. Conversion of early stage investments would be tied more closely to indicators of success. The second and third regressions examine IPO characteristics that are associated with automatic conversion. The price per share and value of an initial public offering that induce conversion are highly dependent upon the price per share paid in the investment round. Investors appear to tie conversion to some multiple of the price paid for the shares or the investment size. The price per share at IPO is more closely related to the size of the investment. Bigger investments lead to higher IPO share price targets. The value of the IPO necessary to force conversion is related to the price of 19

21 investment but not the size of investment. The final regression in Table 3 examines the factors affecting the income benchmark that is associated with automatic conversion. The regression shows that the industry ratio of tangible assets to total assets is negatively related to income conversion hurdle. Firms that have substantial intangible assets have higher income targets that force conversion. Similarly, as the size of the investment increases, the hurdle also increases. Finally, when the supply of venture capital increases, the level of income that forces automatic conversion declines. This decline in hurdle rates suggests that when venture capital is readily available, the restrictiveness of the contracts may decline Separation of cash flow allocation and control rights Marx (1994) and Berglöf (1994) both emphasize the control and intervention incentives imparted by the end of period payoffs using convertible preferred equity in venture capital financing. The actual contracts between venture capitalists and entrepreneurs separate control and cash flow allocation, however. First, the contracts usually contain explicit control rights (discussed in Section 4) that are allocated to the venture capitalist independent of the allocation of cash flows. In addition, Gompers (1995) demonstrates that the staged investment structure of venture capital can effectively control the entrepreneur. The threat of withholding additional financing is, as Sahlman (1990) points out, the most important control mechanism that the venture capitalist can employ. Ownership percentages in venture capital-backed companies are often insufficient to give voting control to the venture investors. Table 4 gives the financing history of eight venture capitalfinanced firms which eventually went public. Their experience illustrates the typical evolution of ownership stakes in venture-backed companies. All but one of the firms, Seagate, received multiple 20

22 rounds of venture financing. In only two of the eight cases, Midway Airlines and Staples, did the first round venture investment give voting control to the venture capitalists. On average, venture capitalists receive 41.4% of the firm's equity in the first round of financing. These early stages investments occur at perhaps the most important time for oversight of the company. Clearly, other control mechanisms need to be outlined in the financing documents. Separation of control and cash flow allocation may be important in an entrepreneurial setting. The use of financing choice as an incentive and screening device is effective because the entrepreneur's ability and effort are critical to the success of the new company. Rewarding the entrepreneur when the firm is sold or goes public ensures that the entrepreneur's incentives are closely aligned with those of the venture capitalist. Large private benefits of control, however, may make it difficult to control opportunistic behavior and provide proper incentives to exert effort. Explicitly assigning certain control rights to the venture capitalist (independent of cash flow allocation) may improve efficiency. Venture capitalists often remove entrepreneurs from the firm or bring in a new CEO when the entrepreneur is no longer the best manager. These changes in control are the result of explicit control rights. Table 5 tabulates the various control features of the fifty Aeneas contracts. Every contract had covenants that restricted various decisions of the entrepreneur. The covenants tabulated included those covenants that were included in more than 10% but less than 90% of the contracts. This ensured that the restrictions were not unimportant because of their rare frequency or that they were not simply boilerplate items included in every contract. One important mechanism of control is representation on the board of directors. When 21

23 classifying the number of board seats controlled by the venture investors, I assume board seats requiring the approval of both the venture capitalists and the common shareholders (normally the founders) are essentially appointed by the venture capitalists. Each party has veto power, but the venture capitalist probably has more control. Venture capitalists controlled 2.68 seats on average, essentially giving them control of the board of directors. Covenants and restrictions in the convertible preferred documents showed considerable variation. In each contract, acquisitions were treated like liquidations. Convertible preferred shareholders would receive highest priority and receive the return of their total investment before the common shareholders receive anything in all cases. Over half (66%) combined the claims of the convertible preferred and common in any claim after the initial amount given back to the convertible shareholder, essentially superpriority. 4 54% of the contracts gave the common some specified payoff before the residual claims of the preferred and common were lumped together. In addition, over half of the contracts (68%), gave the venture investors optional redemption rights. These optional redemption rights give venture investors the ability to put the stock to the company, forcing them to repay the face value of the convertible plus any accrued but unpaid dividends. Major asset sales were also restricted. 58% of the financings included provisions which limited the ability of the firm to dispose of or sell assets. A related covenant often limited the ability of the entrepreneur to transfer control of the company to another party either by selling the firm or selling a controlling equity stake. 62% of the contracts limited such control transfers without the approval of 4 The convertible preferred shares were treated as the maximum number of common shares into which they convert for determining their share in this residual claim at liquidation. 22

24 the venture investors. A substantial fraction of the documents (56%) had restrictions on major purchases of assets that required approval of the venture investors. Similarly, all contracts restricted the ability of the entrepreneur to issue new securities that were senior to the current issue. 66% of the contracts restricted the entrepreneur from issuing any new security (junior or senior) without the consent of the limited partners. Using these types of covenants and restrictions give the venture investors considerable control over the firm's activities. In Table 6 I examine factors that are related to the size of the board of directors and the allocation of board seats to venture capital investors. Independent variables include whether the firm being financed is an early stage company, industry accounting variables to measure potential agency costs, and the amount of venture fundraising in the previous year. None of the independent variables appears to be related to board size. The number of directors appears to be exogenously determined. The regression results for percentage of board seats controlled by venture investors, however, support the predictions of the incentive/screening model. Firms that are in industries with a greater fraction of intangible assets are associated with venture investors controlling a higher fraction of the board of directors. If potential agency costs are higher for such firms, the contracts would assign greater control to the venture capitalists. Similarly, in periods of greater venture fundraising, the fraction of board seats controlled by the venture capital investors declines. Greater competition for investing may give the entrepreneur greater bargaining power and allow him to retain greater control of the firm. Before analyzing the inclusion or exclusion of covenants and restrictions, Simple correlation 23

25 coefficients between the various covenants are presented in Table 7. While correlation among the various covenant classes is always positive and is often significant, all but one of the correlation coefficients are below 0.5. While covenant inclusion is correlated, the regression results will not be driven by an all or nothing choice about covenants inclusion. The contracts are very heterogenous in terms of restrictiveness. Table 8 presents logit regressions for the inclusion of each of the six covenant classifications. The dependent variable is a dummy variable that equals one if the convertible preferred contract included the covenant. Independent variables include the percentage of the board controlled by venture capitalists and a dummy variable that equals one if the firm is an early stage company. I include percentage of board controlled to determine whether board control is a compliment or substitute for other control mechanisms. I also include the industry ratios of R&D expenditure to sales, market value of equity to book value, and tangible assets to total assets. These ratios proxy for potential asymmetric information and agency costs. Finally, I include the amount of money committed to new venture capital funds in the previous year to measure venture capital supply. In general, the results are consistent with the predictions of the agency cost explanation for covenant inclusion. The percentage of board seats controlled by venture capitalists is negatively related to the inclusion of superpriority restrictions, but positively related to the inclusion of mandatory redemption provisions. It thus seems as if board control is neither a substitute nor a compliment for other control mechanisms. The probability of including mandatory redemption provisions is higher for early stage companies. R&D intensity is, in general, positively related to the probability of inclusion of 24

26 individual covenants and is significantly related to superpriority inclusion. Higher R&D intensities increase the probability of agency conflicts and thus increase the need for covenants. The factor that is consistently and significantly related to the probability of covenant inclusion is the industry market-to-book ratio. Firms in industries with high market-to-book ratios have firm values that are dependent upon the exercise of future growth options. The potential for agency conflicts is high and the need to control the entrepreneur via specific covenants increases. Potential agency costs related to growth options may be very important considerations for venture capitalists. Table 9 analyzes the number of covenants included in the convertible financing agreement. The number of covenants is one potential metric for contractual restrictiveness. Because the dependent variable is an integer, i.e., the number of covenants from (one to six) included in the financing, I utilize Poisson regressions to estimate parameter values. The more the venture capitalists are concerned about conflicts, the more covenants they will demand. Again consistent with the agency cost explanation for covenant inclusion, early stage firms are associated with more covenants. In addition, both industry R&D intensity and industry market-to-book ratios are positively related to the number of covenants in the convertible preferred. Early stage companies and companies in industries with high R&D intensities or lots of growth options are associated with greater potential asymmetric information and potential agency conflicts. As such, contracts explicitly assign greater control rights to the venture investors in these cases, independent of the equity ownership purchased at the time of investment to control such behavior. 5. Conclusion The design of venture capital control structures provides important insights into the nature of 25