DP3462 | Venture Capital Meets Contract Theory: Risky Claims or Formal Control?

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20/07/2002

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Abstract

This Paper develops a theory of the joint allocation of control and cash-flow rights in venture capital deals. I argue that when the need for investor support calls for very high-powered outside claims, entrepreneurs should optimally retain control in order to avoid undue interference. Hence, I predict that risky claims should be negatively correlated to control rights, both along the life of a start-up and across deals. This challenges the idea that control should always be attached to more equity-like claims, and is in line with contractual terms used in venture capital, in corporate venturing and in partnerships between biotech start-ups and large corporations. The Paper also rationalizes the evidence, documented in Gompers (1999) and Kaplan and Stromberg (2000), that venture capital contracts include contingencies triggering both a reduction in VC control and the conversion of VC's preferred stock into common stock.