Venture capital and private equity contracting an international perspective douglas JC sofia AJ

The terms venture capital and private equitymay differ in different countries, therefore in this book we generally refer to venturecapital as risk capital for small private entrepreneuri

Venture Capital and Private Equity Contracting

Venture Capital and Private Equity Contracting

An International Perspective

Second Edition

Douglas J Cumming

Professor and Ontario Research Chair, York University,

Schulich School of Business Toronto, ON, Canada

Sofia A Johan

Adjunct Professor, York University, Schulich School of Business

Toronto, ON, Canada

and

Extramural Research Fellow, Tilburg Law and Economic Centre (TILEC) The Netherlands

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Second Edition 2014

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ISBN: 978-0-12-409537-3

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We dedicate this book to our children Sasha Adeline and Dylan Jedi You were too young to read the first edition You are now 7 and 5

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Part One: Introduction

1 - Introduction and Overview, Pages 3-37

Part Two: Fund Structure and Governance

4 - Fundraising and Regulation, Pages 79-143

Part Three: Financial Contracting between Funds and Entrepreneurs

10 - The Investment Process, Pages 305-317

PDF (216 K)

11 - Security Design, Pages 319-368

PDF (501 K)

12 - Preplanned Exits and Contract Design, Pages 369-403

PDF (340 K)

13 - Legal Conditions and Venture Capital Governance, Pages 405-442 PDF (227 K)

Part Four: Investor Effort

14 - Investor Value Added, Pages 445-450

Part Five: Divestment

19 - The Divestment Process, Pages 591-601

Part Six: Conclusion and Appendices

23 - Summary and Concluding Remarks, Pages 725-727

PDF (38 K)

Bibliography, Pages 729-756

PDF (598 K)

This book is intended for advanced undergraduate and graduate students in business,economics, law, and management This book is also directed at practitioners with

an interest in the venture capital and private equity industry We consider a number

of different countries in this book The terms venture capital and private equitymay differ in different countries, therefore in this book we generally refer to venturecapital as risk capital for small private entrepreneurial firms and private equity asencompassing a broader array of investors, entrepreneurial firms and transactions,including later stage investments, turnaround investments, and buyout transactions.Financial contracting is the common theme that links the topics covered in thisbook This book explains the ways in which these contracts differ across differenttypes of venture capital and private equity funds, different types of institutionalinvestors, different entrepreneurial firms, and differ across countries and over time.This book will show when and how financial contracts are material to the allocation

of risks, incentives, and rewards for investors and investees alike This book willfurther show when and how financial contracts have a significant relationship withactual investment outcomes and success

Why should we care about financial contracting? Venture capital and private equityfunds are financial intermediaries between sources of capital and entrepreneurialfirms Sources of capital typically include large institutional investors includingpension funds, banks, insurance companies, and endowments These and other sources

of capital do not have the time or expertise to invest directly in entrepreneurial firms,particularly high-growth firms in high-tech industries As such, specialized venturecapital and private equity funds facilitate the investment process, at a price of course.These funds are for all intents and purposes organizations that are established, capital-ized, and operated under specific contractual terms and obligations agreed betweenthe investors and the venture capital and private equity funds Another different type

of financial contract governs the relationship between venture capital and privateequity funds and their investee entrepreneurial firms, how such firms are capitalizedand how they are in turn operated It is obvious therefore that financial contracting

is not something that venture capital and private equity funds do, it is also in essencewhat they are

Broadly framed questions addressed in this book include, but are not limited to,the following:

G What covenants and compensation terms are used in limited partnership contracts?

G In what ways are limited partnership contracts related to market conditions and fund managercharacteristics, and how do these contracts differ across countries?

G What are the cash flow and control rights that are typically assigned in venture capitaland private equity contracts with investee firms, and when do fund managers demandmore contractual rights?

G Do different contractual rights assigned to different parties influence the effort provided

G Fund governance

G Investee firm governance

G Investee firm performance

In this book, we provide examples of actual contracts that have been used inpractice, including a limited partnership agreement, a term sheet, a shareholderagreement, and a subscription agreement In addition, we provide datasets of venturecapital and private equity that include details on a large number of actual contracts

It is important and relevant to review data to show real investment contracts fromactual transactions, and explain how financial contracts are central to actual invest-ment decisions and investment outcomes Without analyzing data, we would at best

be limited to our best guesses, which is not the intention here The data considered inthis book are international in scope, with a focus on Canada, Europe, and the UnitedStates It is important to consider data from a multitude of countries to understandhow and why venture capital and private equity markets differ around the world Aswell, idiosyncratic features of certain countries may distort our understanding of howventure capital and private equity contracts work in practice

In short, by considering international datasets, and not data from just one countrysuch as the United States, we are able to gain a significant amount of insight intohow venture capital and private equity funds operate in relation to their legal andinstitutional environment Each chapter in this book, where possible and appropriate,will refer to and analyze data Note however that venture capital and private equityfunds are not compelled to publicly report data, nor are they willing to do so Assuch, there is always more data that can be collected It is the authors’ hope that thisbook will not only provide an understanding of how venture capital and privateequity funds operate through financial contracts, but also that it will inspire furtherempirical work in the field so that we may better understand the nature and evolution

of venture capital and private equity markets in years to come

A Brief Note on Organization and Data

Part I of this book comprises three chapters Chapter 1 briefly refers to aggregateindustry statistics on venture capital and private equity markets around the world to

compare the size of the markets in different countries Chapter 2 describes agencyproblems in venture capital and private equity investment Chapter 2 is the onlychapter that does not consider data The intention in Chapter 2 is to provide aframework for understanding agency problems Chapter 3 provides an overview ofthe empirical methods considered in this book The description of the statisticaland econometric techniques used is intended to be user friendly so that all readerscan follow along each of the chapters regardless of background As well, Chapter 3provides an overview of the institutional and legal settings in the countries consid-ered in the different chapters A central theme in this book is that differences inventure capital and private equity markets, including but not limited to contractingpractices, are attributable to international differences in legal and institutionalsettings.

Part II of this book (Chapters 4 9) considers venture capital and private equityfundraising and the structure of limited partnerships (Chapters 4 7), as well aslisted private equity (Chapter 8), and public policy toward fundraising and fundstructure (Chapter 9) In order to understand the contractual structure of limitedpartnerships, we do not exclusively focus on contracts themselves, but ratherprovide a context in which to understand the contracts by providing evidence onmotivations underlying institutional investment in venture capital and privateequity We provide some country-specific data (Chapters 4 and 7) from theUnited States and The Netherlands, as well as data from a multitude of countries(Chapters 4 6, 8, and 9) We start with the perspective of institutional investors

in Chapter 4 to understand the motivations underlying the source of capital—institutional investors Outside the United States, institutional investors havecomparatively less experience with venture capital and private equity investment.Chapter 4 examines recent data from institutional investors from The Netherlands

to study a market somewhat less developed than that in the United States, butnevertheless with significant commitments to venture capital and private equityfunds, commitments to funds both domestic and international, as well as commit-ments in niche areas such as the socially responsible investment class Also, regu-latory changes to make The Netherlands particularly interesting to study from theperspective of institutional investors In the United States, many institutionalinvestors have longstanding relationships with venture capital and private equityfund managers that span multiple decades In Chapter 7, we examine data fromthe United States pertinent to the issue of “style drift,” which refers to situations

in which fund managers deviate from stated objectives in limited partnershipcontracts Chapters 5 and 6 provide a broader perspective with data from venturecapital and private equity funds from a multitude of countries (Belgium, Brazil,Canada, Cayman Islands, Finland, Germany, Italy, Luxembourg, Malaysia,Netherland Antilles, The Netherlands, New Zealand, Philippines, South Africa,Switzerland, the United Kingdom, and the United States) This international com-parative evidence highlights the role of legal and institutional differences aroundthe world and the impact on fund governance Likewise, the data introduced inChapter 8 on listed private equity and Chapter 9 on the role of government andpublic policy are from a variety of countries

xxi Preface

While Part II focuses on fund structure and governance, the subsequent sections

of this book highlight a role of financial contracts with entrepreneurs (Part III),governance provided to investees (Part IV), and the divestment process (Part V).Part III (Chapters 10 13) covers material pertaining to financial contractingwith entrepreneurs Chapter 10 first summarizes evidence on investment activities

in a number of studies from the United States Chapter 11 considers evidence fromfinancial contracting from United States and Canadian venture capitalists, with a focus

on security design Chapter 12 considers evidence on financial contracting fromEurope, and Chapter 13 provides evidence from an even broader set of countriesaround the world It is worthwhile to compare evidence on financial contracts fromthe United States, Canada, and Europe to understand how laws and regulations,among other things, influence the design of financial contracts and venture capitalgovernance more generally

Part IV (Chapters 14 18) relates financial contracts and other investmentmechanisms to the governance provided to the investee firm Chapter 14 provides asurvey of all of the factors that might influence investee governance Chapter 15considers the relation between contracts and actual investor effort in terms ofadvice and monitoring, as well as disagreement between investors and investees.Chapters 16 18 consider noncontractual factors that influence investor effort, par-ticularly the role of geographic proximity (Chapter 16), portfolio size (Chapter 17),and fund size (Chapter 18)

Part V (Chapters 19 22) studies the exit outcomes of venture capital and privateequity-backed companies Because investees typically do not have cash flows to payinterest on debt or dividends on equity, venture capital and private equity investorsinvest with a view toward capital gain in an exit event Chapter 19 provides anoverview of the exit decision and summarizes evidence on exits from Australasia,Canada, Europe, and the United States Chapters 20 and 21 show exits are signifi-cantly related to the governance of the fund (as considered in Chapters 4 9) andcontracts between investors and investees (as considered in Chapters 10 14) and theeffort provided (Chapters 15 18) Exit outcomes are considered with reference toextensive data from Canada (Chapter 20) and Europe (Chapter 21) Thereafter,Chapter 22 provides evidence on the financial returns to venture capital investmentfrom 39 countries around the world from North and South America, Europe,Africa, and Australasia The data indicate financial structures and governance aresignificantly related to returns As well, Chapter 22 discusses evidence on reportingbiases of the performance of unexited institutional investors for companies thathave not yet had an exit event

Selected chapters in this book are based on previously published material, assummarized below:

Chapter 4:

Cumming, D., and S.A Johan, 2007 “Regulatory Harmonization and the Development

of Private Equity Markets” Journal of Banking and Finance, 31, 3218 3250

Cumming, D., and S.A Johan, 2007 “Socially Responsible Institutional Investment inPrivate Equity” Journal of Business Ethics 75, 395 416

Cumming, D.J., and S.A Johan, 2010 “Venture Capital Investment Duration” Journal ofSmall Business Management 48, 228 257.

xxiii Preface

Each chapter of the book has been adapted in a way that begins with a list oflearning objectives As well, each chapter ends with a list of key terms and a number ofdiscussion questions PowerPoint lecture slides for each chapter and online Appendices

1 4 are available online at http://www.venturecapitalprivateequitycontracting.com/andhttp://booksite.elsevier.com/9780124095373/

1 Introduction and Overview

These days it is difficult to not have heard of the terms “venture capital” and vate equity” The venture capital and private equity markets are frequently dis-cussed in popular media and typically referred to as “scorching” in the popularpress, at least in boom times The market has direct relevance for entrepreneurswho want to raise money, investors who want to make money from financing entre-preneurs, and individuals who want to work for a fund or set up their own fund.Also, venture capital and private equity is of significant interest to the public sec-tor, as government bodies around the world strive to find ways to promote entre-preneurship and entrepreneurial finance It is widely believed that venture capitaland private equity funds facilitate more innovative activities and thereby improvethe well being of nations It is thought of as a critical aspect of national growth inthe twenty-first century

“pri-In the next 23 chapters, which are divided into 4 parts, we will provide an sis of the issues that venture capital and private equity market participants face dur-ing the fund-raising process (Part II), investment process (Part III), and divestmentprocess (Part IV) A common theme across all issues involves agency costs, andhence agency theory is reviewed after this introductory chapter in Chapter 2 (Part I).All the issues addressed in this book are analyzed from an empirical law and financeperspective, with a focus on financial contracting Financial contracts are central tothe establishment of the relationship between venture capital and private equityfunds and their investors Financial contracts also govern the relationship betweenventure capital and private equity funds and their investee entrepreneurial firms, aswell as determine the efficacy of the divestment process In most chapters we refer

analy-to datasets analy-to grasp the real-world aspects of the venture capital and private equityprocess Further, it is important to consider international evidence to grasp theimpact of laws and institutions on the respective venture capital and private equitymarkets The empirical methods and legal and institutional settings in this book areoverviewed in Chapter 3

1.1 What is Venture Capital and Private Equity?

At the outset, it is important to discuss what is meant by the terms venture capitaland private equity Venture capital and private equity funds are financialintermediaries between sources of funds (typically institutional investors) and high-growth and high-tech entrepreneurial firms Funds are typically established as

Venture Capital and Private Equity Contracting DOI: http://dx.doi.org/10.1016/B978-0-12-409537-3.00001-3

© 2014 Elsevier Inc All rights reserved.

limited partnerships, but as discussed herein, there are other types of funds A ited partnership is in essence a contract between institutional investors who becomelimited partners (pension funds, banks, life insurance companies, and endowmentswho have rights as partners but trade “management” rights over the fund for lim-ited liability) and the fund manager who is designated the general partner (the part-ner that takes on the responsibility of the day-to-day operations and management ofthe fund and assumes total liability in return for negligible buyin) Chapter 5 exam-ines in detail the structure of limited partnerships and limited partnership contracts.The basic intermediation structure of venture capital and private equity funds isgraphically summarized inFigure 1.1.

lim-Venture capital funds are typically set up with at least US$50 million in capitalcommitted from institutional investors and often exceed US$100 million Some ofthe larger private equity funds raised more than US$10 billion in 2006.1Fund man-agers typically receive compensation in the form of a management fee (often

1 2% of committed capital, depending on the fund size) and a performance fee orcarried interest (20% of capital gains) Chapter 6 discusses factors related to fundmanager compensation Venture capital funds invest in start-up entrepreneurialfirms that typically require at least US$1 million and up to US$20 million in capi-tal Private equity funds invest in more established firms, as discussed furtherbelow

Venture capital is often referred to as the “money of invention” (see, e.g., Blackand Gilson, 1998; Gompers and Lerner, 1999, 2001; Kortum and Lerner, 2000) andventure capital fund managers as those that provide value-added resources toentrepreneurial firms Venture capital fund managers play a significant role inenhancing the value of their entrepreneurial investments as they provide financial,administrative, marketing, and strategic advice to entrepreneurial firms, as well asfacilitate a network of support for an entrepreneurial firm with access to accoun-tants, lawyers, investment bankers, and organizations specific to the industry inwhich the entrepreneurial firm operates (Gompers and Lerner, 1999; Leleux andSurlemount, 2003; Manigart et al., 2002a,b; Sahlman, 1990; Sapienza et al., 1996;

Institutional investors

Entrepreneurial firm

Equity, debt,

Venture capital fund

Figure 1.1 Venture capital financial intermediation

1 See http://www.thomson.com/content/pr/tf/tf_priv_equiconsul/2006_07_17_2Q06_Mega_Funds_Drive.

Wright and Lockett, 2003) Academic studies have shown us that venture backed entrepreneurial firms are on average significantly more successful than non-venture capital-backed entrepreneurial firms in terms of innovativeness (Kortumand Lerner, 2000), profitability, and share price performance upon going public(Gompers and Lerner, 1999, 2001).

capital-Venture capital and private equity investments carried out by a fund typicallylast over a period of 2 7 years A venture capital limited partnership envisagesthis extended investment horizon and hence is structured over a 10-year horizon(with an option to continue for an additional 3 years) so that the fund manager canselect investments over the first few years and then bring those investments to fru-ition over the remaining life of the fund Investments are made with a view towardcapital gains upon an exit event (a sale transaction), as entrepreneurial firms typi-cally are not able to pay interest on debt or dividends on equity The terms of theinvestment often give the venture capital fund significant cash flow rights in theform of equity and priority in the event of liquidation As well, the venture capitalfund typically receives significant veto and control rights over decisions made bythe management of the entrepreneurial firm

The terms venture capital and private equity differ primarily with respect to thestage of development of the entrepreneurial firm in which they invest Venture cap-ital refers to investments in earlier-stage firms (seed or start-up firms), whereas pri-vate equity is a broader term that also encompasses later-stage investments as well

as buyouts and turnaround investments In this book, unless explicitly stated wise, for ease of exposition we use the term “private equity” to encompass all pri-vate investment stages including venture capital The various financing stages aredefined as follows

G Other early stage

2 Financing to firms that have completed the product development stage and requirefurther funds to initiate commercial manufacturing and sales They will not yet begenerating a profit

G Expansion

2 Financing provided for the growth and expansion of a firm which is breaking even

or trading profitably Capital may be used to finance increased production capacity,market or product development, and/or to provide additional working capital

G Bridge financing

2 Financing made available to a firm in the period of transition from being privatelyowned to being publicly quoted

G Secondary purchase/replacement capital

2 Purchase of existing shares in a firm from another private equity investment zation or from another shareholder or shareholders

organi-5 Introduction and Overview

G Rescue/turnaround

2 Financing made available to an existing firm which has experienced trading ties (firm is not earning its cost of capital (WACC)), with a view to reestablishingprosperity

difficul-G Refinancing bank debt

2 To reduce a firm’s level of gearing

G Management buyout

2 Financing provided to enable current operating management and investors to acquire

an existing product line or business

G Management buyin

2 Financing provided to enable a manager or group of managers from outside the firm

to buyin to the firm with the support of private equity investors

G Venture purchase of quoted shares

2 Purchase of quoted shares with the purpose of delisting the firm

G Other purchase of quoted shares

2 Purchase of shares on a public stock market

In practice, sometimes broader categories are used For example,

G Start-up: sometimes used in practice to refer to start-up and other early stage

G Expansion: sometimes used in practice to refer to expansion, bridge financing, and cue/turnaround

res-G Replacement capital: sometimes used in practice to refer to secondary purchase/replacement capital and refinancing bank debt

G Buyouts: sometimes used in practice to refer to management buyout, management buyin,and venture purchase of quoted shares

Precise definitions of terms vary somewhat depending on the norms in a lar country and the specific individuals surveyed As the chapters in this bookmake use of data from different countries, we will define and explain the use ofterms like these, as well as others, in their specific contexts in each chapter.Definitions of stages of development in venture capital and private equity areperhaps usefully viewed in the context of a diagram A common picture used inpractice is shown inFigure 1.2 In this figure, venture capital finance is placed in abroader context of other sources of finance Prior to seeking and obtaining venturecapital finance, entrepreneurs who are just starting their venture often obtain capitalfrom friends, family, and “fools” (known as the 3 Fs or FFF) The term “fools”refers to the high risk associated with investment in nascent stage firms and the

particu-“valley of death” depicted in Figure 1.2 where firms require significant capitalinflows but show little or no revenues until subsequent years Professional individ-ual investors known as “angel” investors are a common source of capital for entre-preneurs prior to obtaining more formal institutionalized venture capital finance(Wong, 2002) Many angel investors are successful entrepreneurs who have,through their experience, specialized abilities to recognize talent in other entrepre-neurs and their new ventures A classic example is Andy Bechtolsheim whocofounded Sun Microsystems He gave US$100,000 to the founders of Google,who could not even cash the check as they had not yet established Google as a

legal entity A limitation in the study of the market for angel investment, however,

is the lack of systematic data.2This book will not be considering angel investment

InFigure 1.2, the term “mezzanine” refers to investment in late-stage firms thatare close to an initial public offering (“IPO”) An IPO is the first time a firm sellsits shares for sale in the public market (i.e., lists or floats on a stock exchange) Aseasoned equity offering involves additional capital-raising efforts by firms alreadytrading on a stock exchange The latter part of this book (Chapters 19 23) willconsider issues involved with the exit of venture capital investments through IPOs,mergers and acquisitions, and other exit vehicles

1.2 How Does Venture Capital and Private Equity Differ from Alternative Sources of Capital?

A salient point about raising capital for entrepreneurial firms is that there are manydifferent sources of capital This book considers venture capital and private equityonly But it is worth mentioning at the outset some general characteristics aboutthis type of financing relative to other sources of financing Table 1.1 provides a

Time Valley of

death

Break even

Angels, FFF

Seed capital

(Could include VC)

1st 2nd 3rd Mezzanine IPO

Public market

SEO

Early stage Later stage

VCs, acquisitions/mergers Strategic alliances,etc.

Figure 1.2 Stages of entrepreneurial firm development

2

Recent efforts spurred by the Kaufmann Foundation have begun to fill this gap, but there is significant work to be done in gathering systematic data Most notably, see Shane (2005).

7 Introduction and Overview

Table 1.1 Greatly Oversimplified Typical Characteristics of Funds ProvidersSource Investment

Motivation Focus ofAttention CashTypically

Available

Source ofFunds BiggestDrawbacks BiggestAdvantages SecurityRequired Subject toMarket

Conditions?Internal

operations

Reinvestment Execution Unlimited Earnings Slow Nondilutive None SomeFounders Ambition Varies $100,000 Savings Personal risk Nondilutive None LittleFriends and

Varies $500,000

$1.5M

Previoussuccesses

Varyingcommitment

Brings credibility None ConsiderableVenture capital

funds

Business plan,team, market,trajectory

Contracts,liquidityevent,valuation

$1M

$20M

Limitedpartners,institutions

Timeconsuming,expensive

Brings help,credibility

Contractualterms andconditions

Greatly

Private equity

funds

Mezzanine,buyout,turnaround

Contracts,liquidityevent,valuation

$20M

$500M

Limitedpartners,institutions

Timeconsuming,expensive

Brings help,credibility

Contractualterms andconditions

Tworepaymentsources

80% ofA/R,50% ofinv

Deposits Regulatory

agencies

Advice, clean,straight-forward,businesslike

A/R,inventory,IP

Warrants Speed (5 days to

get a loan)

All assetsincludingIP

Greatly

Leasing

companies

Risk versusreturn

Liquidationvalues

80% ofvalue

Companytreasury

Costly Cheaper than

equity

Varies Little

Factors (buy

your A/R)

Risk versusreturn

Collections 80% of

A/R

Companytreasury

B5% overprime

Cheaper thanequity

Varies LittleAsset lenders Risk versus

return

Balance sheet 80% of

A/R,60% ofinv

Companytreasury

Expensive Cheaper than

equity

Personalguarantee

2-Way economics,low pricingpressure

Little or none LittleInvestment

bankers at

IPO

Fees Stock market Unlimited Public Costs,

underpricing,publicdisclosure

Advice, publicexposure

Escrow,lock-in

Extreme

helpful, albeit oversimplified, overview of typical characteristics of alternative fundproviders for entrepreneurial firms.3 It shows where venture capital and privateequity fit in within the financing spectrum.

The range of sources of capital enumerated in Table 1.1 is broader than thatshown inFigure 1.2.Figure 1.2presented financing sources for start-up firms on ahigh-growth trajectory But the variety of sources of capital available to firms ismuch broader than that indicated inFigure 1.2

Firms may finance their operations internally from reinvestment of their profits.Alternatively, for firms that do not have internal finance or sufficient internalfinance, they must seek external capital A well-established literature in finance hasestablished a “pecking order” of firms’ preferences for raising capital Theoreticaland empirical work has shown that firms prefer to finance their growth internally

by reinvesting their profits because it is less costly than seeking external finance(Myers and Majluf, 1984; see also Myers, 2000) External capital comes at a cost.The cost of debt finance is the interest payments and the risk of being forced intobankruptcy in the event of nonpayment The cost of equity finance is the dilution

in ownership share associated with the equity sold Where investors do not providesignificant value added to the entrepreneurial firm, equity tends to be a more costlyform of finance than debt.4 In an empirical study of nonpublicly traded entrepre-neurial firms raising external capital, Cosh et al (2009) find evidence that is highlyconsistent with this pecking order

Different sources of external capital for entrepreneurs include banks, venturecapital and private equity funds, leasing firms, factoring firms (that buy youraccounts receivable or A/R), trade customers and suppliers, partners and workingshareholders, angel investors, government agencies, and public stock markets Cosh

et al (2009) find that firms’ ability to access capital from different sources dependsprimarily on the degree of information asymmetry faced by the investors and theirability to do due diligence to mitigate such information asymmetry Informationasymmetry refers to the fact that the entrepreneur knows more about the projectthan the external investor Information asymmetry is a risk and cost to the externalinvestor, and it explains why a firms’ own profits is a cheaper source of externalcapital than external debt or equity finance With internal finance there is no price

to pay in terms of compensating a bank or equity investor for carrying out a duediligence review to assess the quality of the firm before investment and for taking

on a risk if the investment is carried out Internal finance also has the advantagethat it is nondilutive in that the entrepreneur does not have to give up equity owner-ship to an external investor

Apart from the founding entrepreneur’s (or entrepreneurs’) savings, family,friends, and fools (the 3 Fs mentioned earlier) are a common source of capital forthe earliest stage entrepreneurial firms An entrepreneur without a track record typi-cally has an easier time raising this type of capital because these investors will

3

Table 1.1 is a slightly modified version of a chart that was circulated an angel investment forum in Edmonton Alberta Canada in 2003.

4 This issue is discussed more extensively in Chapter 11.

have known the entrepreneur for a long time and possibly for the entrepreneur’sentire life In other words, information asymmetries faced by the 3 Fs are lowerthan that faced by other sources of external capital As mentioned, angel investors

do finance early-stage entrepreneurial firms but in general do not have a prior tionship with the entrepreneur Angel investors typically look for entrepreneurswith their own “skin the game” (personal wealth invested), as well as that of the

rela-3 Fs, as a way to ensure that the entrepreneur is committed to the venture and tomake sure that those who know the entrepreneur believe in his or her abilities.Venture capital funds tend to finance entrepreneurial firms with significantinformation asymmetries in terms of not having a lengthy operating history and inhigh-tech industries with hard-to-value intangible assets Venture capital funds typi-cally require an equity stake in the firms in which they invest.5 Venture capitalfund managers are specialized investors with the ability to carry out extensive duediligence of suitable projects in which to invest One explanation for the very exis-tence of venture capital funds is in fact the pronounced information problems asso-ciated with financing high-tech start-up entrepreneurial firms (Amit et al., 1998)

As venture capital funds are intermediaries between institutional investors andentrepreneurial firms (Figure 1.1) and there are minimum fund sizes that make thecosts of establishing this type of financial intermediary viable, venture capital fundsrarely consider projects that require less than US$1 million and almost never con-sider projects that require less than US$500,000

There are a variety of sources of external debt capital Perhaps the most known source is the typical commercial banks Most commercial bank loans requiresignificant collateral and prefer to finance low-risk projects, and bank managersinvest with a view solely to ensure the loan is repaid on time and with interest.Riskier projects such as that considered by venture capital funds typically will notreceive bank finance Some banks, however, do have a strategy of making loans

well-to venture capital-backed entrepreneurial firms Silicon Valley Bank, which is part

of SVB Financial Group, is one well-known example of this type of bank Otherspecialized merchant banks undertake riskier projects with terms that compensatefor the risk taken

Bridge funds provide quick short-term sources of capital to firms with cant collateral Leasing companies, factors (firms that buy your A/R), and asset len-ders provide terms that are typically less favorable than a typical commercial bankloan but often used by entrepreneurial firms that need to ensure cash flow to con-tinue to pay salaries and other ongoing expenses

signifi-Entrepreneurial firms may receive capital from partner firms (such as major pliers or customers) Costs and benefits depend on relative bargaining power of thetwo organizations and the potential for strategic alliances

sup-Few studies have compared the relative importance of different sources

of entrepreneurial capital Perhaps the most informative data are provided by

5

The form of equity taken is discussed in Chapter 11 Occasionally, funds will also invest with debt securities as shown in Part III.

11 Introduction and Overview

Cosh et al (2009), which are based on a sample of 2520 private firms in theUnited Kingdom for capital-raising decisions in 1996 1997 There were 37.8%(952 of 2520) firms in their data that did seek external finance in the 1996 1997period The average amount of external finance sought was d467,667, and themedian amount sought was d100,000 The average amount obtained was almost81% of that which was sought, and the median percentage obtained was 100%.Overall, therefore, the data do not suggest a shortage of external capital for firmsthat make more than a trivial effort in applying for capital Table 1.2 reports thenumber of firms in their data that did seek external finance by the type of source offinance, as well as the percentage of all their external capital obtained from thesource Among the firms that did seek external finance, 775 approached banks, 474approached leasing firms, 151 approached factoring/invoice discounting firms,

138 approached partners/working shareholders, 87 approached venture capitalfunds, 83 approached private individuals, 53 approached trade customers/suppliers,and 67 approached other sources It is of interest that outright rejection rates werehighest among venture capital funds (46% rejection) and much higher than that forbanks (17% outright rejection) The lowest rejection rate was among leasing firms(5%) Banks comprised the median and mean highest percentage of outside finance

in terms of which type of source was approached and which type of sourceprovided the finance In fact, banks comprised the only type of source for whichthe median percentage of a firm’s total external capital was greater than 0%(for banks, the median percentage is 34%; seeTable 1.2)

The Cosh et al (2009) data indicate that there is not a substantial capital gapfor the majority of firms seeking entrepreneurial finance; rather, firms seekingcapital are able to secure their requisite financing from at least one of the manydifferent available sources There are, however, differences in firms’ ability toobtain finance in the form that they would like Even after controlling for selec-tion effects, Cosh et al find that banks are more likely to provide the desiredamount of capital to larger firms with more assets Leasing firms, factor discount-ing/invoicing firms, trade customers/suppliers, and partners/working shareholdersare more likely to provide the desired capital to firms with higher profit margins.Profit margins are not statistically relevant to venture capital funds and privateindividual investors; smaller firms are more likely to obtain finance from privateindividuals, whereas young innovative firms seek external capital from venturecapital funds

Apart from private sources of capital, a variety of different types of governmentsupport programs exist to enable access to entrepreneurial finance The nature andscope of programs varies greatly across different countries Some of the programsrelated to venture capital are detailed in Chapter 9

Finally, entrepreneurial firms may access external capital by listing their firm on

a stock exchange in an IPO This is one of a variety of different ways in which ture capital and private equity funds exit their investments Part V of this book con-siders why venture capital and private equity funds exit by IPO versus other forms

ven-of exit Also, Part V provides evidence on factors that influence the performance

of IPOs

Table 1.2 Relative Importance of Specific Sources of External Capital in the UKBanks Venture

CapitalFunds

HirePurchase orLeasingFirms

Factoring/

InvoiceDiscountingFirms

TradeCustomers/

Suppliers

Partners/

WorkingShareholders

OtherPrivateIndividuals

Other

Number of firms that did approach

this source for external capital

Number of firms that did not

approach this source, but did seek

external finance elsewhere

Number of firms that did approach

this source but no finance offered

Number of firms that approached this

source but less than full amount

offered

Number that did approach this source

and full amount offered

Mean percentage of total external

capital obtained from this source

42.749 2.851 23.792 5.892 1.624 5.313 3.910 3.598Median percentage of total external

capital obtained from this source

Standard deviation of percentage

obtained from this source

39.451 13.948 33.630 18.261 9.069 17.602 16.605 16.224Minimum amount obtained from this

1.3 How Large Is the Market for Venture Capital and

Private Equity?

The market for venture capital and private equity varies significantly in differentcountries around the world Data on the amount of venture capital and privateequity per GDP for 28 countries is presented inFigure 1.3 Similar data over a lon-ger time horizon is presented inFigure 1.4andTable 1.3.Figure 1.4andTable 1.3also include information pertaining to the value of exit transactions (sales of invest-ments) and fundraising from institutional and other investors More recent data up

to 2011 are discussed immediately thereafter

The venture capital industry in the United States is the largest in the world interms of total capital under management As of 2003, there was over US$100 bil-lion in capital under management by more than 1000 funds Funds in the UnitedStates are predominantly set up as limited partnerships and are typically very spe-cialized in terms of stage of development and industry focus There is significantgeographic concentration of investment activity Route 128 in Boston has a highconcentration of biotechnology investments, whereas Silicon Valley in Californiahas a high concentration of electronics and computer-related investments.6

In Canada, there were around 130 funds in 2003, with US$20 billion in capitalunder management and approximately 50% of this capital managed by tax-subsidized labor-sponsored venture capital corporations (LSVCCs).7 LSVCCs are

The Netherlands United Kingdom

Sweden Belgium Norway Finland

Figure 1.3 Venture capital investment by stages as a percentage of GDP, 1998 2001.Source: OECD

Early stage

Exp ansion stage Total private equity All dispositions

Fundraising Amounts averaged 1990

Netherlands Portugal Spain Sweden UK US

CanadaFigure 1.4 Size of venture capital and private equity markets across countries

Source: Armour and Cumming (2006)

Table 1.3 Size of Venture Capital and Private Equity Markets Across Countries

Stage ExpansionStage Total PrivateEquity Fundraising AllDispositions

The size of the early stage, expansion stage, total private equity (including early, expansion, late, buyout, and turnaround stages), fundraising and dispositions (exits) expressed as a fraction of GDP are presented Values are averaged for the 1990 2003 period.

15 Introduction and Overview

tantamount to a mutual funds that invest in private equity and have individualretail-based investors, not institutional investors (discussed further in Chapter 9;see also Cumming and MacIntosh, 2006, 2007) Relative to their US counterparts,funds in Canada tend to be less specialized in terms of stage of development, indus-try, and geographic focus.

In Australia, there was approximately US$3 billion in capital under managementacross 174 funds in 2003.8 Many funds in Australia are quite small, as they areorganized as pooled investment vehicles and not traditional limited partnershipfunds (Cumming, 2007; Cumming et al., 2005) There was comparatively littleearly-stage investment activity until 1997 when the Government of Australia estab-lished the Innovation Investment Fund (IIF) program, which effectively led thegovernment to be a limited partner in specialized early-stage funds alongside otherinstitutional investors that received more favorable terms (Cumming, 2007).9

In Hong Kong, there were 177 funds in 2003 that collectively managed US$26billion in committed capital.10 In Europe, there were approximately 700 funds in

2003 that collectively managed a little more than US$50 billion capital undermanagement.11

A number of studies have sought to explain international differences in the size

of venture capital and private equity markets Leleux and Surlemount (2003) focus

on differences across Europe and the effect of direct government investment grams in terms of whether they seed or crowd out (displace) private investment.They find little effect of direct government investment programs Jeng and Wells(2000) find evidence that favorable legal regimes that encourage pension invest-ment and tax friendly environments are more likely to stimulate venture capitalacross countries (consistent with US-based evidence from Poterba (1989) andGompers and Lerner (1998)) Black and Gilson (1998), Cumming et al (2006), andArmour and Cumming (2006) present evidence that public stock markets areimportant for venture capital markets, particularly as they offer an exit vehicle forventure capital funds to sell their investments Based on the set of countries inTable 1.3, Amour and Cumming (2006) show laws are as important and may even

pro-be more important and show that the more successful venture capital and privateequity markets are attributable to entrepreneur-friendly bankruptcy laws, legalenvironments that have clearly delineated shareholder rights, and low capital gainstaxes (the latter finding is consistent with empirical work in Poterba (1989),Gompers and Lerner (1998), Jeng and Wells (2000) and is consistent with theo-retical studies of Keuschnigg (2003a,b, 2004a,b), and Keuschnigg and Nielsen(2001, 2003a,b,c, 2004a,b)) Armour and Cumming (2006) find direct government

expenditure programs that create government-subsidized venture capital funds donot play a more pronounced role in stimulating the size of a venture capital market,and may even crowd out private investment, particularly in the case of Canada(as discussed by Cumming and MacIntosh, 2006, 2007) A primary problem withthe Canadian initiative has been the statutory covenants (essentially a statutoryfinancial contract) governing the operations, or rather hampering the operations, ofthe LSVCCs Chapter 9 considers in more detail the relative success of differentgovernment initiatives for stimulating venture capital and private equity markets indifferent countries.

Alternative benchmarks other than GDP for comparing the size of venture tal markets across countries have been proposed in various research papers, includ-ing population and late-stage private equity investments To highlight thedifferences in select country rankings with these measures, in Figures 1.5 and 1.6

capi-we present annual venture capital data from the European Venture CapitalAssociation (EVCA) spanning the years 1989 2011 for the following westernEuropean countries: Austria, Belgium, Finland, France, Germany, Ireland, Italy, theNetherlands, Portugal, Spain, Sweden, and the United Kingdom Figure 1.5 showsamounts of venture capital scaled by total private equity, GDP, and population.Figure 1.6presents a similar graph with the numbers of venture capital investmentsscaled by numbers of private equity investment, GDP, and population

Figures 1.5 and 1.6highlight the differences in country rankings of early-stageventure capital when the denominator is changed InFigure 1.5, the best countriesbased on the ratio of venture capital to private equity are Ireland, Portugal, andAustria, whereas the worst is the United Kingdom InFigure 1.5, the best countries

1.2

Early-Stage amounts invested VC/total private equity Early-Stage amounts invested VC/population (*100) Early-Stage amounts invested VC/GDP (*1,000)

United KingdomFigure 1.5 Comparison of VC amounts by total PE versus GDP and population Thisfigure shows the differences across countries in terms of amounts of early-stage VC/total

PE, early-stage VC/GDP, and early-stage VC/population Amounts are scaled as indicated toenable direct comparisons and show how country rankings for VC amounts change depending

on the benchmark used to compare countries Data are averaged by country for the period

1989 2011

17 Introduction and Overview

based on both venture capital/GDP and venture capital/population are the UnitedKingdom, the Netherlands, and Sweden, whereas the worst is Austria Similar differ-ences in rankings arise from the use of number of investments inFigure 1.6 Simplyput the use of ratios of venture capital to private equity for measuring the success of

a venture capital market gives rise to bizarre country rankings Very similar bizarrecountry rankings were reported by a working paper version of the Da Rin et al.(2006) paper, as explicitly detailed Cumming (2011a,b, 2013).12 In turn, Da Rin

et al.’s (2006) public policy estimates on the effectiveness of public policy arecompletely incorrect, as discussed further in Cumming (2011a,b, 2013).13

1.4 State of the Venture Capital Market Pre- and

Postfinancial Crisis

It is widely recognized that the venture capital industry is subject to massive boomsand busts, but since the start of the financial crisis in August 2007, venture capitalhas been in particularly hard times, as documented in Block et al (2012), among

United Kingdom

Early-stage number of investments VC/total private equity Early-stage number of investments VC/population (*10.000) Early-stage number of investments VC/GDP (*10.000)

Figure 1.6 Comparison of the number of VC investments by total PE versus GDPand population in Europe This figure shows the differences across countries in terms

of numbers of early-stage VC investment/total PE, early-stage VC/GDP, and early-stageVC/population Amounts are scaled as indicated to enable direct comparisons and show howcountry rankings for VC amounts change depending on the benchmark used to comparecountries Data are averaged by country for the period 1989 2011

12

Quite unfortunately, Da Rin et al (2006) deleted these summary statistics from their paper in April

2004, as explained in detail in Cumming (2011a).

others To follow up-to-date specific market trends in venture capital, it is possible

to access publicly available aggregated datasets such as Pitchbook or to purchasedeal-specific data from vendors such as Pitchbook, Thompson SDC, or ZephyrDBV To illustrate the massive boom and bust in recent times, we present datafrom Pitchbook that shows the current state of the venture capital industry in theUnited States We also present data from Thompson SDC to provide an interna-tional perspective in the following

Definitions of venture capital and private equity have differed over time andacross countries Worldwide, the term private equity generally refers to the assetclass of equity securities in companies that are not publicly traded on a stockexchange Both private equity funds and venture capital funds invest in privateequity, the difference being venture capital funds invest in earlier-stage privateinvestments Venture capital funds often style drift into other types of privateequity investments such as late-stage and buyout deals (discussed in this book inChapter 7), and some venture capital funds invest in publicly traded companies(Chapter 22), and even other funds are themselves publicly listed (Chapter 8) Acommon characteristic of most stages of venture capital investments is thatalthough investee companies require financing, they do not have cash flows to payinterest on debt or dividends on equity The more nascent the company, the moreunlikely that the venture capital investor will be able to recoup investmentamounts Investments are made by venture capitalists with a view toward capitalgain on exit The most sought after exit routes are an IPO, where a company lists

on a stock exchange for the first time to obtain additional financing, and an tion exit (trade sale), where the company is sold in entirety to another company.Venture capitalists may also exit by secondary sales, where the entrepreneur retainshis or her share but the venture capitalists sell to another company or another inves-tor, by buybacks, where the entrepreneur repurchases the venture capitalists’ inter-ests, and by write-offs or liquidations (Chapters 19 21)

acquisi-It can be said therefore that if the industry is indeed in crisis, then essentially it

is a crisis for critical growth of new technology companies Not only is there lesscapital to be invested in high-growth companies, but also whatever capital there is

to be invested may not be advanced to the companies that need the capital most.Also, as venture capital investors are increasingly challenged to obtain liquiditythrough preferred, most profitable exit routes, they are increasingly wary of invest-ing in the asset class, thus further reducing the amount of venture capital available.Figure 1.7Ashows the slowdown in venture capital fundraising and the growth

in the overhang of uninvested capital or capital that is being held by venture capitalfunds but have yet to be invested in high-growth companies In 2010, there was US

$81.66 billion in uninvested venture capital For private equity funds, in 2010 therewas US$485 uninvested private equity (Figure 1.7B) The drop-off in venture capi-tal shown inFigure 1.7A is not as dramatic in recent years for venture capital as it

is for private equity shown inFigure 1.7B The reasons are twofold First, privateequity deals have a greater reliance on the use of debt and the credit crisis obvi-ously curtailed credit markets Second, venture capital investments tend to be morecounter-cyclical relative to private equity investments insofar as there are relatively

19 Introduction and Overview

more venture capital deals when IPO markets are weak Venture capital deals take

a longer time to bring to fruition and as such investors invest more heavily in ture deals with the expectation that they will be ready to exit when IPO marketsare at a peak (Cumming et al., 2005)

ven-Figure 1.8A and B may explain why venture capital fundraising has sloweddown, albeit not as dramatically as private equity fundraising Figure 1.8A and B

shows venture capital funds have not performed very well in the past decade andhave been outperformed in many years by private equity funds of the same vintageyear For recent years, one would hope that the J-curve kicks in for subsequentyears; that is, one would hope that despite the current low-performance figures,returns will increase dramatically in upcoming years.Figure 1.8A and Bshows DPI,which refers to distributions to paid in capital, a measure of the cumulative distribu-tions’ returns to limited partners as a proportion of the cumulative paid in capital.

The DPI measure reflects the funds realized return or the cash-on-cash return; itdoes not reflect valuations of unexited portfolio companies, which at times can beinflated relative to actual subsequent investment outcomes (see Chapter 22).Figure 1.8A and B also shows the RVPI, or the residual value to paid in capital,which measures how much of a fund investor’s capital is tied up as equity in thefund (not yet realized) relative to paid in capital That is, while DPI measures therealized return on investment, RVPI measures the unrealized return on investment.Figure 1.8A and Balso shows the TVPI, or total value to paid in capital, which isthe sum of DPI and RVPI DPI, RVPI, and TVPI are measured net of fees and car-ried interest Typically, venture capital funds have a 2% fixed management fee and

a 20% carried interest performance fee (Chapter 6) There has been a strikingincrease in the RVPI component of TVPI relative to the DPI component of TVPI inrecent years for both venture capital (Figure 1.8A) and private equity (Figure 1.8B),but the comparatively lower DPI for venture capital is particularly noteworthy

It is important to note that there are wide discrepancies in reported returns toventure capital and private equity For example, in Table 1.4we report return sta-tistics presented by Thompson Financial in 2006 These statistics differ fromFigure 1.8A and Bdue to the reporting by vintage year versus calendar year anddifferences in the treatment of RVPI Reporting issues in venture capital and pri-vate equity are discussed further in Chapters 4 and 22

Figures 1.9 and 1.10show venture capital fund IRRs by different fund sizes andhorizons There is a growing body of work that shows that venture capital and

Table 1.4 Thomson Financials’ US Private Equity Performance Index (PEPI)Investment Horizon Performance through 09/30/2006 (expressed in %)

Source: Thomson Financial/National Venture Capital Association.

private equity funds exhibit diseconomies of scale, and lower returns and worseexit results as a result of limited attention (Chapters 15, 17 and 18).

Figure 1.11 shows that for median 1-year rolling horizon IRRs by fund type,venture capital has not performed as well as private equity or other comparableasset classes in recent years

Figure 1.12 presents a similar picture showing private equity horizon IRRs(based on long-term index holdings) outperform venture capital (for 1-, 3- and5-year horizons) and the Russell 3000 index (for the 3- and 5-year horizons)

Clearly, the state of the venture capital industry in the United States does notappear to be terribly optimistic or attractive, at least on average, to investors as at

2010 based on performance over the past decade Nevertheless, there is massiveperformance persistence in venture capital and private equity as top quartile funds

Figure 1.11 Median 1-year rolling horizon IRR by fund type

(top 25% of performing funds) have a significant likelihood of remaining in the topquartile over time (Figure 1.13; see also Kaplan and Schoar, 2005) Institutionalinvestors into established venture capital and private equity fund managers there-fore typically have longstanding relationships, and those without such relationshipstypically have difficulty accessing such fund managers.

1.4.1 The Effect of the Crisis on a Venture Capital Industry

Already in Distress

Indubitably, during the crisis, venture capital activity slowed down In Block et al.(2012), the authors found that the crisis led to a decrease in the number of fundingrounds This decrease occurred within all industries and is larger for first roundsthan for later rounds The authors observed that venture capital funds were morereluctant to provide first-round investments toward “new” start-ups during the crisisthan during the precrisis period, especially in the Biotechnology, Internet, andMedical/Health Care industries Within these industries the percentage decrease infirst-round investments was approximately four times larger than the decrease inlater-round investments

The slowdown of venture capital activity due to the crisis has been found to

be more severe in the United States than elsewhere Block et al (2012) not onlyshow that the decrease in the number of funding rounds per month is more pro-nounced within than outside the United States, but also that the difference is

particularly strong for first-round investments in nearly all industries in the UnitedStates This difference in US versus non-US investments is confirmed by theThompson SDC presented inFigure 1.14.

1.4.2 Crisis Leading to Opportunities?

In addition to weakening in fundraising and weakening of performance, venturecapitalists are finding it increasingly difficult to exit from their investments.Looking at Figure 1.15, it is clear that not only have the number of IPO exits for

Figure 1.15 US versus non-US venture capital IPO exits by fund vintage year

Source: Thompson SDC

venture capital funds in the United States drastically declined since 2002, but thisdrop has also been more severe in the United States than outside the United States.This decline in IPOs may not necessarily be attributed to the crisis as the num-bers have been declining since the bursting of the tech bubble and even more soafter the introduction of the Sarbanes Oxley Act of 2002 as companies found themore onerous operational and disclosure requirements too costly to implement It isessentially too expensive for nascent companies to seek listing and as such it is tak-ing longer for these companies to go public As these companies take longer to ini-tiate an IPO, venture capital fund managers are unable to provide their fundinvestors with the sought after profits by the time the fund life ends, traditionally

10 years from fund establishment It may be the case that the traditional life of afund has to be extended to 15 years, and while this may deter fund investors who

do not wish to be locked into an investment for that duration, the extension willenable venture capitalists to dedicate both the financial and value-added resources

to ensure that their investee companies are more than ready to initiate an IPO (seealso Metrick and Yasuda, 2010)

In addition to increased difficulties to exit from their investments through IPOsand particularly since the global financial crisis, there has been a growing market

in secondary private fund interests whereby fund investors transfer their limitedpartner interests to secondaries The market for secondaries represents an importantway for many investors to achieve liquidity, particularly since most funds areclosed ended with the 10-year lifespan and do not offer early redemption rights.Most of these secondaries to date have been buyout fund portfolios, often held bybanks, although there is increasing interest in venture capital by secondaries Forthe secondaries in the buyout market, it has been reported that sellers routinelyachieve 90% of a portfolio’s net asset value With a growing secondaries market, it

is possible that more investors may reevaluate their view of venture capital, andeven when new fund structures with increased life spans are introduced, suchinvestments may still be attractive to potential fund investors And for the sake ofnascent companies, it is crucial that venture capital remains an attractive invest-ment class

Finally, in view of the weak performance of venture capital, it is also possible toquestion the compensation structures currently in place for industry participants Ithas been suggested by Mulcahy et al (2012), among others, that the model of pay-ing a 2% annual management fee and 20% carried interest or performance fee maynot be sufficiently incentivising fund managers to seek the mostprofitable investments, as it may just be easier to rely on the management fees,especially when the funds are large enough

1.4.3 Summary

This overview of the market showed the impact of the financial crisis on the ture capital and private equity in the United States with some international compar-isons These statistics provide insight into changes the industry will likely face incoming years in respect to fundraising and fund structures

ven-27 Introduction and Overview

The recent financial crisis cannot totally be blamed for the marked drops inventure capital fundraising, reduced venture investment, and the hindrance of suc-cessful exits around the world, but it may have exacerbated the existing problems.Poor returns over the past decade indicate most fund managers do not earn theirfees and investors have been increasingly wary of taking on added risk without get-ting the reward Structural changes appear to be inevitable to the venture capitalmarketplace to preserve an essential source of funding for nascent high-growthcompanies.

1.5 What Issues Are Relevant to the Study of Venture

Capital and Private Equity?

1.5.1 Information Asymmetries and Agency Problems

As mentioned earlier,14problems of information asymmetries and agency costs aretwo of the paramount explanations for the existence of venture capital and privateequity funds If there are no agency costs or information asymmetries, thenentrepreneurial firms can simply raise capital from banks or other sources of debtfinance Agency costs and information asymmetries play a central role in shapingthe contracts used to set up limited partnerships Also, agency problems are the pri-mary reason why venture capital and private equity funds use detailed contractswith their investee firms to govern their relationship over the life of the investment.Chapter 2 therefore provides a review of different types of agency problems inentrepreneurial finance, and this material is provided before considering othertopics Agency problems are defined and discussed in Chapter 2 in the context ofdifferent securities utilized by venture capital and private equity investors: debt,convertible debt, preferred equity, convertible preferred equity, common equity,and warrants Chapter 2 discusses agency problems to provide a context for thedata that are presented and analyzed in the subsequent chapters

1.5.2 International Institutional and Legal Context, and

ven-in ven-institutional and legal settven-ings for different countries considered ven-in this book

14 See footnotes 5 and 6 and accompanying text.

In addition, Chapter 3 provides an overview of the statistical and econometricmethods in the book to enable a reader to follow all of the chapters in this bookregardless of prior training.

1.5.3 How to Attract Institutional Investors?

Part II of this book comprises Chapters 4 9 and focuses on the structure of venturecapital and private equity funds Chapter 4 considers factors that influence fundmanager fundraising We will more specifically review the underlying factors, botheconomic and regulatory, that institutional investors consider in making venturecapital and private equity investments The issues involved are illustrated by refer-ence to survey data These issues provide a relevant context for understanding thestructure venture capital and private equity contractual structure and role of regula-tion We present data that compare the impact of regulations (as well as the lack ofregulation), illiquidity, and other risks and rewards that lead institutional investors

to allocate capital allocation to private equity instead of other asset classes In view

of the fact that contracts (studied in Chapters 5 and 6) are incomplete and cannotpossibly cover all eventualities, regulation plays a role in influencing institutionalinvestor commitments to private equity Further, we provide evidence in Chapter 4

on what draws an institutional investor to a particular type of fund style: sociallyresponsible funds

1.5.4 How are Funds Structured?

Chapter 5 analyzes contracts affecting the operation of the fund Private equityfunds are often set up as limited partnerships with the use of very long-term con-tracts that typically last for 10 13 years The fund investors are the limited part-ners not involved in the day-to-day operation of the fund; the fund manager is thegeneral partner Fund investors will expect to impose restrictive covenants onthe general partners in order to mitigate the agency problems associated with theinvestment of the investors’ capital Therefore, to preempt this, the general partnerswill draft the initial contracts which will form the basis of negotiations An exam-ple of a limited partnership fund contract is provided in Appendix 1 The initialcontracts are also drafted by the general partners due to more practical reasons; itallows the general partners to establish and assert its mandate to potential investors,enables the general partners to retain control among the many potential investorsduring the negotiation process, and minimizes legal costs associated with the set up

of the fund The covenants are then privately negotiated between the investors andgeneral partners in a way that efficiently manages the incentives and controls thepotential for opportunistic behavior among the general partners Chapter 5 investi-gates how and why private equity fund structures differ internationally and analyzethe frequency of use of restrictive covenants imposed by investors In addition, weset out five categories of restrictive covenants used in governing the activities ofprivate equity fund managers in areas pertaining to investment decisions, invest-ment powers, types of investments, fund operations, and limitations on liability

29 Introduction and Overview

We also analyze the impact of laws and institutions on private equity governancestructures Finally, we investigate the effect the presence of legally trained fundmanagers has on a fund’s governance structure.

1.5.5 How Well Are Fund Managers Compensated?

Chapter 6 considers the issue of fund manager compensation This chapter explainshow managerial compensation contracts differ across funds and across countries

We show managerial compensation differs depending on legal conditions, nomic conditions, institutional investor characteristics, fund characteristics, fundmanager education and experience, among other things We also discuss recentlegal debates as at 2007 over the taxation of fund managers Fund manager carriedinterest compensation has been taxed at lower capital gains tax rates, but there hasbeen a push in the United States and the United Kingdom, among other countries,

eco-to change this eco-to the higher income tax rates

1.5.6 Style Drift

Institutional investors invest in venture capital and private equity funds with theexpectation that they will follow a certain investment style or mandate Chapter 7 ana-lyzes in detail the issue of when institutional investors may be faced with a problem ofstyle drift by the fund managers and provides a theoretical model Also, empirical evi-dence on style drift is studied with US data in Chapter 7 Note that this material inChapter 7 also fits into the material presented in Part IV starting on Chapter 14; how-ever, we present it in Part II in Chapter 7 due to the fact that every year for the past 14years when we present this material on institutional investors in Section II we encoun-tered questions such as "do fund mangers breach the terms in their limited partnershipcontracts?" or "do fund managers do what they promised their institutional investorswhen they raised their fund?" Chapter 7 provides guidance to this question

1.5.7 Listed Private Equity

Not all venture capital and private equity funds are organized as private limitedpartnerships A recent and growing trend is for funds to list themselves publicly.Chapter 8 analyzes institutional investment in listed private equity funds with refer-ence to international data Based on data provided by LPEQ, Preqin, and ScorpioPartnership covering 171 institutional investors in Europe in 2008 2010, we findlisted private equity allocations are primarily a function of size, type, location,decision-making authority, and liquidity preferences Investment in listed privateequity is more commonly made by institutions that are smaller, private (not public)pension institutions, institutions that have a preference for liquidity, quick access,and administrative and cash flow management simplicity, and institutions that arebased in the UK, Switzerland, Sweden, and the Netherlands Also, institutions areless likely to invest in listed private equity when investment decision-making isempowered to an alternative asset class team