Venture Capital Contracting in Indiaventure capital industry in India is well established, active...
Transcript of Venture Capital Contracting in Indiaventure capital industry in India is well established, active...
Venture Capital Contracting in India
A thesis submitted to the Bucerius/WHU Master of Law and Business Program in partial fulfillment of the requirements for the award of the Master of Law and Business (“MLB”) Degree
Pranay Chandran
July 16, 2010
12603 words (excluding footnotes)
Supervisor 1: Prof. G. Marcus Cole
Supervisor 2: Mr. Manoj Menon
Table of Contents
1 Introduction ..................................................................................................................................... 1
2 Development of Venture Capital in India ....................................................................................... 4
2.1 Development of the Indian Venture Capital Industry ..................................................................... 4
2.1.1 Pre-liberalization ..................................................................................................................... 4
2.1.2 Post-liberalization ................................................................................................................... 6
3 Understanding Venture Capital ..................................................................................................... 10
3.1 What is Venture Capital? .............................................................................................................. 10
3.2 The Venture Capital Process ........................................................................................................ 11
3.3 Why is Venture Capital relevant? ................................................................................................. 14
3.4 The engineering problem .............................................................................................................. 15
4 Rationale of Venture Capital Contracting ..................................................................................... 17
4.1 The Risk in “Risk Capital” ........................................................................................................... 17
4.2 Obligations of the Venture Capitalist ........................................................................................... 18
4.3 Designing a Contract .................................................................................................................... 18
4.4 Control Mechanisms ..................................................................................................................... 19
4.5 Staged Financing .......................................................................................................................... 19
4.6 Syndication .................................................................................................................................... 20
4.7 Use of Convertible Securities ........................................................................................................ 20
4.8 Other forms of Control .................................................................................................................. 22
4.8.1 Board representation and management ................................................................................. 22
4.8.2 Covenants .............................................................................................................................. 23
4.8.3 Compensation ....................................................................................................................... 24
4.8.4 Contingencies ........................................................................................................................ 25
5 The Venture Capital Investor and Portfolio Company Contract ................................................... 26
5.1 Ownership and Voting Rights ....................................................................................................... 26
5.2 Staging .......................................................................................................................................... 27
5.3 Securities ....................................................................................................................................... 27
5.4 Liquidation Rights ......................................................................................................................... 28
5.5 Conversion Rights ......................................................................................................................... 28
5.6 Anti-Dilution Protection ............................................................................................................... 28
5.7 Redemption, puts, buy-backs and calls ......................................................................................... 29
5.8 Board structure ............................................................................................................................. 29
5.9 Pre-emptive rights and Transfer related rights ............................................................................ 30
5.10 Affirmative voting rights ............................................................................................................... 30
5.11 Option carve-out & Employment contracts .................................................................................. 30
5.12 Information rights ......................................................................................................................... 31
6 Discussion and Analysis of Empirical Study ................................................................................ 32
7 Conclusion .................................................................................................................................... 36
8 Bibliography ................................................................................................................................. 37
9 Annexure: Brief Summary of Empirical Study ................................................................................ i
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1 Introduction
Venture capital fulfils a void in financial markets as an intermediary providing capital to
relatively small and young companies which may have difficulties raising finances from
other, more conventional channels. These companies operate in fast changing markets hence
they are faced with high levels of uncertainty leading to high degrees of information
asymmetry for an investor. However these companies bear the potential of high rewards.
While these firms are still privately held, venture capitalists finance them by acquiring stakes
through equity or equity linked securities, despite the high risk components. In its evolution
over time the venture capital industry has developed a wide range of mechanisms designed to
overcome the variety of problems emerging in the venture capital process.1
India today is vibrant and fast growing market for private equity in general and venture
capital in particular. The number of deals and their aggregate value has been steadily
increasing post-liberlaization at a phenomenal rate. As a result of the global financial
meltdown the deal value of the private equity and venture capital industry had experienced a
considerable dip of 62% in 2009. However India was one country that emerged relatively
unscathed by the crisis, and by the first quarter of 2010 the GDP growth rate has returned to
pre-crisis levels of 8% which by most conservative market estimates is expected to grow over
the next few years. Market sources estimate that there are approximately 375 private equity
firms currently operating in India and at least another 50 have raised or are in the process of
raising funds and are planning to start their operations in the near future. The aggregate
amount of funds raised by the private equity firms for investment in India is estimated to be
approximately US$50 billion. Thus the prospects of the private equity and venture capital
industry continue to be robust.
In 2001 Dossani and Kenney2 examined early efforts to create a venture capital industry in
India. In the context of cross-national transference of institutions the authors tried to
determine whether the US style venture capital industry could be successfully transferred to
the Indian context and if so, how: by modifying the environment, by hybridizing the
institution itself, or by a combination of these two factors. Due to the fact that at the time of
writing the paper, the Indian venture capital industry was still in its nascent stages, the
conclusion of this study was necessarily deferred. The authors themselves write:
“For India, we have argued that the environment itself has had to be and needs to continue
being changed..... Interestingly, in India we believe that venture capital as an institution may
actually need to be changed less than in the case of Taiwan, however this conclusion is not
yet entirely verified.”
Nearly ten years on, this paper seeks to pick up at the point left off. There have since been
considerable developments in the global venture capital market, and also in India. By just
looking at the volume of deals and funds being invested one is of the impression that the
venture capital industry in India is well established, active and relatively healthy.
1 Paul Gompers & Josh Lerner, “The Venture Capital Revolution”, Journal of Economic Perspectives, Vol. 15, No.
2 (Spring, 2001), 145-168, at p. 145 2 Rafiq Dossani and Martin Kenney, “Creating an Environment for Venture Capital in India”, World
Development, Vol.30 (2), at p. 249
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This paper primarily seeks to find out whether the institution of venture capital – the complex
contracting structure developed to tackle extreme uncertainty, asymmetric information and
agency costs in a system based on private ordering- has been transferred “as is” or in a hybrid
form. This is sought to be achieved through an empirical examination of a sample set of
actual contracts between the venture capital investor and the entrepreneur in light of what we
already know the existing literature on such contracts in US venture capital investments.
For this purpose we first show that the very institution of venture capital can be
fundamentally understood as being the contracting structure between the limited partners, the
venture capitalist and the portfolio company. This contracting structure is constituted of two
main contracts, the partnership agreement, which governs the relationship between the
limited partner and venture capitalist and the stock purchase agreement, which governs the
relations between the company and the venture capitalist. These two contracts are mutually
related that successful transference of one of these contracts could imply a successful
transference of the entire contracting structure. This paper focuses on the contracts between
the venture capitalist and the company.
The first section contextualizes the discussion with a look at the development of the venture
capital industry in India. In this part we re-visit the historical development of the venture
capital industry in India. It continues to give an overview of the current situation in India. We
also take a brief overview of the regulations specifically governing venture capital in India
today through an examination of the relevant laws and statutes.
The following section seeks to provide an understanding of venture capital. It provides an
overview of the entire venture capital process starting from raising of the fund to the
investment and monitoring of the investment and the exit from the company. It also seeks to
single out the contracting structure as the core of the institution of venture capital, thus
validating the focus on the venture capital financing contract as the basis of determining the
success of the transference of the institution of venture capital.
In the next section we examine the venture capital financing contract in further detail by
looking at the rationale and tools used in venture capital financing agreements. This is
undertaken through a review of existing literature.
The following section we provide the findings of our empirical study. For the purpose of
enabling a comparison we also provide the findings of numerous studies conducted on the US
Venture capital market in order to determine what constitute the standard contracting terms.
Our findings are presented light of this. This is intended to show how similar or different the
actual contracting models are in the two industries.
This is followed by a detailed discussion and analysis of our findings. The last section
encapsulates a brief conclusion.
The scope of this paper is limited to an examination of the contract between the venture
capitalist and the company in the Indian context with the aim of determining if it is a direct
transference of the institution of venture capital. A discussion of the Indian environment, and
framework is undertaken only for the purpose of contextualizing the discussions. Further
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other aspects of the venture capital process is not discussed in detail, they have been
discussed with a view of providing an understanding of the topic in general.
The discussion in this paper is based on a descriptive and analytical review of existing
literature. Further a large part of the paper is based on an empirical study of Indian venture
capital financing contracts. The sample set consists of hand collected set of 30 executed stock
purchase agreements and term sheets used for venture capital financings in India. The data set
was collected for practitioners operating in the field. Due to the confidential nature of these
documents, some of the details in some of the agreements were removed, and thus did not a
permit a complete examination of all the samples in the data set. However as the main aim is
to determine the contractual terms used in the agreements, the sample set was sufficient.
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2 Development of Venture Capital in India
In this section we look at the development of the venture capital industry in India and a brief
overview of the regulations governing venture capital funds in order to contextualize the
discussion in this paper.
2.1 Development of the Indian Venture Capital Industry
In order to understand the development of the venture capital market in India, one must see it
in the context of the development of the overall economic policy and the Indian government’s
interest in encouraging economic growth.
India's first Prime Minister, Jawaharlal Nehru, inspired by the ideologies of Fabian socialism
and the exploitative experience of colonialism, spear-headed the government of newly
independent India towards the path of democratic socialism for its economy. The economic
policy was characterized by central planning, protectionism, public ownership, extensive
regulation, and a great deal of bureaucratic red tape. Noble as their intentions were, this
"license raj"3 resulted in pervasive corruption and massive inefficiency and further strangled
the private sector and led to an overall slow rate of economic growth4.
The 1980s saw a growing consensus on the failure of the effectiveness of the socialist
economic policies and a need for liberalization. Ironically, it was the government of Rajiv
Gandhi, the grandson of Nehru who came into power in 1984, that initiated the move towards
a more market driven economy. The policy reforms in the mid- and late-1980s, although ad
hoc and implemented quietly5, it laid the foundation of the more extensive reforms in July
1991 and beyond. Minor as they may seem in retrospect, were the beginning of the
acceleration of growth. The policy measures included import liberalization, incentives for
exports, corrections of the real exchange rate and freeing up of several sectors from
investment licensing, all contributed to productive efficiency and allowed faster industrial
growth. It must also be mentioned that both external and internal borrowing allowed high
levels of public expenditures and growth through demand. However, these very factors led to
the June 1991 macroeconomic crisis that brought the economy to a standstill.6
As a result, India stagnated until bold neoliberal economic reforms in 1991, triggered the
current wave of rapid economic growth.
2.1.1 Pre-liberalization
As noted before, the period prior to the 80’s were still early days for Venture Capital
globally. Further considering India from 1950 to 1980 was a fairly classic case of a statist,
3 The term was coined by Indian statesman Chakravarthi Rajagopalachari, who firmly opposed it for its
potential for political corruption and economic stagnation 4 The average Annual Real GDP Growth of India between 1950-1980 was 3.7%
5 In view of the continuing dominance of leftist ideology in India, pre-1991 reforms were introduced quietly
and without fanfare, hence the term often used to describe them is “reforms by stealth” 6 Arvind Panagariya, “India in the 1980s and 1990s: A Triumph of Reforms”, IMF Working Paper, WP/04/43,
March 2004
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import-substitution model of development, with a socialist flourish7having a centrally
controlled industrial license regime, it would not be hard to imagine that there was not much
room for an organised venture capital industry to develop. Entrepreneurs mainly had to
depend on private placements, public offerings and lending by the financial institutions and
the need for risk capital was, to minimal extents, fulfilled by Individual investors and
development financial institutions8.The need for venture capital was identified by policy
makers in 1973 with regards to funding new entrepreneurs and technology. This interestingly
coincides with the beginning of the shift in ideology of India’s political economy around
1980 from the statist and nationalist model of development of the Nehru era in the direction
of a more state and business alliance led model for economic growth9.
A more serious consideration of venture capital was juxtaposed to an active interest on the
part of the World Bank in encouraging economic liberalization in India10. In 1988 the Indian
government announced its first guidelines regarding venture capital operations.
Some of the beneficial features included relatively low capital gains tax rate for venture
capital funds, permission to exit investments at a premium. The restrictions imposed by the
guidelines were far more. The promoters had to be banks, large financial institutions, or
private investors (but only upto 20%). It stipulated the maximum amounts that could be
invested; the kind of companies investment could be made in and who the profile of the
founders. It imposed bureaucratic constraints such as a list of approved investment areas,
vetting of the portfolio firm’s application by government-sponsored development banks; and
approval of the Controller of Capital Issues of the Ministry of Finance of the line of business
in which a venture capital firm wished to invest.11
The World Bank’s involvement also included providing a loan of $45 million to the Indian
Government, which was to be passed on to four public sector financial institutions to enable
them to set up venture capital operations under the 1988 guidelines.
The 1988 guidelines essentially only enabled state-controlled financial institutions and banks
to establish venture capital subsidiaries. There was minimal interest from the private sector in
establishing a venture capital firm. The performance of these early venture capital operations
were modest at best. The problems were numerous. The restrictive nature of the regulations
of the time did not give the opportunity to maximise gains. One example was the
implementation of novel instruments like the “conditional loan” by some venture capital
institutions, but these did not provide capital gains. The institutions were also mandated to
operate only in a limited number of sectors or within specific states. This led some of these
institutions to see themselves as organizations funding technology and hence they did not
focus on the best business opportunities. In addition to this, much of the management of these
7 Atul Kohli, “Politics of Economic Growth in India, 1980-2005 Part I: The 1980s”; Economic and Political
Weekly April 1, 2006, at p.1253 8 Chandreshekhar committee report
9 Atul Kohli, “Politics of Economic Growth in India, 1980-2005 Part I: The 1980s”; Economic and Political
Weekly April 1, 2006, at p.1255 10
Chandrashekhar Committe Report, 2000 11
For details see Rafiq Dossani & Martin Kenney, “Creating an Environment for Venture Capital in India”,
World Development, Vol.30, No.2, pp. 227-253, 2002, at p.
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institutions were inexperienced in this unique and new form of finance. They tended to focus
on identifying good projects to invest in and financing them, there was little or no input
forthcoming on the subsequent management of the firm, setting strategy or recruitment.12
However, despite these shortcomings the most important outcome of these early efforts was
that it helped to lay the foundation for the formalization of the venture capital industry in
India. There was a realisation that there was potential for a venture capital market in India
and there were indeed viable investment opportunities in India. In addition it helped to train
the first cadre of venture capitalists in India who were instrumental in the further
enhancement of the industry in the future.13
2.1.2 Post-liberalization
Policymakers have steadily opened up the economy to foreign investment, which is key to the
growth of the venture capital market as a majority of the capital is provided by foreign
investors. India’s progressive foreign trade policy has been implemented through a
combination of fiscal reform, liberalization of trade and investment policies and rational
exchange controls. This combined with strong fundamentals comprising a favorable
demographic profile, human capital, trade openness, increasing urbanization and rising
consumer spending has made India one of the fastest growing markets in the world.
The formalisation of the Indian venture capital community began in 1993 with the formation
of the Indian Venture Capital Association ("IVCA") headquartered in Bangalore. In 1996, the
Securities and Exchange Board of India ("SEBI") introduced the SEBI (Venture Capital
Funds) Regulations, 1996 (“VCF Regulations”), for regulating and promoting the activities of
domestic venture capital funds. The move liberated the industry from a number of
bureaucratic hassles and paved the path for the entry of a number of foreign funds into India.
In 2000 the SEBI announced the SEBI (Foreign Venture Capital Investor) Regulations, 2000
(“FVCI Regulations”) enabling foreign venture capital and private equity investors to register
with it and avail of certain benefits provided there under. The relevant regulators include the
Foreign Investment Promotion Board, the Reserve Bank of India (‘RBI’) and the SEBI.
The legal regime available for formation and functioning of a domestic VCFs is overlapping
and sometimes unclear. The laws applicable to a domestic VCF are the Securities Contract
Regulations Act, 1956 and the Companies Act, 1956. The Indian regulatory system through
the Reserve Bank of India and the Securities and Exchange Board of India regulates and
oversees financial intermediaries. RBI is governed and regulated by the Reserve Bank of
India Act, 1934 and SEBI by the SEBI Act. Any financial institution in India is governed
and regulated by the RBI Act and the rules and regulations made thereunder. However, a
financial institution may also be regulated by SEBI Act and hence by SEBI. IT Act provides
the taxation framework for taxation of VCFs.
SEBI Act does not differentiate between a private equity fund and a venture capital fund. It
refers to venture capital fund without defining it. Section 12(1B) of the SEBI Act
12
Id 13
Id
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provides that, no person shall sponsor or carry on any venture capital fund, unless he obtains
a certificate of registration with SEBI in accordance with the VCF Regulations.
In terms of the VCF Regulations, any company, trust or body corporate proposing to establish
a VCF is required to register with SEBI. The term VCF is defined in the VCF Regulations:
• as a trust or a company including body corporate registered in accordance with the
VCF Regulations; and
• has a dedicated pool of capital, which is raised and is to be invested in the manner
specified in the VCF Regulations.
SEBI registered VCFs can invest in domestic companies whose shares are not listed on a
recognized stock exchange in India and which is engaged in the business of providing
services, production, manufacture of article or things but does not include the following
businesses:
• Non-banking financial services excluding those non-banking financial
companies which are registered with Reserve Bank of India and have been
categorized as equipment leasing or Hire Purchase Companies;
• Gold financing excluding those companies which are engaged in gold
financing for jewellery;
• Activities not permitted under industrial policy of Government of India.
All investments of SEBI registered VCFs are subject to certain conditions , such as:
• It has to disclose the investment strategy;
• It cannot invest more than 25% of its corpus in one SEBI VCU;
• It has to invest at least 66.67% of the investible funds in unlisted equity
shares or equity linked instruments of SEBI VCU;
• Not more 33.33% of the investible funds may be invested by way of:
• -subscription to initial offer of a SEBI VCU shares of which are proposed
to be listed,
• -debt or debt instruments of a SEBI VCU in which the VCF has already
made equity investment,
• -preferential allotment of equity shares of a listed company subject to 1
year lock in,
• -equity or equity linked instruments of a financially weak company or a
sick industrial company whose shares are listed,
• -investment in special purpose vehicles for making investments in
accordance with VCF Regulations.
An FVCI (or Foreign Venture Capital Investor) is an investor incorporated or established
outside India which proposes to make investments either in domestic Venture Capital Funds
(‘VCFs’) or Venture Capital Undertakings (‘VCUs’) in India and which is registered under
the FVCI Regulations. Although foreign investors can invest in India directly under the
Foreign Direct Investment Scheme (the ‘FDI Scheme’), the SEBI grants certain benefits to
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those investors who register themselves under the FVCI Regulations. While considering an
FVCI application, the SEBI reviews the applicant’s track record, professional competence,
financial soundness, whether the applicant is regulated by an appropriate foreign regulatory
authority or is an income tax payer, amongst other factors. The SEBI then forwards its
approval to the RBI, which then grants its approval.
Although, certain restrictions are placed on the manner in which an FVCI may use its funds,
it has the option of using all of its funds to invest in a domestic VCF, which can in turn invest
up to two-thirds of its funds in unlisted companies. While the FDI Scheme does not apply to
FVCIs, an investment by an FVCI in a listed company or in a special purpose vehicle (an
‘SPV’) that does not fall under the definition of a VCU or a VCF would qualify as an
investment under the FDI Scheme, which would be subject to the sectoral caps and other
limitations, unless special permission is obtained.
Indian VCFs are entitled to tax benefits under Section 10(23FB) of the Income Tax Act, 1961
(‘Tax Act’). Any income earned by an SEBI registered VCF, established either in the form of
a trust or a company set up to raise funds for investment in a VCU is exempt from tax.
Although an FVCI is to some degree tax exempt, there remains considerable ambiguity in the
tax regime having the potential of subjecting foreign investors to capital gains tax rate as high
as 40%. For this reason most foreign investments are structured as special purpose vehicles in
Mauritius. The chief reason is that India and Mauritius are signatories to a double-taxation
avoidance agreement. Under certain conditions, the agreement exempts a Mauritius resident
from being subject to capital gains tax in India on the sale of shares. Also, since the local
taxes in Mauritius are nominal and there are provisions for deemed foreign tax credit,
Mauritius is a common route for investments into India.
The regulatory framework has been sufficient to spur considerable venture capital activity in
the country which has shown steady growth. In 2002 India attracted private equity investment
of USD 980.18 million and fourth after in the Asia Pacific region only after South Korea,
Japan and Australia14. 2005 witnessed over 68 investments in India with a total funding of
US$ 1.8 billion. India received over US$16 billion in Private Equity (PE) funding during
2007, ranking it among the top seven countries in the world and the highest in the Asia
Pacific region15. Total number of Venture Capital investments announced in the first quarter
of 2010, despite the repercussions of the global financial crisis stands at 17 with an
announced value of US$117 million as against 23 deals at an announced value of $88 million
in the first quarter of 2009 and 37 deals amounting to $180 million in the first quarter of
200816.
This although the Indian Venture Capital industry may be relatively small compared to other
developed countries it is impressive compared to other developing economies. Due to the
future growth prospects of the economy, the venture capital industry is also set to grow
further. The Indian venture capital industry can to a large extent be considered to be well
established and vibrant in its growth prospects.
14
VCCEdge, “Annual Deal Roundup” December, 2002 15
VCCEdge, “Annual Deal Roundup” December, 2008 16
VCCEdge, “Quarterly Deal Update” April 2010
9
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3 Understanding Venture Capital
In order to determine if an institution has been transferred we need to first understand what
that institution is. The term “venture capital” is colloquially used to encompass a broad genre
of financing of equity based financing. Thus it is important to understand at the very outset
what we are referring to in this paper. Venture capital is undoubtedly an American financial
innovation. The industry traces its origins back to 1946 in the USA to the establishment of
American Research and Development, the first true venture capital firm.17 Since then venture
capital as the institution we know today has emerged over a period of time through an
organic, trial and error learning process within the US venture capital market.18 The industry
has since developed and spread around the globe adapting to different environments, thus
varying the understanding of venture capital. However much of the fundamental literature
and theory on venture capital financing was developed based on the study of the US venture
capital market and still remains relevant today. This paper is thus based on the premise that
the US venture capital industry is the reference point for our understanding of the institution
of venture capital. In this section we seek to highlight what this understanding is and why the
venture capital contracts form the core of the very institution. This provides the basis for
arguing later on that transference of the contracting model amounts to the transference of the
institution itself.
3.1 What is Venture Capital?
Venture capital can be defined generally as independently managed, dedicated pools of
capital that focus on equity or equity-linked investments in privately held, high-growth
companies.19 Venture capital investment is one form of investing under the broad umbrella of
private equity investments. Private equity generally refers to investments institutions or
individuals in either listed public companies or private unlisted companies. As opposed to
mere retail investors, private equity investors are actively involved in the subsequent
management of the companies they invest in. Private equity principally includes venture
capital, leveraged buy outs and management buy outs.
Venture capital investing is further divided on the basis of which stage of development the
investee company is in. Thus there are either seed, start-up or expansion investments. Seed
and start-up stage investments are often clubbed together and termed generally as early stage
investments20.
17
ARD was a publically traded closed-end fund that made high risk investments in emerging companies
involved in developing technology for World War II; see Paul Gompers & Josh Lerner, “The Venture Capital
Revolution”, The Journal of Economic Perspectives, Vol.15, No.2 (Spring, 2001), 145-168, p.146 18
Gilson, Ronald J., “Engineering a Venture Capital Market: Lessons from the American Experience”, Stanford
Law Review, Vol. 55, April 2003 19
Paul Gompers & Josh Lerner, “The Venture Capital Revolution”, Journal of Economic Perspectives, Vol. 15,
No. 2 (Spring, 2001), 145-168, at pp. 155 20
Leslie Jeng & Philippe Wells, “The Determinants of Venture Capital Funding: Evidence Across Countries”,
May 1998, at p.4
11
Seed investment refers to a, typically, small amount of capital provided to an entrepreneur to
determine whether an idea, be it technology or a new marketing approach, deserves
commercialization and further investment. This stage does not involve production for sale21.
Startup investment is targeted at companies that are less than one year old and the funds are
typically used for product development, prototype testing, and test marketing. It involves
examining the market-penetration potential, assembling a management team, and refining the
business plan22.
Once the prototypes exhibit minimal further technical risk and the market studies are
heartening enough to provide comfort in setting up a manufacturing process and shipping in
commercial quantities it is strictly referred to as First Stage, but comes within the general
rubric of early stage. Early-stage companies are typically cash burning and unlikely to be
profitable23.
After completing the early stage the company has already been active and has some amount
of feedback from the market. It is thus in a better position to determine the speed and limits
of the product penetrating the market. It also may be expecting or experiencing rapid
expansion which requires more working capital than can be generated from internal cash
flow. Thus further capital may be used for further expansion of manufacturing facilities,
expanded marketing, or product enhancements. This is termed as expansion stage
investments.24
Venture capital financing generally refers to the investing in such early or expansion stage
companies where the need for cash is high, the chances of success are uncertain and hence
risky, but at the same time in the eventuality of such success the rewards are extremely
beneficial.
3.2 The Venture Capital Process
The Venture Capital process is best understood, and also termed, as the venture cycle25 which
first starts with the venture capitalist raising the venture fund; followed by the venture
capitalists investing these funds in the portfolio firms while monitoring and adding value to
them; the next stage in the cycle is when the venture capitalist successfully exits from the
company and returns capital to its investors; the cycle completes itself when the venture
capitalist raises a new fund.
The venture capital limited partnerships has emerged as the main vehicle used in the
institutional venture capital industry.26 Not only does this form offer certain legal and tax
21
William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial
Economics 27 (1990), pp. 473-521, at p. 479 22
id 23
id 24
William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial
Economics 27 (1990), pp. 473-521, at p. 479 25
Paul Gompers & Josh Lerner, “The Venture Capital Cycle”, MIT Press, Cambridge, (2000) 26
These include incorporated venture-capital companies, publicly traded closed-end funds, venture-capital
subsidiaries of industrial and financial corporations, and independent small-business investment companies,
12
benefits27, but it creates conditions which govern the relationship between the investor and
venture capitalist and corresponding incentives which are fundamental to the functioning of
the venture capital process28. Most of the top venture capital firms are organized as general
partnerships. These firms form a distinct limited partnership fund, typically with a target
amount of capital to be raised and a dedicated investment target sector. The venture capitalist
would also act as the general partner. Although some venture funds are created by public
offerings of the partnership interests, most venture funds are organized by private negotiation
between the venture capitalist and certain institutional investors. The limited partners make
capital commitments, which the general partner then draws on over time as the fund becomes
fully invested.29 These funds usually invest in projects over the first three to five years of
existence which is generally limited and designed to be 7-10 years. As general partner, the
VC firm makes and monitors the venture capital fund’s investments.30 For its services, the
general partner generally receives a percentage claim on the realized return (commonly 20
percent) as well as an annual management fee of 2.5 percent (typically) of the fund’s total
committed capital31.
This is not the same in all parts of the world. In the UK firms are also generally organised as
limited partnerships. However in countries like France and Germany the involvement of
banks is far more prominent. Further in Europe there is a prevalence of captive funds i.e.
where more than 80% of the financing is derived from one source, usually operating as
subsidiaries of banks. Further, while the sources of funds in the US are usually dominated by
pension funds, in countries like Germany funds are mainly sourced by banks.32
As investors commit large amounts of money for long-terms for illiquid, non-transparent
investments over which they exercise no direct control there is vast scope for agency
problems. Venture capitalists have incentives to deviate from behaviour that is in the interest
of the investor33. Monitoring is exercised through the partnership agreement of the fund itself
by the means of numerous covenants.34 Further, structural aspects like the limited term of the
see, William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial
Economics 27 (1990), pp. 473-521, at p. 487 27
Ibid at p.489 28
Paul Gompers & Josh Lerner, “The Venture Capital Revolution”, Journal of Economic Perspectives, Vol. 15,
No. 2 (Spring, 2001), 145-168, at pp. 153-154; The contractual and organizational techniques within this
business form are best suited to respond to the problems of financial contracting in the face of extreme forms
of uncertainty, information asymmetry and agency costs. See Gilson, Ronald J., “Engineering a Venture Capital
Market: Lessons from the American Experience”, Stanford Law Review, Vol. 55, April 2003 29
William L. Megginson, Towards a Global Model of Venture Capital?, December 31, 2001 30
Gilson, Ronald J., “Engineering a Venture Capital Market: Lessons from the American Experience”, Stanford
Law Review, Vol. 55, April 2003, at p. 6 31
The compensation system plays a critical role in aligning the interests of the venture capitalists and the
limited partners. see William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”,
Journal of Financial Economics 27 (1990), pp. 473-521, at pp. 491, 494 32
Leslie Jeng & Philippe Wells, “The Determinants of Venture Capital Funding: Evidence Across Countries”,
May 1998 33
Including setting up new funds to finance the most promising companies and making side deals with the
best portfolio companies, William L. Megginson, Towards a Global Model of Venture Capital?, December 31,
2001 34
e.g.; by specifying the time general partner devotes to managing the fund, ability of general partners to co-
invest in portfolio companies, restrict follow-on funds from investing in securities held by a previous funds,
13
fund which necessitates distributions, combined with informal aspects such as reputational
considerations, help control these agency conflicts35.
Once a fund is raised, the venture capitalists must review and identify investment
opportunities, structure and execute deals with entrepreneurs, monitor investments, and try to
obtain a return on their capital36. Young firms, particularly in high-technology industries, are
fraught with uncertainties and informational asymmetries from the perspective of an investor.
Such firms typically operate in new markets where information to the potential investor is
minimal; have no established track record to assess performance; lack tangible assets; and
much of their value lie in their potential for future growth.37 Such firms require an “active
investor”38 who have a large financial interest in their investments, and can still provide an
impartial view of the management of these firms. By alleviating these information gaps and
agency costs, venture capitalists enable such firms to receive finance which they would not
be able to obtain from conventional sources39. Venture capital has developed different tools
and control arrangements, some unique to this industry, which help them minimize these
issues. This includes extensive scrutiny and due diligences of the firm prior to providing any
capital and subsequently monitoring the firm through staged financing40, syndication of the
investments with other venture capital firms, board representation and control of
management, compensation arrangements creating appropriate incentives such as equity
based compensation schemes, use of convertible securities41, and numerous other restrictive
covenants in the contractual arrangement42.
prevent the raising of a new fund until some part of the existing fund has been invested. see William A.
Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial Economics 27
(1990), pp. 473-521, at p. 492; It should be noted that restrictive covenants are usually costly to negotiate and
hence are only used in very serious cases, see Paul Gompers & Josh Lerner, “The Use of Covenants: An
Empirical Analysis of Venture Partnership Agreements”, Journal of Financial Economics 39 (1996), pp. 463-498,
at p. 35
The fixed term assures that general partner’s performance is readily observable and measurable by the
market in terms of how the general partner’s investment decisions favoured increased risk over expected
return. A general partner’s track record is essential in persuading investments in successor funds. Thus
opportunistic behaviour by the general partner with respect to investment decisions or operating decisions
will be punished through the reputation market when it seeks to raise the successor funds. See Gilson, Ronald
J., “Engineering a Venture Capital Market: Lessons from the American Experience”, Stanford Law Review, Vol.
55, April 2003, at p. 31 36
William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial
Economics 27 (1990), pp. 473-521, at pp. 503 37
Id 38
id 39
Conventional debt based modes of financing are usually not suited for start-ups. They seldom have tangible
assets to serve as collateral on loans. Further it may be inappropriate from a cash management perspective as
such debt may result in tying down the cash flows of the company. Further investment in equity of such type
of companies also may prove too costly considering essential characteristics such as cost due to adverse
selection and moral hazard, administration costs, information gathering and search efforts. See Leslie Jeng &
Philippe Wells, “The Determinants of Venture Capital Funding: Evidence Across Countries”, May 1998 40
See Paul Gompers, “Optimal Investment, Monitoring, and the Staging of Venture Capital”, Vol.50, No.5 (Dec.
1995), 1461-1489 41
Klaus Schmidt, “Convertible Securities and Venture Capital Finance”, The Journal of Finance, Vol. LVII, No.3,
June 2003, pp.1139-1165 42
Paul Gompers & Josh Lerner, “The Venture Capital Revolution”, Journal of Economic Perspectives, Vol. 15,
No. 2 (Spring, 2001), 145-168, at pp. 155
14
The final stage, before the cycle is restarted, requires the venture capitalist to manage an exit
from these investments. Typically, the investor would seek to take the most successful firms
public, as this has the potential for the maximum returns. Other exit options include strategic
sales, or for less successful firms keeping them operational or liquidation. Contractual
arrangements have been developed which provides various flexible options of exit to the
venture capitalist43.
This paper focuses on the investment and monitoring stage of the cycle.
3.3 Why is Venture Capital relevant?
Numerous studies have shown that VC investing has positive economic impacts. In the 90s, a
part of the strong competitiveness and protracted growth of the US economy could be
attributed to the rapid pace of innovation induced by entrepreneurial firms44. Little doubt
today exists that a strong venture capital industry has been fundamental to America’s
leadership in the commercialization of technological innovation. Hellmann and Puri45 show
how firms pursuing an “innovator strategy” are much more likely to obtain VC funding and
that they are, pursuant to such funding, able to bring products to market significantly faster
than other companies. In another study it has further been suggested that venture funding has
a strong positive impact on innovation, to the extent that a dollar of venture capital is three to
four times more potent at stimulating patenting then conventional corporate research and
development.46
Venture capital not only helps in spurring job creation in an economy47, but it has also been
observed that this job creation is at a much faster rate than Fortune 500 companies.48 In 1998
the European Commission’s Communication “Risk Capital: A Key to Job Creation in the
European Union” states as its main message that ‘developing risk capital in the European
Union, leading towards the development of pan-European risk capital markets is essential for
major job creation in the EU’49
. Similar views have been echoed by numerous studies, and
this is one major reason policy makers the world over champion the cause of creating a
venture capital market.
As indicated, entrepreneurial growth companies have great difficulty obtaining external
financing due to various factors such as risky growth options and pervasive informational
asymmetry. Literature on entrepreneurship suggests that liquidity constraints are binding and
43
Paul Gompers & Josh Lerner, “The Venture Capital Cycle”, MIT Press, Cambridge, (2000) p.6 44
Laura Bottazzi & Marco Da Rin, “Venture Capital in Europe and the Financing of Innovative Companies”,
Economic Policy, v.34, 229-69, April 2002 45
Hellmann, Thomas and Manju Puri, “The Interaction Between Product Market and Financing Strategy: The
Role of Venture Capital,” Review of Financial Studies 13 (Winter 2000), pp. 959-984. 46
Samuel Kortum & Josh Lerner, “Assessing the Contribution of Venture Capital to Innovation”, The Rand
Journal of Economics, Vol. 31, No. 4. (Winter, 2000), pp. 674-692, at p.675 47
An NVCA study found that on average every $36,000 in VC investment creates one new job. See William L.
Megginson, Towards a Global Model of Venture Capital?, December 31, 2001 48
Leslie Jeng & Philippe Wells, “The Determinants of Venture Capital Funding: Evidence Across Countries”,
May 1998 49
Laura Bottazzi & Marco Da Rin, “Venture Capital in Europe and the Financing of Innovative Companies”,
Economic Policy, v.34, 229-69, April 2002
15
critical to entrepreneurs50, and thus may restrict growth in entrepreneurial activity. By
financing such companies venture capitalists fill a gap in the financial intermediation market,
which in itself adds value to an economy as these companies go on to generate sales, exports,
research spending, jobs and other factors which contribute to macro-economic growth. By
performing their role as active investors VCs create further value as they bring much more
than money to their portfolio companies, thus facilitating their development and growth.
3.4 The engineering problem
Since the mid-1980s there has been much interest in the transference of institution of venture
capital to other countries. Important proponents of this transfer were the International Finance
Corporation and various bilateral and multilateral development organizations including the
Asian Development Bank, the West German Deutsche Entwicklungs Gesellschaft (DEG),
and the British Commonwealth Fund among others (Kenney, n.d.) with mixed results. By the
90s the importance of venture capital, due to the reasons mentioned above, was
acknowledged and thus the idea received endorsement from institutions such as OECD and
World Bank. This was mainly attributable to the success of the US venture capital industry
and the visible spike in entrepreneurial high-technology firms. Thus policy makers have since
tried to encourage both developed and developing countries to try and create an indigenous
venture capital industry and consider strategies for encouraging the availability of venture
capital.
However, the venture capital industry as the institution we know today has emerged over a
period of time through a learning process, its development has been organic and to a large
extent idiosyncratic.51 The elements of this process of accretion includes a wide range of
mostly random factors such as the prohibition of non-compete covenants in the California
Civil Code; the creation of Stanford Industrial Park; and the clarification of the “prudent man
rule” in relation to the Employment Retirement Income Security Act52. Thus the development
of the U.S Venture capital industry has been without government design and extremely path
dependent which is not duplicable elsewhere.
So while the development path cannot be replicated in other countries the outcome of this
path can. However, other countries would necessarily require their governments to provide
the impetus and direction for the development of a venture capital industry. Thus we have
seen a proliferation of government programs and policies designed to form or nurture a
venture capital market, mostly with luke-warm results, early manifestations in Europe
included Germany in the 1970’s with the Deutsche Wagnisfinanzierungsgesellschaft.53
50
Leslie Jeng & Philippe Wells, “The Determinants of Venture Capital Funding: Evidence Across Countries”,
May 1998 51
Gilson, Ronald J., “Engineering a Venture Capital Market: Lessons from the American Experience”, Stanford
Law Review, Vol. 55, April 2003 52
Paul Gompers & Josh Lerner, “The Venture Capital Revolution”, Journal of Economic Perspectives, Vol. 15,
No. 2 (Spring, 2001), 145-168, at p. 148 53
For details please refer to Gilson, Ronald J., “Engineering a Venture Capital Market: Lessons from the
American Experience”, Stanford Law Review, Vol. 55, April 2003; and Leslie Jeng & Philippe Wells, “The
Determinants of Venture Capital Funding: Evidence Across Countries”, May 1998
16
Thus for any policy maker it is essential to determine what exactly is to be facilitated. Gilson
identified that the essence of the U.S. venture capital market is private the contracting
structure that has been developed to manage the extreme uncertainty, information asymmetry,
and agency costs that characterise start-up financing. Early stage financing has been made
feasible by the venture capital industry in the US as the contracting model manages these
barriers.
This contracting structure confronts a “simultaneity problem”, i.e. requiring the simultaneous
availability of three central inputs: capital, specialized financial intermediaries, and
entrepreneurs. In order to engineer a viable venture capital industry, it is upto the government
to confront this simultaneity problem. This could be achieved by providing seed capital and
helping to create the necessary financial intermediaries that together will encourage the
supply of entrepreneurs, while at the same time maintaining the pattern of intense incentives
coupled with intense monitoring that characterizes the contracting structure. The government
should not deal with the simultaneity problem by both providing capital and itself act as the
financial intermediary as the government cannot respond to the trio of contracting problems
inherent in early stage, high technology financing. A specialized financial intermediary is
necessary for which the government is not a substitute.54
Thus the core of the institution of venture capital is the complicated contracting structure
comprising of two fundamental contracts: that between the limited partners and the venture
capitalist; and that between venture capitalist and its portfolio company. It is also pointed out
how these contracts are “braided”, whereby they are intertwined so as one reflects the other.
Gilsen argues that inorder to engineer a venture capital market one has to facilitate the
complex contracting structure which can be executed only by a financial intermediary. This
could be extended to imply that if this contracting structure is transferred it would amount to
transference of the institution itself. Further, due to the fact that these two fundamental
contracts are so closely linked, a successful transference of one would imply is or could be
also transferred.
54
Gilson, Ronald J., “Engineering a Venture Capital Market: Lessons from the American Experience”, Stanford
Law Review, Vol. 55, April 2003
17
4 Rationale of Venture Capital Contracting
Venture capital investment agreements are legal contracts that essentially allocate risk, return,
and ownership rights between the entrepreneur and the investing venture capital fund. This
distribution of rights depends on a number of factors including the capability of the
entrepreneur; the attractiveness of the portfolio company or the business plan; the stage of the
company’s development; negotiation skills of the parties55; and also the overall state of the
venture capital market56.
4.1 The Risk in “Risk Capital”
All kinds of financial contracts must deal with three fundamental problems, uncertainty,
information asymmetry and agency costs stemming from opportunism. Venture capital
contracting, due to its very nature, faces these problems in a magnified form.
Due to the fact that the company is generally in its early stage of development there is large
uncertainty as to the future performance. Uncertainty surrounds the quality of the
management, which is hard to evaluate upfront, as the success of the company may be
heavily dependent on them. There is also an element of scientific uncertainty with regards to
the technology or innovative aspects of the company57.
The venture capitalist and the entrepreneur are also likely to be placed at different levels of
information. The companies tend to operate in relatively new markets where information is
not readily available. The entrepreneurs may be aware of certain detrimental market
conditions but are incentivised to keep the project going as they receive personal benefits.58
The fate of the companies may be dependent on technologies of which the entrepreneur is in
a far more knowledgeable position than the investor.59 Further much of the company’s value
lies in its future potential, and little on present tangible factors.60 This presents a great level of
informational asymmetry to the detriment of the investor.
Agency costs also may arise from the fact that the entrepreneur may be incentivised to
engage in wasteful expenditure as he may benefit disproportionately since he does not bear
the cost of committing capital.61 He may invest in strategies which may have high personal
55
William L. Megginson, Towards a Global Model of Venture Capital?, December 31, 2001 56 Gompers, Paul and Josh Lerner, “Money Chasing Deals? The Impact of Fund Inflows on Private Equity
Valuations,” Journal of Financial Economics 55 (February 2000), pp. 281-325. 57
Gilson, Ronald J., “Engineering a Venture Capital Market: Lessons from the American Experience”, Stanford
Law Review, Vol. 55, April 2003, at p.13 58
Paul Gompers & Josh Lerner, “The Venture Capital Revolution”, Journal of Economic Perspectives, Vol. 15,
No. 2 (Spring, 2001), 145-168, at p. 155 59
Paul A. Gompers, Ownership and Control in Entrepreneurial Firms: An Examination of Convertible Securities
in Venture Capital Investments 3 (1998), at p.13, (unpublished manuscript, on file with the Harvard Law School
Library) http://www.people.hbs.edu/pgompers/Convert.PDF visited on June 10, 2010 60
Trester, Jeffrey J.: “Venture Capital Contracting Under Asymmetric Information.” Wharton School Working
Paper, Journal of Banking & Finance Volume 22, Issues 6-8, August 1998, Pages 675-699 61
Paul Gompers & Josh Lerner, “The Venture Capital Revolution”, Journal of Economic Perspectives, Vol. 15,
No. 2 (Spring, 2001), 145-168, at p. 154
18
returns but low pay-offs to the investors. Further they may have the incentive to pursue high
risk strategies as they may benefit from success, but suffer little or no loss due to failures.62
4.2 Obligations of the Venture Capitalist
It must be kept in mind that the venture capitalist is also subject to strict obligations to their
limited partners under the terms of the partnership agreement of the fund, which itself is
designed to control similar problems of agency and informational asymmetry.63 The venture
capitalist must create value on its investment as a large part of their income is based on the
profits of the funds. The limited term of the fund and requirements of distribution of returns
make it necessary for the VC to be able to achieve liquidity on their investments within a
specified time-frame, to be able to pay out to their limited partners. Failure to provide timely
returns to their limited partners lead to serious contractual consequences under the
partnership agreement.64 Further the ability to harvest investments reflects the performance of
the venture capitalists and has reputational implications on their ability to raise additional
capital for a new fund, thus affecting their very business.65
Thus one of the main aims of the venture capitalist when investing, is to eventually convert
their illiquid holdings, the investment in the start-up (having no viable market at the time),
into cash or other liquid form and, hopefully, with a sizable return66. For this reason it is
widely recognized that a venture capitalists decision to invest in an entrepreneurial firm is
based on exit potential.67 Although they are not short-term investors, venture capitalists are
not in the business of making long-term or strategic investments, and require liquidity within
term of their funds.
4.3 Designing a Contract
Thus the challenge of venture capital contracting is managing the inherent problems in light
of the eventual goal. Financial contracting theory identifies two kinds of rights in such
contracts, cash flow and control rights.68 The venture capital financing contracts are designed
in such a manner so as to enable the venture capitalists to separately allocate cash flow
rights69 and various control rights. The allocation is made in such a manner that if the
62
Paul Gompers, “Optimal Investment, Monitoring, and the Staging of Venture Capital”, Journal of Finance,
Vol. 50, No. 5 (Dec., 1995), 1461-1489, at p. 1465 63
Paul Gompers & Josh Lerner, The Venture Capital Cycle, (2000) MIT Press, Cambridge, see pp.29-42 64
William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial
Economics 27 (1990), pp. 473-521, at pp. 489-493 65
Gilson, Ronald J., “Engineering a Venture Capital Market: Lessons from the American Experience”, Stanford
Law Review, Vol. 55, April 2003, at p.10 66
Many venture capitalists demand a compound annual return of 50 percent or more on early-stage
investments, but are satisfied with half that on later-stage deals, William L. Megginson, Towards a Global
Model of Venture Capital?, December 31, 2001 67
Douglas J. Cumming, “Contracts and Exits in Venture Capital Finance”, LEFIC Working Paper 2002-14,
October 2002 68
id 69
Means the fraction of a portfolio company’s equity value that different investors and management have a
19
company does badly, the venture capitalists obtain full control, but as performance improves,
the entrepreneur obtains more control rights. If the company is a success, the venture
capitalists only retain their cash flow rights, but relinquish most of their control rights.70
These cash flow incentives and control rights are used in a complementary manner to obtain
optimum results.71 Thus venture capitalists have developed various tools to help optimise
their financing arrangements. The following sections will discuss some of the main and most
common components of venture capital contract design.
4.4 Control Mechanisms
Venture capitalists have developed a structure for their investments which enables them to
keep control of the firm. There are three control mechanisms72 which are common to nearly
all venture capital financing arrangements:
4.5 Staged Financing
Staging the infusion of capital is considered the most important mechanism for controlling
the firm.73 Venture capitalists seldom invest the total required amount at once. They tend to
invest at distinct stages of development of the company and only enough to fund the
company until its next development stage.74 Further they demand a very high required return
on the initial investment “tranche”. On achieving the required targets, the funding for the
next stage is provided at more attractive terms as the risk has been reduced.75 Staged
financing enables the venture capitalists to preserve the right to deny or delay additional
funding when they obtain negative information about the potential of future returns. This has
a signalling effect to other capital suppliers that the company in question is an investment
risk.76 Thus while minimizing risk for the venture capitalist; it transfers much of the financial
risk onto the entrepreneur. It thus keeps the entrepreneur on a “tight leash” and reduces the
claim to. see Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An
Empirical Analysis of Venture Capital Contracts,” Working Paper 7660, National Bureau Of Economic Research
(April 2000); http://www.nber.org/papers/w7660, at p. 14;
Venture capitalists’ cash flow rights are different from those of other participants in the startups they typically
receive convertible preferred stock with preferences that are triggered in a liquidity event. See Power and
Payouts in the Sale of Startups, Brian Broughman and Jesse Fried, U.C. Berkeley, Last Revised: June, 2006 70
Ronald J. Gilson & Bernard Black, “Does Venture Capital Require an Active Stock Market?” (May 1999) as
published in Journal of Applied Corporate Finance, pp. 36-48, Winter 1999. Available at:
http://papers.ssrn.com/paper.taf?abstract_id=219174 Last visited on June 10,2010 at p. 15 71
Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical
Analysis of Venture Capital Contracts,” Working Paper 7660, National Bureau Of Economic Research (April
2000); http://www.nber.org/papers/w7660, at p. 6; 72
Paul Gompers, “Optimal Investment, Monitoring, and the Staging of Venture Capital”, Journal of Finance,
Vol. 50, No. 5 (Dec., 1995), 1461-1489, at p. 1461 73
William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial
Economics 27 (1990), pp. 473-521, at pp. 506 74
William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial
Economics 27 (1990), pp. 473-521, at pp. 506 75
William L. Megginson, Towards a Global Model of Venture Capital?, December 31, 2001 76
Gilson, Ronald J., “Engineering a Venture Capital Market: Lessons from the American Experience”, Stanford
Law Review, Vol. 55, April 2003, at p.17
20
possibility of losses due to bad decisions77. Staged financing incentivizes the entrepreneur to
create value thus aligning their interests with the investors. It also encourages managers to
conserve capital through sanctions of its misuse78.
4.6 Syndication
Syndication essentially refers to the practice by which one venture capital firm brings in
another to co-invest in a particular deal. This enables a venture capital firm to spread its
corpus of funds across more portfolio companies facilitating diversification from firm
specific risk. Syndication also provides the benefit of a “second opinion” which reduces the
possibility of a bad deal to be funded.79 Studies have shown that syndication tends to take
place amongst firms of similar standing and experience indicating that it is not undertaken
purely for funds but also the opinion of another firm with similar abilities and resources.80
4.7 Use of Convertible Securities
The ubiquity81 of the use of convertible preferred stock in the U.S. Venture capital industry is
a distinct and well established feature. Various studies82 have shown that this security is
almost the exclusive means of financing portfolio companies. Further a number of reasons
have been identified for the predominance of this form of security.
The formal attributes of convertible preferred stock is one reason. It provides preferences
over common stock in the payment of dividends, a priority in liquidation, while at the same
time enabling them to exercise rights different from common stockholders83. It thus makes
the venture capitalists claim senior to that of the entrepreneur or other existing owners, and
allocates stronger control rights, providing some degree of protection for the investor. It also
preserves the borrowing capacity of the company, as preferred is still a junior claim to debt84.
The liquidation preferences are of particular importance. In the event of a liquidation event,
which apart from dissolution usually includes a sale of the company, venture capitalists are
entitled to be paid the full amount of liquidation preferences, before common shareholders
receive anything. The liquidation preference acts as a repayment of principal on a loan, and
77
Paul Gompers, “Optimal Investment, Monitoring, and the Staging of Venture Capital”, Journal of Finance,
Vol. 50, No. 5 (Dec., 1995), 1461-1489, at p. 1462 78
William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial
Economics 27 (1990), pp. 473-521, at pp. 506 79
Paul Gompers & Josh Lerner, “The Venture Capital Revolution”, Journal of Economic Perspectives, Vol. 15,
No. 2 (Spring, 2001), 145-168, at pp. 156 80
Josh Lerner, “The Syndication of Venture Capital Investments”, Financial Management, 23, pp.16-27 81
Ronald J. Gilson & David M. Schizer, “Understanding Venture Capital Structure: A Tax Explanation for
Convertible Preferred Stock“, 116 Harv. L. Rev. 874 (January, 2003), at p. 878 82
See Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical
Analysis of Venture Capital Contracts,” Working Paper 7660, National Bureau Of Economic Research (April
2000); http://www.nber.org/papers/w7660. 83
Ronald J. Gilson & David M. Schizer, “Understanding Venture Capital Structure: A Tax Explanation for
Convertible Preferred Stock“, 116 Harv. L. Rev. 874 (January, 2003), at p. 880 84
William L. Megginson, Towards a Global Model of Venture Capital?, December 31, 2001
21
thus is usually equal to the amount invested85, but could be a multiple thereof.86 However, the
validity of this line of reasoning has been questioned as start-ups are rarely in a position to
pay any dividends to their investors especially in the early stages.87 Liquidation preferences
may also be insignificant, in the event of winding-up, as portfolio companies are typically
human capital-intensive activities with few hard assets. Thus, upon liquidation the investor
cannot expect much of a payment from the assets, if any, that remain after creditors stake
their claim.88
The conversion right allows the venture capital investor to share in any upside resulting from
managerial risk-taking thus curbing a manager's incentive to increase risk by “cutting
corners”.89 The holder has the option of converting the preferred stock into common at a
specified ratio. If all classes of preferred stock are converted into common, the liquidation
preferences are eliminated and the cash flow rights become identical to the common
shareholders. The venture capitalist will convert into common stock only if the company is
sold for a sufficiently high price. Further the agreement will often require the VCs to convert
to common if the firm undergoes a qualified IPO.90
Convertible preferred stock also facilitates the separation of control and cash flow rights. This
enables venture capitalists to monitor the firm without compromising management incentives
by reducing managers' share of profits.91 If the venture capitalists invested in common stock
he would only be able to exercise effective voting control if a majority was purchased.92 The
result would place far more of the firm’s business risk on the venture group than on the
entrepreneur as a minority shareholder.
85
Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical
Analysis of Venture Capital Contracts,” Working Paper 7660, National Bureau Of Economic Research (April
2000); http://www.nber.org/papers/w7660 at p.18 86
a “1x” preference or “2x” preference, see Power and Payouts in the Sale of Startups, Brian Broughman and
Jesse Fried, U.C. Berkeley, Last Revised: June, 2006 87
To be meaningful, the dividend preference must be cumulative, so that preferred dividends will accrue even
if not currently paid and combined with a requirement for the company to pay accumulated preferred
dividends before common stockholders receive any liquidity on their investment. see Ronald J. Gilson & David
M. Schizer, “Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock“, 116
Harv. L. Rev. 874 (January, 2003), at p. 880 88
A merger or sale also typically counts as a liquidation that triggers the liquidation preference where the
venture capitalists have a prior claim on acquisition proceeds and the preference is significant here. An
extension of this is the "participating" preferred securities, a type of convertible preferred stock that enables
venture investors to share in the proceeds of "liquidation" along with the common shareholders if the
proceeds exceed the amount of the preference. see Ronald J. Gilson & David M. Schizer, “Understanding
Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock“, 116 Harv. L. Rev. 874 (January,
2003), at p. 881 89
Paul A. Gompers, “Ownership and Control in Entrepreneurial Firms: An Examination of Convertible Securities
in Venture Capital Investments” 3 (1998) (unpublished manuscript, on file with the Harvard Law School Library)
http://www.people.hbs.edu/pgompers/Convert.PDF visited on June 10, 2010 90
Power and Payouts in the Sale of Startups, Brian Broughman and Jesse Fried, U.C. Berkeley, Last Revised:
June, 2006, at p.4 91
Ronald J. Gilson & David M. Schizer, “Understanding Venture Capital Structure: A Tax Explanation for
Convertible Preferred Stock“, 116 Harv. L. Rev. 874 (January, 2003), at p. 885 92
William L. Megginson, Towards a Global Model of Venture Capital?, December 31, 2001
22
Convertible preferred has certain signalling effects. Due to the liquidation preference element
in the security, in the event that the total value of the company is low the investor will receive
a large portion leaving little to other owners. It thus shifts the cost of poor performance on the
management. This enables the venture capitalists to make evaluations as it signals the
entrepreneur’s confidence of the prospects.93
Thus the preferred stock reduces the information asymmetry problem as the entrepreneur
credibly signals that the company is worth more than the liquidation preferences. It also
provides managers with desirable incentive effects by providing a payout only if the company
does very well.94
Another important determinant of the use of convertible security is tax considerations. By
issuing preferred stock to the investors, two classes of securities is created one having
superior rights as compared to the other. This seniority right of the preferred lowers the
economic value of the common enabling the management to buy or retain the common stock
at low prices without incurring taxable income. If the investor has the same security and
rights as the common stockholder then these managers would liable to a tax on income on the
difference between the (usually low) price they paid and the (relatively high) price paid by
the venture capitalists.95 Thus, by allotting a superior stock to venture capitalists it validates
its higher price, and companies lower the tax burden on management's incentive
compensation.96
4.8 Other forms of Control
Other than the tools mentioned above, venture capitalists obtain substantial control rights
against the founder and other shareholders through contractual provisions, board seats, and
shareholder voting rights.97
4.8.1 Board representation and management
Venture capitalists typically sit on the boards of their portfolio companies, often acquiring a
majority of the seats. Board control gives them the ability to initiate fundamental transactions
such as mergers, IPOs, and liquidations.98 It further gives them the power to replace the
93
William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial
Economics 27 (1990), pp. 473-521, at pp. 510 94
Power and Payouts in the Sale of Startups, Brian Broughman and Jesse Fried, U.C. Berkeley, Last Revised:
June, 2006, at p. 5 95
William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial
Economics 27 (1990), pp. 473-521, at pp. 510 96
Ronald J. Gilson & David M. Schizer, “Understanding Venture Capital Structure: A Tax Explanation for
Convertible Preferred Stock“, 116 Harv. L. Rev. 874 (January, 2003), at p. 886 97
Power and Payouts in the Sale of Startups, Brian Broughman and Jesse Fried, U.C. Berkeley, Last Revised:
June, 2006, at p.4 98
Power and Payouts in the Sale of Startups, Brian Broughman and Jesse Fried, U.C. Berkeley, Last Revised:
June, 2006, at p.6
23
management or the entrepreneur with professionals if they are of the opinion that
performance is poor.99
This also enables them to manage and oversee the daily operations of the business. As it is
not possible to anticipate every conflict or event that may arise in the contract, the venture
capitalist chooses to play a role in ‘nursing’ the company rather than just financing them.
Venture capitalists may also add value by providing various services such as forming
strategy, providing technical and commercial advice and attracting key personnel.100 The
mere presence of venture capital in a company brings instant credibility to the firm and
provides easier access to capital and contacts for other resources.101 Further the venture
capitalist also performs a “certification” function when the company goes public, lowering its
costs and maximizing its net proceeds.102 Through their active involvement the venture
capitalist seeks to increase the likelihood of success and improve return on investment.
4.8.2 Covenants
Venture capital investment contracts make extensive use of positive and negative covenants
which are often characterized by their degree of sophistication.103 These contractual clauses
mandate the portfolio firm to do or abstain from doing certain things. The use of covenants is
related to the costs of potential conflicts and agency costs. Thus the riskier a project, like
early stage technology dependant ones, the amount and degree of restrictiveness of the
covenants increase.104
Chief amongst these are those related to liquidation as the venture capitalists are mainly
concerned about converting their holdings into cash. The venture capitalist must rely on a
sale or dissolution of the company to trigger their payouts. Thus the investor’s ability to
liquidate assets if the firm defaults, is the main way to ensure repayment, but there is a
possibility that the management may disagree on the timing or the method.105 Control rights
help the investor obtain a liquidity event within the investment time frame dictated by their
fund obligations, despite the objection of other shareholders who may rather see status quo
being maintained as it would be to their benefit.106 Thus the agreement has a number of
99
Paul Gompers & Josh Lerner, “The Venture Capital Revolution”, Journal of Economic Perspectives, Vol. 15,
No. 2 (Spring, 2001), 145-168, at p. 156 100
Thomas Hellmann, “The Allocation of Control Rights in Venture Capital Contracts”, The RAND Journal of
Economics, Vol.29, No.1 (Spring, 1998), 57-76, at p.57 101
William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial
Economics 27 (1990), pp. 473-521, at pp. 509 102
William L. Megginson & Kathleen A. Weiss, “Venture Capitalist Certification in Initial Public Offerings”, The
Journal of Finance, Vol. 46, No.3, (July 1991), 879-903, at p.879 103
William L. Megginson, Towards a Global Model of Venture Capital?, December 31, 2001 104
Paul A. Gompers, “Ownership and Control in Entrepreneurial Firms: An Examination of Convertible
Securities in Venture Capital Investments” 3 (1998) (unpublished manuscript, on file with the Harvard Law
School Library) http://www.people.hbs.edu/pgompers/Convert.PDF visited on June 10, 2010, at p. 5 105
William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial
Economics 27 (1990), pp. 473-521, at pp. 509 106
Power and Payouts in the Sale of Startups, Brian Broughman and Jesse Fried, U.C. Berkeley, Last Revised:
June, 2006, at p.6
24
features that control the process by which the liquidation can be achieved, the primary one
being the use of convertible preferred securities, as discussed above.
Demand, participation in transfers, and redemption rights preserve exit opportunities and
avenues to attain liquidity for venture capital investors. Demand registration rights enable
them to force the firm to initiate procedures for a public offering.107 Further, through
participation rights, venture capitalists ensure that exit avenues through transfer of shares are
always open to them, even if such sales are arranged by other stakeholders.
The venture capitalists often have the right to force redemption of their stock or the right to
put the stock to the company inorder to achieve liquidity. These give the investor the right to
demand that the firm redeems their claim, usually at liquidation value, after a certain time
period merely by putting their securities back to the company. This strengthens their ability to
attain liquidity as it does not require them to wait for arduous winding-up procedures to
receive their claim.108 This right may be exercised if there is no other exit alternative
available, such as sale or IPO, but the company is still financially viable and able to pay.
The financing contracts also typically contain protective provisions which provide the
venture capitalists with specific veto rights or affirmative voting rights. These provisions
require that for certain transactions or actions by the company or its managers would require
the specific approval of the venture capitalist. These are actions which would affect the
investment or any interests of the investor, such as the sale of the company’s key assets.109
4.8.3 Compensation
Compensation schemes are designed that align the interest of entrepreneurs with that of the
investor. Entrepreneurs are typically offered smaller cash salaries, which is offset by stock
ownership in the venture. The common stock or stock options do not pay off unless the value
of the company is built leading to an opportunity to convert illiquid holdings to cash.110
Usually sanctions are also incorporated. If the employee is terminated, perhaps for poor
performance, all unvested shares or options are returned to the company and, usually, the
company retains the right to repurchase shares from the employee at predetermined prices.
The sanctions help to mitigate the entrepreneur’s incentive to increase risk.111
107
William L. Megginson, Towards a Global Model of Venture Capital?, December 31, 2001 108
Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical
Analysis of Venture Capital Contracts,” Working Paper 7660, National Bureau Of Economic Research (April
2000); http://www.nber.org/papers/w7660. at p.14 109
Power and Payouts in the Sale of Startups, Brian Broughman and Jesse Fried, U.C. Berkeley, Last Revised:
June, 2006, at p.6; also see Annexure Table 2, for typical liquidation events in Indian VC financing contracts 110
Gilson, Ronald J., “Engineering a Venture Capital Market: Lessons from the American Experience”, Stanford
Law Review, Vol. 55, April 2003 at p.22 111
William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial
Economics 27 (1990), pp. 473-521, at pp. 508
25
4.8.4 Contingencies
Further it has been noted that investors often design contracts such that, cash flow rights,
voting rights, control rights, and future financings are contingent on observable measures of
financial and non-financial performance in the future. These contingencies are related to the
performance measure that is most important to the investors and the company.112
112
Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical
Analysis of Venture Capital Contracts,” Working Paper 7660, National Bureau Of Economic Research (April
2000); http://www.nber.org/papers/w7660. at pp.6-7
26
5 The Venture Capital Investor and Portfolio Company Contract
In this section we examine the fundamental document governing the relationship between the
venture capitalist and the company, the stock-purchase agreement.113 It has been observed
that the contracts between the venture capitalists and companies, in the US Venture capital
industry, are similar in many ways. Numerous studies have described these regularities that
have been observed in almost all real funding agreements. Sahlman (1990) and Kaplan &
Strömberg (2000) conducted perhaps the most extensive of these studies. In the paragraphs to
follow we will outline these “standard” clauses as established in Sahlman, Kaplan &
Strömberg and other studies on venture capital investment contracts in the US.
Further, we present the findings of our sample-set of Indian venture capital financing
agreements in light of these standard practices of US venture capital contracting so as to
make apparent the similarities or differences. This is done with the aim of determining
whether the basic contracting model between venture capitalists and their portfolio company
in India is a direct transference of the US venture capital model, or if there are significant
variations to say it is hybridized or completely different. Discussions and analysis is reserved
for later on in this section.
5.1 Ownership and Voting Rights
Studies show that although substantial equity ownership on the part of the entrepreneurs is
desirable, a large part of the ownership is provided to the venture capital investor. Further
venture capitalists almost always have a voting majority, particularly in early stage financing.
It has also been noted that voting control switches between parties depending on various pre-
determined contingencies.114
The Indian VCs tend to take a large stake in the company while leaving a majority to the
entrepreneur. The average VC stake in the sample is around 32.32%, with a majority of them
being in the mid to high 30% range. Only 2 agreements in the sample provided a majority to
the VC.
All financings provide that the venture capitalist exercises his votes on a fully converted basis
thus the votes exercised are in proportion to their stakes in the company. Thus we did not
note any tendency for the VCs to have a voting majority in the companies. However it was
noted that the stakes of the VCs in early stage companies was substantially higher than the
stakes taken in late stage financings.
A majority of the financings in the sample provided for an increase in the stake and voting
control of the VC in the event that certain milestones or performance targets were not
achieved.
113
Different terms are used for the same document such as “Share Purchase and Investor Rights Agreement”,
“Share Subscription and Shareholders Agreement” etc., here we use the term “stock purchase agreement” to
refer to the legal contract between the investor and the company to purchase shares and govern the
relationship between the parties. 114
Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical
Analysis of Venture Capital Contracts,” Working Paper 7660, National Bureau Of Economic Research (April
2000); http://www.nber.org/papers/w7660. at p.15
27
5.2 Staging
The investments, under US contracts, are typically staged, i.e., they invest more than once
during the life of a company. The investment amounts are expected to be adequate to take the
company to the next stage of development, when more capital will be required for further
development115. Further the investment amount often increases with each round.116
In the sample, about 67% of the investments were staged. The agreements typically set the
parameters of the development to be achieved by the company upon which further financing
would be provided. A number of financings which were not staged were noted to be of
smaller investment amounts. However the financings which were staged, it was noted that the
second tranche funding amounts were typically of the same or smaller investment amounts,
and primarily on similar terms. The time period between each funding stage was usually one
year or less.
5.3 Securities
As discussed in the previous section convertible preferred stock is by far the most common
form of security used.117 A number of financings also provide for cumulative preferred
dividend rights.118 A variant of convertible preferred called participating preferred is also
seen to be prevalent.119
In the Indian financing arrangements 25 out of 30 contracts in the sample used some form of
convertible preferred shares. Except only seven, all the 25 provided the investor with, a
mostly nominal amount, of equity shares also. Out of the remaining three contracts used
convertible debentures as the security, the rest using common equity shares.
A majority of the convertible preferred securities provide for pro rata participation in the
remainder after liquidation, and also provided the investor the rights to cumulative dividends.
Further, 16 of them were compulsorily convertible after a specified time period.
115
William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial
Economics 27 (1990), pp. 473-521, at pp. 503 116
Paul Gompers, “Optimal Investment, Monitoring, and the Staging of Venture Capital”, Journal of Finance,
Vol. 50, No. 5 (Dec., 1995), 1461-1489, at p. 1485 117
Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical
Analysis of Venture Capital Contracts,” Working Paper 7660, National Bureau Of Economic Research (April
2000); http://www.nber.org/papers/w7660. at p.13 118
Ronald J. Gilson & David M. Schizer, “Understanding Venture Capital Structure: A Tax Explanation for
Convertible Preferred Stock“, 116 Harv. L. Rev. 874 (January, 2003), at p. 883 119
Id.
28
5.4 Liquidation Rights
Upon liquidation the venture capitalist’s claim is almost always senior to the common stock
claims of the founders and other shareholders. Further the claims of the investor are typically
at least as large as the original investments.120
In the sample all but one contract provides the investor with a preferential claim in
liquidation to the common shareholders. The amount of the claim in all these financing
arrangements was at least equal to the investment amount. A majority of these liquidation
claims were for more than the investment amount, adjusted upward by means of a required
return multiple or on the basis of accumulated dividends. It is further noted that definitions
for a liquidation event typically include, change in control, a merger or reorganization in
addition to winding up.
5.5 Conversion Rights
In the US, venture capital contracts typically provide for automatic conversion of securities.
The contract explicitly provides the events that trigger conversion. Initial public offerings,
meeting specified qualifications, almost always trigger a conversion121. Automatic conversion
is also provided for upon reaching other milestones. These include income, sales or other
targets which tend to measure the performance and success of the company. It also sets the
conversion price, usually to the purchase price of the convertible security so as to ensure a
one for one conversion.122
A large majority of the Indian financing contracts provide for automatic conversion. As most
of the instruments are compulsorily convertible they prescribe a term after which it has to be
converted. The triggering event for most of these financings providing automatic conversion
is an IPO, a small number also includes a strategic sale or some specific milestone. The
conversion price is almost always adjustable, to the benefit of the investor, by computing the
conversion ratio based on various factors including achieving revenue projections, post-
money valuations, or to maintain a pre-determined stake.
5.6 Anti-Dilution Protection
In the US, contracts typically include anti-dilution protections to the venture capitalist against
future financing rounds at lower valuations than the current round, it also ensures that the
120
Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical
Analysis of Venture Capital Contracts,” Working Paper 7660, National Bureau Of Economic Research (April
2000); http://www.nber.org/papers/w7660. at p.17 121
As no investment bank would be willing to underwrite an equity offering if venture investors maintained a
higher priority claim. See Ronald J. Gilson & Bernard Black, “Does Venture Capital Require an Active Stock
Market?” (May 1999) as published in Journal of Applied Corporate Finance, pp. 36-48, Winter 1999. Available
at: http://papers.ssrn.com/paper.taf?abstract_id=219174 Last visited on June 10,2010 at p. 15 122
Paul A. Gompers, “Ownership and Control in Entrepreneurial Firms: An Examination of Convertible
Securities in Venture Capital Investments” 3 (1998) (unpublished manuscript, on file with the Harvard Law
School Library) http://www.people.hbs.edu/pgompers/Convert.PDF visited on June 10, 2010, at p. 9
29
entrepreneur does not try to take undue advantage by performing stock splits or issuing
special dividends.123
All but 4 contracts in our sample provided for some mechanism of anti-dilution protection. A
majority of these were on a “Full-Ratchet” basis. The second most popular form was the
“Broad Based Weighted Average” basis. Many of these also provided for adjustment for
bonus issues, stock splits, dividends, etc.
5.7 Redemption, puts, buy-backs and calls
VC Agreements in the US typically give the venture capitalists the right to put the security to
the company for redemption in order to strengthen their liquidation rights. Under these
provisions after a certain period of time the investor has the right to require the firm to
redeem its claim, typically at liquidation value.124 Sometimes, the company retains the right
to call the security from the venture capitalists on certain conditions for a predetermined
price125.
In the Indian contracts, 83.3% provided the investor the right to demand the company to buy-
back their securities. While most of these provided that redemption could be exercised after a
certain period of time, some contracts provided redemption/buy back as a remedy for breach.
Most contracts provided that the redemption price would be the same as the liquidation
preference amount, however some, especially where redemption was a cure for breach,
provided for a repayment of a larger amount. Only two of the contracts gave the company the
option of calling the security.
5.8 Board structure
Most VC agreements provide for venture capitalist representation on the company’s board.
They are less likely to have board control than they are to have voting control. Board control
tends to increase with subsequent funding rounds.126 Often, the agreement calls for other
mutually acceptable people to be elected to the board.127
In our sample, only three financings did not provide the investor with board representation.
Among the others only one agreement provided the investor with a majority of seats on the
123
Paul A. Gompers, “Ownership and Control in Entrepreneurial Firms: An Examination of Convertible
Securities in Venture Capital Investments” 3 (1998) (unpublished manuscript, on file with the Harvard Law
School Library) http://www.people.hbs.edu/pgompers/Convert.PDF visited on June 10, 2010, at p. 9 124
Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical
Analysis of Venture Capital Contracts,” Working Paper 7660, National Bureau Of Economic Research (April
2000); http://www.nber.org/papers/w7660. at p.18 125
William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial
Economics 27 (1990), pp. 473-521, at pp. 504 126
Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical
Analysis of Venture Capital Contracts,” Working Paper 7660, National Bureau Of Economic Research (April
2000); http://www.nber.org/papers/w7660. at pp.16,17. 127
William A. Sahlman, “The Structure and Governance of Venture-capital Organizations”, Journal of Financial
Economics 27 (1990), pp. 473-521, at pp. 506
30
board. Two provided for exactly 50% of the board seats. Typically the number of board seats
is reflective of their stake in the company.
5.9 Pre-emptive rights and Transfer related rights
Generally the venture capitalists retain rights to sell shares after conversion at the same time
and on the same terms as the entrepreneurs or other main shareholders. They are also entitled
to participate in new financings by buying the newly issued shares in proportion to their
holdings on a converted basis prior to the new issuance128.
Apart from 3 instances all the contracts in our sample provide the investor with pre-emptive
rights. Almost all the agreements provide the investor with a tag-along right whereby the
Investor has the option to sell or transfer its shares with the selling shareholder to a third
party on the same terms and conditions. About 75% were also provided with a Right of First
Refusal requiring the other shareholders offer any shares to the investor before trying to sell
them. A large number also gives the investor a Drag-along right whereby they can require the
other shareholders to sell shares along with the investor if he so requires in order to facilitate
an exit through a third party sale.
5.10 Affirmative voting rights
The financing contracts typically contain protective provisions which provide the venture
capitalists with specific veto rights or affirmative voting rights.129
Almost all contracts in the sample provide the investor with an affirmative voting right on
numerous issues affecting them. The most common manner of incorporating this provision is
by requiring the presence and vote of the investor or his representative inorder to put forth
and pass any resolution or take any action on a matter affecting the investor. All agreements
providing for such a right also list out specifically the issues which would require such an
affirmative vote, both at a board and shareholder level.
5.11 Option carve-out & Employment contracts
US contracts commonly fix the number of shares outstanding and the size of the pool of
shares that would be granted to employees and provide for making amendments. Further most
agreements require key employees to execute employment contracts and abide by non-
compete provisions.130
A large number of contracts in the sample (particularly companies in information technology
related business) provided for a carve-out of the option pool. Other than specific provisions in
this regard, the carve-out was often accounted for in arriving at the relavant capital structure,
128
Id 129
Power and Payouts in the Sale of Startups, Brian Broughman and Jesse Fried, U.C. Berkeley, Last Revised:
June, 2006, at p.6; also see Annexure Table 2, for typical liquidation events in Indian VC financing contracts 130
Id
31
and other calculations related to the shares of the company. The agreements also typically
provide that any option scheme would be made only with the approval of the investor.
Further a majority of agreements provided that the promoter and the key management team
would execute employment agreement as approved by the investor. The clauses also provide
the key terms of these employment agreements which include non-compete clauses,
minimum term, assignment of intellectual property, etc. Further many of the agreements
themselves included non-compete provisions.
5.12 Information rights
Most agreements require regular transmission of information, including financial statements
and budgets, and permit the venture capitalists to inspect the company’s financial accounts at
will.131
In the Indian contracts all but three provided the investor with detailed information rights
namely to do with accounts and financial statements of the company. Further investors
typically have a say in the appointment of the auditors of the company, often requiring them
to appoint auditors known to the VC.
131
Id
32
6 Discussion and Analysis of Empirical Study
The Indian VC financings in the sample are similar in many ways to their US counterparts.
There are some differences and variations, but what is apparent is that the Indian VC
contracts predominantly use the same tools and contracting mechanisms to contend with the
problems inherent in venture financing.
By taking up a large stake, well short of the majority, we see that Indian VCs approach is
consistent with the existing theories on the use of cash flow rights to incentivise the
entrepreneur inorder to alleviate agency costs132. One point of difference from the US
contracting is that Indian VCs seldom have a majority of the voting power, even in early
stage companies. This is primarily due to the provisions of the Indian Companies Act
whereby a shareholder’s voting right can only be in proportion to his share of the paid-up
equity capital of the company.133 Further the conditions pursuant to which a company can
issue equity shares with differential voting rights are unlikely to be fulfilled by start-ups.134
However, a large stake combined with the other contractual clauses is sufficient for the VC to
exercise considerable control.
The use of staging in Indian VC contracts is consistent with existing theories based on US
practices.135 The companies, being mostly early stage, received relatively small investment
amounts for a short duration thus facilitating monitoring by the VC. Although it must be
noted that the terms of investment were not made more attractive upon achieving the required
targets136, but this could be attributed to the fact that, due to the short time period, they
remained within the broad early stage which remains risky for an investor.
The overwhelming use of convertible securities is testament to the adoption of US tools.
Particularly in relation to the use of cumulative participating preferred shares, which is a
unique innovation of the US VC industry. This essentially provides that the preferred
dividends will accrue even if not currently paid, and enables the investors, upon liquidation,
to first receive their principal preference amount137, and thereafter participate in the
remaining proceeds along with the common shareholders on a pro rata basis. This helps
strengthen a liquidation preference.138
The use of a nominal amount of equity shares in combination with the preferred is mainly to
enable investor to be represented at meetings of all classes, as a preference holder can vote
132
William A. Sahlman, “The Structure and Governance of Venture Capital Organizations”, Journal of Financial
Economics, 27 (1990). 133
Section 87(1)(b); This also explains why Indian VCs retain the right to vote on an “as if converted” basis 134
One such condition is distributable profits for last 3 years; see The Companies (Issue of Share Capital with
Differential Voting Rights) Rules, 2001 135
Paul Gompers & Josh Lerner, “The Venture Capital Cycle”, MIT Press, Cambridge, (2000) 136
See supra n.87 p.506 137
Usually equal to the amount invested or a multiple thereof. 138
Supra n.68 at pp.883-884
33
only on resolutions which directly affect their rights139. However, it must be noted that
venture financing in the US sometimes use securities in combination with convertible
preferred stock.140
The predominance of a preferential claim in liquidation is a corollary of the choice of
security, however the particularly onerous computations of the liquidation preference
amounts are of particular note. By often seeking “2x” or 30% IRR multiple, the Indian VCs
exhibit their high expectations and strong bargaining power, alternatively perhaps pointing to
the lack of sophistication of the entrepreneurs.
This trend is also apparent in the buy-back/redemption rights141 in the sample. Most of them
are in the form of a “Put Option” of the investor, giving them the benefit of a guaranteed exit,
if all else fails. However it is noted that many of them are for at least, if not higher than, the
liquidation amount. Only a negligible number of contracts gave the entrepreneur the right to
“Call” the securities. Pointing again to the stronger position of the VC in many of these
arrangements.
A similar trend is noted in the use of the full ratchet as the main tool of anti-dilution
protection. It is the most onerous of all options as it reduces the price of the protected issue to
that of the new “down” round diluting the entrepreneur’s stake. In a weighted average ratchet,
and its variations142, the adjustment of the conversion price is based on the number of shares
issued and the conversion price of the new issue, muting the effect of dilution on the
entrepreneur. 143 Still another example is the use of the drag along right in various
agreements, which, although used, is not considered a regular clause in the studies on US VC
contracts as compared to pre-emptive, tag or ROFR rights.
Automatic conversion provides that the security held by the venture capitalists automatically
convert into common equity under certain conditions. This conversion to common equity
represents a call option on control for the entrepreneur as it eliminates the restrictive
covenants and control rights of the VC.144 Thus it would be beneficial for an entrepreneur to
have various triggers for this conversion. However we see that most financings only provide
139
See Sections 87(2) & 106 Indian Companies Act 140
Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical
Analysis of Venture Capital Contracts,” Working Paper 7660, National Bureau Of Economic Research (April
2000); http://www.nber.org/papers/w7660. at p.13 141
There exists some ambiguity on issuing Redeemable preference shares to foreign investors preventing exit
through redemption, as they may be classified as debt under foreign exchange regulations, see Press Note
dated 30 April 2007 in supersession of the earlier Press Note dated 31 July 1997;and, RBI Circular, dated June8
2007, A.P. (DIR Series) Circular No.73
A buyback of shares is subject to numerous restrictions including that it may only use certain types of it funds
to effect the buy back, and may buy back only 25% of its securities in any financial year; see Section 77A, read
with Private Limited Company and Unlisted Public Limited Company (Buy-back of Securities) Rules, 1999 142
“Broad-based weighted average ratchet” or “narrow based weighted average ratchet” 143
Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical
Analysis of Venture Capital Contracts,” Working Paper 7660, National Bureau Of Economic Research (April
2000); http://www.nber.org/papers/w7660. at p.22 144
See Ronald J. Gilson & Bernard Black, “Does Venture Capital Require an Active Stock Market?” (May 1999)
as published in Journal of Applied Corporate Finance, pp. 36-48, Winter 1999. Available at:
http://papers.ssrn.com/paper.taf?abstract_id=219174 Last visited on June 10,2010 at p. 15
34
IPO as a conversion trigger, reducing the entrepreneur’s options to regain control. Although
many of the agreements provide for compulsory conversion after a fixed term, due to
requirements of foreign exchange regulations145, this does not represent a valid option to the
entrepreneur as the terms are extremely long.
The conversion ratios in the Indian VC contracts were often adjustable based on performance
and how they match the projections in the business plan. This is also a well established
method of dealing with agency issues:
“...projections are critical to valuing the company and pricing the venture capital fund’s
investment. This reduces information asymmetry by its impact on the credibility of the
projections contained in the entrepreneur’s business plan. Yet, the entrepreneur
obviously has better information concerning the accuracy of the business plan’s
projections ....... the entrepreneur has an obvious incentive to overstate the project's
prospects. By accepting a contractual structure that imposes significant penalties if the
entrepreneur fails to meets specified milestones based on the business plan’s projections
..... the entrepreneur makes those projections credible.”146
Similarly various rights and benefits are made contingent on performance by the company, in
accordance with studies on the US VC industry where it has been found that state
contingencies are common in early stage financings.147
The Indian VCs ensure that they have a representation on the board but do not require a
majority as they have the protection of extensive affirmative voting rights. This is
strengthened by provisions related to quorum whereby inorder to constitute the quorum for
all meetings the presence of the investor’s nominee is required.
It is noted, in stark contrast to the use of other tools, that the VC investments in the sample
were rarely syndicated. This perhaps can be explained by the fact that the deal sizes are
relatively small compared to the average US VC investment. However, this line of reasoning
would question the “second opinion” explanation148 provided for syndicated deals, making
financial considerations chief in the minds of VCs when syndicating their investments.
It must be clarified that all the contracts in the sample also contained numerous other clauses,
including detailed provisions regarding exit and their procedures. However these are not
presented as it would be beyond the scope of this paper.
In summation it is firstly noted that the typical Indian VC contract provide for terms which
may seem to place onerous burdens on the entrepreneur and being weighted heavily in favour
of the investor. However, as it has been emphasised throughout, due to the very nature of
venture capital financing the contract must deal with extreme forms of uncertainty,
informational asymmetry and agency costs. These problems may be further magnified in the
145
see Press Note dated 30 April 2007 in supersession of the earlier Press Note dated 31 July 1997;and, RBI
Circular, dated June8 2007, A.P. (DIR Series) Circular No.73 146
Gilsen engineering at p.18 147
Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical
Analysis of Venture Capital Contracts”, National Bureau of Economic Research, Working Paper 7660 (April
2000). Available at: http://www.nber.org/papers/w7660, visited on June 10, 2010 at p. 6 148
Paul Gompers & Josh Lerner, “The Venture Capital Cycle”, MIT Press, Cambridge, (2000)at p. 186
35
context of an emerging economy like India where markets and industries are still developing.
Also aspects like the regulatory environment and corporate governance standards being
relatively lower than more mature economies. Further cultural aspects like a tendency
towards closely held, family controlled companies may also contribute to some extent. Thus
the venture capital contract in India uses the strongest available tools to deal with these issues
of uncertainty and agency.
Of greater interest is the observation that the tools and mechanisms used in Indian venture
capital contracting to combat these issues in this different environment are those that have
developed in the US over a period of time through an organic learning process. Although
certain variations exist, the contracting model of Indian venture capital financing cannot be
said to be hybridized. Due to the fundamental similarities in the contracting models it could
be considered as more of a direct transference.
36
7 Conclusion
The core of the institution of venture capital is the complicated contracting structure
comprising of two fundamental contracts: that between the limited partners and the venture
capitalist; and that between venture capitalist and its portfolio company. Thus if this
contracting structure is transferred it would amount to transference of the institution itself.
Further, due to the fact that these two fundamental contracts are inter linked, a successful
transference of one would imply the other is or could be also transferred.
Venture capital investment agreements are legal contracts that essentially allocate risk, return,
and ownership rights between the entrepreneur and the investing venture capital fund.
Venture capital contracting, due to its very nature, faces the problems of uncertainty,
information asymmetry and agency costs in a magnified form. The venture capitalist is also
subject to strict obligations to their limited partners under the terms of the partnership
agreement of the fund, which itself is designed to control similar problems of agency and
informational asymmetry. Thus the challenge of venture capital contracting is managing the
inherent problems in light of the eventual goal. Thus venture capitalists have developed
various tools to help optimise their financing arrangements. The following sections will
discuss some of the main and most common components of venture capital contract design.
Through our examination of contracts we noted that typical Indian VC contract provide for
terms which may seem to place onerous burdens on the entrepreneur and being weighted
heavily in favour of the investor. However, as it has been emphasised throughout, due to the
very nature of venture capital financing the contract must deal with extreme forms of
uncertainty, informational asymmetry and agency costs. These problems may be further
magnified in the context of an emerging economy like India where markets and industries are
still developing. Also aspects like the regulatory environment and corporate governance
standards being relatively lower than more mature economies. Further cultural aspects like a
tendency towards closely held, family controlled companies may also contribute to some
extent. Thus the venture capital contract in India uses the strongest available tools to deal
with these issues of uncertainty and agency.
Of greater interest is the observation that the tools and mechanisms used in Indian venture
capital contracting to combat these issues in this different environment are those that have
developed in the US over a period of time through an organic learning process. Although
certain variations exist, the contracting model of Indian venture capital financing cannot be
said to be hybridized. Due to the fundamental similarities in the contracting models it could
be considered as more of a direct transference.
Thus from the perspective of the venture capital financing contract itself we conclude that the
institution of venture capital has been directly transferred with little modification. However,
further research is required regarding the contracting governing the relationship between the
venture capitalist and the limited partner in order to truly determine if it is a complete
transference of the institution of venture capital.
37
8 Bibliography
Articles
1. Arvind Panagariya, “India in the 1980s and 1990s: A Triumph of Reforms”, IMF
Working Paper, WP/04/43 (March 2004). 2. Atul Kohli, “Politics of Economic Growth in India, 1980-2005 Part I: The 1980s”,
Economic and Political Weekly, (April 2006). 3. Brian Broughman and Jesse Fried, “Power and Payouts in the Sale of Startups”, U.C.
Berkeley, Last Revised: June, 2006. 4. Douglas J. Cumming, “Contracts and Exits in Venture Capital Finance”, LEFIC
Working Paper, 2002-14 (October 2002). 5. Gilson, Ronald J., “Engineering a Venture Capital Market: Lessons from the
American Experience”, Stanford Law Review, Vol. 55 (April 2003). 6. Jeffrey J. Trester, “Venture Capital Contracting Under Asymmetric Information.”
Wharton School Working Paper, Journal of Banking & Finance, Vol.22, Issues 6-8 (August 1998).
7. Josh Lerner, “The Syndication of Venture Capital Investments”, Financial
Management, 23. 8. Klaus Schmidt, “Convertible Securities and Venture Capital Finance”, The Journal of
Finance, Vol. LVII, No.3 (June 2003). 9. Laura Bottazzi and Marco Da Rin, “Venture Capital in Europe and the Financing of
Innovative Companies”, Economic Policy, Vol.34 (April 2002). 10. Leslie Jeng and Philippe Wells, “The Determinants of Venture Capital Funding:
Evidence Across Countries”, May 1998 11. Paul Gompers and Josh Lerner, “The Use of Covenants: An Empirical Analysis of
Venture Partnership Agreements”, Journal of Financial Economics, 39 (1996). 12. Paul Gompers and Josh Lerner, “The Venture Capital Revolution”, Journal of
Economic Perspectives, Vol. 15, No. 2 (Spring 2001). 13. Paul Gompers, “Optimal Investment, Monitoring, and the Staging of Venture
Capital”, Vol.50, No.5 (December 1995). 14. Paul Gompers, and Josh Lerner, “Money Chasing Deals? The Impact of Fund Inflows
on Private Equity Valuations”, Journal of Financial Economics, 55 (2000). 15. Paul A. Gompers, Ownership and Control in Entrepreneurial Firms: An Examination
of Convertible Securities in Venture Capital Investments 3 (1998), at p.13, (unpublished manuscript, on file with the Harvard Law School Library) http://www.people.hbs.edu/pgompers/Convert.PDF visited on June 10, 2010
16. Rafiq Dossani and Martin Kenney, “Creating an Environment for Venture Capital in India”, World Development, Vol.30 (2).
17. Ronald J. Gilson and Bernard Black, “Does Venture Capital Require an Active Stock Market?”, Journal of Applied Corporate Finance, (May 1999). Available at: http://papers.ssrn.com/paper.taf?abstract_id=219174 visited on June 10, 2010.
18. Ronald J. Gilson and David M. Schizer, “Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock“, 116 Harv. L. Rev. 874 (January 2003).
19. Samuel Kortum and Josh Lerner, “Assessing the Contribution of Venture Capital to Innovation”, The Rand Journal of Economics, Vol. 31, No. 4 (Winter, 2000).
20. Steven Kaplan and Per Strömberg, “Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts”, National Bureau of
38
Economic Research, Working Paper 7660 (April 2000). Available at: http://www.nber.org/papers/w7660, visited on June 10, 2010
21. Thomas Hellmann, “The Allocation of Control Rights in Venture Capital Contracts”, The RAND Journal of Economics, Vol.29, No.1 (Spring 1998).
22. Thomas Hellmann, and Manju Puri, “The Interaction Between Product Market and Financing Strategy: The Role of Venture Capital,” Review of Financial Studies, 13 (Winter 2000).
23. William A. Sahlman, “The Structure and Governance of Venture Capital Organizations”, Journal of Financial Economics, 27 (1990).
24. William L. Megginson and Kathleen A. Weiss, “Venture Capitalist Certification in Initial Public Offerings”, The Journal of Finance, Vol. 46, No.3 (July 1991).
25. William L. Megginson, “Towards a Global Model of Venture Capital ?”, December 2001.
Books
Paul Gompers & Josh Lerner, “The Venture Capital Cycle”, MIT Press, Cambridge, (2000).
Reports
• VCCEdge, “Annual Deal Roundup” December 2002.
• VCCEdge, “Annual Deal Roundup” December 2005.
• VCCEdge, “Annual Deal Roundup” December 2009.
• VCCEdge, “Quarterly Deal Update” April 2010
• Chandreshekhar Committee Report, 2000
i
9 Annexure: Brief Summary of Empirical Study
Table 1
Control Mechanisms
Contract
No.
Stake/
Voting
Right
Staging Syndication Securities
1. 40.6% Yes 2 tranches of equal sums
No Tranche I – equity Tranche II – convertible preferred
2. 30% Yes Cash flow linked
No Compulsorily Convertible Cumulative Preference Shares
3. NA Yes No Fully Convertible Cumulative Preference Shares
4. 38.6% Yes No -Equity -Redeemable Optionally Convertible Cumulative Preference Shares
5. NA No No -Equity -Redeemable Optionally Convertible Cumulative Preference Shares
6. 42.75% Yes Upon achieving milestones
No Equity
7. 10.08% No No -Compulsory Convertible Preference Shares -Equity
8. NA Yes Upon achieving milestones
No -Tranche I- Optionally convertible debentures Tranche II- Optionally -Convertible Redeemable Preference Shares
9. NA Yes Upon achieving milestones
No Equity
10. 38.8% Yes Upon achieving milestones
No Compulsorily Convertible Preferred Stock
11. 51.5% Yes No Convertible preferred
12. 39.02%
Yes No Optionally Convertible Debentures
13. 15.2% No No -Equity -Non Cumulative
ii
Contract
No.
Stake/
Voting
Right
Staging Syndication Securities
Compulsorily Convertible Preference Shares
14. 7.5% No No Compulsorily Convertible Preference Shares
15. 21.14% Yes Cash flow linked
Yes -Equity Shares -Compulsorily Convertible Cumulative Participating Preference Shares
16. 49% Yes No Preferred Stock and Equity Stock
17. 32.8% Yes Cash flow linked
No Optionally Convertible Debentures
18. 14.3% Yes Yes - Equity -Compulsorily And Fully Convertible Preference
19. 37.40% No Cash flow linked
No -Equity -Compulsorily Convertible Cumulative Participatory Preference Shares
20. NA No Yes Redeemable Optionally Convertible Cumulative Participating Preference Shares
21. 21.07% & 4.05%
Yes Upon achieving milestones
Yes - Equity -Compulsorily Convertible Participating Preference Shares
22. 32.44% & 19.64
Yes Yes -Equity - Compulsorily Convertible Debentures
23. 24.55% Yes Cash flow linked
Yes - Equity -Compulsorily Convertible Cumulative Participating Preference Shares - Optionally Convertible Cumulative Participating Preference Shares
24. 33% Yes Cash flow linked
No - Equity -Compulsorily Convertible Cumulative Participating Preference Shares
25. 51% Yes Upon achieving milestones
No -Equity - Optionally Converted Preference Shares
26. 40% Yes Cash flow No - Equity
iii
Contract
No.
Stake/
Voting
Right
Staging Syndication Securities
linked -Compulsorily Convertible Cumulative Participating Preference Shares
27. NA No No Equity & Preferred Shares
28. NA No Yes Equity & Preferred Shares
29. 16.22% No Yes Equity & Compulsorily Convertible Preference Shares
30. NA No No Equity & Compulsorily Convertible Preference Shares
iv
Table 2
Contract Terms I: Liquidation Rights
Contrac
t No.
Liquidatio
n
Preference
to
Common
Minimum
liquidation
amount
Redemption or Puts Liquidatio
n Events*
1. Yes With participation
1x Yes In events of breach of agreement
Standard
2. Yes 1x Promoter’s Call Option
Standard
3. Yes With participation
1x No Standard
4. Yes With participation
1x+ 30% IRR
Yes -Optional redemption within prescribed time -Put option in events of breach of agreement - both with premium of 30% IRR
Standard
5. Yes With participation
1x + 25% compounded annual return
Yes -Optional redemption within prescribed time (+25% CAR) -Put option in events of breach of
Standard
v
Contrac
t No.
Liquidatio
n
Preference
to
Common
Minimum
liquidation
amount
Redemption or Puts Liquidatio
n Events*
agreement (+30% CAR)
6. Yes With participation
2x No General right to demand liquidity
Standard
7. Yes With participation
1x +accumulated dividends
Yes Standard
8. Yes 1x No Standard
9. No No No No
10. Yes 1x Yes At FMV or 1x + 10% pa
Standard
11. Yes With participation
1x Yes Standard
12. Yes As debenture holder
2x Yes General right to demand liquidity
Standard
13. Yes Statutory preferred rights
No No Standard
14. Yes With participation
1x + accumulated dividends
Yes Standard
15. Yes With participation
1x + 25% IRR
Yes Upon liquidation or breach of terms also at 1x + 25% IRR
Standard
16. Yes 1x +25% annualized return
Yes Standard
17. Yes As debenture holder
1x plus accumulated interest
Yes General right to demand liquidity
Standard
18. Yes With 1x + Yes On breach Standard
vi
Contrac
t No.
Liquidatio
n
Preference
to
Common
Minimum
liquidation
amount
Redemption or Puts Liquidatio
n Events*
participation
accumulated dividends
at FMV or 1.1x
19. Yes With participation
1x Yes On breach Standard
20. Yes With participation
1x + 27% IRR
Yes At 1x + 27% IRR Also provides a call after 2 years
Standard
21. Yes With participation
1x + 14% p.a.
Yes Standard
22. Yes 2x Yes Standard
23. Yes With participation
1x + accumulated dividends
Yes At 1x + 14% annualized returns
Standard
24. Yes With participation
1x + accumulated dividends+ 18% annualized returns
Yes Standard
25. Yes With participation
1x + accumulated dividends+ 18% annualized returns
Yes Standard
26. Yes With participation
1x + accumulated dividends+ 18% annualized returns
Yes Standard
27. Yes 1x Yes Standard
28. Yes 1x + 25% IRR
Yes Standard
29. Yes With participation
1x +adjustment
Yes Standard
30. Yes With 2.5x Yes Standard
vii
Contrac
t No.
Liquidatio
n
Preference
to
Common
Minimum
liquidation
amount
Redemption or Puts Liquidatio
n Events*
participation
+adjustment
31. Yes With participation
1x Yes 1x + 30%p.a.
Standard
*Standard Liquidation Events:
(i) A compromise or arrangement with the creditors/debtors of the Company
or failure to pay debts, under which the Company may be wound up as per
law;
(ii) Appointment of a provisional or official liquidator by an appropriate court
under any applicable Law;
(iii) Commencement of any voluntary liquidation, dissolution or winding up;
(iv) A merger, acquisition, Change in Control, consolidation, or other
transaction or series of transactions in which the Company’s shareholders
prior to such transaction or transactions will not retain a majority of the
voting power of the surviving entity;
(v) A sale, lease, license or other Transfer of all or more than 50% (fifty per
cent) of the Company’s Assets;
viii
Table 3
Contract Terms II: Conversion Rights
Contract
No.
Automatic
Conversion
Triggers for
Conversion
Conversion
ratio
Anti dilution protection
1. No Optional after 1 year
Adjustable according to revenue targets
Full ratchet
2. Yes IPO, Strategic Sale
Adjustable Broad Based Weighted Average Anti-Dilution Protection
3. No Optional upon Notice by investor within 5 years
Adjustable according to revenue targets
No Only ROFR
4. Yes Only for IPO; Optional after 1 year
Adjustable according to Post money valuation formula
Full ratchet Adjustment for stock splits, etc.
5. No Optional Adjustable according to achieving revenue projections
Full ratchet
6. Nil (equity) Nil Nil Full ratchet
7. Yes 20 years Adjustable according to achieving revenue projections
Full ratchet
8. No Optional Based on predetermined stake of investor
No
9. No Nil Nil Nil
10. Yes IPO and fixed term
Adjustable based on projections in pre money valuation formula
Broad Based Weighted Average Anti-Dilution Protection
Adjustment for stock splits, etc.
11. NA NA NA NA
12. No Optional after specified date
Adjustable based on revenue targets
Full ratchet Adjustment for stock splits, etc.
13. Yes Milestone One for one Narrow Based
ix
Contract
No.
Automatic
Conversion
Triggers for
Conversion
Conversion
ratio
Anti dilution protection
and fixed term
Weighted Average Anti-Dilution Protection
14. Yes IPO or 19 years from closing
Based on post money valuation
full ratchet basis Adjustment for stock splits, etc.
15. Yes IPO and fixed term
At pre-determine price, subject to adjustment, but within pre-determined stake
Full Ratchet Basis
Adjustment for stock splits, etc.
16. Yes IPO NA Adjustment to reflect specified return/valutaion
Adjustment for bonus, stock splits, etc.
17. No Nil At pre-determined price
Nil
18. Yes IPO or 20 years
1:1 Broad Based Weighted Average Anti-Dilution
Adjustment for bonus, stock splits, etc.
19. Yes IPO and fixed term
Adjustable according to Post money valuation formula
Full Ratchet Basis
Adjustment for bonus, stock splits, etc.
20. Yes IPO, Milestones, or 20 years
Variations in resultant shareholding based on performance
Yes (not specified)
21. Yes Upon “qualified” financing and IPO and fixed term
Adjustable based on projections in pre money valuation formula
Full Ratchet Basis
Adjustment for bonus, stock splits, etc.
22. Yes IPO Adjustable as per revenue target
Full Ratchet Basis
23. Yes IPO, 10 years At pre-determined price
Broad Based Weighted Average Anti-Dilution
Adjustment for bonus, stock splits, etc.
x
Contract
No.
Automatic
Conversion
Triggers for
Conversion
Conversion
ratio
Anti dilution protection
24. Yes IPO, 10 years At pre-determined price
Broad Based Weighted Average Anti-Dilution
Adjustment for bonus, stock splits, etc.
25. Yes IPO At pre-determined price
Full Ratchet Basis
Adjustment for bonus, stock splits, etc.
26. Yes IPO, 10 years At pre-determined price
Broad Based Weighted Average Anti-Dilution
Adjustment for bonus, stock splits, etc.
27. Yes IPO Based on milestones
Full Ratchet Basis
Adjustment for bonus, stock splits, etc.
28. Yes 3 years Based on Post Money Equity Valuation
Full-Ratchet Basis
Adjustment for bonus, stock splits, etc.
29. Yes IPO and fixed term
Adjusted to arrive at pre-determined stake
Full Ratchet Anti-Dilution Protection
30. Yes IPO and fixed term
Adjusted on Post Money Valuation
Full Ratchet Anti-Dilution Protection
Standard Conversion Triggers:
i. IPO
ii. Sale, disposal, transfer or other exit in part or full, by a majority of the investors
iii. liquidation events
iv. Exercise any go-along along rights
v. Any buyback
xi
Table 4
Contract Terms III: Other Controls and Transfer Restrictions
Contract
No.
Affirmative
Voting
Rights
Board
representation
Transfer
Related**
Pre-
emptive
rights***
1. Yes Yes 1 of 4 seats
Drag, Tag, ROFO, ROFR
Yes
2. Yes Yes 1 of 4 seats
Drag, Tag, ROFO, ROFR
Yes
3. Yes Yes 1 of 3 seats
ROFO Yes
4. Yes Yes 1 of 4 seats
Tag, Drag, Promoter ROFR
Yes
5. Yes Yes 1 of 9 seats
Drag, Tag, ROFO
No
6. Yes Yes 2 of 5 seats
ROFR, Tag, Drag
Yes
7. Yes Yes 1 of 8 seats
ROFR, Tag, Drag
Yes
8. No No No No Second round debenture funding
9. Yes Yes 2 of 5 seats
ROFR, Tag Yes
10. Yes 4 of 7 seats
ROFR, Tag, Drag
Yes
11. Yes Yes 1of 4 seats
ROFR, Tag, Drag
Yes
12. Yes Yes 1 of 5 seats
ROFR, Tag, Drag
Yes
13. Yes Yes 1 of 4 seats
ROFR, Tag Yes
14. Yes Yes 3 of 7 seats
ROFR, Tag, ROFO Promoter ROFO
Yes
15. Yes Yes 1 of 4 seats
ROFR, Tag, Drag
Yes
16. No No No No
17. Yes Yes 2 of 5 ROFR, Tag, Yes
xii
Contract
No.
Affirmative
Voting
Rights
Board
representation
Transfer
Related**
Pre-
emptive
rights***
seats
18. Yes Yes 2 of 6 seats
ROFR, Tag, Drag
Yes
19. Yes Yes 1 of 4 seats
ROFR, Tag, Yes
20. No No No No Debentures Round 2
21. Yes Yes 3 of 6 seats
ROFR, Tag, Drag
Yes
22. Yes Yes 3 of 6 seats
ROFO, Tag, Drag
Yes
23. Yes Yes 1 of 5 seats
ROFR, Tag, Yes
24. Yes Yes 1 of 5 seats
ROFR, Tag, Yes
25. Yes Yes 1 of 5 seats
ROFR, Tag, Yes
26. Yes Yes 1 of 5 seats
ROFR, Tag, Drag
Yes
27. Yes Yes 1 of 5 seats
ROFR, Tag, Drag
Yes
28. Yes Yes 1 of 5 seats
ROFR, Tag, Drag
Yes
29. Yes Yes 3 of 8 seats
ROFR, Tag, Drag
Yes
30. Yes Yes 1 of 4 seats
ROFR, Tag, Drag
Yes
* Standard Consent/Affirmative Voting Requirement:
As long as the Investor holds shares, then the Company cannot approve or take any of the
following actions without having first received the written consent of the Investor/ favourable
vote of the Investor at a Board/ Shareholders meeting:
i. Business and Assets
ii. Capital Structure
iii. Additional Debt, Creation of Liens
iv. New Business Initiative
v. Dividend
vi. Auditors
vii. Intellectual property rights
viii. Annual business plan
ix. Bylaws and articles of incorporation
x. Dissolution
xiii
xi. Delegation or Change Of Board
** ROFR: Right of First Refusal - The Promoter cannot sell or transfer any shares to a
third party without first offering them to the Investor on the same terms. The Investor has the
right, but not the obligation, to purchase them.
ROFO: Right Of First Offer - A Shareholder may not sell or transfer any of Shares to a third
party without first offering them to the other Shareholders on the same terms. The other
Shareholder has the right, but not the obligation, to purchase them.
Tag: Tag-along Right - The Investor has the option to sell or transfer its Shares with the
selling shareholder to the third party on the same terms and conditions.
Drag: Drag Along Right- The Investor has the right to require the entrepreneur or other
shareholders to sell such number of shares held by them along with the entire Investor Shares
being sold to a third party buyer as maybe required, inorder to facilitate the sale of Investors
stake, at the same price and on the same terms and conditions applicable to the Investor.
*** Pre-emptive Right: The Investor has a pre-emptive right of subscription in the event
that the Company proposes to undertake any future equity financing, whether by making a
preferential allotment and/or fresh issue of Shares or convertible instruments to third parties.