Contracts and Effort

© Cumming & Johan (2013) Venture Capital Investing

Contracts and Effort

Cumming and Johan (2013 Chapter 15)

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Motivation

• Corporate finance literature dominated by “incentive effects”

• Vast theoretical literature• Scant empirical literature

• Significant need for empirical assessment

• The fundamental basis of all work in venture capital and private equity

MotivationTheoryData

RegressionsConclusion/Summary

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Chapter Objectives

• Do contracts affect effort, and if so, how?

• Focus on venture capital contracts, syndication, legal environment

• Assess total effort

• Distinguish between advice and monitoring



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Particular Features in this Chapter

• Measure actual hours of work contributed by VCs to each investee

• Distinguish between VC advice and monitoring

• Assess the role of specific contractual details, & syndication across VC funds, etc.

• Provide very specific empirical details Contract structures, portfolio size, entrepreneurial firm, VC, exit

outcomes, etc.

• Relate results to vast theoretical literature



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Theoretical Focus in VC Literature

1. Cash flow rights

2. Control rights

3. Legal Systems

4. Control variables



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1. Cash Flow Rights

• Casamatta (2003 JF), Schmidt (2003 JF), Farmer and Winter (1986 JF) Bilateral moral hazard in VC finance Role for convertible preferred shares

• Hypothesis 15.1a: Venture capital fund managers provide more effort and advice to entrepreneurial firms financed with convertible securities (instead of common equity or debt). Moreover, the effort exerted by the venture capital fund manager and advice provided is directly correlated with the venture capital fund’s ownership percentage.

• Concern with endogeneity• Frequent use of non-convertibles outside the US



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1. Cash Flow Rights (Continued)

• Cornelli and Yosha (2003 RES) Convertible securities mitigate signal manipulation in staged

financing

• Hypothesis 15.1b: There are fewer venture capital fund manager-entrepreneur conflicts within entrepreneurial firms financed with convertible securities.

• Concern with endogeneity• Competing behavioral finance ideas



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2. Control Rights

• Chan et al. (1990 IER); Kirilenko (2001 JF) Control is related to project risk

• Hypothesis 15.2a: Venture capital fund managers provide more effort and advice for entrepreneurial firms for which the venture capital fund has been allocated greater control rights.

• Hypothesis 15.2b: Venture capital fund manager-entrepreneur conflicts are more likely among investee firms for which the venture capital fund has been allocated greater control rights.

• Concern with endogeneity• Heterogeneous allocation of control across firms



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3. Legal Systems

• Hypothesis 15.3: Countries with better legal systems mitigate the scope for venture capital fund manager–entrepreneur conflict as better legal systems facilitate more certainty in the enforcement of contracts, as well as the interpretation of incomplete contracts.



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4. Control Variables

• Type of VC (captive / non-captive)• Portfolio size / VC Manager• Capital Managed / VC Manager• Staging• Entrepreneur stage of development• Entrepreneurial firm industry• Entrepreneur experience• Exit outcomes



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Control Variables (Continued)

• Syndication– Lerner (1994 FM), Brander et al. (2002 JEMS),

Casamatta and Haritchabalet (2007 JFI)Effort complementarities

• Expect VCs work more when syndicated investors work more

• Endogeneity concerns



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Hand Collected Sample

• 121 investment rounds

• 74 entrepreneurial firms

• 14 VC funds

• 7 European countries (Belgium, Denmark, Germany, Hungary, Italy, Portugal, The Netherlands)



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OLS, Ordered Logit and IV Estimates

• Dependent Variables Hours/Month, Advice Rank, # Disagreements

• Explanatory Variables VC characteristics, ENT characteristics, Exits, Contract Terms,

Risk Measures, legality, etc.

• Instruments Year of investment and exit dummies, MSCI returns over

investment period Correlations (Tables 3 and 4) work “fairly” well, but not

100% perfect



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Tables 15.5 – 15.7

• Table 15.5: Dep Var: Hours / Month

• Table 15.6: Dep Var: Advice Rank

• Table 15.7: Dep Var: # Disagreements

• 5 Models per Panel to show robustness– Regressions with and without instruments– Regressions with different sets of explanatory variables



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© Cumming & Johan (2013) Venture Capital Investing15

Table 15.4: Dep Variable Hours Per MonthModel (1) OLS Model (2) OLS Model (3) OLS Model (4) OLS Model (5) 2SLS

Coefficient t-statistic Coefficient t-statistic Coefficient t-statistic Coefficient t-statistic Coefficient t-statistic

Constant 10.75 2.00* 1.43 0.17 10.20 1.02 14.87 0.46 -3.55 -0.10

Contractual Terms and Legal Conditions

Convertible Security (H1) 2.25 0.51 1.88 0.50 -3.23 -0.92 -2.22 -0.66 -10.33 -1.87**

Ownership % (H1) 4.55 0.30 20.83 1.50 25.69 2.30** 30.67 2.67*** 38.76 1.64*

Veto Rights (H2) 13.44 4.98*** 7.96 2.10** 11.36 3.26*** 12.15 3.22*** -0.87 -0.07

Board Rights (H2) -0.004 -0.48 -0.001 -0.15 0.003 0.65 0.002 0.44 -0.03 -0.91

Special Control Rights (H2) -1.49 -0.23

Country Legality (H3) -0.39 -0.50

Project and Environment Related Risk

Project Risk Ranking -4.67 -0.56 -9.77 -1.12 -4.07 -0.46 2.51 0.29 -6.01 -0.37

Entrepreneur Experience Ranking 0.21 0.40 0.24 0.43 0.36 0.26

Late or Buyout Stage -8.35 -2.13** -10.50 -3.22*** -9.15 -2.47** -7.44 -1.89* -5.87 -0.66

Medical / Biotechnology -4.70 -0.92 -5.33 -0.93 2.77 0.31

Computer / Electronics -4.92 -1.54 -3.95 -1.13 -4.31 -0.78

Communications / Internet -11.58 -2.82*** -11.16 -2.48** -9.70 -1.58

Foreign Investment 0.46 0.10 -2.85 -0.63 -0.79 -0.20 1.87 0.39 2.75 0.44

Investment Characteristics and Performance

Hours from Syndicated Partners 0.49 5.60*** 0.40 5.51*** 0.38 5.07*** 0.67 2.07**

Investment Rounds 3.81 2.59** 4.00 2.55** 1.64 0.19

(Log of) Book Value 0.51 0.72 -0.21 -0.28 -0.96 -1.13 0.94 -0.06

Investment Months -0.30 -3.35*** -0.30 -3.61*** 17.09 1.74**

IPO Exit 10.76 2.44** 16.26 3.26*** 0.25 0.03

Acquisition Exit 7.74 2.09**

Venture capital fund manager Fund Characteristics

Limited Partnership Venture capital fund manager 1.74 0.42 0.96 0.29 -2.92 0.74 3.00 0.62

Venture capital fund manager Portfolio Size / # of Venture capital fund manager Managers

-1.98 -2.53** -1.19 -1.55 -2.39 -2.67*** -1.69 -1.88* -3.01 -1.40

Number of Observations 74 74 74 74 74

Adjusted R2 0.10 0.31 0.47 0.48 0.24

F-statistic 1.96* 3.99*** 4.57*** 4.16*** 2.18***


Table 15.5. Dep Variable Advice RankingModel (1) OLS Model (2) OLS Model (3) OLS Model (4) OLS Model (5) 2SLS


Constant 0.44 0.85 2.31 2.96** 1.64 1.64 3.31 1.19 -2.24 -0.72


Convertible Security (H1) 0.97 2.87*** 0.83 2.59** 0.48 1.27 0.62 1.93* -0.11 -0.19

Ownership % (H1) -0.52 -0.53 -0.11 -0.12 -0.19 -0.24 -0.07 -0.09 0.09 0.04

Veto Rights (H2) 2.63 6.90*** 2.57 5.63*** 2.63 5.63*** 2.45 5.17*** 3.80 3.67***

Board Rights (H2) 0.001 1.69* 0.001 1.51 0.001 1.20 -0.007 -2.61**

Special Control Rights (H2) 0.24 0.31

Country Legality (H3) -0.07 -0.64


Project Risk Ranking 1.36 1.51 2.15 2.59*** 2.46 2.83*** 2.30 2.60** 3.10 2.33**

Entrepreneur Experience Ranking 0.14 1.98** 0.14 1.85** 0.27 2.07**

Late or Buyout Stage -1.34 -4.46*** -0.98 -2.92*** -0.86 -1.88** -0.80 -1.80** -0.48 -0.59

Medical / Biotechnology -0.47 -0.63 -0.46 -0.68 0.32 0.33

Computer / Electronics 0.30 0.75 0.26 0.64 0.93 1.73*

Communications / Internet -1.03 -1.50 -1.06 -1.68* -0.68 -1.10

Foreign Investment -0.29 -0.84 -0.26 -0.74 -0.28 -0.82 -0.19 -0.63 0.45 0.78


Hours from Syndicated Partners -0.003 -0.29 -0.008 -0.78 -0.008 -0.77 -0.01 -0.46

Investment Rounds 0.25 1.10 0.34 1.36 0.99 1.21

(Log of) Book Value -0.25 -2.98*** -0.30 -4.13*** -0.30 -3.65*** -0.29 -1.95*

Investment Months -0.008 -0.84 -0.006 -0.71 0.10 0.11

IPO Exit 0.12 0.33 -0.05 -0.13 0.002 2.11**

Acquisition Exit -0.24 -0.61


Limited Partnership Venture capital fund manager -0.18 -0.43 -0.01 -0.04 -0.16 -0.45 0.57 1.08


-0.07 -0.78 -0.14 -1.59 -0.22 -2.21** -0.26 -2.78*** -0.37 -1.76*


Adjusted R2 0.38 0.40 0.44 0.44 0.44

F-statistic 6.69*** 5.50*** 4.02*** 4.01*** 4.01***


Table 15.6. Dep. Variable Scope of DisagreementModel (1) OLS Model (2) OLS Model (3) Ordered Logit Model (4) Ordered Logit Model (5) IV Ordered Logit


Constant 0.53 0.61 7.75 2.72*** 3.67 1.50 9.97 2.07** 7.79 2.13**


Convertible Security (H1) -0.04 -0.13 0.31 1.01 0.03 0.40 0.36 0.48 0.20 0.15

Ownership % (H1) 1.21 1.22 1.55 1.67* 3.14 1.14 3.03 1.76* -0.34 -0.06

Veto Rights (H2) 0.27 0.86 -0.42 -0.95 -0.12 -0.11 -0.93 -1.17 -2.57 -0.81

Board Rights (H2) 0.83 0.15 3.27 1.15 0.002 0.48

Special Control Rights (H2) -2.92 -1.75* 1.64 0.26

Country Legality (H3) -0.29 -3.10*** -0.40 -2.17**


Project Risk Ranking (H2) -0.23 -0.28 0.41 0.49 0.73 0.20 0.34 0.14 -0.89 -0.40

Entrepreneur Experience Ranking (H2) -0.16 -1.83* -0.39 -1.81* -0.32 -1.84* -0.39 -2.35**

Late or Buyout Stage (H2) -0.88 -2.83*** -0.34 -1.09 -2.76 -2.46** -1.30 -1.08 -2.15 -2.02**

Medical / Biotechnology (H2) 1.15 1.43 1.93 1.45 1.10 0.93 -0.08 -0.05

Computer / Electronics (H2) -0.33 -0.90 0.44 0.53 -0.06 -0.09 -0.47 -0.41

Communications / Internet (H2) -0.78 -1.80* -1.05 -0.93 -1.29 -1.38 -1.19 -0.81

Foreign Investment 0.21 0.60 0.48 1.19 0.81 0.75 0.78 0.86 -0.58 -0.25


Hours from Syndicated Partners 0.03 3.72*** 0.03 4.00*** 0.09 2.24** 0.06 2.40** 0.02 0.44

Investment Rounds 0.16 1.14 -0.42 -0.84 0.06 0.13 -2.57 -2.38**

(Log of) Book Value 0.03 0.34 0.03 0.33 0.19 0.90 0.14 0.61 0.12 0.50

Investment Months -0.01 -1.87* -0.04 -1.35 -0.02 -1.02 1.96 1.38

IPO Exit -0.14 -0.28 0.16 0.19 0.81 0.90 0.43 0.52

Acquisition Exit -0.02 -0.04 0.53 0.73


Limited Partnership Venture capital fund manager -0.98 -2.24** -0.53 -0.62 -1.23 -1.43 -0.61 -0.82


-0.23 -3.22*** -0.18 -2.20** -0.79 -1.91* -0.74 -1.55 -0.42 -1.05

Mu (1) 0.95 3.03*** 0.84 2.74*** 0.66 2.96***

Mu (2) 1.30 2.41** 1.20 3.10*** 0.95 3.42***

Mu (3) 2.59 2.52** 2.60 3.09*** 2.01 3.37***

Mu (4) 3.69 2.78*** 3.77 2.74*** 2.98 2.35**


Adjusted R2 (Pseudo R2 for Models (3) – (5)) 0.16 0.32 0.38 0.34 0.31

F-statistic (Chi-square for Models (3) – (5)) 2.44** 2.81*** Chi-squared: 67.30*** Chi-squared: 60.94*** Chi-squared: 38.28***


Explanatory VariablesImpact on

Total hours effort Advice Disagreement

Use of Convertible Securities 0 + 0

VC Ownership % + 0 + / 0

Veto Rights + / 0 + 0

Board Rights 0 0 0

Syndication + 0 + / 0

Early Stage + + +

Project Risk 0 + 0

Entrepreneur Experience 0 + -

VC Portfolio Size / # Managers - - -

Success Potential + / 0 0 0

Length of Investment Period + 0 +

Legality 0 0 -

‘+’ refers to robust positive effect, ‘-’ refers to robust negative effect, 0 refers to no significant impact, and ‘+ / 0’ refers to positive but non-robust estimates.


Summary

• Rare direct look at investor activities• Important aspect of most theory papers • Prior empirical papers tend to look at effect of effort,

not actual effort

• Novel empirical approach in distinguishing between advice and monitoring

• Advice: congruent with entrepreneurial interests• Monitoring: dissonant with entrepreneur interests



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Key Findings (1)

• Cash-flow and control rights enhance advice but not monitoring.

• Supports Casamatta (2003 JF), Repullo and Suarez (2003 RES), Schmidt (2003 JF), De Bettignies (2008 MS)

• Does not support Cornelli and Yosha (2003 RES), although not a direct test of that model



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Key Findings (2)

• Complementarities in VC Syndicate effort• Supports Lerner (1994 FM), Brander et al

(2002 JEMS)

• Complementarities in VC-Entrepreneur effort

• Supports Casamatta (2003 JF), Cestone (2013 RF), Repullo and Suarez (2004 RF)



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Key Findings (3)

• Strong and robust negative relation between VC portfolio size/manager and involvement

• Funds with larger portfolios per manager tend to provide less effort in both advising and monitoring.

• Consistent with– Kanniainen and Keuschnigg (2004 JCF, JBF)– Keuschnigg (2004 OEP)– Cumming (2006 J Bus)



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Key Findings (4)

• Better legal systems mitigate VC-Entrepreneur conflicts

• Consistent with evidence in other parts of book on the importance of legality in the development of VC markets



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Contracts and Effort

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